John Mauldin's Midyear Thoughts

the economy is in relatively good shape and from their speeches they believe that the good times continue. Headline unemployment is down to 5%. The US government deficit is coming down as tax receipts are way, way up. (Now if Congress could only show a little discipline and stop spending!) Corporate profits, both as a percentage of GDP and on an absolute basis, are at an all- time high. Corporations have significant cash reserves.

First, it is not altogether clear that raising short-term rates will have any real effect on long-term rates, and thus on mortgage rates. It certainly hasn't had much of an effect so far. As I noted last January, I don't think the Fed wants to create an inverted yield curve by purposely raising short-term rates above the 10-year note.

And there are questions about the real strength of the economy. Unemployment may not be as good as it sounds. The current low U.S. unemployment rate probably understates the true level of joblessness by 1 to 3 percentage points, says Katharine Bradbury, the senior economist at the Boston Federal Reserve. Millions of potential workers who dropped out of the labor force during the recession four years ago have not returned as expected and are thus not counted in the official unemployment statistics. (http://www.bos.frb.org/economic/ppb/2005/ppb052.pdf)

There are many observers who think the economy will soften in the latter half of this year. I agree. But please note that soften is not a recession. But raising rates while the economy is in the process of softening can help bring about a recession. And a recession today (or an economy only growing 1-2%) with inflation so low would almost certainly bring back the deflationary scares of 2002. The 10-year note could drop to 3% and mortgages would go to 4%. What such a scenario would mean is open for debate, because I can argue at least three scenarios forcefully, and another 2-3 that might be of interest. It would create a lot of uncertainty. Markets HATE uncertainty.

Then one area I really missed it my annual forecast was on the euro. I thought it would continue to rise, as I repeatedly said since early 2002 (one of my better timed calls - every now and then I get lucky). I did issue a mid-course correction to in April, not too far from the top, as things changed and I thus I changed my view on the euro. I am now getting bearish on the British pound as well, though for different reasons. Count me a selective US dollar bear. I would make my dollar bearish long term currency plays on the Asian currencies which float against the dollar.

For all the reasons I have written about over the past months, I am still bearish on the euro. Until they sort out the issue of just exactly what is Europe and how it should be run, there is just too much pressure on the currency.Further, all those central banks which bought the euro in 2004 as a way to diversify probably now wish they hadn't.

As for gold, I expect it to rise in dollar terms over time, but nothing like we have seen the past few years. Oil needs to correct. The longer it doesn't, the more it will drop when it does. I am still a long term bull on energy, but enough is enough. I would like to see a healthy correction and then on to the next bull leg.