Firstly, before we get into this letter, a quick explanation of the new format. I have set up a blog (click here) to try an encourage building a membership and utilise an easier way to archive previous letters. It will make it easier for your comments to be posted and accessed too. I have enjoyed the feedback from various readers out there, I have received really good, thought provoking comments that deserve a wider viewing and this format should help.
Its free, as promised. Its a simple blog, so what I intend to do is send out an email to the members to let them know a new letter is available. To view it you need to create a Google email address (after 30 days, you can sign in as a guest until then) it only takes a minute or so. The advantage of membership is that you will get to view the letter first, publishing it elsewhere will be delayed. I will also look to start publishing more frequently (alright, who groaned?)
Right lets get on with it.
What have Paulson, Bernanke and Greenspan got in common? Let me show you and then I want to write about what I think they are alluding to, ie what they see is coming but dare not utter, not yet anyway. I also want to walk you through the steps to deflation ( that's a good title for an album) and why those steps are throwing up the current confusion of thought in the mainstream media.
Here are the comments that caught my eye this past week:
Paulson: "The housing decline is still unfolding and I view it as the most significant current risk to our economy," he said. "The longer housing prices remain stagnant or fall, the greater the penalty to our future economic growth."
"The ongoing housing correction is not ending as quickly as it might have appeared late last year," he said. "And now it looks like it will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet."
Bernanke: who said "market uncertainty" in September led to the cut in federal funds rate by a 0.5%. Bernanke said the assessment of Fed governors and bank presidents was that market uncertainty was thought to be "unusually high."
Greenspan: the market does not appear to have priced in the risks posed by the ongoing housing slump.
As recently as 2 months ago these 3 individuals didn't agree with each other, Greenspan was talking of highish odds of a recession, Bernanke was waiting for more data and worrying about inflation and Paulson saw no signs of a spillover into the economy from the housing slump. Now we have a consensus, they all have something in common.
Its the markets. Be it either adverse impact, lack of pricing risk or unusually high uncertainty its all down to whats happening in the markets.
What does this tell us? Firstly, there is a real fear out there that the markets are getting out of control and that reality has yet to visit. Secondly, the watchkeepers/booksellers of the economy are no longer looking ahead, even if they say they are. This means trouble is brewing, big trouble.
It looks like Bernanke and Paulson are preparing the "Excuse Quotes " chapters for their eventual books. Since early this year we have been subjected to the official line that the fallout from sub-prime (now housing, an upgrade to include prime, Alt A and Jumbo loans) would not harm the economy, that there would be no spillover. Then we began to get the odd mention of minimal spillover but the problem was contained. All this talk was to keep confidence in the markets, be they stocks, bonds or derivatives.
Not anymore. Now we get warnings (Darling, the UK Chancellor, is also now warning of economic harm to the UK) that this will affect the US economy, because the scope, size and the timescale of the problem is much greater than previously imagined. Greenspan, whose remarks about a recession in the US made earlier this year were ignored, is now joined by the Fed and the US Tsy. We are still getting remarks that US growth is "strong" and will be "about trend". Yeah, like that's believable after the back tracking on the causation that could affect growth.
The actions of the Fed are also interesting. Contrary to what the media will tell you, the Fed is not pumping money into the economy. It did initiate a few new weekly rolling repos back in August that it is still allowing to be rolled but there has been no ongoing infusion of cash, the Fed has remained tight. You can check this out at the NY Fed site: http://www.ny.frb.org/.
So we can see, debt (ABCP), lent out as an instrument to secure short term debt( electronic cash), the proceeds of which is used to lend as credit - has imploded.Banks are not exactly banging on the glass at the discount window either. It looks pretty obvious that after the setting up (if it happens, its not a done deal) of the Super SIV, the Banks and Institutions have been told to use their own cash to sort out the mess of the off sheet imbalances. It seems the US Tsy has adopted Enron accounting practises as acceptable, maybe Enron was just ahead of the curve in financial innovation?
So, why have such practises now been condoned? That's simple. The problem is so big, so interconnected with all forms of the derivative markets that the only way out is to park the toxic instruments into a dump. I suspect the dump will have a long history of leaks, drip feeding poisonous paper into the community.
I want to walk you through why I see deflation in the future.
At this point I have to make something clear, whilst the traditional view of deflation is less money in the economy, I do not see cash as the current driver of inflation/deflation. The mover is credit. Allowing an unfettered increase of credit to replace the traditional over printing of notes to sustain a bubble(s) or ponzi scheme (if banks have, as a % of loans, effectively no reserves, what else can the system be based on?) then a reduction in credit must be deflationary.
The importance of this cannot be under-estimated. Credit itself has/is being used as an asset to beget more credit. This explains the exponential rise in credit, it feeds on itself as credit notes become the asset to allow further credit to be lent out. By allowing credit to underwrite itself to form other types of credit the whole system becomes reliant on the confidence of lenders and borrowers having the means to eventually repay. If that confidence is put under pressure, the system stops. If confidence cannot be restored in a very short timescale (Central Bank / Tsy intervention) then the system begins to reverse, as credit is redeemed. The reversal will be at the same pace as the initial rise in credit growth. Although painful, the reversal would be orderly, as long as all the borrowers have the ability to repay. If that ability to repay is impaired then the redemption becomes disorderly. This is the stage we have reached today.
The Super SIV mooted by the Banks is the last gasp attempt to stop a disorderly destruction of credit. A disorderly destruction of credit will invoke deflation.
Now some readers will be looking at the price of commodities and scratching their heads, trying to resolve the high prices they see with a deflationary outlook. I sympathise, the confusion is understandable. The thought would be if the price of "stuff" is going up, surely the price of end products will rise too? That must be inflationary!
Well it would be inflationary if prices caused an increase in credit. Its the horse and cart. The cart (price inflation) is dragged along by the availability of the horse (credit) to work and to continue to work at an ever increasing amount of effort. If the horse has a heart attack, the cart stops. If the cart is loaded with debt and its on an uphill slope, it will roll backwards.
So if this simple writer can see this surely all those buyers of commodities can too? They can. They are not buying "stuff" as an inflation hedge. They are buying hard assets. Something that the destruction of credit cannot take away. Except for those who bought using leverage and margin of course.
I'll leave you with a simple chart from the St Louis Fed that says a lot.
As we can see Financial CP flat lined for most of the year and after a slight rise, dropped. It is struggling to reach the gain line. Financials are not putting their own cash into the market in any great amount. This shows fear and uncertainty. ABCP looks to be in a terminal decline.
ABCP (the assets being debt) lent out to secure electro-cash, which is used to finance long term borrowing by a third party - has collapsed.
The horse is dead. That rumbling noise you can hear is the cart careering downhill.
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