The Event Horizon For Credit
I was going to write a letter that pointed to evidence that supported the scenario that you see near the beginning of my occasional letters. I decided not to.
A recap of the scenario:
bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation.
The trouble was as I reached the half way point of the now defunct article, I realised it contained far, far too many quotes from various sources and not enough thought from the writer. So I deleted it. If you are reading this letter, you want my opinion not the regurgitated words of others.
The other thought (I am blessed in being able to have more than one thought a day) was the frequency of my recent writing. I have been writing more of late. Which made me think (see?) that if I am seeing more events then the pace of the scenario is increasing. Not only that, the scenario is not just a list of events, its interactive, events overlap and are intertwined.
Firstly, I want to show you a chart.
Call me a cynic but when I see conditions repeating themselves I tend to think the outcome will be the same. It looks to me that conditions are ripe for a recession. Closer examination of this chart though yields some very important information. Unless there is a major Fed policy change, I think the path to a major deflationary recession or even depression is looming.
Now, before you all jump to the conclusion that I am basing a very large assumption on 3 wiggly lines on a chart, I better show you how I think it will happen.
There is a wealth of information on this chart. Lets start with the St Louis Fed Monetary base, which is supposed to be superior to the traditional measure. Look at that uptrend, the monetary base has increased from circa $475bn to $850bn in 10 years, its nearly doubled. Looking closer though and the uptrend appears to have been broken, its still rising but the acceleration is much slower to the point where it looks to be leveling out from around early 2006.
Why is this important? Well lets read the words of The Fed or more specifically the following quote from A Reconstruction of the Federal Reserve Bank of St. Louis' Adjusted Monetary Base and Reserves, written by Richard G. Anderson and Robert H. Rasche, with Jeffrey Loesel, July 2003 (revised August 5, 2003). Its a gripping read, honest.
Recent analyses suggest two roles for the monetary base in policymaking.
The first focuses on the long-run implications of monetary base growth for the price level and inflation rate.
These authors argue that the truth of Milton Friedman's proposition -- "inflation is always and everywhere a monetary phenomenon" -- does not depend on whether a monetary aggregate appears in the central bank's policy reaction function. Rather, at least in the theoretical long-run when the effects of other shocks have played out, the inflation rate is determined by the growth rate of money because, absent such growth, the inflation could not continue.
It matters not at all in the long-run whether policymakers target interest rates or monetary aggregates for, so long as their actions permit the necessary increases in the central bank's balance sheet, the inflation will follow. Hence, observations on the monetary base may be important evidence useful to analysts seeking to understand the ex post, if not ex ante, effects of central bank actions."
Well that makes sense, if the amount of money increases then so does inflation. I doubt anyone disagrees with that.
I disagree - and right about now, if you have been paying attention and scrolled back up to the chart, your doubts are increasing too. How can we have inflation both in monetary terms and in prices, which according to many commentators out there are understated, if the monetary base has barely moved since early 2006 when compared to previous years?
Glancing back at the chart again, this time looking at the Total Revolving Credit Outstanding and the Individual Consumer Loans From All Banks. Debt at a consumer level. TRCO has gone up in a similar fashion to the monetary base but diverges from this path in early 2006. As the monetary base leveled off, credit took up the slack, the same can be seen with ICLFAB. Let there be no doubt, the US consumer has used credit to replace the lack of growth in real cash, the consequence of a lack of paycheck rises coupled with a boom in asset prices, especially housing. Inflation is being caused by an expansion of credit which, when coupled with demand, is causing asset prices to rise.
This has ramifications beyond the simple visual warning of a recession highlighted on the chart by the 2 ellipses. As important as that warning is, it is minor when we examine the result of what will occur when the recession hits.
Lets look at what the consumer has to deal with. Credit has to be serviced, you pay back what you owe plus interest. You pay with money, earned by your labour. That reduces the amount of monetary base (cash) and therefore over a period of time - without the monetary base being inflated - the debt swallows an increasing amount of cash due to the continuing application of interest to the outstanding amount. If however interest rates rise whilst the monetary base does not then the burden increases to the point when payment becomes difficult or impossible. The consumer has 2 options, either default or arrange for a new debt payment plan, usually in the form of a new loan.
As we have seen happening over the past 5 years, the latter option has been the preferred choice of the consumer especially the use of refinance on property. Not anymore. The game has stopped as the asset prices and the confidence of the markets has fallen. Now the first option is becoming the new choice.
We can see the over-stretched consumer/debtor is becoming the next event horizon. Not only are financial markets having to deal with the continuing destruction of wealth caused by the current batch of defaulting consumers but now access to credit is becoming problematic for many. The next batch of defaulters will arrive at the tipping point into insolvency at a much quicker pace due to the inability to refinance but also with a higher debt burden.
Lenders, of whatever type, will have to raise capital reserves as debt gets downgraded as well as setting aside reserves to cover defaults. Add to this a raising of lending standards and credit doesn't just get squeezed, it stops.
The credit crunch can only get worse from here on in. As credit is withdrawn the effect it has had, as a substitute for a non-inflating monetary base, is lost. You can see in the first chart what happened when credit leveled off in 2001 but at least the monetary base was rising, cushioning the blow to spending power. Now we have a flat and if viewed over the past few months (below), a falling monetary base coupled with a flattening in consumer credit as shown in the Fed figures:
You can now see why, as a result of a flat to falling monetary base coupled with a contraction of credit, I see the risks of a deflationary recession as a very high probability. A depression is not as remote as many think.
Is this just a US-centric problem? Not according to Esteban Duarte and Steve Rothwell at Bloomberg, who unearthed this:
Europe Suspends Mortgage Bond Trading Between Banks
Nov. 21 (Bloomberg) -- European banks agreed to suspend trading in the $2.8 trillion market for mortgage debt known as covered bonds to halt a slump that has closed the region's main source of financing for home lenders.
The European Covered Bond Council, an industry group that represents securities firms and borrowers, recommended banks withdraw from trades for the first time in its three-year history until Nov. 26. Banks are still obliged to provide prices to investors, according to the statement today.
Banks including Barclays Capital, HSBC Holdings Plc and UniCredit SpA took the step as investors shun bank debt on concern lenders face more mortgage-related losses than the $50 billion disclosed. Abbey National Plc, the U.K. lender owned by Banco Santander SA, became the third financial company to cancel a sale of covered bonds in a week as investors demanded banks pay the highest interest premiums on covered bonds in five years.
"We are in a deteriorating situation," Patrick Amat, chairman of the Brussels-based ECBC and chief financial officer of mortgage lender Credit Immobilier de France, said in a telephone interview. "A single sale can be like a hot potato. If repeated, this can lead to an unacceptable spread widening and you end up with an absurd situation."
You can find more about Covered Bonds at: http://ecbc.hypo.org/Content/Default.asp
- if you can spot the difference between a CB and the MBS, ABCP or ABX derivatives then you have a keen eye.
Oh, and yes, you read that correctly - that is a $2.8 Trillion lending market that has been closed. No wonder LIBOR has been climbing to new 2 month highs and above and reaching new all time high in spreads from the Fed Funds Rate.
So far in this letter I have not mentioned the US dollar. Just about all those who see inflation in the future point at the falling dollar. All well and good but as I have written it doesn't matter one jot how expensive an asset is, if there is no money or credit to buy it.
We all know what happens to expensive items that nobody buys.
Which brings me to the problem I mentioned about a need for the Fed to change its policy.Below is an excerpt from the Fed FOMC minutes taken at the 30/31 Oct meeting:
"In their discussion of individual sectors of the economy, participants noted that the recent declines in housing activity -- while substantial -- had largely been anticipated. Nonetheless, the potential for significant further weakening in housing activity and home prices represented a downside risk to the economic outlook.
Most participants pointed to the deterioration in non-prime mortgage markets as well as higher interest rates and tighter credit standards for prime nonconforming mortgages as factors that had exacerbated the deterioration-ration in housing markets, and they noted that these developments could further limit the availability of mortgage credit and depress the demand for housing.
Some participants also pointed to downside risks to the housing market stemming from the large volume of substantial upward interest-rate resets that were likely on subprime mortgages in coming quarters, which could lead to a faster pace of foreclosures in the near term, thereby intensifying the downward pressure on house prices.
Participants generally agreed that the available data suggested that consumer spending had been well maintained over the past several months and that spillovers from the strains in the housing market had apparently been quite limited to date. Nevertheless, a number of participants cited notable declines in survey measures of consumer confidence since the onset of financial turbulence in mid-summer, along with sharply higher oil prices, declines in house prices, and tighter under-writing standards for home equity loans and some types of consumer loans, as factors likely to restrain con-sumer spending going forward.
Moreover, anecdotal reports by business contacts suggested a softening in retail sales in some regions of the country. Participants expressed a concern that larger than expected declines in house prices could further sap consumer confidence as well as net worth, causing a pullback in consumer spending.
All told, however, participants envisioned that the most likely scenario was for consumer spending to continue to advance at a moderate rate in coming quarters, supported by the generally strong labor market and further gains in real personal income."
Where is the focus of the Fed? Are they truly looking at price inflation, asset depreciation, spillover effects, consumer spending, unemployment and not quoted above, disruption in the financial markets and waiting to see what the effects are?
Because if they are then the focus is blurred and the current policy of "wait and see" as to which of the upside or downside risks wins out will place the Fed in a position not unlike that of the Bank of Japan in the early 90's.
The Fed has no easy choices. Rate cuts alone cannot repair the damage caused to a financial system were confidence has been replaced by fear. So far I see no signs of reflation and I am beginning to wonder if the Fed wants a lower benchmark in the economy before it initiates such actions. If they do it could be a most dangerous course to take in a system reliant on an inflationary bias.
The speed and size of the credit contraction is growing, as it should where credit was used to beget more credit. A Fed that is still bias toward an inflation fighting stance could greatly exacerbate the situation.
Does the Fed possess the agility and the correct policy to react in a timely fashion?
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