November 17, 2006
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.
It looks to me that we have gone beyond the discussion of stagflation, I see it rarely mentioned now on the newswires or in articles and I think I may know why. Unlike most, I postulated at the time when M3 reporting was withdrawn that rather than it being done away with to cover massive inflationary moves by the Federal Reserve it was more likely that it was disguising a drawdown of liquidity.
This disguising was required for domestic, political reasons because if it had been seen - in conjunction with some figures I have been watching closely - the Public may well have realised that the pain required to balance the economic ship was about to be visited upon them. Have a look at the following figures and remember your first reaction:
--------M1---- | ----M2---- | |
Jan. | 1380.3 | 6724.8 |
Feb. | 1375.6 | 6747.1 |
Mar. | 1384.6 | 6763.8 |
Apr. | 1386.7 | 6782.0 |
May | 1393.1 | 6787.9 |
June | 1370.3 | 6817.4 |
July | 1373.4 | 6838.7 |
Aug. | 1370.2 | 6862.3 |
Sep. | 1357.7 | 6878.8 |
These are the seasonally adjusted figures for M1 and M2 for 2006. Now what caught my eye was the relative difference that has occurred this year, you can see M1 (currency, travellers checks, current accounts etc) has declined, yet M2 (retail money mutual funds, small time deposits, savings,etc) has climbed. The amount of actual cash has halted its climb and reversed in....May 06. Anyone else hearing ringing bells? Just under $36 Billion of cash has vanished, in 4 months. Now these figures only go to September but I fully expect to see a continuing deterioration in the M1 figure. Why has M2 gone up? I suspect its more to do with interest received than an increase in saving.
All well and good, you say, and thanks for the explanation of some of the more boring numbers I have seen but what is the importance?
It is important, very important. Firstly it is simply saying that there is less physical cash around. Secondly its saying those who deal in cash, make cash purchases, have less of it. Third and most importantly its the first sign I have seen that confirms my earlier thoughts about why M3 was hidden.
You must bear in mind my reasoning about how I saw the US was going to rebalance the books. I do not believe the US is going to debase the $ by allowing it to plummet 30/40/50% from where it is now. On the other hand we know that the US has to stop the ever increasing flows of the $ and make its own domestic economy, both in the short term and the long term, balance well enough to ensure a systemic collapse is avoided. The problem in the US is one of credit, too much credit was created and given, in many cases, to people who never had a hope of repaying it, poor credit control on the behalf of Lenders, or so it seems. Trouble is if you are a Lender that has access to CDO's etc you repackage the loans, mix them up a bit, good with bad risk, and sell the obligation of the borrowers on to someone else, who buys the wrap hoping to earn nicely on the interest return. So Lenders have protected themselves and the risk is shifted. By doing this they don't need to increase any fractal reserve requirements, in fact the debt ends up being an asset on the books. So a massive amount of liquidity was created, and this is the important bit, not by The Fed or the US Govt (I have ignored tax breaks, the US Tsy has been pleasantly surprised by the larger than expected tax inflows of late) but by private lenders and banks.
I can almost hear the threats of burning at the stake being muttered by some, I am heretically moving the blame away from the US Tsy and The Fed. Don't worry, they share part of the blame, mainly through poor regulation and a lack of enforcement of standards.
Now though, good reader, I am going to spell out how all the above is connected together. The hard bit is for you all to realise that I do not think the Fed or the US Tsy are stupid. They may be late, lax in standards and have been too dazzled by worship at the Altar of Greenspan and the demonic forces of the Bubble but they are not stupid. There are 2 areas that need to be addressed, liquidity caused by credit and maintaining $ strength. I wrote awhile back that the Fed under AliG was not co-operative with the US Tsy. That has changed, both Snow and AliG have moved on. It means that the tools required can be unleashed upon both the domestic and international stage.
We know that to mop up liquidity, someone needs to give the markets something that they are willing to part with $'s for. That's the job of the Tsy, bond issuance is about to reach its maximum over the next few weeks, I hope you all noticed that rates have dropped? How unusual is that, a commodity hits the market and it becomes more valuable? The Tsy are seeking to soak up $'s from overseas first and then, through the primary dealers, soak up some domestic liquidity. Now this has 2 effects, it strengthens the $ and helps to curb credit creation, money given to the US Tsy cannot be lent out to, or by, private or commercial borrowers. Next is the Fed. It too will sally forth and fight this unbacked credit creation. Firstly it will start to make noises and then enforce lending practises to make sure that the standards are strictly applied, this has already started. It will also slow the repo machine. This too has already begun, forcing banks to ensure that short term shortfalls in reserves become less frequent, stopping excessive lending.(*DJ Fed's Poole: Not Fed's Responsibility To Bail Out Housing) These measures, when combined, will slow the economy by decelerating the velocity of money. With less liquidity around but demand still high, rates will go higher until the payment on the borrowed amount cannot be covered by the return on the relending (all money used is lent to someone) of the principal. Lending stops, or at least, slows down drastically. The $ keeps its strength, excess liquidity is drained. Inflation is controlled.
The cost? It starts to show up in little things. Things that seem unconnected at the time. A drawdown of real cash, as electronic numbers are no longer converted into "real" cash. Tightened credit standards stop people from getting mortgages that they cannot afford, it might cause a housing crash but in the scheme of things that helps, the lessened worth of the assets means less $'s are around, electronically wiped off the slate. Even those that default on their loans play a part, the debt gets written off, the $'s disappear, the flippers lose deposits, spending slows and profits fall. Less $'s, better balanced economy. The banks are happy, they sold the now defaulted debt to the Institutions (some of whom, of late, have been very angry, demanding the sellers of the CDO's take them back and refund the Insts money because the risk has suddenly shot up. We can see who is scared now.) It helps the Foreign Central Banks too. All those consumers, burdened with paying off expensive debt or defaulting, won't have money to spend on cheap imports, a relief for those FCB's drowning in $'s that need a home (US TBills), they no longer need to recycle the supply, which helps the US Tsy who don't need to issue the paper to mop it up. A consequence of all this is the lack of inflation, disinflation they call it, its a real bonus because wage demands will be kept down. In fact, with all this lack of spending, lay offs will also keep wage margins competitive, no need to attract workers, they will be grateful of the work at almost any price. That's good, less $'s to have to mop up domestically too.
There will be other markers, signs to view as we walk the path to economic nirvana. Watch gold and oil, both will see a withdrawal of speculative funds and a recognition of a strengthening $ as the US heads to fiscal responsibility. Stock markets, once the watchdog of economic health, have now become short-sighted, driven by hedge funds and mutual funds seeking to enjoy the trend, they too have a part to play in rebalancing the books, they too will help reduce the amount of $'s. All they have to do is commit too much cash into the assets, turn it into electronic numbers, ready to have the slate wiped when the time is ripe. Just now the bonus hunters and those tied to performance options drive down the same street. Until the fuel runs out.
For some, the fuel has already dried up. Here is a newswire reaction, from someone who wears rose tinted specs:
Via HFE's Ian Shepherdson - "October retail sales fell 0.2%, less than the -0.4% consensus. Sales ex-autos fell 0.4%, well below the consensus -0.2%. September sales were revised down by 0.4% headline, 0.7% ex-autos. The ex-autos number was pulled down by a 6.0% drop in gasoline sales, reflecting the drop in prices. But when this is stripped out, along with food and autos, our measure of core sales rose only 0.1%. Core sales are now believed to have risen only 0.3% in Sep, compared to the initial 1.0% estimate. These are much softer numbers than we had expected in the wake of the drop in gas prices, and suggest people are being very cautious despite the rebound in sentiment. In addition, the housing crunch is now hurting: Sales of building materials were down at a 10.6% annualized rate in the three months to Oct. Ouch, all round."
That's good stuff, all that spending has stopped, all those $'s will never reappear. Its good to see a permabull seeing the effects of the tightening and how it will help the US.
A lack of cash, driven down by tighter, more expensive credit, a lack of liquidity that starts at the bottom and works its way higher up the food chain, until even those, referred to in whispered tones as daz boyz, see that the health of the US economy is going to require a donation of wealth from everyone. Even them.
Can you see what I have caught a first sighting of?
And out there, somewhere in Hedgeland, someone is finding it more and more difficult to sleep at night, thinking about all those CDO's sitting on the books. No one to lay it off to, a one way bet on liquidity. The signs are there too. Someone once said the economy has a copper roof. Anyone looked up recently? Still, as long as the Japanese don't raise there is still the carry trade.......
I hope you enjoyed this letter. I have tried to say what I am thinking but its difficult to express without sounding like a doom monger. In many ways what I am saying is positive, in the long run. The pain along that road though is what will cost the unprepared. I hope this letter helps you to think about how to preserve your wealth.
As usual, I shall set up a thread with the same title on www.livecharts.co.uk so that we can discuss points brought up.
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