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Monday, 8 October 2007

The Second Sighting - Letter 5 of 07

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.

(This letter was originally published on the 11th Sep 07)

Its been a few months since I did an update and thats been deliberate. As I'm not trying to sell anything then I have the luxury to allow my letters to be occasional. As an aside, you will see a link in this letter to, its a free financial bulletin board which helped me acquire the technical means to be able to publish my thoughts. Its well worth a visit and deserves a mention.

If I can grab an extra 5 minutes of your time, I want to demonstrate the difference between my approach to financial thinking compared to most other writers. This isn't a boast, its just a reflection of the fact that my work is new to you, the readers. So before I continue with this letter, I would appreciate it if you read this article first, it lays the groundwork for the rest of this article: or visit the archives at Safehaven and look for Mick P. My last letter, written in June, is also part of this ongoing thread of thought.

I was going to talk about why I thought the Federal Reserve shouldn't cut rates but it looks like ever increasing attention is being pointed at this matter and adding my voice wouldn't help. It seems more valuable to examine what the consequences will be of a Fed cut / non cut and how its going to affect the economy.

I've been saying for sometime that the Fed is stuck, not because it cannot do anything but because the 2 choices left are both going to be poisonous to the economy. Simply put, the Fed will either inflate liquidity or will follow a path that allows for a US domestic recession. You notice I say "allows" rather than forces. The Fed is not as omnipotent as many think.

The Fed seems to be following the path I laid out back in November last year (now you have to read the link) which allows for a cut at the September meeting. I think the cut will be 0.25% (discount rate will be 0.5%) but it will not make any difference to the outcome for the economy.

It does mean the Fed is seen to be doing the right thing for a domestic audience without overly hurting the foreign holders of US debt. Foreign holders can continue to sell off debt at a controlled pace. In the US it won't make any difference. Rates are set by the markets not the Fed. Rates are also set by risk. So whilst Treasuries are attracting a bid, thanks to the safe haven label, other areas of debt are pricing risk the other way, building in a risk premium into the yield, forcing yields higher. We are seeing that with 3 month LIBOR. The yield is rising to build in a risk premium and this is on the rate Banks charge to lend to each other.

Come to think of it, if the Banks don't trust each other with lending funds, why should you? Surely a risk premium on your savings, giving you a higher yield, should be in place? Maybe its time to check out your Bank, do a bit of research and confirm its health and what protection your cash has?

So if Banks are having to pay higher yields to each other and will be forced to pay higher rates to savers, whats going to happen to the rates charged by Banks on borrowings, you know, mortgages, loans and credit cards? How much higher will rates have to go to keep the system running? Maybe its time for a look at real yield curves, rather than the yield curve produced by US Treasuries.

This leads us back to a rather large problem. In fact its huge problem and its not being talked about out there in Medialand. What happens to a tapped out consumer, loaded with debt, trying to roll a teaser/innovative (thanks AliG) mortgage if rates are going up? Its not going to happen, its a train crash. Borrowers are already operating under tighter credit controls so the ability to re-fi is curtailed for many. Add in much higher rates and the situation becomes impossible. Banks are going to suffer from a curtailed income stream, as debt default rises, just as the teaser rates for the Banks’ borrowings come to an end and reset much higher. Can you see the irony?

Banks are no better off than over stretched sub-prime mortgage borrowers. They need an income stream from lending to ensure they can pay the liabilities they owe to savers, savers that will demand higher yields. Its unsustainable and its going to stop, soon.

An enormous amount of money (liquidity) is just going to disappear as the debts are defaulted. Credit will become a luxury, given only to those who can truly afford it (and probably don't need it). When credit is withdrawn from a fiat money based economy then the dynamics of money change. The withdrawal of credit based liquidity means that a fiat based currency has to realign to the fundamentals. That means deflation.

You can see the end game clearly now.

The Banks will have no option but to drop saving rates, they simply will not be able to afford to pay higher yields. Savers will move cash into assets that provide a higher return, shunning deposit accounts. Banks are hit with a double blow, as a lack of income leaves them either unable to service their own debt and default or forces them into repaying the debt using capital holdings or returns from assets sold in the markets. Either way, credit for business and consumers becomes impossible to provide. A massive contraction of activity is a given.

Its been noticeable of late to see the recession word crop up, even in the mainstream media. I think they are wrong. I think the future contains a scenario much worse than a recession.

So, my forewarned reader, will you be leaving your money in a "sub-prime" bank?

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