Markets Still Watching the Wrong Thing

For much of 2H 2007 and through 1H 2008 it was obvious to many, myself too, that market participants were ignoring credit market signals…blowing out of credit spreads, downgrades of RMBS, CDOs and spiking CDS on all sorts of securities. Remember the stock market put in a record high in Q4 2007. Many at the time were saying no big deal…employment was holding up and the economy seemed like it was working. Why sweat credit spreads when stocks were up and home prices not yet falling?

Well by the fall of 2008 that all changed. The economy fell off a cliff and the recession went from mild to severe. Stocks crashed, home prices plummeted and credit dried up, credit spreads blew out and the world flirted with a 1930's-like great depression.

I bring this up only to make a point about how the financial crowd tends to focus on what was important yesterday but not today. ECB President Trichet today, like Bernanke and Geithner, rattled off all the indications from credit spreads to IONIA to show how markets were functioning and more or less normalizing. And if we look at the parameters that many ignored through 2007 and 2008 he and Bernanke and Geithner are right - the crisis is over and we can sit back and wait for a recovery, even a gradual one.

However, all is not okay. Massive central bank liquidity infusions across the planet have succeeded in reducing risk aversion as measured by credit spreads, financial asset prices and large financial firms' access to private capital.

But something is seriously still broken in the system. Banks are not lending, because they have legacy lending exposure that threatens new huge write downs…and households and firms are not demanding credit - they are trying to rid themselves of credit. The credit creation machine is broken. Trichet was asked about why EZ bank lending is now negative…he did not have a convincing answer.

So the liquidity infusion has improved the appearance of the banking system much like cosmetic surgery. But the internals in the banking system remain problematic…the quality of assets on and still off the balance sheet and leverage (more a European problem than US or UK now). Relatively free money does not guarantee money creation - money multiplier.

What should markets be looking at if not all the indicators that showed a massive problem was brewing starting in 2007?

Banking system deposits with the central bank - these are enormous and reflect the fact that the banking system is not inclined to go out and lend to the private sector (and not even lending to the US Treasury so far despite the upward sloping yield curve). Moreover, much of the collateral the banks are posting with central banks for cheap funds would never be taken in by authorities in normal times. Does anyone think the central banks want to see dicier bank assets entering the waste management recycling bin as collateral against central bank funds ahead? Is there not already a massive shortage of quality collateral?

Look at the Riksbank's actions today to get a feel for what may really be going on - it cut rates to 0.25% from 0.50% after signaling at the last meeting that policy was about as easy as it was going to get. But it also began charging banks 25 basis points for holding excess reserves with the central bank and then set a fixed 1-yr repo for SEK100bln. While this may not be symptomatic of the Stockholm syndrome, it smacks of official panic (Bank officials said rising unemployment, weaker than forecast growth and slumping exports were behind this move, but heck the banking system is broken in Sweden as it is in Europe and the US and no amount of liquidity will get credit creation machine restarted.

Nassim Taleb, author of The Black Swan, was on CNBC today and his main point was the world is drowning in debt (he said $30-70trln public and private debt globally - pretty wide range…) and the only way to fix this is to have a massive conversion of debt to equity by lenders and borrowers. That underwater homeowner having trouble making a monthly mortgage payment gives the bank equity in the house in exchange for an affordable monthly payment. I think he has a point. I don't think it is very practical for all the obvious reasons including the impossibility of the politics needed to even scratch the surface on this kind of approach.

Sadly the only really effective growth engine ahead is government spending (not tax cuts). And this just adds to the Taleb problem…and most countries that need to spend can't afford to because they did nothing to rein in deficits in the good times.

I am not suggesting a deflationary spiral ahead, but I am suggesting near zero growth rates bought by government spending at a ever higher future cost and nothing short of a generational technological innovation capable of managing these liabilities.

David Gilmore

Foreign Exchange Analytics
http://www.fxa.com

Disclaimer: The opinions expressed herein are those of the author and not a recommendation to buy or sell specific securities.