Derivatives Deleveraging, Debt Deflation, Gold and Bailout II

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Wednesday, October 08, 2008

Derivatives Deleveraging, Debt Deflation, Gold and Bailout II

By: Christopher_Laird

Now that Bailout I voted down, bailout II comes up next. Surely some new bailout manifestation will emerge this week and pass. We suspected in our Sunday newsletter Bailout I would fail to pass. But, Congress, shell shocked by fast moving events, will do something.

But it won't work. Ultimately, even if they came up with a $1 trillion program, all it would do is buy time. I mentioned that there is $1000 trillion of various leveraged markets deleveraging, and putting up 1 trillion against that just won't work.

I remember a year ago, when the credit crisis started in Aug 07, a banker said â€˜the deleveraging will not be denied.' How true that has proved to be.

Using some basic math, I count total US and ECB temporary lending injections at $3 trillion so far. It's failing to stop deleveraging. It's simple math really, $3 trillion thrown against a deleveraging $1000 trillion is not much. The central banks can lend money to banks, even taking bad assets as collateral, but it does not force lenders to lend to one another. They all know that, the truth be told, no one is admitting the extent of the bad paper they hold. So, they won't lend in interbank lending markets, and Libor rates skyrocket. That effectively negates interest rate cuts by the central banks.

Borrowed short, but can't roll over

In effect, that means that banks/any borrowers cannot roll over short term financing, and that means that the commercial paper markets (short term business credit) does not roll forward, and that means that companies can't make payrolls, buy inventory, or do whatever. Since everyone from central banks, to businesses, to even people (ARMs) are borrowing short term money, and have to roll forward each term/month; the entire world credit market is being forced to deleverage since banks are refusing to roll forward new short term credit. This specific problem of not being able to roll forward short term credit is a system wide problem.

The math of this is simply called debt deflation. And when it results in actual defaults, banks fail, people and businesses go insolvent, economic activity stops cold incrementally. And that is what is happening. The next phase for the remaining months of 08 will be the hundreds of thousands of layoff notices each month. It's called a deflationary spiral.

Doomed to fail

So, even as the Fed injects an incredible $600 billion of currency swaps (lending USD to central banks in trade for their currency as people sell out of foreign markets and go to cash and repatriate money to the US) to EU banks Monday, a failure to pass Bailout I â€“ the TARP, causes a 777 point fall in the Dow. And more importantly, the credit markets continue to contract. The central banks are trapped. All they can do is single handedly try to replace all the gazillions of vaporizing short term credit that is not rolling over everywhere. And that is simply doomed to fail.
â€œ "The interbank market has collapsed," said Hans Redeker, currency chief at BNP Paribas.
"We're now seeing a domino effect as the credit multiplier goes into reverse and forces banks to cut back lending to clients," he said.
Mr Redeker said the latest alarming twist is a move by banks to deposit â‚¬28bn in funds at the European Central Bank in a panic flight to safety. This has jammed the mechanism used by the authorities to shore up the financial system in a crisis.

" The ECB is no longer able to inject liquidity because the money is just coming back to them again. This is extremely serious. If monetary policy is no longer working, there is a risk that the whole system will blow up in days," he said.

The euro plunged on Monday as the wave of bank failures hit the newswires, dropping 2pc to $1.43 against the dollar. It recovered slightly as the US Federal Reserve flooded the markets with $630bn of dollar funding with fellow central banks in the biggest liquidity blitz in historyâ€¦â€
Telegraph.co.uk

As we said, Congress will pass something. But, even though that will cause a relief rally, credit contraction will not be halted. And that means the world is now in the beginning of debt deflation. So, really, all that will happen in the next two weeks will be a relief rally followed by more and more bank crises, as they find they cannot roll forward short term paper, and short term credit of all types, ARMs, corporate paper, and pretty much any kind of credit you can imagine out there just sort of disappears from the world economies like smoke.

What's next

This week the US Congress will likely pass something. But as we said, these efforts are doomed to fail. All that a new TARP will do is buy some time and a short relief rally, but it will not stop the relentless deleveraging, and the ongoing disappearance of short term credit and economic disintegration in the West right now, and it's now spreading to Asia. This is a world debt deflation.

The relief rally will give the astute a chance to do some more liquidating. The only real solution to this mess is for interbank lending to begin again, and businesses and consumers to get access to credit to roll forward their expiring short term credit. And that is not happening either. So the economies will continue to deteriorate rapidly. And layoffs are coming big time.

This economic demand destruction does not bode well for general commodities. See the oil prices falling $10 Monday, and commodity bellwethers like Freeport McMoran falling to new lows.

Old Hat

In the beginning of 08, as inflation raged worldwide but economic growth was slowing, it appeared we were headed for stagflation. In that environment, gold and oil did really well. But toward the middle of 08 it started to become clear there was some real economic slowing, and demand destruction. This was a leading indicator of a more serious problem, relentless world deleveraging and debt deflation, which we are now seeing. And the new prospects are debt deflation and not stagflation.

Stagflation is commodity bullish, but deflation is not.

Even so, the flight to cash in general and the credit crisis has proven a potent combination for gold. You can track all the major movements in the gold market since August 07 with developments in the credit crisis. Most recently, the failure of the TARP and the debate over TARP for the last week caused gold to rally strongly, even as oil fell drastically because of expected demand destruction. Why is this?

That is because gold is cash par excellence. Even though gold has an exasperating $100 price volatility week to week, it's the final place of safety for cash worldwide. So, flight to cash and liquidity finds its way to gold ultimately. People know that, despite a rallying USD, gold ultimately will be the safest place for cash.
The investing mantra, that the world economy will drive basic commodities relentlessly up, is what we heard for the last 5 years, but the markets are saying that is old hat. What's new hat is a contracting world economy and debt deflation. But it's typical for the economic commentary and thinking to be 6 months behind seeing the obvious, that the investing climate has now changed decidedly away from the general â€˜economic growth to infinity' paradigm we heard for the last 5 years. Hence we see bell weather Freeport McMoran (base commodities like copper and some gold) falling.

Real problem

The real problem now is what to do about the deleveraging and progressively evaporating short term credit and interbank lending. For the moment, there is no viable solution. That ultimately means severe economic contraction going into 09, something that scares the hell out of every economy in the world. But the central banks are proving totally impotent to stop it, and are merely accumulating all the illiquid assets on their balance sheets, and are only buying time with their ever increasing short term lending to financial institutions, which is NOT finding its way to businesses and the economy now.

Unless this dilemma of relentlessly contracting short term credit is resolved, we will have a severe world depression and big upcoming layoffs. I don't see any way around this.

So, for the moment, the USD and gold rise together. There is flight to cash generally. We might have a hiatus of this as we pass quarter end after September. But then we enter the cash crunch of end of year. So the USD will still likely rally, and gold will continue rather strong too as it's the ultimate cash, and the credit crisis continues to plague the planet's economies and banks.
Oil's prospects are down going forward too, as people realize the â€˜growth to infinity' paradigm is crashing on the reef of the credit crisis. Deleveraging is forcing economies to contract violently.

I can imagine what will happen to stock markets, after the upcoming new TARP the US congress will pass. There will be a relief rally, and possibly in oil too. But toward the end of 08, the markets will finally realize their growth to infinity paradigm is dead, and the world entering a relentless debt deflation. And that means stocks going into 09 are down down down.

Flight to cash is the order of the day, and gold ultimately is a beneficiary, albeit with infuriating bouts of $100 price swings.

There is one more problem worth noting. We are just entering a stage of bank runs. What happened with the 5 EU banks bailed out this week, and then the failures of all the investment banks and banks/institutions in the US in the last two weeks were bank runs. I am quite concerned that a wave of these in the US and the EU can lead to a failure or interruption of credit cards and ATMs and debit cards.

So, not only do people have to accumulate cash in general and sell investments, but also they will start to need actual cash in hand. I think everyone should be stocking a month or so of cash, just in case they need to pay some bills, buy gas (have you noticed big gas stations not accepting credit or plastic money?).

By Christopher Laird PrudentSquirrel.com

Copyright Â© 2008 Christopher Laird

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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