Thursday July 2, 2009 - 16:11:16 GMT
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Forex Blog - Markets Still Watching the Wrong ThingFor much of 2H 2007 and through 1H 2008 it was obvious to
many, myself too, that market participants were ignoring credit market signalsâ€¦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 dealâ€¦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 1930â€™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 â€“
the crisis is over and we can sit back and wait for a recovery, even a gradual
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 firmsâ€™
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 downsâ€¦and households and firms are not demanding credit â€“
they are trying to rid themselves of credit. The credit creation machine
is broken. Trichet was asked about why EZ bank lending is now negativeâ€¦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 problematicâ€¦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 â€“
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 â€“ 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 Riksbankâ€™s actions today to get a feel for
what may really be going on â€“ 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 â€“ pretty wide rangeâ€¦) 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 donâ€™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
problemâ€¦and most countries that need to spend canâ€™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.
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