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Sunday, July 20, 2008


the best case scenario

tim duy via economist's view responds to brad delong's defense of federal reserve banking since the 1990s. first delong:

The dot-com bubble and the real-estate bubble were bad news for the investors in Webvan, WorldCom, Countrywide, FNMA, and securitized subprime mortgages. But they were, by and large, good news for the rest of us. And investors are supposed to take care of themselves.

Now we are not yet out of the woods. If the tide of financial distress sweeps the Fed and the Treasury away--if we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism was a mistake. But so far the real economy in which people make stuff and other people buy it has been remarkably well insulated from panic at 57th and Park and on Canary Wharf.

duy seeks to explain this disconnect between financial (particularly credit) markets and the "real economy".

1. ... The primary channel through which housing supported the economy was via consumer spending, generating a tepid growth dynamic compared to the equipment and software investment boom of the 1990’s. The tepid upside suggests a tepid downside. ...

i don't think this carries much water. the suggestion does not consider the changing impact of debt financing as a greater and greater fraction of the resultant levered income is directed to debt service -- we've gto very close to zero hour, and economic performance of the 2000s vs the 1990s is likely a reflection of the limitation of debt financing being approached. from such a condition, the potential of the following unwind is greater, not smaller.

2. The impact of the consumer slowdown is partially offshored, a point which I think deserves greater attention. This shifts job destruction to an overseas producer. In fact, as spencer at Anger Bear shows, the recent improvement in the real trade balance has less to do with rising exports, which continue to follow recent trends, than the sharp slowdown in real import growth. Note too that exports are not falling as they were in the 2001 recession as the global economy has held up better than expected.

in a globalized economy, i'm not sure this is solace so much as a time lag. diminished import growth is also a function of yuan appreciation, which closes the current account deficit (ex-oil, anyway). this has the function of reducing the impetus for vendor financing.

and that relates to the point of substance here.

3. Perhaps most importantly, however, is the massive liquidity injections from the rest of the world, or what Brad Setser calls “the quiet bailout.” In the first half of this, global central banks accumulated $283.5 billion of Treasuries and Agencies, something around $1,000 per capita. This is real money – I outlined the likely implications in January. Foreign CBs are happily financing the first US stimulus package; will they be happy to finance a second? Do they have a choice? Their accumulation of Agency debt is also keeping the US mortgage market afloat. Do not underestimate the impact of these foreign capital inflows. If the rest of the world treated the US like we treated emerging Asia in 1997-1998, the US economy would experience a slowdown commensurate with the magnitude of the financial market crisis. The accumulation of US assets is also forcing an expansion of foreign CB’s balance sheets, creating global monetary stimulus that allows the rest of the world to decouple from the US economy, supporting continued US export growth (see point 2 above).

do they have a choice? the answer is yes -- moreover yuan appreciation is the policy execution of the decision to end chinese vendor finance of the united states.

the difference between credit market disaster and mild "real" recession is setser's quiet bailout. the question is whether this will be a durable feature of the downturn, resulting in recapitalizing support from asia and the mideast -- a continuation of the last decade-plus -- or whether the downturn is part of a process which results in the end of that perverse capital flow from wealthy natiions to poor.

the bank credit analyst has gone on record as expecting the former. but for my part i tend to agree with the critique forwarded by yves smith on this topic.

... [T]he timeline for economic events to play out is remarkably languid, always taking longer than one expects. And given the fact that one views it unfolding in a sense through a series of discreet datapoints, some of which are manipulated, and all of which are subject to "noise" and some serendipity, it is both really hard and really important to focus on the underlying trends in order to maintain a clear view of the larger picture.

Tim gingerly tiptoes around the issue my friends and I always come back to at our "Austrian" lunches. And this is the thought that we've issued more paper than our economy can ever pay back--given the size of the economy, it just does not compute. How long foreign central banks will continue to play the game is a difficult question to answer, and the attempts at answering are pretty much pure speculation anyway. But again, trying to view the situation from 30,000 feet, the trend of moving away from the dollar is certainly apparent. Bulls, and what me worry types can certainly find enough datapoints to continue in a fool's paradise, but at some point this becomes one of Herb Stein's what can't go on forever, stops, moments, and either interest rates go through the roof, or the dollar really collapses, or both.

this mirrors something todd harrison, kevin depew and others at minyanville often say -- depression is a process, not an event. the current obsession is to declare the thing over -- after all, how much bottom-calling can we absorb before the whole idea transcends into the ridiculous? but a more pragmatic view of events is to see the flow of events as a process which has passed an inflection point -- from systemic levering to systemic delevering. whether or not asian central banks pull the plug on the united states' line of credit now or in a few years is, in that, context, not really the issue from my vantage point. even the best case scenario comes as a reprieve, rather than a solution. that's something to consider as we all wait in dread of that first TIC report that demonstrates decisively that foreign central banks have broken the balance of terror.

UPDATE: yves smith with more -- is america too big to fail?

"Obviously, this is going to come to an end," Schiff said. "Foreigners are not charitable organizations, and they're going to demand that we pay them back."

"Foreigners could decide it's just not worth the risk and sell," says Andrew Tilton, an economist at Goldman Sachs. "The really dire scenarios have become a lot more likely than they were a year or two ago."

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