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Friday, November 21, 2008


profound new depths of delevering

the ongoing disaster in the equity market is the lesser part of the devastation -- like the proverbial iceberg, it's the highly-visible but minor part of the whole thing. the credit markets are now enduring some of the most amazing liquidation symptoms ever seen.

for example, massive liquidation of agency debt held by overseas investors has driven agency spreads to treasuries to all-time and previously inconceivable highs. asian central banks have clearly decided to vacate the GSEs, and that will have further severe ramifications for a housing sector that even with GSE support is dying (though to be sure the treasury may force-feed the mortgage market through the conservatorship). the financial times offers this stunning commentary regarding china:

Dresdner, in a note out today, observes that it won’t be long before all the world’s big central banks are operating a Zirp: that is, a zero interest rates policy.

There’s one economy, though, for which a Japan-style recession is of particular significance to the world. And no, we’re not talking about the US.

Writes Dresdner’s Peter Tasker (HT he also, for the headline):

China’s jumbo fiscal package is eerily similar to Japan’s 1990s stimulus plans, which totalled Yen 100 trillion, 20% of GDP. Japan’s attempt to bolster already excessive levels of fixed asset investment failed. China must take radical measures to raise the consumption share of GDP or face a long and painful adjustment.
Japan was, like today’s China, an economy with a structural surplus of savings. As with China, super-easy monetary policy generated an investment-led boom and an explosion in financial asset prices. As the bubble inflated, investment rose to an unsustainably high proportion of GNP and consumption fell to historically low levels. The opposite phenomenon took place in the economies of key trading partners, which were undersaving and over-consuming.

When the inevitable happened and Japan’s financial bubble burst, the authorities understood that a rapid deflation of the fixed asset investment bubble would risk a depression. Hence the strategy of replacing corporate capex with government-led big projects. …

Is China following the same path? It certainly looks that way.

What significance this? Well, only the fact that the world economy has grown pretty dependent on China’s fixed-asset habit. ...

As FT Alphaville observed yesterday, the stability of the US - and its ability to whether a crippling depression - is dependent on dollar inflows. Foreign buyers have already turned away from anything but Treasuries.

China - as of only last week - is now the world’s largest holder of Treasury bills. If Dresdner is right, and China will be forced to reevaluate that hard-won position, then who knows what will happen.

further -- and perhaps even as ominously -- observe what is happening in swap spreads, where what was only recently thought to be a mathematical impossibility -- that the market would offer long-term fixed rates at a significant discount to floating rates -- is an ever-deepening reality. david merkel noted:

... long duration managers (pension plans, life insurers) have for some reason felt forced to buy fixed-rate promises through the swap market, rather than buying zero coupon bonds, the longest of which yield more than 3.5%, considerably more than swap rates. Anyone holding a position to receive 30-yr fixed, pay floating saw it appreciate by 9-10%, which is pretty amazing.

the invaluable john jansen offers an explanation for what is happening here.

I just spoke with an options trader about this historic move. He said that there structured product trades buried in trading books all over the world which are melting. There is a massive short in the 30 year sector (in Treasury paper and in the swap market) which resulted from sales of cheap volatility. Some of these positions have been on the books of various entities for years and it is only recently that the chickens have come home to roost. Each time the spread turns more negative, that movement forces some one to receive in swaps to hedge there position. There are short the long end trades in every permutation and combination along the curve. The receiving creates a self fulfilling prophecy which compels someone else to receive. He had no opinion on when this would end.

in essence, if i understand the dynamic (which is questionable), underfunded pension funds are being compelled to buy fixed long-term treasury yields because they are being hurt killed slaughtered on the titanic piles of shorter-duration structured finance they have bought over the last five years in an effort to grow their way into an ability to meet the obligations of retired workers. CMBS have this week followed RMBS and CDOs and LBOs and corporates down the toilet -- all of the above being now severely illiquid. they are in the swap market most likely because they no longer have the balance sheet to, as merkel noted, buy bonds directly, and cannot make room by sales because there is no sizable bid.

if institutional money is in this kind of pain and being pushed to the wall, there may be yet more frightening deleveraging to come in short order.

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