The Myth of the Slow Crash

[WDCRob]

Re: The Myth of the Slow Crash

it is no longer as clear to me as it once was that cutting rates will tank the dollar. the ecb has backed off its hawkish stance as sarkozy et al are crying out about the difficulties of living with a strong euro. japanese rates remain very low, and the chinese are taking their own sweet time in allowing the renminbi to rise. coordinated cuts by cbs around the globe might be in store. all currencies will decline together against real goods, and the dollar might not look particularly bad, relatively to other fiat currencies. gold would do well in this scenario.

JK, I never remember the titles of these things, but I'm pretty sure EJ said exactly that in his 'Gresham's Law' post last year. If CBs coordinate gold does well against all currencies. If they don't gold does well vs the dollar. Either way if you're in dollars gold is good.

But what happens when all rates are so low that there's no significant differential between rates in Japan and the US? Does that force a revaluing and a relative decline by the dollar?

[Finster]

Re: The Myth of the Slow Crash

Good question. Look forward to EJ's clarification.

One thought: Bernanke's Jackson Hole speech included "The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets."

Seems the Fed still views their responsibility as "standing by ready to clean up the mess". If so, isn't any pre-emptive Funds rate cut (before a significant equity market decline) inconsistent, and therefore unlikely? :confused:

Strictly speaking, one can infer that EJ's 1987' scenario would stand intact even after aggressive Fed easing, because that was assumed in his original framing of it - that 1987' would occur after it became apparent that the Fed's machinations were impotent. So presumably 1987' happens regardless, and the aggressive Fed easing would instead act to stave off a subsequent multi-year Japanese-style deflationary mire. On the other hand, it's so widely assumed that Fed cuts would boost the stock market (the market has been rallying as Treasury and Fed funds price in expected easing), and the view EJ states above does not refer to the earlier 1987' outlook. And don't forget we have an avowed deflation-fighting printing-press-armed Fed chairman and a chief executive in the helicoper cockpit, so it's hard to imagine that even if deflation got rolling that it could not be reversed even if the Fed waited for clear evidence of "real economy" spillover before acting.

[Finster]

Re: Bernanke on helicopters, price indexes

I must admit, I just read the full text of that speech, and I would encourage anyone who hasn't to do so. In context, the helicopter line is not such a big deal in my opinion. He's simply saying that a money-financed tax cut is a way to get dollars directly to Americans as an extreme method of combating deflation, provided that rate cuts are ineffective and rates are approaching zero. What's so bad about that?

What I was a bit shocked to read was Bernanke's footnote regarding inflation measurements and price indexes.

6. Several studies have concluded that the measured rate of inflation overstates the "true" rate of inflation, because of several biases in standard price indexes that are difficult to eliminate in practice. The upward bias in the measurement of true inflation is another reason to aim for a measured inflation rate above zero.

Does he really think the rigged CPI understates inflation?!? What are these "studies" to which he refers?

Jimmy

This is the one thing that truly worries me about Bernanke. If you just look at the way the Bernanke Fed has conducted itself, you have to give him pretty high marks. But his apparent endorsement of the notion that the CPI overstates inflation has to make you wonder what he's been smoking.

First the "headline" CPI omits a lot of inflation, mostly through its use of so-called "Owner’s Equivalent Rent", as Tim Iacono points out in his Seeking Alpha article "How Owner's Equivalent Rent Duped the Fed".

To make matters even worse, he is fond of taking it yet a step further and focusing on so-called "core" inflation stats. Barry Ritholtz remarks in a recent article on Seeking Alpha: "The risk of focusing on the core is that Fed risks losing credibility in the eyes of the public. Future inflation expectations are not nearly as muted as the Fed's benign core rate."

You got that right! A Fed that persists in pretending inflation is much lower than we know it to be out here in the real world simply cannot be credible.

Cover Up Those Signs! The Problem With Gasoline Prices and "Reported Inflation"

[zoog]

Re: Bernanke on helicopters, price indexes

Barry Ritholtz remarks in a recent article on Seeking Alpha: "The risk of focusing on the core is that Fed risks losing credibility in the eyes of the public. Future inflation expectations are not nearly as muted as the Fed's benign core rate."

You got that right! A Fed that persists in pretending inflation is much lower than we know it to be out here in the real world simply cannot be credible.

And then presumably that eventually leads to, or at least ties into, this:

The 1987 type event I warned July 25 is coming does not happen until the market participants lose confidence in the ability of central banks to control events. Typically this happens some time after several of the kinds of Fed interventions that we saw today in a 50 basis point discount rate cut. If a major revelation follows soon after, then market participants start to wonder if there is a bottom at all.

[c1ue]

Re: The Myth of the Slow Crash

it is no longer as clear to me as it once was that cutting rates will tank the dollar. the ecb has backed off its hawkish stance as sarkozy et al are crying out about the difficulties of living with a strong euro. japanese rates remain very low, and the chinese are taking their own sweet time in allowing the renminbi to rise. coordinated cuts by cbs around the globe might be in store. all currencies will decline together against real goods, and the dollar might not look particularly bad, relatively to other fiat currencies. gold would do well in this scenario.

JK,

I agree that the dollar as a ratio to Euro, yen, or other currencies could possible be fairly stable.

However, I have never looked at this ratio as my primary cause for concern.

Rather, what I fear mightily is the purchasing power reduction of the dollar.

It is possible that although the dollar stays stable, that PPP drops dramatically just for the dollar.

My rationale is as for internal China: In the days when there were both 'internal' and 'foreign exchange' RMB, things like washing machines could only be bought with 'foreign exchange' RMB. Although theoretically the 2 currencies were equal, in reality you could by 6x 'internal' RMB (iRMB) vs. each 'foreign exchange' RMB (feRMB). But, of course, there was basically zero reverse trade (iRMB to feRMB) conducted by internal Chinese.

My fears are thusly:

1) Dollar depreciation - this is the most straightforward and perhaps best result: we get our inflation quick, but the incentives for internal manufacturing and labor employment are immediate. Interest rates go up somewhat but are kept from being too high by our government printing credit. This is due to foreigners not wanting to lend credit which will depreciated.

2) Dollar PPP depreciation - looks good, screws the economy really bad. We get the combo punch of inflation without internal economy compensation. Interest rates go up higher than 1) as this is a mild form of dollar repudiation.

3) Dollar repudiation - officially the exchange rates look good. But no one wants dollars. I call this the 'Ebay effect': in the past all transactions by foreign sellers were in dollars. These days it is all in AUS$ and GBp. Basically if you aren't exchanging a physical good, you won't get any foreign currency for it. Not an immediate effect as the rest of the world engages in dollar dumping, but once the dollars outside of the US run out...it gets bad.

Time for FAST kits...

All of these scenarios are based on my view that the US economy has basically sold out almost all physical value creation in favor of financial engineering. Thus even coordinated cuts around the world will affect the least healthy economies disproportionately. Would that be Europe? Russia? China? Brazil? I think not.

[c1ue]

Re: The Myth of the Slow Crash

But what happens when all rates are so low that there's no significant differential between rates in Japan and the US? Does that force a revaluing and a relative decline by the dollar?

Iinterest rates are set by the government, but trade flows are a function of the economy.

Japan's economy is much healthier than the US in terms of trade/currency account surplus.

Even with both countries at zero interest, Japan will be fine as they are exporting and bringing in foreign currency to offset their imports. Japan doesn't need high interest rates to attract new loans despite their fiscal indebtedness.

The US needs to import a lot, and has only its own crap currency - not to mention pay interest on the money already owed.

Thus in this scenario the interest rates are only a factor in the performance of the dollar. Ultimately the underlying economies will put pressure on currencies to conform to 'ideal' levels.

As mentioned before, Japan is looking to the US as a military balance point vs. China - they are happy to continue their part of the partnership so long as the US can maintain its military power.

However, the Japanese cannot offset 2.5x as many Americans with bad habits - especially given roughly par per capita wages.

[GRG55]

Re: The Myth of the Slow Crash

it's not inconsistent if they think someone's already made a mess.

Perhaps. But does the Fed think the mess already visible is the one THEY are supposed to clean up? It would seem not based on this from Bernanke's Jackson Hole speech: "...the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally."

Strictly speaking, one can infer that EJ's 1987' scenario would stand intact even after aggressive Fed easing, because that was assumed in his original framing of it - that 1987' would occur after it became apparent that the Fed's machinations were impotent. So presumably 1987' happens regardless, and the aggressive Fed easing would instead act to stave off a subsequent multi-year Japanese-style deflationary mire. On the other hand, it's so widely assumed that Fed cuts would boost the stock market (the market has been rallying as Treasury and Fed funds price in expected easing), and the view EJ states above does not refer to the earlier 1987' outlook. And don't forget we have an avowed deflation-fighting printing-press-armed Fed chairman and a chief executive in the helicoper cockpit, so it's hard to imagine that even if deflation got rolling that it could not be reversed even if the Fed waited for clear evidence of "real economy" spillover before acting.

Good point about the market pricing in a Fed cut, but as long as that expectation is maintained doesn't it allow them to defer an actual cut? Does anybody know if the Fed has EVER pre-emptively cut the Funds rate prior to an equity market dislocation? The Fed claims not to be able see asset bubbles; a potential equity market crash would seem even more difficult for them to detect.

In addition to "the market will rally on a Fed cut", there appears an overwhelming consensus that Bernanke can hardly wait to use his rotary wing pilot licence. I am suspicious when opinions become so widely fashionable. The potential the Bernanke Fed may deliberately try to engineer a sharp, short deflationary shock can't be entirely dismissed IMHO. $50 oil and $500 gold (or less!) is not inconceivable in that circumstance. Very few would be expecting that.

[Finster]

Re: The Myth of the Slow Crash

Perhaps. But does the Fed think the mess already visible is the one THEY are supposed to clean up? It would seem not based on this from Bernanke's Jackson Hole speech: "...the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally."

This may be because the Fed knows the mess is one of its own creation. I’d love to hear Bernanke admit that; just come out and say he realizes that it remained (mostly under Greenspan) tooo accommodative tooo long in 2004-2006. Both in keeping Fed funds too low too long and in being too predictable (euphemism: "transparent") in bringing them back up, thus encouraging the very speculation, housing bubble, and - most of all - credit bubble that threatens the financial system and economy now. Such an admission would be very encouraging to hear because it would allow the Fed to pursue its cleanup effort more vigorously without creating as much fear that it will yet again commit a similar error in doing so.

But we’re not holding our breath …

Good point about the market pricing in a Fed cut, but as long as that expectation is maintained doesn't it allow them to defer an actual cut? Does anybody know if the Fed has EVER pre-emptively cut the Funds rate prior to an equity market dislocation? The Fed claims not to be able see asset bubbles; a potential equity market crash would seem even more difficult for them to detect.

I think so, GRG55. In taking down Treasury yields across the yield curve (most conspicuously on the short end) the market has already cut interest rates (except for uncreditworthy borrowers). By cutting Fed funds, the Fed would merely be following and validating expectations. The next part is impossibly circular to fully answer. For if the Fed cut rates in advance of an equity market dislocation in an effort to prevent the dislocation, and if it were successful in doing so, there would be no dislocation with which to compare the preemptive action. Only an unsuccessful attempt would show up in the record.

In addition to "the market will rally on a Fed cut", there appears an overwhelming consensus that Bernanke can hardly wait to use his rotary wing pilot licence. I am suspicious when opinions become so widely fashionable. The potential the Bernanke Fed may deliberately try to engineer a sharp, short deflationary shock can't be entirely dismissed IMHO. $50 oil and $500 gold (or less!) is not inconceivable in that circumstance. Very few would be expecting that.

I don’t think it was deliberate, since the Fed obviously would have preferred a gradual adjustment, but we have already had at least one "sharp, short deflationary shock". Another such event would IMO be even less deliberate! But that doesn’t mean we won’t get one. Or two or more. But this is an inherent problem in allowing speculative credit excess to build up in the first place. Despite the Fed’s baby-step gradualism and "transparency" in trying to gradually reign in the excess, it just kept building until it collapsed of its own weight. That’s the way real markets work. As suggested above, the slow pace and predictability of the Fed’s "removal of accommodation" merely served to embolden speculation. If it had chosen instead to throw in a couple ad hoc inter-meeting 50 bp hikes back in 2005- 2006, it could have let off some of the steam before it blew out the boiler.

But as you suggest, whether we see $50 oil and $500 gold is very much in the Fed’s hands. Remember it has been on an avowed inflation-fighting mission. This latest market event is the first tangible evidence of success. If it is as gradual and "transparent" in cutting rates as it was in raising them, then it will have won that fight and we could well see your $50 oil and $500 gold. But that would also mean a genuine consumer-led recession. If instead it is determined to try and prevent such recession, then we will not likely see a five-handle on either one ever again.

Unless it’s with another zero at the end…

[jk]

Re: The Myth of the Slow Crash

In taking down Treasury yields across the yield curve (most conspicuously on the short end) the market has already cut interest rates (except for uncreditworthy borrowers). By cutting Fed funds, the Fed would merely be following and validating expectations.

treasury yields are low because of a flight to safety. meanwhile credit to borrowers other than the government is less available across the board.

"...the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally."

credit tightens in 2 different ways. one is by raising the rate, the other is by restricting availability irrespective of rate via higher underwriting standards. thus even a lowered fed policy rate may not succeed in loosening credit conditions. in fact, credit will likely continue to constrict irrespective of cb action. the market has been reminded of the existence of risk, and this repricing of risk is a process that will go on for some time.

[Finster]

Re: The Myth of the Slow Crash

treasury yields are low because of a flight to safety. meanwhile credit to borrowers other than the government is less available across the board.

Nothing I said implies otherwise. Risk-free interest rates fell. But don't forget that credit spreads (rate differentials) between risk-free Treasuries and junk were notoriously, abnormally, low for a long time prior to this latest adjustment. It would be a little misleading to refer to a return to normalcy as a "flight to safety".

We had some fleeting overshoot that we could call the latter, but for the time being things have settled into a tentative equilibrium.

credit tightens in 2 different ways. one is by raising the rate, the other is by restricting availability irrespective of rate via higher underwriting standards. thus even a lowered fed policy rate may not succeed in loosening credit conditions. in fact, credit will likely continue to constrict irrespective of cb action. the market has been reminded of the existence of risk, and this repricing of risk is a process that will go on for some time.

Again, we have the phenomenon of abnormally loose credit returning to a more normal state. If we were to call lack of credit availability for uncreditworthy borrowers "tight" credit conditions, we may as well stand atop Everest and call the entire rest of the world a valley.

Nevertheless, we arrive at similar conclusions if by different routes. A lower Fed policy rate will not magically result in E-Z credit for the insolvent. At the margin, however, it will make credit within the quality spectrum a little more competitive with risk-free credit, and all else being equal, make it a little cheaper than it would otherwise be. The markets would not long tolerate a differential between Treasuries yielding 1% - 3% and lower-investment-grade credit at 7-9%, no more than they were able to sustain the microscopic differentials they sported barely weeks ago.

[Chris Coles]

Re: The Myth of the Slow Crash

credit tightens in 2 different ways. one is by raising the rate, the other is by restricting availability irrespective of rate via higher underwriting standards. [/size][/font][/font]

JK,

you have missed the third and, perhaps the most important reason for a tightening credit spiral, fear. I well remember during 1992 here in the UK that National Westminster Bank was paying big fat bonuses to their staff for the amount of funds they could get back by calling in overdrafts and had put a complete stop on sale of any loans to anyone.

Fear of a complete collapse and thus that, as the collapse spiralled downwards, their own fundamentals for the underlying capitalisation of the bank was driving total fear.

It is fear of what will happen if the collapse continues that has the most dramatic effect upon access to credit. A bank profits from the sale of loans, yes, but survives disaster by calling in everything it can lay its hands on when times get rough.

[WDCRob]

Re: The Myth of the Slow Crash

Iinterest rates are set by the government, but trade flows are a function of the economy.

Japan's economy is much healthier than the US in terms of trade/currency account surplus.

Even with both countries at zero interest, Japan will be fine as they are exporting and bringing in foreign currency to offset their imports. Japan doesn't need high interest rates to attract new loans despite their fiscal indebtedness.

The US needs to import a lot, and has only its own crap currency - not to mention pay interest on the money already owed.

Thus in this scenario the interest rates are only a factor in the performance of the dollar. Ultimately the underlying economies will put pressure on currencies to conform to 'ideal' levels.

As mentioned before, Japan is looking to the US as a military balance point vs. China - they are happy to continue their part of the partnership so long as the US can maintain its military power.

However, the Japanese cannot offset 2.5x as many Americans with bad habits - especially given roughly par per capita wages.

Thanks C1ue.

[jk]

Re: The Myth of the Slow Crash

Nothing I said implies otherwise. Risk-free interest rates fell. But don't forget that credit spreads (rate differentials) between risk-free Treasuries and junk were notoriously, abnormally, low for a long time prior to this latest adjustment. It would be a little misleading to refer to a return to normalcy as a "flight to safety".

We had some fleeting overshoot that we could call the latter, but for the time being things have settled into a tentative equilibrium.

with fed funds at 5.25, lower than inflation [in my books], normalization required all rates going up, with longer rates going up more. what happened mostly is that short riskless rates dropped sharply, while long risky rates went up only a bit. and whatever the absolute level of rates, spreads are still too low, reflecting a continued underpricing of risk.

Again, we have the phenomenon of abnormally loose credit returning to a more normal state. If we were to call lack of credit availability for uncreditworthy borrowers "tight" credit conditions, we may as well stand atop Everest and call the entire rest of the world a valley.

i am not privy to details on the credit markets, but the impression i receive from my readings is that credit is tight even for traditionally creditworthy borrowers. i suspect we are heading into an overshoot.

i also suspect that there is value in some of the debt instruments that are currently unmarketable. one real underlying problem is the lack of transparency in these instruments. the abcp market is evaporating rapidly, for instance, because people don't know how to value the underlying collateral. that doesn't mean the collateral is worthless. so this [abcp unmarketability] is already an element of overshoot.

i realize that the last remark appears to contradict my assertion that spreads are too low. the variability of risk pricing is what is striking. i think the generic junk bond market is still underpricing risk, while there are pockets in which risk is being priced at infinity and more exotic paper can't be sold at all. these disparities will be resolved, i guess, by risk being priced into junk, not by risk being priced out of exotic junk.

[Guest]

Re: The Myth of the Slow Crash

JK wrote:

<< with fed funds at 5.25, lower than inflation [in my books], normalization required all rates going up, with longer rates going up more. what happened mostly is that short riskless rates dropped sharply, while long risky rates went up only a bit. and whatever the absolute level of rates, spreads are still too low, reflecting a continued underpricing of risk. >>

Bob Hoye [ Institutional Advisers ] in a Sept. 1st article is reiterating long rates are indeed due to rise soon ( is an inflationary acknowledgement by the long bond to be read as the definitive word on the direction of future inflation? ).

http://www.safehaven.com/article-8319.htm

I think I understand, he is further observing that changes in the yield curve within a < credit crunch > - can indeed be with an inflationary bias - with a steepening yield curve scenario, with plunging short rates being the first symptom of credit contraction (already seen). He says we'll also soon see rising long term rates (hence steepening a good bit further).

Meanwhile Prechter is sounding more apocalyptic on the "cusp of deflation" each passing week. For one to be right, the other must be wrong?

[jk]

Re: The Myth of the Slow Crash

JK wrote:

<< with fed funds at 5.25, lower than inflation [in my books], normalization required all rates going up, with longer rates going up more. what happened mostly is that short riskless rates dropped sharply, while long risky rates went up only a bit. and whatever the absolute level of rates, spreads are still too low, reflecting a continued underpricing of risk. >>

Bob Hoye [ Institutional Advisers ] in a Sept. 1st article is reiterating long rates are indeed due to rise soon ( is an inflationary acknowledgement by the long bond to be read as the definitive word on the direction of future inflation? ).

http://www.safehaven.com/article-8319.htm

I think I understand, he is further observing that changes in the yield curve within a < credit crunch > - can indeed be with an inflationary bias - with a steepening yield curve scenario, with plunging short rates being the first symptom of credit contraction (already seen). He says we'll also soon see rising long term rates (hence steepening a good bit further).

Meanwhile Prechter is sounding more apocalyptic on the "cusp of deflation" each passing week. For one to be right, the other must be wrong?

lucumone,

prechter has been calling for deflation since at least 1987. i suppose it is possible that at some point he will be right. hoye isn't really clear [in the article you link] why he thinks long rates are going to go up, but long tbonds must embody the pure time cost of money, and thus expectations of future inflation. so i don't see how they can both be right, unless you have a deflation we're on the cusp of, which nonethess brings with it inflationary expectations. i.e. ka-poom. [though "ka" really implies disinflation with deflationary fears, not true deflation.]