Quiet Meltdowns and the Money Panic
By Frank Barbera CMT. August 21, 2007
Last week, Fed Chairmen Bernanke reacted with outstanding sensibility to try and calm the outwardly irrational fears that have gripped the international credit markets. While we may, as of yet, be unable to know whether these fears were truly irrational, the degree of paranoia and the degree of real fear was unmistakable. Just look at the Canadian Commercial Paper market last week, and it's near seizure. For our part, while we realize that the Fed’s move may not be seen in the best light by those in the Austrian School (and they may well be right in the medium term), from a more ‘here and now’ mainstream point of view, the move was inventive, for the Fed may have calmed some nerves by re-introducing the Discount Window as a more viable funding tool.
Stepping back for a moment, we were stunned by the revelations which emerged from the commercial paper market, where total outstanding paper plunged by $91.10 billion dollars in just over a week. This was a clear sign that borrowers were unable to roll over short term debts, with the nearly 2.20 trillion dollar Asset Backed Commercial Paper market (ABCP) now transcending the Sub-Prime market as the next flash point in the Credit Crunch. According to Ambrose Evans Pritchard at the London Daily Telegraph, “This short-term debt is used to fund long-term investments, creating a maturity mismatch that has now turned deadly. The Fed quietly softened its rules yesterday to let banks use the ABCP loans as collateral, a move that effectively offers a government floor.” Quoting a senior strategist at Barclays, Pritchard continues, stating that, in effect, “The sub-prime losses have been spread through the system in such a way that nobody knows who’s got what, and where the losses are, so the safest thing is to not lend to anybody.”
As liquidity drained from this nation's Commercial Paper market, with financial officers unwilling to lend out short duration paper for fear of purchasing toxic debt, the Feds pledge to open the discount window and extend Open Ended 30 day loans on a rolling basis if needed, seems to initially calmed many nerves. Strangely, while things in Canada appear to be normalizing, the sudden plunge yesterday in T-Bill yields took the market off guard and hints that to a great degree a genuine calm has still not been restored. From the Financial Times, ”The yield on one-month Treasury Bills fell 160 basis points to 1.34% in early trading, while the 3 month Treasury Bill tumbled to 2.51% at one point, 123 basis points below Friday’s close — a sharper fall then during the October 1987 stock market crash.”
“We had clients asking to be pulled out of money market funds and wanting to get into Treasuries,” said Henley Smith, fixed income manager at Castleton Partners. “People are buying T-Bills because you know exactly what’s in it.”
Above: the 30 day spread on Commercial Paper versus Treasury Bills.
It is at times such at these where all moves on behalf of the Fed need to be carefully attenuated. Those looking to the Fed for a solution to ‘make it all go away’ are in many ways, grossly exaggerating the power of the Fed. In today’s credit crisis, the lack of liquidity is emanating from an abject fear surrounding credit quality. Is this system permeated with bad CDO debt? Increasing the supply of funds by injecting money into the system may allow the “walking wounded” another day to inhale fresh air, yet in the end, it will do nothing to embolden those making the decisions to lend out funds that creditworthiness has been restored.
Put another way, the Fed can create the conditions where there is ample liquidity in the system, but the Fed cannot force the market to create new credit. In a debt contraction, the Fed needs to maintain its objectivity and not look to bail out public markets, otherwise, credit markets could turn savagely on government paper introducing an even greater crisis in the currency markets. For the Fed, the tight rope walk has likely just begun, and this time, it is crossing the street ninety-nine floors above the mid-town intersection. The entire dynamics seen in the last few days remind me of the first few chapters of Dr. Martin Weiss' fictional 1989 book, “The Money Panic.” In that book, he illustrated a classic financial panic, where a cascading credit contraction began in the commercial paper market and quickly infected the broader banking system. In the final chapters, as the crisis reached its zenith, the interplay between the Fed Chairmen and the US President went along these lines.
“I see,” the president said. “We want to bring the corporate bonds up to the level of the government bonds. What’s happening is precisely the opposite. The governments are falling down to the level of the corporates. In short, we are not lifting them up, they are dragging us down. The question is, “Why?” Why don’t they believe our promise, our pledge? Why haven’t we restored confidence? At the meeting, it was said that we can create cash, that the law gives us the authority to funnel this cash wherever we please. The answer is, we can create cash, but we cannot create credit. What’s the difference?" the president queried. "There is a very big difference. To create more cash, all we have to do is speed up the printing presses at the mint. And when we distribute it, no one is going to turn us down. But to create credit, we have to convince investors and bankers to make loans to each other, and in this environment of falling confidence, I can assure you that is not easy.”
From: The Money Panic 1989 Probus Publishing
In the book, the raging credit contraction was summarized as follows:
“The crux of the problem was this: Either side of the debt pyramid — illiquidity or inflation fears — forced interest rates higher then they would have been otherwise. No matter what the politicians did, and no matter which way the economy went, until the debts were reduced, those interest rates could not come down to normal levels.”
The diagram above illustrates the “Catch 22” embedded in the Credit Markets and embodied by Corporate-Government Quality Spreads. In the book, when the government intervenes to “too great an extent,” quality spreads narrow, with ‘Treasuries’ falling toward ‘Corporates.’ While this was just a fictional book, the dynamics of today’s credit market contagion may rapidly force the Fed to stand aside, “hands tied” by the market instrument, and a Fed “Box” created by years of interventionist policy. Today, we find that the “Greenspan Put” established a terrible moral hazard, a moral hazard of the worst sort, and for the Bernanke Fed, the time to come to grips with the Federal Reserves proper role in aiding the private sector is now rapidly coming to the fore. With the inter-connected nature of global markets, and the Chinese government threatening the use of the Financial Nuclear Option only weeks ago, it is a very touchy tight rope indeed.
China threatens 'nuclear option' of dollar sales
By Ambrose Evans-Pritchard. Last Updated: 8:39pm BST 10/08/2007
The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.
Fistful of dollars - China's trade surplus reached $26.9bn in June
Two officials at leading Communist Party bodies have given interviews in recent days warning - for the first time - that Beijing may use its $1.33 trillion ('658bn) of foreign reserves as a political weapon to counter pressure from the US Congress.
Shifts in Chinese policy are often announced through key think tanks and academies.
Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels.
It would also cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession. It is estimated that China holds over $900bn in a mix of US bonds.
Xia Bin, finance chief at the Development Research Centre (which has cabinet rank), kicked off what now appears to be government policy with a comment last week that Beijing's foreign reserves should be used as a "bargaining chip" in talks with the US.
"Of course, China doesn't want any undesirable phenomenon in the global financial order," he added.
He Fan, an official at the Chinese Academy of Social Sciences, went even further today, letting it be known that Beijing had the power to set off a dollar collapse if it choose to do so.
"China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency. Russia, Switzerland, and several other countries have reduced the their dollar holdings.
"China is unlikely to follow suit as long as the yuan's exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar," he told China Daily.
The threats play into the presidential electoral campaign of Hillary Clinton, who has called for restrictive legislation to prevent America being "held hostage to economic decisions being made in Beijing, Shanghai, or Tokyo."
Over the last few weeks, the downside action in the S&P 500 and other major indices has been well confirmed by the action in the daily Advance-Decline Line. To date, accelerated rising trendlines have been broken, long term moving averages violated. The price action is 100% consistent with an emerging bear market of high strength and intensity. The Defensive strategy outlined in these articles in the last two months remains in place as priority #1 for today, remains the return and protection of one’s money, not the return on one’s money. While there have been some minor issues with a very few money market funds, for the most part money market funds still yield a very nice 5% which looks very attractive when compared to the harrowing roller coaster ride seen daily in the stock market. Will the Fed cut rates at its next meeting, or in October? In our view, the Fed tight rope mandates a “Dollar” conscious component, and if the Fed is to hold to its true mandate, then we may see more time pass and require substantially larger problems before aggressive rate cuts are issued. For the hopeful bulls, the panacea of Fed Cuts could prove to be a misplaced hope as it was during the last bear market between 2000-2002, and as it was during the Great Depression 1929-1932.
The DJIA ended lower on Tuesday finishing down 30.49 index points at 13,090.86, with the S&P 500 up 1.57 index points at 1447.12, and the NASDAQ higher by 13.05 at 2521.64. That’s all for now,
© 2007 Frank Barbera