The Myth of the Slow Crash

[GRG55]

Re: The Myth of the Slow Crash

...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.

From the lofty heights of Wall St., with its breathtaking compensation, the entire rest of the world does look like a valley. Now that they are in danger of sliding off the peak, the chorus is calling for an alternate means of escape..."Somebody call Ben to send the helicopter. We need a "flight to safety..."

[Finster]

Re: The Myth of the Slow Crash

Agree. The only time I can recall the Fed admitting any reponsibility for anything was when Bernanke told Milton Friedman, at his birthday party, that the Fed caused the 1930's Depression.

You are more familiar with this anecdote than I am, GRG55. But Bernanke writings have suggested that the blame lay in the Fed’s having been too slow to ease when the bubble popped, rather than for in its role in inflating it in the first place. This is in contrast to Greenspan, who in a (pre-Fed) incarnation identified the Fed’s blunder with the first cause. Gold and Economic Freedom Greenspan was right.

I am not saying the Fed WILL deliberately try a sharp, short deflationary shock treatment on the patient; but IMO it's within the range of reasonable possibilities. Recognising it would take Fed courage (not an abundant character trait), in no particular order here's some reasons why they might try such a stunt, prior to the inevitable massive re-flationary actions (critique of the soundness of this line of reasoning welcomed):

• period of pain much shorter than the slow drip Japan deflation experience - assuming they don't screw it up;
• forces and concentrates the asset devaluation and debt write offs in the most egregiously inflated sectors (structured credit, real estate, finance sector equities);
• reduces risk of deflationary bleed-through into other parts of the economy by time-function quarantining the really sick part of the economy (the FIRE economy part);
• the more accumulated debt burden that can be euthanized in a deflation event, the less the Fed has to inflate away later, and the greater its future capacity to expand credit to goose the economy without creating excessive inflation;
• magic of securitization has stuffed every foreign pocket with US asset backed credit risk; Volker once pointed out that the Fed is not responsible for the effect of its policies on foreign economies, its only accountable for what happens in the USA.
• driving a wooden stake through the heart of the structured finance mania restores some future control over credit creation that the Fed lost in recent years.
• finally, it would cement Bernanke's reputation (genius if it works, goat if it doesn't) as the man who caused the Greenspan Put to expire and didn't cave in to Wall St's clamour for an immediate rate cut.

However, if they decide their mission is to act aggressively to prevent a recession then you are correct - a 5 handle is unlikely.

If Bernanke is a Volcker, then your scenario is well within the realm of possibility. There’s no denying the positive features of the getting-it-over-with-sooner-rather-than-later argument. But if he (as discussed above) believes the Depression was caused not by excessive Fed ease, but by too much Fed restraint …

[GRG55]

Re: The Myth of the Slow Crash

...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.

The vulture funds seem to be cashing up. Goldman, Blackstone, all da boyz are waiting to pounce. I would guess they are 1. waiting to see what the Fed and the Govt plan to do; 2. still raising their war chests; 3. waiting for someone else to be first mover; 4. trying to figure out how to value some of this stuff (yo, we need to build another model...). I would guess either they, or some Govt RTC-style entity, or both, will be the catalyst to get transactions underway again.

[GRG55]

Re: The Myth of the Slow Crash

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.

There were reports that continental European banks were so desperate to raise cash some were calling borrowers during the week of August 13-17, trying to persuade them to make their mortgage payments a few days earlier than contractually required...

[GRG55]

Re: The Myth of the Slow Crash

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…

Agree. The only time I can recall the Fed admitting any reponsibility for anything was when Bernanke told Milton Friedman, at his birthday party, that the Fed caused the 1930's Depression.

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…

I am not saying the Fed WILL deliberately try a sharp, short deflationary shock treatment on the patient; but IMO it's within the range of reasonable possibilities. Recognising it would take Fed courage (not an abundant character trait), in no particular order here's some reasons why they might try such a stunt, prior to the inevitable massive re-flationary actions (critique of the soundness of this line of reasoning welcomed):

• period of pain much shorter than the slow drip Japan deflation experience - assuming they don't screw it up;
• forces and concentrates the asset devaluation and debt write offs in the most egregiously inflated sectors (structured credit, real estate, finance sector equities);
• reduces risk of deflationary bleed-through into other parts of the economy by time-function quarantining the really sick part of the economy (the FIRE economy part);
• the more accumulated debt burden that can be euthanized in a deflation event, the less the Fed has to inflate away later, and the greater its future capacity to expand credit to goose the economy without creating excessive inflation;
• magic of securitization has stuffed every foreign pocket with US asset backed credit risk; Volker once pointed out that the Fed is not responsible for the effect of its policies on foreign economies, its only accountable for what happens in the USA.
• driving a wooden stake through the heart of the structured finance mania restores some future control over credit creation that the Fed lost in recent years.
• finally, it would cement Bernanke's reputation (genius if it works, goat if it doesn't) as the man who caused the Greenspan Put to expire and didn't cave in to Wall St's clamour for an immediate rate cut.

However, if they decide their mission is to act aggressively to prevent a recession then you are correct - a 5 handle is unlikely.

[Finster]

Re: The Myth of the Slow Crash

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.

I agree fed funds @ 5.25% was definitely, by far, lower than inflation for most of the past four or so years. But that changed very fast just in the past few weeks. We hit a deflationary cliff. If anything this highlights the non-utility of very slow, lagging inflation indicators favored by conventional econometricians.

The real financial markets, however, respond instantaneously. The new, lower natural level of interest fell through a cataract. So this normalization occurred, but rather than with respect to past inflation, it was with respect to a rapidly moving target.

With a big caveat, of course. The above does not take into account default risk, real or perceived. That is, it is limited to consideration of the risk-free interest rate. So it does not even attempt to address your contention that spreads are "still too low" …

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.

This is hard to dispute, given the infamously low degree of transparency in credit exotica. But worse yet, we have the veracity of credit rating agencies having been called into question. That being the case, shouldn’t we view the ratings as the tail and the actual market pricing as the dog? In other words, if the market is pricing a certain issue at X default risk and the rating agencies are assigning it a Y default risk, the market’s opinion is arguably more valid. So we have little concrete basis upon which to criticize spreads as being "too narrow" or "too wide", just armchair arguments. We will only have such basis for arguing whether risk was being mispriced when we can look back with 20-20 hindsight and identify areas that were being priced for default risk where it turned out to be rare and vice versa. Just as we can do now with issues once given AAA blessings!

[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.]

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

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.

[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.

[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.

[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.

[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

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…

[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.