Green Shoots Into Dead Weeds?
The popular consensus has become that the economy has “bottomed” and will most likely resume growth by the end of the year. Even a lot of bears like Paul Krugman and Nouriel Roubini are now more concerned about prolonged stagnation rather than continued economic collapse.
I’m just not buying it. Since learning about our problems back in 2006, I always anticipated that we would follow the Great Depression route and in real (i.e. inflation adjusted) terms I feel no differently today. The Great Depression played out as a major drop in late ’29 followed by a slowing and minor bounce in 1930, with a strong and prolonged collapse that reached its peak in 1932. Our system held together better from the initial strain (I thought it was going to go in Fall 2007) but seems to be doing a similar thing now.
When looking at assets over the three periods, the best way to describe the Great Depression is large drop in equities and bonds of poor companies, with little effect on bonds of good companies; a huge rally in equities and credit of poor companies, with a minor effect on credit of good companies; a massive collapse of credit for companies of all types, extinguishing credit and leading to a sustained downturn in equities. One of the stock quotes about the Depression is: “Just when we thought it was over, it was really only beginning.” That quote is referring specifically to the collapse in bonds that precipitated the worst of the Depression.
One of my greatest concerns was always that the amount of bad debt we had in the system was so large that it was unmanageable and would lead to massive defaults. I thought it was imperative that the government not take all that debt on its balance sheet or else it would threaten the ability for the government to function as it would be difficult to sell bonds and lead to a wildly fluctuating currency that would curb trade. When they started such purchases in the fall it was like a bad dream and I felt kind of insane, since the dangers were so obvious to me, but everyone else (even people whom I respected for seeing it come) felt like it was no big deal.
And in that context, the last week has been worrying. I wouldn’t say that it’s cause for huge concern so far, but over the last four days yields on the 10 year have gone up 0.5%. The Fed said that it would start with purchases when it was at 3.0%, and now it is currently at 3.7%. As I wrote at the time, the Fed wasn’t doing enough to actually affect interest rates but was leaving open the option of “monetization” if its bluff didn’t work. Well the bluff isn’t working and that is what has China, etc. developing more concern.
I believe the chance of hyper inflation is remote. I think it is far more likely that creditors will realize that problems are far bigger than the US Government can handle, and fear that it will try to take them on will cause flight from bonds. This will lead to a large interest rate increase and choke off any prospect of growth*, leading to the second, larger wave of the crisis.
For example, mortgage rates exploded today. OK, so Denninger is a tad alarmist, but still, that data is real. It was such a large move that even the general-interest deal site SlickDeals.net had the topic on their front page. A 0.75%-1% jump in mortgage rates in a day is definitely cause for concern if it’s not unwound over the next few weeks.
Even while stocks have been rallying the last couple of months, the reality is that the underlying ability of the economy to service its debt has been steadily deteriorating. The bulk of defaults are yet to come in housing, and the number of foreclosures over the next year (or 18 months at least) will dwarf the number of foreclosures thus far! Meanwhile, commercial real estate and credit cards have imploded, and will lead to hundreds of billions in further write downs. It should be remembered that the IMF projected we are only 1/4 of the way through global writedowns and about 1/3 of the way through US writedowns. In addition, it should be remembered that higher interest rates lead to lower house prices, and a large increase in interest rates will push those down even further and cause more defaults…so the projected losses are most likely on the low side.
If government bonds are selling off strongly (or the dollar does if the Fed prints to buy bonds) then there will be no way that the government can continue to prop up the banks as these writedowns continue to grow, and will lead to an event larger than September 2008. Hopefully it’ll turn out that the last few days (and today’s mortgage action) was a blip due to trading, but we shall see.
* It should be noted that the official line is that the sell off is due to the prospects of economic recovery and thus people are chasing higher yields. This line is ludicrous because out of the other side of the mouth they are saying that we will need to keep 0% interest rates for the foreseeable future, and no companies are projecting increased profits.