Sunday, October 26, 2008

A Little Credit

That really is all that is available in the debt markets today and the consequences are obvious. At the same time, we'd like to claim a little credit for calling the direction and - to some extent the magnitude of this crisis. We felt that these (then pending) consequences were obvious 18-24 months ago. In fact, one of the first posts on this blog in August 2007 noted:

Today's actions by the European Central Bank and the Federal Reserve confirm that the real threat is DEFLATION - not inflation. Central Banks don't pump $150 billion dollars into the banking system because they are afraid of creating too much money.

Again this June:

That is where we are now. The Fed has failed. The Great Oz has been exposed a just a man behind the curtain. Prepare for severe credit deflation and falling asset prices in markets that traditionally use leverage to purchase or hold positions.

For years massive credit inflation raged unchecked and asset prices soared as the pool of buying power increased far faster than the assets available to absorb it. As the debt machine began to break down and collapse under its own weight, credit creation proved insufficient to continue propping up all asset prices. At this point the Universal Debt Bubble (UDB) began to falter selectively. First housing, then junk bonds, asset-backed securities, commercial real estate, equities, corporate bonds and sovereign debt all fell off the wagon in turn. By early 2008, the one asset class that had not yet been hammered was commodities - though in reality, that was also a fragmented market with the highest profile stuff still going up while nearly everything else was down.

Selected commodities proved to be the final bastion of credit-driven asset inflation - leading many analysts to mistakenly call for inflation when the exact opposite was looming. Credit creation has now fallen to such a low level that asset inflation is now dead virtually everywhere. Grains, metals and oil were the last holdouts of the UDB and they are now being hammered into the ground. The WSJ provides us with evidence and a salutary example of how demand destruction works in Metals Meltdown Burns Scrap Dealers:

Now demand and price are in a freefall. Does the Miami businessman sell his now high-priced inventory at basement prices, or wait for the market to recover?

...

But in the last six weeks, scrap steel prices have fallen nearly 60% to about $400 a ton. Prices for aluminum scrap has dropped 33%, copper 25% and nickel about 15%. Peter Marcus, metals analyst for World Steel Dynamics, says, "We aren't near the bottom yet."

For a while, the trend in price seemed to be in favor of commodity inflation. The reality was that the huge amount of "money" (really credit) created during the UDB has been running around looking for someplace, anyplace to hide and commodities were the last asset bubble it ran towards. But the economic function of bubbles is draw in such phantom "capital" and destroy it as if it had never been. The trend-followers and and performance chasers will never understand this as they are always late by definition. One has to take a systems analysis approach to understand how pulling a lever over here can impact things that have no obvious connection to the original stimulus.

The last bubble is over. Oil has collapsed from nearly $150 to less than half that. Grains are down 60% or more. Industrial metals are in worse shape than that. Deflation is now the order of the day. Governments will try to stop it but will fail repeatedly. They do possess the power to stop it before deflation runs its full, natural course but the price will be self-destruction and national suicide via devaluation and hyper-inflation. In this case the cure is much, much worse than the disease.