• Home
• /
• Business

This is Not Recession but Debt Deflation

Obamanomics vindicates the ancient Chinese curse that “may you live in interesting times”. The most interventionist American government since FDR has clearly changed the rules of the game in the financial markets on a scale guaranteed to trigger Republican outrage even as Citigroup becomes a ward of Uncle Sam.

By Matein Khalid

• Follow us on
• 
• 
• 

Published: Tue 3 Mar 2009, 12:21 AM

Last updated: Thu 2 Apr 2015, 7:43 AM

This is no mundane business cycle recession but something far more ominous, a debt deflation unlike anything we have ever experienced.

In fact, I can think of only four episodes in modern finance when bank shareholders were wiped out, central bank balance sheets exploded, commodities prices sank, corporate cash flows proved unable to service debt, governments began a witch hunt of disgraced financiers, international trade credit lines were slashed. The world of 2009 bears an eerie resemblance to the economic nightmare that swept America in the 1930’s, Weimar Germany in the 1920’s, Japan in the 1990’s, Brazil and Argentina in the early 1980’s.

This is a classic Nassim Taleb black swan event, a world without rules, a world running on the whims of Congressmen and a President determined to impose an anti-capitalist, populist economic agenda. It is imperative that investors in the Gulf not underestimate the sheer trauma of debt deflation on the value of their homes, properties, businesses, shares and currency holdings in 2009. It is fatal to ignore thin tails in the probability curve, to confuse a liquidity squeeze with a solvency crisis, to try to bottom fish in a black hole, to navigate minefields of a debt Armageddon.

Investment implications of debt deflation?

One, $5 trillion in global consumer bank and sovereign debt faces write offs and default.

Two, bank credit growth will plummet as entire banking system capital is wiped out.

Three, Obama’s stimulus is too mild to revive GDP growth, as was Bush’s tax cuts.

Four, with the securitisation model extinct in banking, property values will fall another 30–80 per cent from current levels depending on the specific case.

Five, Superdollar will be king of forex. Note the dollar rose almost 5 per cent against the Japanese yen last week, a per cent against the euro, swissie, Canadian dollar and pound sterling.

Six, commodities are the kiss of death in a debt deflation.

Seven, recessions last 18 months, debt deflations last a decade.

Eight, every major buildup in debt by a reserve currency state (the Roman Empire two millennia ago, Victorian Britain, post Bretton Woods America) has only one endgame. A catastrophic devaluation. Devaluation is a de facto invisible default. The Roman dinari, pound sterling and the dollar’s fate should warn us about the tsunami of wealth destruction that is inevitable now that Uncle Sam is in the saddle in Ground Zero of the credit tsunami. Lord Keynes called the cynical manipulation of a reserve currency “signorage”, the modus operandi of the US Treasury.

While it thrills me to revel in Platonic philosophical musings on financial markets and geopolitics, it is imperative to make money next week. So I expect the Old Lady to cut by 50 basis points and embrace quant easing (buying gilts), a downside risk to cable if we break 1.41. The Japanese yen will bounce off chart support at 96.80 for a 100-102 target. Selling Euro-Norwegian kroner is my trade de jour to take advantage of the debt time bomb in the Balkans, Baltics, Hungary and Ukraine that will gut the balance sheet of German, Austrian and Italian banks. Norway’s consumer spending and industrial production is a lot more resilient than the Eurozone, so selling EUR-NOK for a 8.20 target is not unreal. The RBA will give me reason to buy the Aussie against the Kiwi. A mutiny against Trichet is brewing in the ECB and Euro-Sterling will be a victim. Selling Canada was a great idea now that we are at 1.27, as was selling the Indian rupee, where we are headed to 52. The long gold trade is my Chicken Little hedge, but only will commit new money at $780 or so major support. Motto of next week’s trading “Sayonara, Aso-san, Dai Nippon and honorable yen.

It is no coincidence that emerging markets currencies were gutted after the collapse of Lehman Brothers. When the securitization Ponzi scheme collapsed the Eurodollar/Treasury bill risk spreads (the TED, a proxy for international bank credit risk) escalated after the interbank money markets froze in October, the world was trapped in history’s greatest dollar short squeeze. The dollar’s surge against the Euro, the Swissie, the Aussie, Kiwi, Sing et al had everything to do with risk and architecture of capital markets, with the hyper-volatile pools of digital hot money worldwide, as with Fed policy or short rate differentials. This is the paradox that falling equities or nasty US data leads to dollar strength even if US Treasury yields fall relative to say, German bunds. In essence, the greenback has decoupled from American economic softness and the woes of Wall Street money centre banking while the Euro, sterling and the Swiss franc have not.

Commodities are a natural loser when King Dollar is a rampage, even though Obamanomics (tax, regulate, spend, banker bash, rewrite mortgage contracts. a trillion dollar Uncle Sam borrowing binges) has been nirvana to the goldbugs because it seriously resurrect the nightmare scenario of the Weimar Republic. Not even the Chinese fiscal stimulus will trigger a Rip Van Winkle bull market in copper, crude oil, zinc, aluminium or nickel, despite their steep losses or the economics of marginal production. This is the reason I believe that not even Opec supply cuts can prevent oil prices falling below $30. Of course, the fall in commodities also means that deflation risk will dominate the thinking of central bankers.

The biggest macro impact of the collapse in Chinese export markets and Beijing’s fiscal stimulus is a slowdown in reserve accumulation at the Peoples Bank. This means it is inevitable that foreign buying in the US Treasury bond market will shrink even while US banks, with collapsing loan to deposit ratios as the US consumer deleverages, buy Uncle Sam IOU’s, on a scale never seen in history.

The Fed’s toxic asset book will be financed by the issuance of Treasury bill, notes and bonds to the US megabanks. In fact, the Bernanke Fed has explicitly stated he will buy US Treasuries, as the Bank of Japan did in the 1990’s. Yet the JGB yield shrank to 0.5 per cent in the 1990’s? So why cannot the ten year T note yield 1 per cent or lower? Obamanomics budget deficit will surely prevent such a scenario in the bond market. Not at all. Japan had (and has) the West’s highest public deficit to GDP ratio even while its JGB bond yield shrank to near zero.

It is tough to be bullish about China as the communist Party faces its first global depression. With 20 million jobless migrant workers in the Middle Kingdom, I doubt if rate cuts or fiscal stimuli alone will ignite economic growth at a time of wage cuts, price deflation, falling exports and closed factories. Will handout to Chinese peasants (with per capita income at 5-10 per cent of their US peers) save the global economy? Dream on. Like it or not, debt deflation is now the new reality of our times. Even though a Fen Shui analyst predicts a revival in property prices in a month, my macro tarot cards argue exactly the opposite. As always, time will tell.