Saturday, December 30, 2006

The Specter of Deflation

I have said before that deflation seems the most likely outcome of the current path the U.S. housing market seems to be on.

It comes down to spending. Americans do a lot of it, mostly on credit. This presents a problem. Over the last few years home prices in the U.S. have skyrocketed. This led to a psychological phenomenon we called the ‘wealth effect’.
Equity extraction, (liberation of that extra home value into spend-able cash) resulted and reached historical highs in 2005 and 2006.

The U.S. housing market began to show cracks in 2005 and that signaled an impending end to the equity cash liberation and the spending it was currently fueling.

U.S. domestic spending is 70% of domestic economy. Spending is now anemic and dropping faster than home values.
This is a major choke point addressed in Michael Nystrom’s article. Credit can not expand if no one is borrowing.

Mr. Nystrom goes on to predict how this end to credit expansion will most likely play out as deflation.

After all, if no one is buying, how does one raise prices on goods?

This peice on deflation from Bull Not

From what we know of economic history, credit expansions lead to economic booms - this much is clear. What comes next is still up for debate. Austrian economist Ludwig von Mises tells us
"The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The credit expansion boom is built on the sands of banknotes and deposits. It must collapse. There is no means of avoiding the final collapse of a boom brought about by credit expansion."

Wednesday, December 27, 2006

Where does the money come from?

Hedge funds and derivatives are still a gray area to me as they may be to many readers of my blog.

Carry trades are a little easier to understand; borrow a currency from a country with low interest rates and buy currency in the form of bonds of another with high interest rates, pocket the difference and Bob’s your uncle.

If you are like me you might wonder where all of the money is coming from to fuel the orgies of mergers and acquisitions that we have seen lately. Professor Succo addresses this in the article below.

There are a lot of financial shenanigans happening right now making many young traders a lot of money. The playing field is not level and this leaves the door open for those who would behave badly.

One concern that Professor Succo’s letter to Mr. Stein does not address is the possibility that some of the foreign central banks buying U.S. dollars and assets may in fact be hostile and could participate with one another in a coordinated financial attack on the U.S. economy.

I think it goes without saying that the longer these equity schemes are in play the harder the correction will be as Professor Succo points out.

Timed correctly a coordinated shift of assets could cause a lot of problems for an economy already on a fraying tightrope. Whether or not that happens the result of a correction in the derivatives market is sure to have a bad effect not just in the U.S. but the whole global economy.

"This situation is very unstable in the long run. The Federal Reserves’ balance sheet this year alone has expanded by $30 billion in this way and created $3.5 trillion of new credit in the U.S. Public debt around the world is growing exponentially and total debt in the U.S. now stands at nearly 3.6 times GDP (1929 was 2.8 times)."

Read the full article, Global Savings Glut Revisited at:

Tuesday, December 26, 2006

A look back at FOMC statements in 06

I find it interesting to go back occasionally and look at what was being said leading up to large events like the deflating U.S. housing market.

To be fair I have to say that professional economists or anyone with a career to protect will tend to stay away from the edge, preferring to use conservative language, so let’s not fault them for that. It is on the other hand interesting to see how the FOMC chased the market down in their statements on housing. Have a look.

This from: Paper-Money

The most significant result of today’s FOMC meeting was the simple insertion of the single word “substantial” in their statement regarding the housing decline.

It appears that Bernanke and the other Fed officials are not only firmly aware of the extent of the housing downturn but they are now also willing to share their outlook publicly.

Let’s examine the changes made to the FOMC housing sentiment in 2006.

“The Committee sees growth as likely to moderate to a more sustainable pace, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.”

“Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.”

“Economic growth has moderated from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.”

“The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market.”

“Economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market. Going forward, the economy seems likely to expand at a moderate pace.”

“Economic growth has slowed over the course of the year, partly reflecting a substantial cooling of the housing market. Although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over coming quarters.”

Monday, December 25, 2006

Global economy faces a dangerous year

From: Asia Times online
Read full article at:
"The combination of rising defaults, foreclosures and falling collateral values is beginning to weaken the balance sheets of mortgage lenders, including several of America’s largest banks. Growing weakness in the banking sector is very alarming. Banking sector and economic crises in many countries over the past 25 years can be traced to overly enthusiastic credit growth used to finance either capital investment or real estate speculation, or both. Japan offers a stunning example of what can happen after a real estate bubble bursts."
Given all the possibilities for economic trouble in 2007, many economists overlook the psychology of downward momentum. The perception of the average person that things are sliding south can put the brakes on spending, investing and other lesser monetary activities. This counts, after all, it all comes down to the consumer doesn’t it?

Dow component companies that are experiencing rapid stock price gains will eventually have to substantiate P/E ratios to actual end user sales, not private equity group stock purchasing.

Joe Six-pack has stopped spending.
His wages haven’t risen much over the last decade, his house is starting to drop in value (no more equity loans). He faces higher home payments now due to that second mortgage he took out to extract real cash from his domicile which he used to buy his new Dodge Ram pick-up truck. He might still have some of that money in the bank, but do you think he is going to spend it now?
Chances are greater that he has already set those dollars free and is back to the old 9 to 5 to pay the bills and he’ll be lucky if a cooling economy leaves him with even that next year. The economic environment has become a little hostile toward the average Joe.

That simple fact will have a ripple effect that will touch the whole global economy. 2007 promises a bumpy road.

Friday, December 22, 2006

Credit contraction is upon us

Note: I have moved from
You can go there to see previous posts.

It was only a matter of time before it happened, the massive expansion of credit reaching the stall point at the top of the stratosphere before gravity took hold and pulled it Earthword once more.

We are all borrowed out! We have no more room to fit additional payments into our over-stretched budgets, now that our personal ATMs (home values) are no longer rising in value.

I have maintained that mid February 07 will produce unpleasant economic numbers which will no boubt have a wet blanket effect on a now foundering housing market. The implications of that will be widespread.

Increasing volatility in economic and currency markets will surely be a precursor. Look no further than Thialand's actions to curb currency speculating last week. Volatility will spread to the stock markets and other areas as well and I expect sooner than later.

Mish Shedlock had some interesting things to say today.
Read the complete article at,

On Minyanville today Professor Bennet Sedacca citing Ned Davis research reported: Credit exposure relative to risk based capital by the top 5 banks rose to a record 433.5%.
Am I the only one that senses a future changing priority of banks away from ever increasing credit exposure?
What about consumers? You can already see a shift away from buying condos, second homes, furniture, appliances, remodeling, etc. Consumers are cutting back. Willingness to take on more debt and ability to take on more debt have changed. Those problems are highlighted in decreasing profits at Circuit City, cutbacks at Home Depot, and UPS. Where is the need to expand?

Bankruptcies and foreclosures are massively rising, in some states as much as 300%. That is forced credit contraction. And as priorities of consumers and businesses shift away from expansion and risk towards risk avoidance and debt paybacks, we are of course talking about a shift from inflation to deflation. We are right there right on the cusp and "changing priorities" will seal the fate.Note: Changing priorities will be one of the subject of tonight's podcast on Howe Street. Ironically enough, it was changing priorities that caused this delay from our normal Wednesday schedule. Tune in and find out.
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