On my last entry, I wrote about how the US is creating false GDP. Basically by counting the government spending, debt, as growth. Another way of putting it, is if I had a job(the economy) but wasn’t making enough to buy some clothes. So I used a credit card(selling bonds) and I went out and bought clothes(fake GDP) and went into debt to do it. I would then say the purchase of the clothes is growing the economy. As we can see, it’s not really growing the economy because we are doing it with debt that needs to be paid back at some future point with interest. In other words we are spending money we don’t have or that we think we will have sometime in the future. If we had an economy that was really growing, we wouldn’t have to go into debt each year to a tune of about 600 billion.
Now the Fed is tapering and we are reducing our debt spending in government. All this happening at about the worst time. This should have taken place in September of 2013 of last year when we had more growth. Second and third quarter GDP of this year will tell a lot. The growth thus far has not been impressive. See chart below.
Why am I harping on growth so much? Well my argument has been that the US has never really escaped the deflation it felt in 2008. There is still more to go before we can grow again. QE and debt spending have both given us a false picture and hope. The implementation of these vices have only created more money supply and expanded our debt to unheard of levels. At some point these instruments or tools won’t make a dent in growth. Look at Japan. All these years of QE and still growth is nowhere but their debt is 240% of GDP.
We talked about foreigners buying our bonds. This week the 30 year was in high demand as the bid-to-cover ratio rose to 2.69 from a 2.45 average. This is the highest level in 16 months. The 30 year since the auction has posted further gains and is up 30/32 in price and its yield has fallen further to 3.417%. Are investors moving back into safety? Do they see the deflation move on the horizon?
Having deflation take over at this point would be extremely dangerous to total credit market debt. Credit markets are an indication of the overall health of the economy. These markets are much larger than the equity markets in dollar terms. The credit market shows us that companies are seeking to raise funds through debt issuance. Companies raise funds because they expect growth or are having growth. Also if there is more demand from investors it will prompt companies and lenders to issue more bonds, and this will spill over into the equities market.
Below is a chart of Total Credit Market Debt.
Credit markets are an indication of the overall health of the economy. These markets are much larger than the equity markets in dollar terms. The credit market shows us that companies are seeking to raise funds through debt issuance. Companies raise funds because they expect growth or are having growth. Also if there is more demand from investors it will prompt companies and lenders to issue more bonds, and this will spill over into the equities market.
Below is a chart of Total Credit Market Debt. You see the small dip that occurred during 2008. We are beginning to flat line at the top and looking at this with a technical eye, that means a correction or a credit contraction. Another sign of deflation at our doorstep and another sign that dollars will evaporate as defaults increase, job layoff become more abundant and prices fall. Banks may be force to write down these loans in the billions. Their dollar liabilities may out way their dollar assets. Instead of rolling over this debt, cough China, they may buy dollars in the spot market to repay debt. When dollar evaporate, dollar strength increases. Less of something, it becomes more valuable.
Another item we must look at is the unwinding of the carry trade. If the idea of deflation is here to stay grabs hold of the markets, we could see an unwinding in the carry trade. When financial markets become very volatile, modest day-by-day yield differentials captured by carry trades pale in comparison to possible daily losses. So investors at that point would reduce their exposure to risk. So currencies like the Kiwi and Aussie with lucrative yields would suffer the greatest losses. Hence my NU, GN, EN prediction of being a Kiwi bear. On the other hand the funding currencies like the JPY, USD or CHF would appreciate. I would add EUR to the list of funding currencies now with their last drop in rates.
What about countries that have accumulated dollar assets well beyond their dollar deposits? They may be funding the deference in the interbank and other wholesale markets. If they are doing this in currencies besides their own, it could cause an imbalance. If for example a bank in Great Britain invested in assets over in the US and the US didn’t invest equally in assets in Great Brittan, and there was a crisis where these banks had great exposure, the interbank market would dry up. They would rely on the swap lines but as they would swap pounds for dollars there would not be the same demand from US banks from dollars to pounds creating a shortage in dollars. US bank expand their foreign claims more conservatively. This could also strengthen the dollar.
So our augment for dollar strength is this. First, low to no real growth in GDP. Second, a possible flight to safety by the purchase of long term bonds. Third, the deleveraging of debt in the credit markets and banks exposure to debt. Fourth, the possibility of the unwinding of carry trades due to volatility. Fifth, banks of other countries that have accumulated dollar assets beyond their dollar deposits. We see these possibilities forming and will be vigilant in watching when these forces begin to take over creating dollar strength.