Money Sage (archive)

The stock market panic is escalating. We are led to believe that a major component of this sell-off is the dumping of large quantities of solid -- and not so solid -- stocks by hedge funds and other highly-leveraged speculative players who have lost huge sums gambling in the mortgage-backed and junk bond markets, and who are now desperate to raise cash by selling whatever salable assets they still possess in order to avoid bankruptcy, liquidation, disaster.

There is, of course, absolutely nothing new about this. The history of financial manias and subsequent panics is replete with such examples. Indeed, every speculative frenzy develops in the same way, and only is enabled by the leveraging of liquidity to reach the maniacal phase from which it inevitably crashes and typically produces a general financial panic, an acute liquidity crisis, and, ultimately, an economic depression. Immense capital destruction ramifies through the economy.

Of course, we have been living for 60 years under the illusion that this sequence of events would not again transpire TO SUCH A DEGREE THAT IT WOULD RAISE THE SERIOUS RISK OF A GENERAL DEFLATIONARY COLLAPSE, such as those which have punctuated American economic history (1830s, 1850s, 1870s, 1890s, 1930s). Unfortunately, there has been a very significant LACUNAE in maintaining the indispensable barrier to a truly resounding crash, with depressive implications. This gap consists in the FAILURE OF THE REGULATORY MECHANISM. This mechanism was created by Congress with the precise intention of containing speculative manias -- an inevitable cyclical phenomena fuelled by herd behavior -- before they become so large that the inevitable collapse threatens to generate a deflationary shockwave which can produce a general economic DEPRESSION (D-word, NOT R-word). This mechanism, of course, is the FEDERAL RESERVE. The FED has several key responsibilities, one of which is to PREVENT PRECISELY THE TYPE OF SPECULATIVE FRENZY IN REAL ESTATE AND SUNDRY LEVERAGED INSTRUMENTS ENABLING A DANGEROUS DEGREE OF OVERSPECULATION. The Greenspan FED registered GROSS FAILURE OF VAST MAGNITUDE in declining to avoid its responsibility to regulate the banking system. This is the Greenspan FED's true legacy.

Of course it is true that Dr. Bernanke and other current colleagues did occupy policymaking positions at the FED for varying lengths of time during the Maestro's sway. However, we will accept the conventional wisdom that Greenspan pretty much dominated FED-decision-making. Still, this hardly exculpates his fellow FED GOVERNORS and REGIONAL BANK PRESIDENTS.

And now? Are the markets sending a signal?

You better believe it.

And what is that signal?

The Treasury bond market has been signaling deep economic trouble and potential DEFLATION ahead for well over a YEAR. This has always been the meaning of a yield curve inversion. Today, Treasury bond prices continue to skyrocket, all the persistent nay-saying of the FED, of economists, and of Wall Street gurus to the contrary notwithstanding. The bond market MUST BE NUTS: AFTER ALL, IT IS SENDING A SIGNAL NO ONE WISHES TO BELIEVE! More dangerous still, it is continuing to send this signal even as the FED is supposedly taking sufficient measures to preclude the deflationary prospects the Treasury market has been signaling for more than a year. The more DENIAL from Greenspan (the curve inversion he proclaimed to be a "conundrum") and Bernanke (he claimed it was the result of a supposed "savings glut," not a meaningful signal,) once the Greenspan FED had determined to renew the liquidity tightening process subsequent to the passing of the 2002 deflation scare, the longer the FED has been able to raise rates dangerously high and force liquidity dangerously low. Now, the chickens are indeed coming home to roost.

And the stock market? The stock market is merely confirming what its more mysterious and arcane cousin, the Treasury bond market, has been signalling for many, many months. The stock market draws infinitely more attention, and has an inescapable impact on policymakers for very obvious reasons -- it is NOT deniable, it immediately affects household wealth, it scares corporate executives whose mood and perceptions determine the level of business investment and corporate spending. However, the Treasury market is a FAR MORE RELIABLE AND FARTHER SEEING FORECASTER THAN THE EQUITY MARKET. The Treasury market is the seer; the stock market is the herd.

Now, the herd is stampeding. This is the delayed, or perhaps we should say the REFRACTED RESONSE to the deepening credit contraction. While the stock market is quite retarded relative to its far more prescient and more sophisticated cousin, the bond market, it is still way,way ahead of the economy.

The FED, in conducting a monetary policy based upon the emotions and desires of its policymakers, disguised as being rationally-based upon CURRENT OR RECENT DATA and LAGGING INDICATORS has been able to proceed along its merry way until this autumn. But to what end?

The FED has now brought us to the brink of deflation. The deflationary threat is a multiple of what it was in 2002, when the FED was seized with a deflationary panic. This time the threat is real. The FED is panicking on schedule, exactly as we predicted late last year (please click here and here). The question is: are they too late? We do not know. We hope not. We think they may have awakened in the nick of time. However, what we "think" doesn't really amount to a hill of beans. We will await the verdict of the Treasury market and the equity market.

The general bearishness of the gurus on Treasuries (too expensive, too high, rates too low), together with the bullishness of key gurus on stocks suggests that we are a lot closer to a deflationary collapse than the "experts" believe -- or choose to believe -- or choose to profess to believe.