How is it now then that some form of political agreement on the debt ceiling and budget deficit can be so negatively perceived by the markets? Wouldn’t one expect that a reduction in uncertainty would tend to (all things equal) lift markets? Apparently not today. Rather we have had a continuance of the three major trends which led up to the congressional action today: a run up of Gold, the Swiss franc, and the Yen against the dollar – combined with a drop in the stock markets and falling long bond yields.
Our good friends at zerohedge tell us that the market is pricing in economic contraction and deflation. Considering I have most of my assets in liquid issues I personally would love that outcome however that sort of price action simply isn’t allowed to happen on a broad scale in the Keynesian economic plan. So is the market saying that the Federal Reserve and Congress are abandoning Keynesian economic theory (ie spend more to make more)? I wouldn’t bet on it if I were you.
The Problem with Gauging Market Reaction
Watching intraday movements like today and trying to interpret them correctly is a fool’s errand. Was there an element in the market that had made leveraged bets on dollar plunge via default? It seems that way given so many of the “risk on” currencies are falling off their early week peaks today. Everywhere you look you see carry trade covering-like trades, Yen rising, Swiss franc solid in the black, US dollar up against everything but (perceived safer haven currencies) Yen, Swiss franc, and gold.
The buzzword of this whole crisis has been liquidity. The Lehman collapse and subsequent bailout were necesitated by what industry insiders called “liquidity tightness.” What exactly does that mean to an investment banker versus the guy buying a house with a mortgage? Seems to me there is a considerable difference between the two. I’m tending to believe that what insiders refer to as credit tightness may have more to do with fewer borrowers willing to sign mortgages, a.k.a. a demand problem rather than a supply problem. Consumer credit / debt levels have been falling with great regularity in the monthly measurements, which leads me to believe the mechanism behind the fractional reserve system is contracting at the consumer level, regardless of Federal Reserve policy activity.
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The Argument for Deflation
It seems to me that the biggest driver of global economics in the fractional reserve system is the demand for money via credit borrowing. Given consumer loans can be fractionally leveraged the most in our economic system it stands to reason that the more consumers of credit stand aside, the greater the impact on the overall leverage in the system. Given that increased leverage inflates all prices (except that of debt), it stands to reason declining leverage reduces all prices (again except debt). So if debt has been demoninated in treasuries, the Swiss franc, the Yen, and gold (and they are rising)… and assets bought with that debt (stocks, real estate, and durable goods) are falling, then one can reasonably conclude the race for deflation is back on again – after we had given that argument up for dead whilest the Fed continued its POMO buybacks.
