On November 3rd, I wrote that the market was already stating deflation in the US was on its way. TIP yields were priced way above treasury yields, even correcting for recent large capital flight into the US.

Today, the market reacted to the  price declines in the UK and the US for the month of October:

• For the US, prices declined by 1% for the month of October
• For the UK, October hosted the steepest drop in prices since 1997

Lesson one: even in illiquid times, its hard to bet against the market.

Here are a few reasons why it is not surprising to see price declines of this magnitude in either country.

• I would argue most importantly, both countries have witnessed massive home value declines. Essentially, every family in each country was forced to estimate their now reduced net worth (with great uncertainty) and reign in spending on everything from cars to consumer durables.

• Oil, which both countries import, has declined almost $100 a barrel in the last few months. The fact that oil has declined has two profound effects:

1. While the FED dismissed energy as part of core inflation, increases in energy increase the cost of goods produced and sold (including food), increasing prices throughout the economy. In turn, a decline in energy should result in a decline in all prices.
2. Increases in import prices put stress on the balance of accounts, forcing currency devaluation, which in turn increase prices in the short term. Therefore, a decline in imports (as oil has declined) should improve the current account balance, improve currency (as the dollar has strengthened) and reduce prices.

However, now the UK and the US are in two different positions.

• The UK has a base rate of 3%

• The US has a base rate of 1%

The UK therefore has greater room to maneuver. The US has all but exhausted its monetary toolkit to fight deflation and grow our economy. All but certain, the Fed will slash rates by 50 basis points this December, and perhaps provide guidance it will not increase rates anytime soon.  When Obama assumes office, the new administration can only (and must) invoke a massive fiscal stimulus to revive the economy, hopefully in the form of infrastructure spending and tax cuts.  Across the pond, The UK still has the ability to do both to fight deflation and revive its economy. Further, a decline in rates for the UK should further reduce the Pound, allowing the UK to help export its way out of this malaise. The US does not have this luxury.

While many in the US are against government spending, I hope they realize that as of now, we do not have a choice.

Remember the good old days of 2006-07?

On a random January 17th, 2007 3-Month LIBOR was 5.36%. Yet two treasuries were bidding 4.91%. The Fed Funds target rate was 5.25%. In short, spreads were short.

More amazing were Emerging Market Bonds and the market’s confidence in sovereign performance.

• On that same January 17th, 2007, the Ukraine’s debt expiring in June, 2013 was priced only 1.35% higher than US government bonds of the same duration.
• South Africa was only 0.97 basis points more and
• Russia, the country that would 18 months later invade Georgia, had debt set to expire in March, 2030 only 100 basis points more than the US treasuries.

(sigh)

The picture is significantly different today.

• At market close on November 12th, Ukraine’s debt noted above is now 18.13% more than US treasuries.
• South Africa’s is 6.61% greater .
• And Russia’s debt is 5.45% higher.

Why?

Current Account Deficits are the place to look.

• Ukraine: At the end of 2006, 3.71% of GDP. Today,  the IMF estimates it is 7.2% of GDP
• South Africa: At the end of 2006, 7.26% of GDP. Today,  the IMF estimates it is 8.0% of GDP
• Russia: At the end of 2006, it had a surplus of 9.50% of GDP. Today,  the IMF estimates it had dropped to 6.4% of GDP.

In general, owing more to debtors outside your own walls creates one of two possibilities:

1. Default (as in the case of Argentina)
2. Currency devaluation, which when importing basic staples or other durables, causes inflation, making the bond payments less valuable

But further, this massive spread increase could also be caused by a flight to “quality” of US Treasuries. Capital is simply skittish of anything but the US Taxpayer. Which, at this point, should give us all pause.

Regardless, the bailout the G1, G3, G7 are trying is crimping the ability for emerging markets to raise capital, increasing strain on IMF funding and solvency.  Crowding out 101 is in effect.

Reporter Saskia Scholtes of the Financial Times was wise to diagnose our current crisis correctly almost one year ago on Newshour with Jim Lehrer. We had a “financial markets problem” We still do.

Since Ms. Scholtes’ diagnosis, it is becoming clearer the “financial markets problem” is spreading to the overall economy. This is particularly worrisome over this past week with special attention the Fed’s policy decision.

As we correctly noted in our previous post (to be sure, this blog is large enough for our over sized ego),

Ben Bernanke and the Federal Reserve enacted a massive rate cut. But has it worked? Has it bolstered confidence in the overall markets? We present two frameworks to analyze the cut and the market’s reaction (assuming additional pricing was occurred).

First is oil. Oil’s trajectory in various days in October (below) has been remarkably unchanged.

Sure, oil rose from the cut. But the real story is how powerful dollar’s pricing is behind oil’s future prices. And here is the real concern:

The Fed’s cut has two objectives:

• Lower credit conditions to ease lending strain, bolstering the economy
• In anticipation of further economic contraction, ensure deflationary conditions do not persist.

The Fisher Equation derives the market’s inflation expectations. Below is the previous Monday and Friday (before and after the Rate Cut) TIPS and Treasury Yields, and the derived inflation expectations.

No doubt treasury yields are low in an investor. But suppose treasuries were priced 100 -200 basis points higher. Given TIPS yields, there is still a view we are headed into a deflationary period. Given the dollar’s increased pricing power tomorrow vs. today, it should give us pause about the following:

• What is Oil’s true future price?
• Given that holding cash under the mattress is now worth more tomorrow than it is today, is the treasury fix fixing anything?

Since the First Note, The Government’s Credit Committee, with members Barney Frank, Chris Dodd, and Richard Shelby took more time to get comfortable with Hank Paulson’s proposal.

While the debate in Washington raged on, one month LIBOR increased from 3.19% to 3.70%. Three month LIBOR increased from 3.21% to 3.76%. Commercial Paper increased from 2.50% to 2.70%. Letter of Credit facilities are not expanding. Essentially the way balance sheets are funded is grinding to a halt.

So, how could most corporations raise capital faced with this problem? One answer would be to short treasury securities of the same duration. Simply borrowing the securities, selling them into the market for cash, with the promise to deliver those securities later would do the job.

And why not? Treasury securities expiring on Dec 31 are yielding a paltry 1.02%. Treasury securities expiring on Dec 15 are yielding .68%. Would a betting man believe yields would increase or decrease in the next week? Considering inflation increased over the past year and that the US will sell an additional $700 Billion of debt into the market, yields will most certainly rise.

So, given the demand to short and the rational argument that yields will increase, the fact that the spread is so significant is in fact very significant. Money that normally would buy commercial paper and be infused into interbank offerings is now moving to “quality”. That quality is the United States government backed bonds and notes.

We can quickly examine the balance sheet and income statement of the US Government to know the following:

1. Liabilities just increased by close to $1 trillion, including Fannie Mae, Freddie Mac, AIG and the proposed bailout.
2. Projected top line tax revenue is expected to decline as housing values sink and oil relief is still far off.
3. Inflation is still a huge risk.

So how is this quality? The simple answer is that it is not. And if the US Government is not quality, then imagine how much mistrust is in the private market right now. And this is exactly why those shorting trades are not occurring and not helping to re-balance the spread, lowering TED.

For all of 2008 until now, we heard and read the financial sector was amuck, but corporate American remained strong. Yet now, we are conceivably in a macro-economic death-spiral.

1. If companies continue to be faced with high interest rates and refusal of credit, they will stop expanding.
2. Further, for all those companies who did not hedge exposure (and with lack of quality counter-parties, it is conceivable this is a lot), they will be forced to pay higher rates of interest now on all existing loans and notes.
3. To meet higher rates, companies will have to cut expenses, essentially wages. Reductions of wages will depress the economy further.
4. Consumer spending will continue to decline, making more companies unable to meet existing obligations.
5. Credit spreads will increase for fear of company credit and the cycle will continue.

This week will be as wild as the last one….

Secretary of the Treasury Henry Paulson aka Hank, AKA King Henry, the former chairman of Goldman Sachs appeared on Meet the Press this Sunday. He said “Last week there were times when the capital markets or credit markets were frozen.”

Was he lying?

No. Hank was telling the truth.

Let’s look at markets for short term money. Why? When prices for short term money move, prices for other money must concurrently move. Starting on Monday, September 15^th, when Lehman Brothers, an investment bank, declared bankruptcy, one month LIBOR rates for money were 2.49%. Essentially, the base opportunity cost of private investing for one month was 2.49% on an annualized basis. While the S&P 500 and Dow Jones Industrial Index swooned wildly, one month LIBOR ticked up every day, closing on Friday at 3.19%. In other words, the private sector opportunity cost of efficient investment swooned by 33% in five business days.

Why? Did inflation increase? Did oil prices increase? No. None of this occurred. What did occur was the increased need for cash on banks’ balance sheets. Faced with dramatic uncertainty answering questions such as :

• what do we own? and
• what do our competitors own?

The best answer every bank came to was “don’t loan and keep cash for our own security”.

But it wasn’t just LIBOR that increased ….

Short term 30-Day Commercial Paper, the basic note that keeps corporation engines oiled increased from 2.2 to 2.5%. And to show how much the average American did not trust the solvency of the banks (rightly so if all their business model is now preserving cash and not efficiently loaning cash), One Month Certificate of Deposits increased from 2.51% to 5.0% in the same span of days this week. In other words, if you – dear reader - had a goal of opening a CD last Monday, got sick, and went to the bank on Friday, your rate of return would have doubled.

Is this unheard of?

I think so. If we examine the changes in the same rates from randomly June 4 to June 8, 2007 there was no change in LIBOR rates. If we examine the same rates randomly from July 16 to July 20, 2007 again, no change again. LIBOR held steady at 5.32%. What was the Fed Funds discount rate then? 5.25%. Historically, this has been the case: a strong convergence of the two rates.

What was the Fed Funds rate this week? 2.00%.

Let’s take a deep breath: 3.19% one month LIBOR vs. 2.00% Fed Funds Target Rate means private sector’s unease forced efficient private sector rates north of 50% above the “discount rate”. Given this over 100 basis point difference in discount rate money vs. private credit, Hank was most certainly telling the truth.

What could be next?

This week will be as wild as last week.