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Deflationary Credit Downturn Is Underway


The problems are too many and to severe to be permanently fixed by anything other than a major recession and deflationary write-down of debt.


In the U.S., credit flowing to American companies is drying up at a pace not seen in decades. This idea was discussed in Lenders Rapidly Tighten Credit. The same thing is happening in the UK there are Pleas for rate cut as interbank loans dive:

The sterling interbank market has collapsed at the fastest rate in modern history, prompting pleas for immediate rate cuts from a chorus of top British economists.

  • "This is one hell of a shock to the financial system," said Professor Tim Congdon, a leading monetarist at the London School of Economics. "A market that has taken 30 years to build has completely imploded in a matter of months. Lenders have been squeezed savagely. We've moved into a different era," he said.
  • Mr Congdon called for a half-point cut to the interest rate to 5.25pc when the Monetary Policy Committee meets this week, warning that the M4 money supply is slowing fast and might contract over the next six months.
  • Patrick Minford, a professor at Cardiff University, called for a three-quarter point cut, accusing the MPC of "standing idly by" as three-month Libor spreads rocketed by 75 basis points - a severe tightening of credit.
  • SMPC member Peter Warburton, from Economic Perspectives, called for a half-point cut, with further easing in the New Year. "A profoundly deflationary credit downturn has taken hold," he said. "Recent weeks' dramatic events have infected urgency into the situation."

What the above British economists are talking about is LIBOR or the rate at which banks lend to one another. Not only is there a shock going on in the UK, the same shock is occurring in the US. Indeed LIBOR spreads are at 75 basis points in the US as well as the following chart shows.

LIBOR as of December 3

Click to enlarge image

  • One month LIBOR is 75 basis points above the Fed Funds Rate.
  • One month LIBOR is 221 basis points above the 3 month Treasury note.
  • 15 year mortgages are only 2 basis point higher than 1 month LIBOR.

You can get a 15 year mortgage at nearly the same rate banks are willing (in this case reluctantly willing) to lend money to each other overnight. This is rather amazing.

For a refresher course on LIBOR please see Professor Depew's column Why Should You Care About LIBOR?

The important point here is that LIBOR, which normally trades at 7-10 basis points above the Fed Funds Rate is now a whopping 75 basis points above the Fed Funds Rate in the US and 75 basis points above the BOE Funds Rate in the UK as well.

UK M4 vs. US M3

I find it interesting that M4 money supply in the UK is slowing fast and might contract over the next six months. M4 in the UK is roughly equivalent to the discontinued M3 in the US.

M3 in the US is still soaring as shown by the following chart from Bart at Now and Futures.

M3 As Of November 30

Click to enlarge image

Bart had this comment on M3: "Most of the large growth in M3 lately has been in flows into CDs and Money Market Funds, a normal occurrence during financial turmoil."

I talked to Paul Kasriel a week or so ago and asked him about M3 and he felt the growth was in part due to companies tapping credit lines.

Is there a mad dash for cash while those lines of credit are still good?

Meanwhile, banks themselves are very strapped for cash. Please see Where's the Cash? for more on this idea. Whatever the reasons, banks are very reluctant to part with cash and proof is one month LIBOR.

Zero Hour

These are very unusual conditions to say the least and Professor Sedacca is saying No Toto, Credit Markets Not in Kansas Anymore:

I have written many times about the concept of 'Zero Hour' (recall the wonderful lyrics from Elton John in Rocket Man: "She packed my bags last night pre-flight, Zero hour nine am"). Zero Hour was the concept of Barry Banister at Legg Mason (LM) that dealt with the interplay of debt growth and GDP growth. When we are in a debt-induced, asset-based economy, "Are we there yet?" means arriving at Zero Hour, which is a scary proposition. For those unfamiliar with the concept of 'Zero Hour', it is the moment at which creation of new money no longer has an impact on GDP, or the real economy.

"Are we there yet?" Perhaps the U.S. is. If not, it is close or, at a minimum, it is on its way there. Zero Hour. How do we know we are at zero hour? We know we are because M3 has now exploded to an 18% year over year rate while the Fed has downgraded 2008 GDP growth expectations to 1.8-2.5%. Yes, money is growing at a rate ten times that of new economic output.

Yield Curve As Of December 1

Click to enlarge

Plunging yields across the entire curve while the Fed is harping about inflation and M3 is exploding is yet another sign we are no longer in Kansas.

Note the strong similarity between the yield curve in 2000-2001 and 2006-2007. The yield curve itself suggests we are already in a recession regardless of what the GDP says. One thing is certain: The treasury market is expecting more rate cuts.

The interaction of M4, M3, the yield curve, and LIBOR both in the US and abroad are signs of an impending major market dislocation or bank failure of some kind. If this stress in not alleviated soon, we will literally be in crash conditions.

On the other hand, if these conditions, most importantly LIBOR, temporarily return to normal, perhaps we have a Santa rally. Regardless of what happens in December, the problems are too many and to severe to be permanently fixed by anything other than a major recession and deflationary write-down of debt.
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