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From Deflationary Spiral to Inflationary Spout?


Beware of restrictions on CDS transactions.


Earlier today, Toddo offered that he's sniffing something coming down the mark-to-market pike and/or the credit default swaps (CDS) pike. A few minutes ago, Bloomberg reported that as part of the ongoing AIG (AIG) bailout, next week the government will back-stop approximately $300 billion of AIG's CDS liability.

Considering that the government is now regulating the advertising budgets of banks under TARP, it would be utterly foolish not to consider the possibility that next week's AIG bailout will include rules or proposals to restrict future CDS transactions.

If that in fact happens, the reactions in most markets could be head-spinning:

  • The primary, if not only, tool short sellers of credit have had since the beginning of
    the credit implosion would effectively vanish overnight;

  • The safety premium in Treasury bonds would get pulverized;

  • Corporate credit spreads would initially collapse; however that improvement would probably prove temporary as the buyers of credit -- who will still be allowed to purchase CDSs to protect underlying positions -- will find a market even more illiquid then it already is, and therefore will effectively have to buy credit without protection;

  • If 1/100 of the monetary base piled into the system by the Fed's operations spills into the economy, the fears of hyper-inflation in the Treasury and precious-metal markets could leave them begging for bids and offers respectively;

  • God only knows how many hedge funds will be blown up in a matter of a day;

  • Equities could have a double-digit percent move to the upside, followed by more.

Would it mean this whole crisis is over? In my opinion not by a long shot, but I do believe that the government will have succeeded in turning the current deflationary spiral into a hyper-inflationary spout. Ultimately, the misery of having to deal with trillions of dollars of bad debts -- either through default or debasement -- will end up feeling the same, but in the process, we'll be able to giggle at all the zeros on our worthless currency.

The above is a hyperbolic scenario of course, but one which must be respected given the consequences. I'm buying upside protection accordingly.

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