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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: Elroy Jetson who wrote (29922)	4/3/2005 8:07:44 AM
From: el_gaviero	Respond to of 110194

Thanks Elroy, that is really a great and very helpful post.

To: Elroy Jetson who wrote (29922)	4/3/2005 12:09:28 PM
From: russwinter	Read Replies (3) \| Respond to of 110194

The twist I see on this, is that during a credit contraction, the financial instruments that are in demand shift. So money that had been allocated to carry trades, and speculative ventures gets withdrawn (perhaps rapidly), the air comes out of these trades, and a flight to quality is on. The result is that the yield curve steepens, with rates further out in duration rocketing up, and short rates (I'd say two, or at most three years or shorter), staying stable, or even dropping a bit. The best position to be in would be US T-bills, and gold. I feel the ultimate trade would be long 2year/short 10 years or 30 years in this set-up. I hope to spot an opening via the COTs signal. It's just not there yet. Bob Hoye had an interview (since the intriguing one he did in Barrons in Dec) discussing this: howestreet.com HOYE: The carry trade has been around since at least 1720. It is usually described as borrowing short and lending long (I call it the BSLL factor). And there is a compulsion in any speculative boom to borrow short and lend out long. Either to buy junk bonds or the stock market or whatever. The symptom of that is the flattening yield curve. And the game is over when the yield curve reverses to steepening. Elsewhere: HOYE: Oh yes. January’s sharp drop in the stock market and widening credit spreads suggests a sudden loss of liquidity. The concept of liquidity is badly abused. For example, in the summer of 2000, the street was fully bullish because there was so much liquidity to buy the stock market. They didn’t grasp the importance that it was stock prices rising that permitted all speculators to leverage up their positions. But that is borrowed money. That isn’t liquidity. While an asset price is going up it gives the appearance of liquidity and then when that asset price heads down, all of a sudden liquidity disappears. So that is what we are dealing with now. And in different part of the interview: HOYE: Well, I think the market will disappoint even the most ambitious of today’s central bankers. And the thing to understand is that unless they go to a pure paper inflation—which would require them to chew through the whole credit market—that would provoke such an uproar that it would force them to quit it. So here we are: it’s a credit inflation, which depends on margin. As long as the prices are going up, everything is fine and it doesn’t matter that short rates are going up. The cost of money doesn’t matter if you know you can double your money every six months. And once the contraction starts, I suggest that it overwhelms the ability of the Fed to pursue its portion of credit creation. I’m not saying that the Fed is going to suddenly tighten. No bloody way—not willingly! But the whole system is going to tighten as all the leveraged “liquidity” disappears. TAYLOR: Because the private sector or the economics don’t allow it to generate returns any longer. So, out of economic necessities, start to turn their non essential items into cash and repay debts? HOYE: As prices start going down, it gives undeniable power to the margin clerks. And their job description is vastly different to that of your typical central banker. TAYLOR: The margin clerks and I would guess it also will involve the fractional reserve banking system overall? HOYE: Yes. TAYLOR: Let me understand. As prices drop, the loan officers and margin clerks at brokerage houses and in banks begin to worry that their clients won’t be able to repay their loans, so they ask for more and more margin—which then triggers further liquidation because people have to sell non essential items to raise cash to meet margin requirements. That then results in a collapse in the value of less liquid assets relative to cash and the ultimate liquidity, namely gold? HOYE: That’s happened many times but, at the top, the street ardently believes that “this time it’s different.” TAYLOR: But the argument is that the Fed can always expand the money supply, as Ben Bernanke suggested when he said if need be, the Fed could use its magnificent digital technology to create as much money as was needed to escape deflation. He even said we could drop money from helicopters if need be! HOYE: That’s credit, not money. It’s a misnomer to call M-1, M-2, and M-3 money. And so once the prices of the assets being speculated turn down, then the margin clerk takes over. TAYLOR: One of the economic dynamics I talk frequently about in my letter, but which is almost never talked about in the mainstream press, is the almost exponential growth in debt compared to income, as measured by GDP and that in fact economic returns are simp ly not sufficient to generate enough cash to service the debt. And when the debt can’t be paid the loans are called by as you say, the margin clerks and then the debt repudiation process gets underway. HOYE: That is what happened in every bubble. Credit is taken on because of soaring asset prices. As the prices stop going up, you are left with the debt. That kills the ability to promote any story. As we have seen in so many promotions, so long as the trend is up the street will believe the most preposterous of touts.