Are we Out of The Woods Yet? - Dec 7, 2008

charts courtesy of stockcharts.com

A while back I predicted that the talk of the town would soon move from credit to economy. That certainly has been the case. Instead of hearing horror stories about bank closures and impending soup lines, we hear horror stories about layoffs, and double D’s (deflation and depression).

You’ve got to hand it to main stream financial media, they know how to scare us when scaring is needed, and how to pump us up when pumping is needed. They pick and choose the theme that should scare us (or excite us). Now, it seems like they are telling us that we should forget about credit woes and be overly concerned with the state of the economy.

But, let’s forget about propaganda masters and see if the credit woes are behind us?

This is a chart of TED spread that found a sudden burst of quick fame and became a point of discussion everywhere.

It has improved a lot from the freight heights of October, but still it is high. I would like to see it get below 1.5 and stay there.

The bottom panel of the chart is the chart of a High Yield Corporate Bond ETF (HYG). Notice how it started its collapse when TED was starting its meteoric rise. The collapse of corporate bond market displays the degree to which major players are avoiding risky market endeavours.

Here’s a larger chart of HYG

For myself, I need to see an uptrend in the corporate bond market to consider changing my day trading hat for a swinger jacket in the market.

Quite unlike corporate bonds, long term Treasury paper has been having a wonderful time

The momentum behind the move on daily and weekly time frames is such that I think we have a high probability of seeing a higher price than 113.

I think it was in November that Bernanke talked about targeting interest rates. Many believe there is a need for stabilization of housing prices before credit situation can truly heal. High mortgage rates are not a contributor to any home price stabilization efforts. So, long end of yield spectrum has to come down. With FED unable to cut in any meaningful way, and with the short term rates effectively at zero, one way to bring the long term yields down is to purchase long bonds. I am not sure if that is what is actually happening or not, but something other than just panic seem to be driving long term bond prices up. There also maybe the double D (deflation, depression) that the bond market is pricing in.

I saw a chart similar to the above at MISH'S Global Economic Trend Analysis. Mike Shedlock, Mish, is a very smart market observer, and his daily ramblings are a must read in my humble opinion.

Some pundits have pointed out that LIBOR has also come down from its October peak

But 1-month T-Bill is now at zero yield, so, true that Libor – TBill has come down from 2.5 of October, but it is still at 1.75 which is high by historic norms – banks are not trusting each other all that much yet.

There are many, among them, die-hard gold bugs, who say all the liquidity being injected into the system around the world will get us hyper-inflation at levels never seen before. That may be, but that is not the message we are currently getting from the commodities, and not even from gold.

I do not see any notion of even a modest measure of inflation, let alone the fear of hyper-inflation, at this time.

Going back to the bond market, we see that the Treasury Inflation Protected Securities (TIPS) have also been signalling a market not worried about inflation

Notice that TIP started to accelerate on the way down same time as when TED started to rise and corporate bonds started to collapse.

It’s been having a couple of good days, but we cannot say if it is a true move or just a reaction off oversold levels.

Our global financial system needs bubbles to thrive, it also needs a controlled rate of inflation to breathe. At some point, we may see the inflationary effects of liquidity being injected into the system around the world. I do not know when that point is. But, well before that point, we will see the signs from charts like I have presented here. That point cannot even be deemed close until the credit situation is truly resolved. Just a change of theme by talking heads of TV from credit to economy does not mean that credit situation is good and tame. As long as the liquidity created by central bankers does not find its way into global economy, it will have no effect stimulating anything, let alone causing inflation. A first step would be bankers trusting each other. After that, an uptrend in corporate bond market will be a welcome change indicating confidence in sustainability of businesses. That may lead to a recovery in the commodity space signalling a market that expects the world economic engines to be humming again.

Willie Nelson once famously said: “money is a whole lot like manure, it just ain’t no good unless you spread it around.” There is a whole lot of freshly minted manure bankers are taking home with them every night.