Reflating Deflation

So we're back where we started before the War on Terror, before the oil-price surge, before the housing bubble and crash...

EVIL DAYS indeed. Scared and scarred by losses in all other assets, the world's wealth suddenly wants to sit in the safety of US Dollars and US Treasury bonds.

Only low- and no-yielding cash need apply, in short. Yet these safe havens are also set for destruction. Because whatever rosette the White House wears after November, it simply cannot allow the value of money – and therefore of debt – to keep rising.

Maybe that's why Standard & Poor's felt it had to re-state its "AAA rating" on US sovereign bonds this weekend after the Treasury took Fannie Mae and Freddie Mac onto its balance-sheet – just like Bill Gross at Pimco, the world's biggest bond fund, demanded.

Either that, or the S&P team hope an appeal to irony might keep them out of the courts if the world's No.1 debtor itself finally turns "subprime" in future.

And perhaps that's why the cost of insuring US Treasury bonds against default – as measured by credit-default swaps (CDS), at least – has now tripled since April to a still-tiny but greater-than-Japanese-or-German level of 0.18% on the five-year note.

Paying 18¢ per $100 of bonds might look expensive after a true US default. Who would be left to cover your losses? But with the five-year yielding just 2.89% – while US inflation runs at 5.6% on the last official count – a few basis points clearly don't matter. Washington's ink is all global investors will buy.

"Weak growth, falling interest rates, lower commodity prices and a surging US Dollar are fundamentally changing the risk-reward picture in financial markets," says Jeffrey Palma at UBS.

In particular, "the unwinding of long commodity/short financial sector positions is a key development," he believes. "The link between these sectors has been broken."

Out on the broader stock market, Monday's "Frannie Bounce" was pretty much reversed by Tuesday's plunge on Wall Street and Wednesday's losses in Asia. Not even $200bn will buy much of a "relief rally" these days – and the Treasury's check-book could soon run empty if Lehman Brothers fails to close all the cash-raising deals it's so far, ummm, failed to close.

Its own little "debt deflation" must roll on regardless, meantime, dragging stocks and securitized debt prices lower as the City and Wall Street de-lever. America's fourth-largest bank ended last month with a gearing of assets-to-capital above 21 times. That ratio of assets to shareholder equity stood at 24:1 three months before, itself sharply lower from February's gearing of 31.7 times at Lehman Bros.

The wind's whistling through the commodity pits too, as investors flee hard assets for the musty clutches of Uncle Sam's greenbacks. Platinum and palladium prices have collapsed even faster than Gold after reports leaked out of China that new car sales fell by 10% last month.

Asia's largest stainless steel maker, Posco, is cutting its output for the third month running thanks to the collapse in demand. And not even the Hurricane Season is trying to support crude oil or orange juice futures this year.

"Currencies like the Australian and New Zealand Dollar are [therefore] suffering a huge double-whammy," writes Steven Barrow for Standard Bank in Johannesburg.

"Commodity prices are tumbling and the markets assessment of 'risk' is rising. These currencies have already been pummeled, but we see little hope of a significant recovery, especially against the [zero-yielding] Yen. The fact that both central banks are cutting rates as well is also worrisome for these currencies."

Early Sept. brought a surprise 0.50% cut to interest rates from the Reserve Bank of New Zealand, "and there should be plenty more where this came from," says Barrow. The Kiwi Dollar promptly sank to a two-year low vs. the all-conquering US currency, despite still paying more than three times as much annual interest to cash-savers.

Just who's to blame for this blunt affront to key fundamentals, plus the sudden death of the bull market in everything? Go back to the start and ask instead where that global bull market began.

"If we all join hands and go buy a new SUV, everything will be all right," said Dallas Fed governor Bob McTeer after 9/11. "What we dearly want is for Americans to spend like Americans – to do the patriotic thing and go out and spend," agreed Bill McDonough, head of the New York Fed, in October '01.

Depression-era interest rates then followed, sparked by the risk of "Dot.Com Deflation" and given political force by the War on Terror. But reflation was always going to turn into inflation...which in turn would curb the pace of global expansion – if not destroy it – just when everyone was geared up on cheap money to double-up on the new trends that, by the start of 2008, looked never-ending.

So now we're back where we started, with a collapse in retail investments (then stocks, now housing) and the collapse of institutional debt portfolios (then high-tech capex, now asset-backed paper led by securitized mortgages). Trouble is, the key route to reflation in 2002 – the consumption and housing bubbles – has become today's sink of value. So where to turn next?

"Ultimately," says Martin Wolf of the Financial Times, "if you want to rescue a very badly damaged financial sector, you need a credibly solvent government, and the US government is not in quite as strong a position as the Japanese government was [at the start of the 1990s].

"So this could go on for a long time," be now believes, "and we could find many difficulties on the way." Not least, says Wolf, "the government has now become officially and quite openly the principle guarantor of mortgage lending in the US economy...operating in the context of a falling housing market, with ever rising bad debt.

"This is not a situation in which one can expect the private sector to suddenly leap forward and take the government's place – particularly when the government is of course doing it on subsidized terms, because the risk is in fact being borne by the taxpayer.

"What private-sector institution can compete with this?" Wolf asks. And more crucially, perhaps, "the US is a very large net debtor to the rest of the world. It depends on foreign creditors to sustain the credit of both the private and the public sectors.

"If the United States were to lose the confidence of the rest of the world – and that was surely very important in making this decision just now – then it might be much more difficult to solve the problems of the financial sector as the Japanese tried to."

The comparison bears repeating, provided we remember that Japan was (and still is) a savings-rich nation with a surplus on its balance of payments. So after the failed 1996 rescue of Japan's zombie banks – costing more than $100 billion in public funds – the Obuchi Plan thought nothing of pumping another $500bn of taxpayers' money (some 12% of Japan's GDP) into trying to settle loan losses, bank recapitalizations and depositor protection only two years later.

Still the reflation failed to showed up, however, and even today the Nikkei stock index remains under-water from its 1989 top by more than two-thirds. Tokyo real estate has lost some 70% of its inflation-adjusted value. And for the last 13 years and more, Japanese savers have effectively made zero on their cash-in-the-bank as the government fought to reflate an economy that was all done with inflating.

Ready for the next US attempt to pump up what's busted? Still want to buy "safe-haven" T-bonds and Dollars...?