No one will ever forget that the financial crisis began to take on frightening proportions that was creating a self-sustaining death spiral, when it became clear how much trouble the big banks and non-financial lenders were in. We witnessed the failure of Bear Stearns, the demise of the GSE's, Fannie and Freddie, and the rest... you know.
The banks are the source of credit that consumers and commercial borrowers need to be functioning in order for the US economy to recover. So far, the consumer is missing in action in the economy, placing all the pressure on both commercial and government balance sheets. Commercial balance sheets are doing everything possible to restore financial health, including cutting expenses by laying off workers and paying off debt. Most businesses do not have pricing power, so prices are holding the line. The lenders are lending too little to assist with economic recovery and expansion. The only entity stimulating our economy is the US Treasury, by printing new dollar bills.
Many of the 2010 outlooks I read are concerned about the timing of Fed tightening. Tightening is a way of describing an undefined process (policy) of getting the money out of circulation. How the Fed, will do it is unclear and there is not widespread confidence that they can do it without increasing inflation expectations that could also become self-sustaining and fulfilled. The result is a vote of no confidence so far, which is reflected in the dollar index. The widespread assumption is that tightening is going to happen and that the Fed will make mistakes in their implementation of it. The question is seldom will there be a need for tightening. What's up with that? I wonder about the wisdom in this assumption. Are people forgetting how we got here and what has happened to make things appear to be improved, the condition we desperately want to believe.
Is the problem that caused the self-sustaining death spiral resolved? No! It is still a problem! As a result, we are still experiencing the problem, though our experience is manipulated. In other words, the US consumer, as the financial engine of the economy, was addicted to endless and cheap cocaine (credit) and now is being given meth (good news) to hide the pain of withdrawal and blunt the need to ask, "what happened?". If you've never felt manipulated, you might want to open yourself up to the possibility now. The self-sustaining spiral would certainly have reached deadly levels had it not been stopped. But the causes of the crisis have not been stopped. Let me explain.
The big banks and other lenders held some toxic assets off their books on what we called the shadow banking system. The shadow banks are where a huge amount of highly profitable, non-banking business has occurred. A shadow bank is directly tied to a regulated (a technical term, used loosely) bank. The toxic assets were not then considered to be toxic since they were contributing massively to profit. When the low quality of these toxic assets became more well-known, the profit collapsed into losses of colossal amounts, rapidly. Had the Financial Accounting Standards Board (FASB) not accommodated the banks, by changing the rule book for them, some may have gone out of business literally. The size of the problem has been reduced by allowing the assets to be valued at a level more favorable to the banks needs rather than maintaining the rule which imposes quality controls. So the problem is now smaller, but still a big problem. There is some evidence for this in the following graphs.
First let's look at the amount of outstanding loans and leases at all commercial banks. For the economy to recover they are going to be a critical participant. Our economy is a credit based economy. We are on a path to restore the credit based system. However the graph suggests that credit is not expanding, though there was a spike to a new high. Perhaps people used lines of credit before they were modified.
Next let's consider a graph that also illustrates how comfortable lenders feel with their role as lenders. If they are comfortable, they would first of all be lending and secondly, they would not feel a need to hoard cash in reserve balances at the Fed in anticipation of future losses. With the next graph, we look at reserve balances at the Fed and now see a picture that shows real concern. It appears that the banks are completely willing to maintain enormously greater reserves than at any time in recent history.
My feeling is that the need for Fed tightening in the foreseeable future is based on the hope that lending is going to be restored, and that borrowers are going to be willing to borrow. In other words, the credit based US economy is going to be restored. This credit recovery hope needs both lenders to be willing to lend and borrowers to be interested in borrowing. If both of those conditions are observed, then there is going to be incredible pressure on the Fed to surgically remove stimulus through its undefined tightening policy. My contention is that the need for Fed tightening is way down the road, perhaps years. I am a skeptic on a recovery of the credit based system in the short to medium term.
The following graph illustrates total savings deposits. You can see that savings has taken on a slightly greater importance recently. This graph gives us some clear signals about the consumer. If consumers become much more dedicated savers, that will be at the cost of lending. They will borrow less and the economy will adjust (meander) during a period of stagflation, or little economic expansion. This would be a tide change, a paradigm shift, of enormous size. A change to becoming a saving based economy instead of a debt based economy. Is this possible?
One of the assumptions I have used is that enablers of our current situation do remain in place. In particular, buyers of our new US Treasury bonds continue buying our debt. This assumption can blow up easily since the foreign buyers of our debt have been warning of their weakening appetite for our debt. Never-the-less I ask, what else are they going to use their dollar reserves for. Many other economies are functioning, by design or structure, in support of the US consumer. Many foreign governments are willing to play what seems to be a perverse, illogical game, just to maintain the status quo of their currency. If one of our enabler's steps back, then a new one must step forward. If this does not occur, then the outcome I envision here gets changed radically. A previous article on this Blog talks more about the risks I am referring to in that scenario, . Because nothing stays the same, we should expect the enabler's to be different in how they work with the US. We cannot know when or how much their role changes.
Let's look at charts for the 10 year and 5 year Treasury yields. Nothing indicating a new direction is clear yet. Looks like yields are still in a narrow, declining to level range for both terms.
It seems to me that the dollar might experience some strength in the near term as long as there continues to be stories of an improving domestic economy and worsening problems in sectors of euroland. Eventually, there will be more widespread awareness of the weakness of the whole financial system, not just in the euroland but also the US. We know the dollar is always priced relative to other currencies, so it can move solidly higher since the US financial system is still considered to be a strong link in the global financial structure. The weakening of the dollar will return, unless the strong dollar talk is actually becomes policy. For an alternative conclusion, inquiring minds might consider Don't trash our US dollars or else.... The observations I make in this article lead me to maintain my economic expectation for a deflationary condition. I remain on alert for changing circumstances and to changing my outlook. What do you think? Leave your thoughts in a comment. Scanner