A Credit Depression

ANZ followed NAB’s shocking result with a bad one of its own. CEO Mike Smith dished out the bad news to investors yesterday. He said bad debts had doubled to $1.4 billion. He also revealed that the cash profit-a measure that excludes volatile items-had fallen 43% to $954 million from $1.67 billion.

You don’t need to own subprime loans to take loan losses in a credit depression. Smith said the area that concerned him most was the surge in small and mid-size businesses simply closing up shop unexpectedly. “In the real economy,” he said, “there is no evidence that the world economy is yet bottoming.” Commercial property looms as the big threat to the Aussie banks this year.

The bad banking result may be enough to sink shares today. But not if they follow Wall Street’s lead. Both the Dow and S&P closed up over two percent. It was a strange reaction to a do-nothing statement by the Federal Reserve.

The Fed merely reaffirmed that it would be dishing out US$1.75 trillion to buy mortgage backed securities, agency debt, and U.S. Treasury bonds, bills, and notes. What it did not say is that it would be increasing its purchases of U.S. Treasury bonds and notes. This may explain part of the rally in stocks. Why?

Well, bond prices fell after the Fed said it would do nothing. The yield on the ten-year note went as high as 3.12%. That’s as high as it’s been since the Fed telegraphed its intention to buy Treasuries and try and force mortgage rates down. If investors can surf higher bond prices in the Fed’s wake, perhaps they are happy to rotate into stocks for a bit.

The rally certainly isn’t explained by the GDP figures released yesterday in the U.S. Those showed that the economy shrank at a 6.1% annualised pace in the first quarter. That was a slight improvement on the 6.4% shrinkage in the fourth quarter. But is it the sort of thing-along with yesterday’s improving consumer confidence number-that hints of a recovery? More on that in a moment.

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The copper market seemed to interpret the Fed’s statement that things were getting less bad as a sign that things are getting better. Copper prices were up 4.5% in New York. Copper is generally a leading indicator of economic growth because of its use in new construction (housing and commercial property).

Dr. Faber might be in agreement with Dr. Copper (as copper is sometimes called for its ability to ‘diagnose’ the economic conditions). Dr. Marc Faber’s latest letter landed in the mailbox yesterday. There were some real gems in this month’s Gloom, Boom, and Doom Report. One was this quote from Charles Kettering, “Success is getting what you want, happiness is wanting what you get.”

Got it?

Dr. Faber also has quite a bit to say about whether the large rallies in global stock markets since March (and earlier in some cases) constitute a recovery in the economy or just a “bear market rally.” He says that, “At least in nominal terms, the global printing presses being run by the world’s central banks and fiscal deficits have begun to impact asset prices positively.”

This is a concession that the big quantitative easing efforts of the Fed have found their way into bond prices and certain other sectors. Also, by trashing cash the Fed has made stocks look relatively more attractive. Dr. Faber also thinks that, “In the case of resource and mining stocks, as well as Asian equities (and, for that matter, most emerging and other stock markets around the globe), the lows that were reached between October and March of this year are likely to hold-that is, for now.”

And what about Australia specifically? He did not single the country out. But he did say that, “The markets that have the highest probability of having made major longer-term lows are resource-related equities, emerging markets, and Japan.”

“Conversely,” he writes, “the asset market that has the highest probability of having a made a secular high (such as Japan in 1989, or the NASDAQ in March 2000) is the U.S. long-term government bond market. Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside.”

Dr. Faber appears to be right. And we have the chart to prove it. The chart tracks the yield on 30-year U.S. bonds over the last year. We’ve included two moving averages (MA), a shorter-term 50-day MA and a longer-term MA of 100days. So what story does this chart tell?

Click to enlarge

Source: www.bigcharts.com

For one, you can see that when the Fed first announced its intention to buy mortgage backed securities in November of last year, it sent the 30-year yield cliff diving. And remember, because bond prices move inversely to yields, this sent 30-year bond prices up (which would have been good if you were a large holder and eager seller of those bonds like, say, China).

But at the turn of the year when the stock market swooned, thirty-year yields started creeping up again. Bond investors began doubting the Fed’s resolve (or ability) to keep rates low with regular purchases (quantitative easing). The really interesting point on the chart is in Mid-March.

That’s when the Fed said it would buy up to $300 billion in Treasuries. Yet from a technical perspective, this is exactly the point the short-term moving average (50 days) crossed over the longer-term moving average (100 days). In other words, when the Fed announced it would be coming into the market to buy bonds, 30-year yields experienced a bit of a technical breakout.

Now weather people began selling bonds because they thought stocks were a better bet, or for some other reason, we can’t say. What we can say is that this chart may indicate the Fed’s basic inability to control interest rates even with quantitative easing.

If ten-year yields keep rising too, the Fed is going to have to come back to the market with something even more jaw dropping. But will the market believe it? Or is Dr. Faber right? Has the secular bear market in long-term bonds begun at just the moment the Fed stepped in to support bond prices and try to force yields down?

We think the question is important because there is a lot of cash on the sidelines at the moment. Higher yields may suck in some cash looking for safety. But we reckon higher bond yields could just as easily trigger a bigger move into stocks. This would get a lot of people who are sitting on the fence back into the market. The rally would go even higher. And then?

That depends on the economy. And on that score, yesterday’s GDP figures also revealed two important numbers. Residential investment (housing) declined at a 38% annualised pace in the first quarter of the year. It’s been falling for 13 consecutive months, but this latest performance was by far the worst of the lot.

The other number that shocked was the huge decline in business investment. Business investment in equipment and software fell at a 33.8% annualised investment. Investment in non-residential structures fell 44.2%. Why does it shock?

If businesses are not investing now, where will GDP and wage growth come from later this year? We have a possible answer. But before we get to it, let’s look at another chart. The chart from the excellent bloggers at www.calculatedriskblog.com shows the respective contributions of residential and business investment to U.S. GDP. So what story does this chart tell?

Click to enlarge

This chart is telling us that previous recessions, residential investment tends to recover ahead of business investment. In other words, it’s telling us that households begin to spend again before businesses do. We can’t quite work out why that might be (if it’s actually correct, that is). It could be that at the low point of a recession, interest rates decline low enough to finally stimulate new demand for mortgages. The rates suck households in and the new housing activity stimulates the rest of the economy.

We’re not saying we buy that theory. But the chart is indicating a bounce in residential investment. Our suspicion is that the bounce is re-financing activity at lower interest rates or foreclosure sales (which are doing a ripping business in California). In other words, most of the activity in the housing market is coming from market-clearing prices being reached in the most over-priced markets.

The big question is if the up-tick in home sales (and residential investment) actually stabilises house prices. If those keep falling, there could be a whole new wave of defaults and foreclosures that sweeps the U.S. market. This would have follow-on effects for the banks (more stress, loan losses, capital raisings) and for the job market (thus the economy).

It’s also possible more people lose their houses anyway, even if prices stabilise. How? The economy. If the unemployment rate keeps going up, you can expect more Americans to lose their homes.

So it’s a bit of chicken and an egg situation isn’t it? Will housing investment lead to an economic recovery? Or will higher unemployment blow out the housing investment rebound and send us all into wave two of the Great Credit Depression?

This brings us back to the question of wage and GDP growth this year. If it’s not going to come from the corporate world (still busy cutting costs and shedding jobs), is it really possible for housing to lead the American economy out of recession in 2009?

The only way we can see that happening is if the Fed is even more massively involved in supporting the mortgage backed securities market than it already is. It’s committed $1.25 trillion to the market already. This backing could make it possible for millions of homeowners to refinance into new fixed rate 30-year loans this year. And if that happens, then you might see that housing-led recovery.

Don’t hold your breath. Goldman Sachs reckons the U.S. government will have to raise $3.25 trillion in the debt markets this year to make up for the Federal budget deficit of $1.75 trillion and to fund the Fed’s various credit-easing operations. And if the Treasury can’t raise the money for the Fed on favourable terms, what do you think the Fed will do?

More on that tomorrow.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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5 Comments on "A Credit Depression"

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Trading System Development
Trading System Development

Marc Faber gets it right often, however I feel that when he makes predictions in the shorter term, his ‘act’ of predicting stalls the event, as too many of the dumb money are following him.

Daniel Newhouse

Er, does this mean that GDP is likely to decline by ~35% before we hit bottom?

Richard Ward

It’s going to take a lot of patience to turn the U.S. “super tanker” in the right direction!

Dan Denning: “So it’s a bit of chicken and an egg situation isn’t it? Will housing investment lead to an economic recovery? Or will higher unemployment blow out the housing investment rebound and send us all into wave two of the Great Credit Depression?” Um, how would housing investment lead to an economic recovery? Higher house prices means higher mortgages, which means LESS retail spending. Just shuffling money around to these supposed real estate ‘assets’ doesn’t do anything, unless of course you are living the high life on ‘equity’. Propping up house prices doesn’t help people spend, it only stops… Read more »
Coffee Addict
One important issue is the extent to which markets have priced in the predicted “second wave” of credit defaults and the impact of money printing. My gut feel is that the expectation of some more automotive, property and financial bankruptcies are priced into the market. The market also expects that Obama will do what it takes to protect the Alt2 mortgagees and the like. The two unpriced events that would lead to a second market rout would be sovereign defaults amongst the G20 economies and a collapse of the government bond markets. The latter will almost certainly happen because associated… Read more »
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