Global Markets: Signs of Emerging Deflation?

``Liquidity exists when there are counterparties available to trade at any moment in time. It follows that liquidity is both an expression and a consequence of the ability of market participants to take risks on each other. For liquidity to exist, therefore, there must be a general sense, in the market, that each participant (or, at least, most of them) are suitably equipped to face the risks they are taking. This is what we call confidence.” Jean-Pierre Landau, Deputy Governor of the Bank of France

We were supposed to deal with the aspects of “decoupling” but a seemingly more important development has come to fore; global financial markets appear to signal the emergence of deflation!

Financial markets rarely transmit messages in consonance, but when they do we ought to pay attention.

Over the last two weeks, such latent messages have become more apparent as shown in Figure 1. But again the caveat is that two weeks may not a trend make.

Figure 1: Stockcharts.com: Signs of Deflation?

On the topmost pane, Dow Jones world equity index (blue arrow) has fallen steeply, just as gold (pane below center window-blue arrow) plummeted over 5% this week. Moreover, we see broad based US Treasuries massively rallying, where in terms of the benchmark 10 year (lowest pane-blue circle) its yields have dropped abruptly. Bond prices move inversely relative to yields. When US bonds rallies markedly, this signifies investor’s “flight to safety” on fears of an economic recession.

Now this comes as the US dollar index appears to be consolidating or forming a bottom, see main window, albeit this is too premature yet to conclude.

Again the US dollar’s action could be in reaction to technical oversold levels or possibly a reflection of a narrowing current account deficit or due to expectations on narrowing interest rate spreads, where the recent financial market crisis could possibly impel the Euro zone and the Bank of England to equally cut rates.

Since we have observed that the world has been outrageously levered via different mechanisms such as the CARRY TRADE, one notices that today’s downside volatility has been coincident with meaningful rallies in currencies which had been utilized as funding sources for cross asset arbitrage trades as shown in Figure 2.

Figure 2: Carry Trade Unwind?

The Japanese Yen and the Swiss Franc has substantially gained during the past two weeks (bar chart and superimposed line chart at the main window, respectively) as markets resonated on the jitters from the unfolding credit crisis.

Notice that the Salomon Brothers Emerging Market Debt Index (pane below main window) appears to have peaked as the Yen-Franc tandem bottomed during early November. This could mean that levered arbitrage positions which were sourced from such currencies had been unwound.

Nonetheless if industrial metals are priced to reflect on global economic growth then the present streak of declines forebodes of decelerating trend of world growth as shown by the lowest pane in the chart via the Goldman Sachs Industrial Index.

Nevertheless, the issue revolves around the continuing saga of accelerating strains in the US credit markets which continues to ripple across the financial markets worldwide with some incipient signs of spillover to the real economy.

Aside, the US financial sector remains under severe pressure, compounded by the recent implementation of Statement 157, as required by the Financial Accounting Standards Board (FASB), a non-profit private organization, whose purpose is to standardize financial accounting and reporting guidance. The new reporting guidance requires firms to specifically disclose its assets into 3 three categories: Levels 1, 2 and 3 starting on the November 15^th. Recent moves to defer the implementation were rejected.

Under the FASB, Level 1 is defined as liquid assets or assets that can be assessed or priced from the market or “marked-to-market”. Level 2 are assets with less liquidity but could be assessed or priced based on estimates from “observable inputs” from similar assets or otherwise known as “marked-to-model”. Meanwhile Level 3 is classified as highly illiquid assets with no point of reference or “unobservable” inputs. Level 3 is basically a guess.

Analyst Nouriel Roubini points out that some major financial institutions in the US have enormous level 3 assets exposure relative to equity capital base, he cites Citigroup 105%, Goldman Sachs 185%, Morgan Stanley 251%, Bear Stearns 154%, Lehman Brothers 159% and Merrill Lynch 38%. While this does not suggest that all Level 3 assets will go kaput, this suggests of the risks of incurring more losses from these institutions which should eventually be reflected in the financial markets.

This also implies that these institutions would be hoarding money to defend or buttress its capital base such that lending activities would be stymied. Essentially contracting liquidity in the marketplace and in the economy translates to a phenomenon called as deflation.

As example, Goldman Sach’s Jan Hatzius recently forecasted that financial institutions such as banks, brokerages and hedge funds would see a cut of liquidity or lending by as much as $ 2 trillion which could result to hard landing in the US.

Bloomberg quotes Hatzius, ``The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized,'' Hatzius wrote. ``It is easy to see how such a shock could produce a substantial recession'' or ``a long period of very sluggish growth,'' he wrote.

In addition there have been signs that the housing recession has now began to spillover to the Commercial Real Estate, where office buildings, shopping malls and construction for structures for manufacturing have likewise began to crack.

Quoting Nouriel Roubini (highlight mine), ``And indeed the boom in CRE investment – with excessive construction of commercial real estate is leading – like in the case of housing – to a glut of unsold or empty properties that is leading to a fall in prices. As reported by the FT: “Moody’s index of commercial real estate prices is expected to show that prices flattened or fell in September, after rising nearly 14 per cent in the 12 months to August. RBS Greenwich Capital predicts that US commercial property prices will fall 10-15 per cent next year.”

``The coming meltdown of commercial real estate is also evident by the sharp widening in credit spreads for CRE mortgages and commercial mortgage backed securities (CMBS). One of the most clear signals of this extreme stressed in the non residential MBS (CMBS) market is given by the CMBX index that is reported by Markit. The data are scary: for BB tranches the spread is now over 1500bps; for BBB- the spread is 1,100; for BBB is 965; even for A is 540; and 326 for AA tranches. All these spreads have sharply widened compared to their spring 2007 levels. At these spreads the ability to finance any new CRE investment – apart from those already committed and financed – is practically null. After the pipeline of already financed projects is finished the market for financing and securitizing CRE – apart from the highest rates projects – is practically frozen. Indeed, the issuance of CMBS fell to $6.3 billion in October, down 84% from a record $38.5 billion in March that finance about half of commercial property purchases. So the CRE market now behaves similarly to the sub-prime market; it is totally frozen.”

Respected independent Canadian research outfit BCA Research somewhat shares the deflation outlook given the present readings from economic indicators as shown in Figure 3…

Figure 3: BCA Research: US Inflation…or Deflation?

From BCA (highlight ours), ``Core CPI is just over 2% on an annual basis, and is set to decelerate. Earlier upward pressure from the shelter component of CPI is easing, while goods prices are already firmly in deflationary territory. Service sector inflation (outside of housing) failed to gain a head of steam during the economic boom, and is likely to drift lower with the economy growing at a sub-par pace. Retailers are back in aggressive price discounting mode. Inflation is not going to be a constraint on the Fed, and we expect further rate cuts ahead, especially with the credit crunch continuing to roll on.”

Remember, US equity markets have now begun to falter anew even after TWO rate cuts, which means that the equity markets are currently anticipating even more forthcoming weaknesses and thus the renewed selling pressures.