1937 Redux: Deflationary Wave Has Returned

Almost a straight shot down in the junkiest junk since the end of quantitative easing in October 2014.
Would you want to own Chinese WMPs yielding 8-12% or would you rather own U.S. junk yielding 12-16%? Deflation is underway, rates are rising at the riskiest end of the market first, foreign currencies are devaluing versus the dollar as the supply of credit contracts.

I couldn't find the source where I saw this, but Alhambra posted a chart showing that when the BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread hits 7.5%, the stock market tanks. I reproduced the chart below:
The peak this year was 6.83% on October 2, on December 8 it was 6.65%. At the current pace, 7.5% could be hit in a month. The bigger rally goes back to June 2014, just before the U.S. dollar rally begins. The pattern of the spread matches that of the U.S. dollar index.

Jeffrey Snider at Alhambra paints a portrait of major deflationary trends underlying the market, such as the death of eurodollars:
If Morgan Stanley’s FICC units can only make money when QE is pressing on prices and spreads (or so everyone might believe), then what does it say about QE in Morgan Stanley’s behavior after Q3 2013, especially now when, by cutting a quarter of the staff, that places an exclamation upon the withdrawal? QE was supposed to create a recovery and thus great profit opportunity, but the absence of QE leaves banks to only leave, meaning no profit and thus truly no recovery. This financialism becomes the economic misimpression that “unexpectedly” showed up this year to spoil the self-congratulatory party as the FOMC tries over and over for a lift off.
These aren't small numbers:

He also looks at the PBoC and the ongoing depreciation in the renminbi:
The PBOC is not intervening by “selling UST” in order to “prop up the yuan” at all, but rather trying to maintain a steady supply of global currency for its own point of access – the credit-based reserve “dollar” currency. The central bank is attempting to fill a void of created by a foreign, market imbalance. Therefore, the price of that is incorporated into the exchange rate of the yuan to the dollar. A further depreciation in the yuan makes (means) funding more expensive, thus the PBOC has a great interest in trying to keep it from getting too far out of hand (while balancing the need of China’s banks to bid even at expensive funding costs for “dollar” rollovers).

The events of mid-August were a huge break on that account; China’s banks met a wall where rollovers in “dollars” were no longer permissible at the PBOC’s manipulated exchange rate. The central bank either had to supply the equivalent of the “dollar” drain itself, let China’s banks default on “dollar” rollovers and risk being catastrophically shut out of the credit-based reserve currency system, or allow China’s “dollar short” to be funded at whatever increasing cost necessary (“devaluation”). They chose the third option because it was the only realistic alternative, and still they endured great and ongoing calamity.
The key insight when mixed with the credit market moves above is this:
That is the main point about China, namely that in a credit-based reserve currency system global money can be destroyed rather than being redeployed somewhere else. In fact, dependent upon balance sheet conditions in the aggregate, the credit-based reserve dollar can just disappear at a moment’s notice if balance sheets so contract themselves. Given the plethora of indications that big banks, the actual eurodollar supply, have been doing just that, none of this should truly be misunderstood let alone surprising.
He goes on to discuss the renminbi depreciation in A Very Disturbed Global ‘Dollar’:
Given that the only comparable period to the last few days in repo was when the PBOC was under such huge “dollar” strain the last time, being so far as forced into abandoning whatever it was doing in CNY and allowing “devaluation”, it is unsurprising to find the PBOC once more fixing CNY in that direction almost to that degree. It bears repeating, the CNY exchange rate is not devaluation (classical thinking) but rather the relative “dollar” cost for rolling over the “dollar short” (quantum thinking); thus, a higher fix is the PBOC acknowledging the need for Chinese banks to bid more for that funding.

In that case, the events of the past few days in repo are quite confirming as the PBOC’s reference rate, or middle rate, for CNY exchange has similarly exploded. On November 30, the middle rate was set at 6.3985; on December 4, as the franc, gold and repo started to move toward reduced wholesale risk “flow” and offer, the middle rate was pushed up to 6.4039; yesterday the middle rate was 6.4185. Today, in a huge one-day move, again, telling us a great deal in cooperation with the surge in repo rates, the PBOC fixed the middle rate at 6.432!
Dollars are becoming scarcer and the impulse to repay debt is driving up funding costs, expressed in the exchange rate. "If you want my dollars, you have to bid for them." He closes:
In other words, liquidity, for all that it is supposed to be in these kinds of conditions, really just describes the exits. Here, we see them already narrow and now far more uncertain even at that. The franc, gold and perhaps yen suggest that even the shrunken exits we see now are misleading as the Chinese can attest – try to use them, in size, and run the high risk of being visited close hardship. For commodity producers (and eventually industrial firms and manufacturers) this isn’t just some esoteric interest, if your balance sheet is replete with running debt rollovers better to start thinking of firesales now before it gets too late and the exits so narrow that your company is instead punished (forced toward its own liquidation) by the mere suggestion of it.
Several credit market charts are posted in Very Disturbed: Selloff Accelerates and Spreads.

The hyperinflation crowd was proven wrong because the inflation ended in 2007/8. That was the crisis. Global central banks stopped the deflation and caused a small rebound, but in 2011, the decline started again. Gold and commodities peaked, the Morgan Stanley's eurodollars peaked (above). Pressure on the yuan also began at that time. Greece ran into trouble in 2010 and still isn't out of trouble. The fundamentals kicked into high gear at the end of June 2014. The fallout in credit markets is accelerating and the Federal Reserve is widely expected to raise interest rates next week.

1937! 1937!

It was 8 years from 1929 to 1937 and it is 8 years from 2008 to 2016. Must be a little more than coincidence, but I'll leave it to the cycle-theorists and socionomists to explain it. No doubt there will be those who argue the Federal Reserve caused this mess by their recent (and imminent as of today) policy. They have the villain correct, but not the weapon. The Fed held credit deflation at bay for 8 years by swapping debt for fiat in its QE programs. If the new fiat currency circulated, as it had in the past, it could have created inflation and sparked an economic recovery as borrowing revived. Instead, the market behaved as if peak debt was reached.

There was never going to be a painless end to a market that doesn't want more debt, when you're running a credit based monetary system. The Federal Reserve chose the least painful course of action: delay. Hope the credit system restarts. A political act, such as Steve Keen's plan for a Debt Jubilee, is a possible end game, but the Federal Reserve lacks the tools and authority to solve the problems created by a fiat backed credit money system. It cannot create new money when all it can do is swap a debt instrument (Federal Reserve notes) for existing debt. The market must create new credit money. And the market has been doing it at a far slower pace than in the past.

Hence a slowing rate of credit growth:
Due to Fed policy response, this declining ratio of credit to fiat:
(TCMDO was discontinued, but it can be replicated. See: The Replacement for TCMDO)

Anecdotal Evidence

A big change had already unfolded in many assets, ranging from commodities to emerging market currencies. Social mood reflects the change. There is growing political discord in Europe and the United States, rising strikes in China, Russia contemplating war with Turkey and nuking ISIS, terrorists have slipped passed demoralized European and American security agencies, the migrant crisis in Europe, even a horror comedy Christmas movie did well at the U.S. box office.

The market could be very close to a bottom and a reversal in some key markets such as the U.S. dollar may already be underway. If not...

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