- Global Delevering

I’ve heard all manner of ridiculous analysis on the financial channels this morning, but what has caused all this global turmoil is clear. This is delevering. People are selling everything, to raise cash for margin and reserve requirements. It’s the same sort of thing that happened in 2008. And it means that if you have cash, there will be real bargains to be had, when the dust finally settles.

Greece is going to default, and whatever else happens, that means the Euro area will be going into recession. Since our own economy has all the strength of a man just recovered from malaria, we’ll probably be doing a double dip too. None of that has helped, but I don’t think it’s the principle catalyst for this sell off.

I think what brought this around was an expectation of QE3 which didn’t happen, and operation twist which did. We hadn’t had enough sell off in my opinion, to justify QE3 in the current political environment. But if and when the S&P 500 ticks down in the territory of 1,050 (which has been my QE magic number for months now) much of that opposition will evaporate. With his political star somewhat in decline, I doubt Rick Perry will be lobbing any new charges of treason toward the fed in the weeks to come either.

This will make a new policy initiative politically easier, and falling commodity prices indicating possible deflation will be used as justification. When you hear people tell you the fed is out of arrows, don’t you believe it. Once you add the Q to QE, there’s always room for one more.

The output from operation twist was really interesting. By flattening the yield curve the fed eliminated the US Treasury carry trade, the one totally risk free source of revenue for the money center banks. And although it increased the value of the treasuries they’re holding as collateral, it’s not so shocking to imagine that a finite reduction in future revenue would cause them to reign in risk in other areas. This is a risk reduction, undertaken by everyone at once.

So there were a few macro events conspiring to lower asset values, but if you’ve been following along at home, nothing has really changed. My peers have been waiting for the Greek default for a year, and it was never a secret that it would bring with it a risk of recession and deflation. The question is, now that it’s happened, what will policymakers do about it?

On the fiscal side the most effective route is simple – transfer assets and capital from unproductive activities like writing new EPA regulations and other bureaucratic guidelines, to productive activities like basically anything in the private sector. But it’s election time in the US so that won’t happen until next year at the earliest if Obama loses, and 2016 if he doesn‘t. Sound fiscal thinking has not been the hallmark of this administration.

Then, on the monetary side, like it or not, the answer is more liquidity.

My buddy Randy, my fixed income ‘goto’ guy thinks any more QE would be disastrous and will put the global fiat money system at risk. I disagree. (In fairness, he might feel differently if we face our second dip and falling commodity prices – I haven’t had a chance to talk to him) The state of affairs in Japan, who is a decade further along than we are, makes me believe the waterfall is further downstream than anyone believes, if it’s actually down there at all. And because that’s so, I think we have much further to run on the QE train before the end of the line is imminent.

The European waters are a bit muddier because it’s not clear who will be deciding what. something will change with the Greek default. It’s the financial equivalent of the immovable object and the irresistible force. It would be economic suicide for Greece to default on its debt and remain in the euro. The deflation there has already been unprecedented in modern history, and facing a total collapse, they would be fools to stay with the common currency.

The Greeks need liquidity, but the ECB won’t give it to them so long as it’s run by Germans. Or maybe they will….who knows. Things change on a moment by moment basis with the European ruling elite doing all they can to maintain their power, and the European public demanding that they had better do something else. This is further complicated by the fact that the “something else” is usually outside the authority of the institutions that the people are demanding it from. It’s all a great big cluster F--- in Europe right now. So naturally that remains the focus of the markets.

The knife is falling fast, but very soon I think it will be worth the risk to grab it. As an example, nearly everyone I know had returns on their personal portfolios above 50% in 2009. Thanks to this sell off, there is no reason 2012 can’t be the same.