Bill Gross says The Shadow Knows.

As the commercial paper market shrinks by hundreds of billions a month, central banks worldwide are facing a giant stress test of the modern-day shadow banking system. The publicized and photographed overnight “runs” on Countrywide and the UK’s Northern Rock in mid-August were nothing compared to what’s taking place in the shadows of the real banking system. Credit contraction, with its inevitable companion of asset destruction, is spreading with the speed of an infectious bacterial disease. …

How does one protect “deposits” during a run that no one can see? Commonsensical analysis has only to ask what investments did especially well during the shadow’s formation in order to understand where future losses may lie. …

Chairman Bernanke and his divided band of governors will have to feel their way along this treacherous path with canes in hand—not totally blind, but significantly hampered by a lack of historical context which might point the way to the ideal rate via precedent as opposed to feel. ..

It is logical to me therefore, to assume that 1½% is the neutral rate required to keep the future Shadow oiled and properly functioning. If so, then 2% core inflation and 1½% real Fed Funds require a drop to at least 3½% just to maintain current momentum. To restart a near recessionary economy we may need to eventually go down to 3% or lower.

Forward-looking bond investors should understand that the shadow banking system has been built on leverage and cheap financing and that to keep it from imploding, a return to Fed Funds levels closer to those of 2003 may be required. While the Fed is not likely to repeat its 1% “deflation insurance” levels of that year, current Fed Funds futures which predict a 3¼% bottom are not likely to be correct either. Standby for a tumultuous 2008 as the market struggles to move from the shadows back into the sunlight of sounder banking and financial management, accompanied by Fed Funds levels at 3% or lower.

William H. Gross

Unlike the majority who are screaming at the top of their lungs about the threats of inflation, I heartily endorse the idea that “Credit contraction, with its inevitable companion of asset destruction, is spreading with the speed of an infectious bacterial disease.

Indeed that is the very idea that I portrayed in Deflationary Credit Downturn Is Underway.

Asset destruction is spreading rapidly, but the amazing thing to me is how few see the inherent risks of it. I am not even sure if Bernanke sees it. If he does, he sure isn’t saying so. This means Bernanke is being purposefully opaque while professing a policy of fake transparency, or he is completely oblivious as to what is really happening.

However, that is the beginning and the end of my agreement with “commonsensical” analysis. I do not think the Fed, Bill Gross, or anyone else knows what neutral is. One thing we know for sure is that neutral was not the 1% rate that Greenspan set while fighting a deflation scare that was not in the cards then but is now. A second thing we know is that neutral is a moving target.

Thus the Fed or Bill Gross could only hit neutral by accident, typically on an overshoot in the wrong direction. The only way to find out for sure where neutral lies is to abolish the Fed and let the free market decide what neutral is.

Ironically, Greenspan brought about the very conditions he sought to avoid by helping create the biggest credit bubble the world has ever seen.

While looking for “commonsensicalness”, Gross fails to look ahead as to what a return to 3% will accomplish. Will 3% create jobs, reinflate the housing bubble, or reignite commercial real estate? Will it do anything at all for wages?

I propose it will do none of the above. For starters, a 3% Fed Funds Rate will likely to do little for housing given that so many are underwater on their houses and default risk is increasingly being priced into mortgage rates. In addition, 3% rates will not stop global wage arbitrage, the deflationary effects of outsourcing, or cure rampant over capacity in darn near everything including Home Depots, Pizza Huts, strip malls, nail salons, and WalMarts. Nor will 3% rates strengthen neglected infrastructure which may mean higher state taxes.

And what about the possibility of a major stock market correction? What would that do to pension plan assumptions? Heck, pension plans are probably in serious trouble if the market simply stagnates for a few years.

Should Congress be dumb enough to start invoking retaliatory tariffs to protect jobs, heaven help us. Certainly such actions are not out of the question in light of absurd reactions we are seeing from Congress and the Treasury over the housing debacle.

While 2008 is likely to be tumultuous, Bernanke, the Fed, the Treasury and Congress are all doing everything in their power to avoid the sunlight of free market forces. With that in mind and given the propensity for politicians to meddle (see Paulson Strikes Out), it takes a real optimist to believe 3% rates will accomplish much of anything other than prolonging the agony. We are closely following the footsteps of Japan even though history has warned us that path leads nowhere.

Mike “Mish” Shedlock
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