In a sea of red, government bonds and are gold both rising as the world’s banking system cracks under the weight of the biggest debt expansion in history.

Credit Freeze Prompts New Bailouts

Bloomberg is reporting Government Bonds Rise as Credit Freeze Prompts New Bailouts.

Government bonds around the world rose as stocks tumbled and the freeze in credit markets prompted new bailouts of Hypo Real Estate Holding AG and Fortis, stoking demand for the safest assets.

U.S. Treasuries climbed for a fourth day, sending two-year notes to their longest winning streak in six weeks, and gains for German two-year notes drove yields to their lowest levels since March. Japanese 10-year bonds advanced for a second day, pushing yields down to the lowest level since April.

Investors are piling into government bonds on concern the bailouts will fail to stem further bank failures, driving the world’s biggest economies into a recession. At the same time, the short-term debt markets that provide financing to the global economy have frozen. The Libor-OIS spread, a gauge of the scarcity of cash among banks, widened to a record today.

The prospect of a global economic slump has caused investors to raise bets the biggest central banks will cut interest rates. Futures on the Chicago Board of Trade show a 60 percent probability the Fed will slash its benchmark interest rate by a half-percentage point at its Oct. 29 meeting. The odds were zero a month ago. The chances of the European Central Bank reducing its main refinancing rate next month are 100 percent, up from 21.5 percent a week ago, according to a Credit Suisse Group index of derivatives.

Inflation expectations as measured by the difference in yield between regular bonds and index-linked bonds fell around the world, giving added cause for policy makers to cut borrowing costs.

Banking Crisis In Europe Widens

For more on the European banking crisis and how it is affecting the US dollar, please see Pound and Euro Sink in European Bank Crisis.

Deflation Models

In Treasury Bull Alive And Kicking I presented my model of how I see things. Here is a small snip:

Deflation Models

I had several models for how deflation might play out. Here they are.

  1. Everything but treasuries sink
  2. Everything but treasuries and gold sink
  3. Gold sells off initially then rallies with treasuries

Yes, this treasury bull is extremely long in the tooth. And yes there will be a time to short treasuries. But there has not been a bull market in history, in anything, that ended with that asset class being nearly universally despised.

And make no mistake about it, treasuries are despised. Foreign central banks do not count because they are not buying treasuries to make a profit, and they are relatively unconcerned about losses.

All things considered there is genuine pent up demand for treasuries right here in the US should foreign buying subside. The reason is simple. It is far better to make 3% in treasuries than to lose 30% in equities, commodities, or corporate bonds.

Potential For Deflationary Crash

At this juncture the markets are definitely in a potential deflationary crash mode. And as stated above, I believe the Fed is essentially powerless to do anything about it. The Fed cannot possibly bail out every bank, brokerage, airline, and automotive company that is in dire straits. They cannot force sovereign wealth funds to do so either.

Sun Sets On Bretton Woods II

The sun is finally setting on Bretton Woods II dollar hegemony as noted in French President Nicolas Sarkozy Calls For “New World”.

Trillions of dollars have been borrowed that cannot be paid back, and what cannot be paid back will be defaulted on. Government bonds will not default, and of course gold being no one’s liability, will not default either.

Global Credit Boom Goes Bust

Gold is in the green, and the U.S. dollar is soaring along with treasuries. Those are about the only things on my screen that are in the green. Global equities, corporate bonds, and commodities in general are getting hammered. This is entirely consistent with the deflation thesis I have been talking about for a long time.

The global credit boom has gone bust as all credit booms do, and there is nothing the Bernanke Fed or any other Central Bank can do about it (except of course, make matters worse). The Fed itself is the problem and should be abolished. Instead, Congress is giving the Fed more powers exactly as predicted by the Fed Uncertainty Principle on April 3, 2008.

Uncertainty Principle Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

If you have not yet read the Fed Uncertainty Principle, please do so.

Mike “Mish” Shedlock
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