Comment 48: Tracing the panic in the financial market: Self healing? Then what?
The recent panic in the financial market is caused by the steady deflation of the debt bubble. However, the panic itself is not identical to the deflation of the bubble. The inflation and the deflation of a debt bubble is controlled by the behavior of the US trade deficit and will stretch through a time period measured by years as discussed in Comment 46, whereas a financial market panic is like a sudden violent turbulence appearing and disappearing during the process of the debt bubble deflation. An effective way to track the progress of a panic in the financial market is to observe the yields of short-term treasuries, for example, the yield of 1 month T-bill. On Aug. 8, just before the onset of the panic, the yield of 1 month T-bill stood at 4.94%. In the following two trading days, the yield dropped to 4.60% and then to 4.28%. In the first four trading days of the week of Aug. 13, the yield was 4.51%, 4.53%, 4.10% and 3.03% respectively. During this series of dropping yields of 1 month T-bill, FED continuously injected short-term liquidity into the financial market, but was not able to ease the panic. On the morning of Friday, Aug. 17, FED lowered the discount rate by 0.5% and encouraged the financial entities in distress to borrow from the discount window with asset backed securities as collaterals. This discount rate cut, though hailed by the stock market, was ignored by the financial market and the yield dropped to 2.91% on that day. On the following Monday, Aug.20, the yield dropped further to 2.35%, but on Tuesday, Aug. 21, the day when this comment is written, the yield has bounced back to about 3.0%.
This financial market panic is ironically created by the financial invention of bundling many small loans into a large batch of asset backed securities. The advancement of computer technology enabled such bundling possible, but also made the identification of what kinds of small loans contained in a specific security difficult. As the subprime mortgage woes worsen, the financial market is not sure which financial entities are in trouble due to this difficulties of tracing small loans. Thus it becomes the pastime of the market to see who is hit by the woe day by day and the mood of the financial market has been darkening for months. Around Aug. 8 the information, that some entities issuing commercial papers are in trouble due the woe and will not be able to repay the money borrowed through the issuance of commercial papers, spread through the market. The major buyers of commercial papers are money market funds that tout the liquidity and safety as their selling point. The managers of money market funds must have panicked and have started to scrutinized every commercial paper in their portfolio and everyone offered to them in the market. During this simultaneous massive scrutinization period, the trading of commercial paper is disrupted. Money market funds parked their idled cash in the safe heaven of short-term treasuries, causing their yields to tumble. However, as the scrutinization proceeds, more and more safe commercial papers are also identified and the trading of those healthy commercial papers will resume. Thus the parked funds in the short-term treasuries will return to the commercial paper market and the yields of short-term treasuries will rise again. The rebound of the yield of 1 month T-bill on Aug. 21 gives the hope that this self-healing process of the financial market may be taking place. However, we need to observe a little while longer to be sure of that assumption. If this guess is correct, the yield of 1 month T-bill should move back to the level of pre-panic days, that is, around 4.9% soon.
One may wonder what is in store after the panic disappears spontaneously according to the script discussed in the previous paragraph. We should note that irrespective of the panic the deflation of the debt bubble is going on and the deflation process will continue for quite a while since the stagnating US trade deficit is not going to change course in near future. Thus more overextended financial entities will run into trouble and the economic growth will slow down further. Some claim that FED should lower the federal-funds rate at this juncture. However, if the panic will self heal, the lowering of the funds target rate is not designed to calm the panic, but to reflate the debt bubble by replenishing the lost liquidity due to the stagnating trade deficit. History tells us that to reflate a debt bubble hastily is inflationary, and will require the prescription of an even harsher medicine to correct the mistake later on.