The Great Risk Aversion and The Global Economy

The Great Risk Aversion is unfolding and nowhere is this more obvious than in interest rates and credit spreads.

The 3-month US T-bill is at 3.22%, much lower than the Fed Funds target rate of 4.50%. This is not only a signal that the market expects further Fed rate cuts, but it also shows that participants are getting so risk averse they are willing to accept significantly lower returns from an instrument deemed 100% safe (the government can always print more money), instead of lending to the interbank market. The spread between Fed Funds and 3m T-bills is at a 17-year high (see chart below).

Data: FRB

Longer-term Treasury rates are also moving lower: the 2-year note is at 3.07%, the 5-year at 3.41% and the 10-year at 4.00% - all much below the Fed Funds rate and going down fast (click chart to enlarge).

Chart: FRB St. Louis

There is flight to "certainty" taking place right now, even as commodity prices are soaring. Bond investors are clearly dismissing all current inflation worries: the 20-year inflation indexed Treasurys are now yielding 1.98%.

Chart: FRB St. Louis

Credit spreads are rising, signifying increased unwillingness to provide credit to those borrowers deemed riskier. Commercial paper spreads are on the rise again (chart below).

Chart: FRB

There are many more indicators of credit spreads widening, in the asset-backed and straight corporate bond and loan sectors. The various CDS indices (ABX, CMBX, CDX, LCDX) are all making new lows in most tranches, pointing to increased worries about upcoming defaults and credit events. The result is that as interest rates drop precipitously for government bonds, other borrowers are not benefiting. Lenders are becoming increasingly worried that they are not going to get their principal back, never mind interest payments. Treasury bond rates are no longer indicative of the general level of borrowing costs in the wider economy.

If this was all that was happening, we would unequivocally expect credit destruction to lead to deflation, or at least disinflation. But the ongoing Chinese boom is lifting the economies of the commodity economies (oil block, Brazil, Canada, Russia, Australia), providing a cushion to the global economy.

The question is this: can China replace the US as the global economic locomotive and prevent a worldwide slowdown? In my estimation, no. Despite its soaring growth rates, China remains a poor country and cannot create nearly as much final demand for goods and services as the US. Replacing export business with domestic consumption may be sustained for a while by the expenditure of accumulated reserves, but after they are gone the pantry will not be restocked with export earnings.

Data show that US imports from China are already slowing down; in September they grew by only 9.5% from a year ago, the slowest in at least five years (see chart below).

US Imports from China, percent change from year-ago level (3m moving avg.) Chart: FRB

Bottom line? The evidence suggests that we are heading for a global economic slowdown, despite the surge in commodity prices. Such price action may be better explained by three factors unrelated to marginal physical demand:

a) The weakness in the dollar as global reserve currency.
b) Late-stage market events (i.e. final speculative blow-off) .
c) Resource extraction maximization (e.g. Peak Oil).