The collision of global markets and social mood

Monday, November 8, 2010

The Yin and Yang of Credit and Debt

The supreme ultimate, otherwise known as yin and yang.

In Daoist philosophy, it is thought of as the highest conceivable principle, that from which all existence flows. Its inexhaustible source of meaning and wisdom has been written about for thousands of years.

For our purposes, consider it to be a graphic way of simply saying that which is in excess yields its opposite.

Keep this in mind when thinking about credit and debt. An excess appetite for credit eventually leads to an inability to service the corresponding debt. In a marketplace saturated with debt there is no longer the appetite for more credit, even at extremely low interest rates.

Try as it might, the Fed can't yet force a lender to lend, nor can it force a consumer to borrow. It can only attempt to foster the conditions that make lending and borrowing palatable.

So for all of the Fed's huffing and puffing, it is up against an exceedingly pesky reality.

It is up against market psychology.

There has to be an overall willingness to lend and borrow, which is based on the confidence levels of both parties, and the borrower has to have the ability to service the debt. Willingness and confidence are in short supply as psychology shifts from expansiveness and optimism to pessimism and conservation. That which is in excess yields its opposite.

While QE's bottom line is merely a slightly lower long-term interest rate, it does have the potential to aggravate commodity and currency prices in the near term. One raises prices, while the other leads to protectionism. One puts pressure on a borrower's ability to take on more debt. The other cuts growth. Neither will help the Fed.

Curiously, both could have the unintended effect of putting a floor under the dollar. Further contraction in outstanding credit will cause outright deflation, the Fed's deepest fear. In a deflation, the senior currency (that which underpins the majority of the debt which is liquidated) soars in value because so much credit is destroyed. That currency is the dollar. (See 2008.)

Additionally, other nations tend to get angry when their currencies soar in value and their exports suffer. They then devalue their currencies by buying dollars.

Right now, according to the Daily Sentiment Index, there are just 3% bulls in the dollar and over 90% bulls in the Euro. That which is in excess yields its opposite.

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