Financial Tsunami, Updated

I know it’s McCain’s day and I don’t want to step on the parade, but you might have noticed that the US stock market dropped three percent yesterday. Bonds had a fairly significant rally, but not a barn-burner.

A pile of really bad economic data came out yesterday, and this morning everyone is anxiously awaiting the monthly labor data. The consensus estimate going in is that about 75,000 jobs were lost in August. If the number comes in much worse than that estimate, hold on to your hat. (Even though New York isn’t expecting a visit from Hurricane Hannah until Saturday.)

At the beginning of this week, I was beginning to scent some signs of a possible turnaround ahead in the financial markets. For one thing, the US dollar is continuing to strengthen rapidly (or more precisely, the euro is continuing to weaken), and commodity prices (including oil) continue to fall. But even the inward signs have been pointing to a mild return to stability in some sectors of the credit and housing markets. Yesterday may have changed that benign picture.

Update: The BLS August employment report is UGLY. See additional comments below the fold.

Bill Gross appears to have touched off a lot of selling yesterday. He’s the investment chief of Pimco Funds (a unit of Allianz Insurance), and he’s one of the most important bond investors in the world. He wrote in a blog post yesterday that, in his opinion, the Federal Government needs to start using its balance sheet to support the value of debt securities, and specifically prices of mortgage-backed debt. Otherwise, the world might experience what he called a “financial tsunami” of falling asset values.

What on earth is he talking about? In a word, he’s worried about deflation. There is too much risk-bearing debt in the world, issued during the years when global markets were systematically underpricing risk and volatility, and now there isn’t enough equity to support it all.

For a perfect storm of reasons (which I’ve been recounting to you over the thirteen months of this continuing financial crisis), there is very little ability for private markets to generate new credit. There is a tremendous appetite, on the other hand, for risk-free and near-risk-free credit, as the continued success of US Treasury and Fannie/Freddie/Ginnie issuance attests.

Why are we worried about conditions in the credit markets? For the same reason you worry about there being oxygen in the air. Business conditions can’t improve without credit. All the economic news focuses on consumer spending, which it’s possible to stimulate through deficit spending. But things can’t improve systemically and permanently as long as credit formation is so impaired.

That’s why the $150 billion tax rebate program earlier this year was such a monumental waste of money. It was like taking an aspirin to cure cancer. It masks the pain a little, but doesn’t fix the disease.

Should the US taxpayers step in and execute a leveraged buyout of the world financial system? More or less like West Germany bought out East Germany in 1989 (by exchanging deutschemarks one-to-one for the far less-valuable östmarks)?

That would be a great question to ask the two candidates for President. Something tells me I won’t get the chance to ask. Something else tells me that their answers wouldn’t matter anyway, because whoever becomes President next January will have one heck of a mess to deal with, and very few good options.

Update: An hour ago, the Bureau of Labor Statistics reported that 84,000 net jobs were lost in August, and the unemployment rate ticked up from 5.7% to 6.1%. In keeping with the pattern seen almost every month this year, the only sectors that added jobs were healthcare, education, and government. Bond-market reaction so far appears moderate.

-Francis Cianfrocca