This Is What Happens When Deflation Begins

Libor Shows Strain, Sales Dwindle, Spreads Soar: Credit Markets

By John Glover and Caroline Hyde

May 24 (Bloomberg) -- Corporate bond sales are poised for their worst month in a decade, while relative yields are rising at the fastest pace since Lehman Brothers Holdings Inc.’s collapse as the response by lawmakers to Europe’s sovereign debt crisis fails to inspire investor confidence.

Companies have issued $47 billion of debt in May, down from $183 billion in April and the least since December 1999, data compiled by Bloomberg show. The extra yield investors demand to hold company debt rather than benchmark government securities is headed for the biggest monthly gain since October 2008, Bank of America Merrill Lynch’s Global Broad Market index shows.

Concern that European leaders won’t be able to coordinate a response to rising levels of government debt from Greece to Spain, while U.S. legislation threatens to curb credit and hurt bank profits, is driving investors away from all but the safest securities. The rate banks say they charge each other for three- month loans in dollars has almost doubled since February.

“This is a quintessential liquidity crisis,” said William Cunningham, head of credit strategies and fixed-income research at Boston-based State Street Corp.’s investment unit, which oversees almost $2 trillion. “It’s not inconceivable to imagine a situation where the markets behave so poorly, the liquidity behaves so badly, and risk-tolerance just evaporates that -- particularly in Europe -- consumers contract, businesses stop hiring and stop investing, and economic activity halts.”

Libor has been climbing as concern grows about the quality of banks’ collateral amid the euro-region’s financial crisis. Citigroup Global Markets Inc. strategist Neela Gollapudi in New York said in a report that the rate has the potential to reach 1 percent to 1.5 percent “over the next several months” after the U.S. Senate approved a financial-regulation overhaul that may increase banks’ uncertainty about how they will be able to fund themselves.

The spread, a gauge of banks’ reluctance to lend, surged to a record 364 basis points on Oct. 10, 2008, as Lehman’s collapse almost triggered a freeze in interbank lending. Overnight index swaps, or OIS, shows where traders expect the Federal Reserve’s overnight effective rate will average for the term of the swap.

“De-risking by investors and regulatory uncertainty are combining to create deteriorating liquidity in fixed-income markets,” debt strategists at New York-based JPMorgan Chase & Co. said in a report dated May 21. “Look for the flight to liquidity to persist, liquidity differentials to widen, and less liquid asset classes to cheapen in the near term.”


The dark lord Libor is rising again.

It is yet another warning in a litany of indicators pointing to deflation.

The problem, contrary to this article, is not a liquidity crisis, but one of solvency.

We have moved from a banking crisis in 2008 to a sovereign debt crisis in 2010.  The bond market will only tolerate so much and it is near its limit.

Banks, with their bailouts, have still not addressed their inadequate capital issues fully, which is why they are restricting lending.  As lending drops, so does the credit portion of the money supply, reinforcing the issue of shrinking velocity.