By: Larry MacDonald

Yesterday’s market crash was triggered by the U.S. and European financial sectors reporting tumbles in earnings and asking for billions more in aid from governments. The need for capital infusions is still so overwhelming — despite the hundreds of billions already poured in — that it appears there will be no stabilizing the crisis until more radical solutions are adopted.

These include nationalizing the sickest banks (e.g. Royal Bank of Scotland in UK), setting up “an aggregator bank” to swallow toxic assets, and injecting government money into the banks through huge equity stakes. The measures seem to imply substantial dilution of existing equity holders. So the latter shoveled out positions onto the market yesterday, dragging the S&P Financials index down by over 16% and the S&P 500 over 5%. Investors in many institutions were worried, to put it another way, that the U.S. will follow the example of the UK and introduce a rescue package that wipes them out. That’s not quite the source for the sell-off expected, but it will do.

Interestingly, though, the S&P 500 is still up about 7 per cent since the November 20 low while the financials are down more than 13% since. The market seems to be betting the more radical policies on the way will draw a line under the debacle. Bank investors may suffer but investors outside the sector could be okay since their companies should be better assured of having access to credit. In Canada (as an aside), I still remain a little worried about the chartered banks being able to avoid further drops in share prices, with the world around them in flames (it shouldn’t be a decline anywhere as bad as elsewhere, though).

A dissonant note was the sell-off in U.S. government bonds. The flight to safety lost out to concerns that the requirement for greater government assistance will finally result in too many bonds being issued. That development is a little disconcerting because it hints the capacity of the U.S. and Europe to bail out its banks is near its limit.

When added to existing debt and commitments, the debt burden will be so huge that it could mean it’s not possible to finance it in a non-inflationary way. This may not be entirely evident in the near term with deflationary forces still strong, but if the world economy is to keep climbing out the hole without unnerving interruptions, central banks may feel compelled down the road to allow more inflation than what their targets allow. We shall see; a clearer picture will emerge in months ahead. Anyway, shorting government bonds still seems to be one way to ride out the crisis.