The economics websites came out regarding China's currency devaluation with the term "Shocked". Shocked is an economics term. Demand shock is a  term describing an event that reduced or threatens to reduce demand for goods and services in the world. Shock puts economies in danger, and shock can lead to deflation.

Bill Gross was on the money when he warned of deflation and currency wars, and China obliged by lowering the value of the Yuan. The shock could get more pronounced if the currency is devalued more, over time. This would signal a real race to the bottom amongst central banks of the world.

And, certainly, deflationary expectations can work to destroy economies all over the world. Consumers worldwide are already fragile. The US consumer, who I once called the golden goose of financial stability, was destroyed in the Great Recession by hot money entering and then leaving the housing market. Even America was ripe for the picking, and not shielded from activity that was mostly seen in developing nations.

So, then, shock is a code word for sell. The consumer is weak, but too smart to fall for easy money lending. The millennials cannot be conned into investing in stocks, or houses, in this environment. Could no-money-down, interest-only mortgages overcome that, as money escapes the stock market to the housing market? I don't think it could.

Mistrust in the financial system at the same time the financial system is weakened by demand shock could spell massive distress in world economies, including the US economy. If people don't want loans, there is no powerful economic recovery. We are in a mortgage depression, still. And there are laws to overcome to let the easy money flow again, to those who may not want it this time around.

Not only that, we have derivatives needing more collateral. The Fed needs to move those bonds off the balance sheet at attractive rates. That is necessary as these bonds are necessary for sound collateral. But that movement will not happen if China keeps devaluating, or the dollar will become too strong. This is what is meant by the Fed being caught in a box. It is boxed in by the value of the dollar and the need to get the bonds back into circulation.

That is why the lowering of the Chinese Yuan is seen by the insiders as being a shock. I am sure it scares the living daylights out of the Federal Reserve that it is stuck with 3 trillion dollars of bonds at such low interest rates, while there is a massive shortage of collateral needed for derivatives transaction. Banks creating derivatives contracts without collateral are all playing in the dark with one another. LIBOR rates will be key to watching going forward.

I would think that the Federal Reserve would mandate that the banks use collateral in every derivatives transaction, because this would increase the demand for bonds at whatever interest rate, and allow the Fed to unload. Why the Fed is not forcing the banks in this direction is just not understandable to me. But I know why this is. If the Fed forces banks to buy more bonds, the yields will go down, and make it even harder to get rid of more excess bonds!

This all may not hit the fan in the near future, but the race to the bottom by China could make the crisis hit a whole lot sooner than it otherwise will. Unless demand can be found for all these treasury bonds, by making them needed as the new gold collateral of financial transactions in all cases, then banks could learn not to trust each other again. And yet, more demand for bonds just lowers the rates for them.The Fed is in a box.

It is possible that low interest rates on the long bond is proof that the economy is weak. But it could also be proof that there is a shortage of good collateral. Bonds may not be an effective measure of economic health anymore, although I think the economy on main street is weak but getting a little stronger. Bonds are the gold of financial transactions and that is a new demand created for them. They are not the barometer of economic health anymore. That is my opinion only. 

Raising rates is probably a bit of a pipe dream. 25 basis points is all the market can handle. Will Rogers once spoke to that sort of economic weakness. He said:

"The whole financial structure of Wall Street seems to have fallen on the mere fact that the Federal Reserve Bank raised the amount of interest from 5 to 6 per cent. Any business that can't survive a 1 per cent raise must be skating on mighty thin ice... But let Wall Street have a nightmare and the whole country has to help get them back in bed again." DT #950, Aug. 12, 1929

In truth, it doesn't matter how weak the economy is, it matters whether the banks are weak or not. They are the ones skating on "mighty thin ice". Of course, if interest rates could be raised it will make the banks stronger. So, QE didn't work for the people, and the Fed and the government need to get money into the hands of the people. "Shovel ready" is probably not a silly idea the way things are going. Bankers and Republicans laugh at that idea of real stimulus to real people, but everything else is turning to failure. And banks are at risk of not trusting each other again.