US economic data releases make grim reading these days. Jobless claims hit their highest level for seven years in September. US factory orders tumbled 4% in August.

MarketWatch says recent data “make it all but certain that the academic economists will eventually declare that the economy is in a recession.”

Charles Delvalle says we are in a deflationary cycle that will only get worse as more credit is sucked out of the financial system. He recommends high-yielding corporate bonds for investors looking to avoid the stock market gloom.

This from Charles at Investor’s Daily Edge:

M3 has grown rapidly when you average it since 2001. But when I talk about a shrinking money supply, I’m talking about a very recent phenomenon. The following quote is from The Telegraph…

The US money supply has experienced the sharpest contraction in modern history, heightening the risk of a Wall Street crunch and a severe economic slowdown in coming months. Data compiled by Lombard Street Research shows that the M3 ”broad money” aggregates fell by almost $50bn in July, the biggest one-month fall since modern records began in 1959.

“Monthly data for July show that the broad money growth has almost collapsed,” said Gabriel Stein, the group’s leading monetary economist.

As you can see, this is something that started in July, not all of 2008. This isn’t shocking either for a variety of reasons.

First, let’s address the Fed. The Fed is issuing very short-term loans to banks in exchange for their junk mortgage assets. All the Fed is doing is making bad assets more liquid so that banks have some leeway. This isn’t adding funds to the market, it’s simply making funds already there more liquid.

People get this confused sometimes. They believe that this is nothing more than the Fed injecting money into the market. But after the 28-day period (or however long the loan is for) the Fed simply gives the assets back to the bank who borrowed them. Then that bank has to give the Fed their money back plus interest.

So the Fed takes on risk for about 30, 60, or 90-days. After that, the risk is on the bank again. So if the Fed held assets of $50 billion from Lehman (this is purely an example), when Lehman went bankrupt, the Fed would have been left holding the bag.

Depending on the valuation of these assets, the Fed may still come out at a profit (if they valued the collateral at 40 cents on the dollar and are able to sell it for 50 cents in the market).

Granted, these term auction facilities don’t shrink the money supply. It’s the $500 billion + losses that the banks have seen which shrink the money supply.

You might wonder how $500 billion would be enough to shrink the money supply.

One word – leverage.

If you’re holding assets worth $500 billion and you leverage that ten times, now you control $5 trillion. If you lose that $500 billion, you have to close out all the leveraged trades. Some of those will be closed out at a profit and others at a loss, which means you could actually lose even more money just trying to unwind such a massive position.

In other words, when leverage is factored into the equation, a $500 billion loss really turns into a $2.5 - $5 trillion loss from the money supply.

Now trillions can certainly affect the US money supply and this in and of itself is the biggest reason why the money supply isn’t growing (past the level of inflation).

Now imagine, some economists expect $2 trillion in credit losses. That would mean that total losses (including leverage) could total up to $20 trillion.

Just for reference, US GDP is $13 trillion a year. So losses could eclipse the size of the US GDP.

And all this talk of deflation is really starting to pan out. The prices of virtually all commodities have taken a 20-30 percent hit. Lower gas prices mean lower input costs. In other words, producer prices should come down. And just as expected, last month they dropped 0.6 percent.

With less credit out there, people have less purchasing power. Lower purchasing power means less spending, and that ALWAYS means more sales-incentives. These incentives given by retailers (like the GM employee pricing plan, and the ridiculous back-to-school sales) will lower prices, which in turn takes a bite out of consumer level inflation.

Let’s not forget that lower consumer spending also means companies will go bankrupt, causing a jump in the jobless rate, meaning even less money going into the economy, which translates into even lower prices.

As cash-rich corporations see sales plummet, they’ll put off big capital upgrades until the economy is doing a little better. In the meantime, they spend less and other firms are forced to lower prices in order to motivate corporations to spend.

Is it any wonder government spending has been going through the roof. It’s all in an effort to minimize the deflationary cycle we are in now.

$150 billion in tax benefits here… a $30 billion bailout there… a $202 billion bailout somewhere else… and finally a $700 billion bank bailout. Next we’ll probably see more tax cuts and rebates (depending on who becomes president) which creates more government spending, all in an effort to keep the economy humming along.

But no amount of government spending will replace the money lost to this mortgage mess. The worst part is that it’s nowhere near over.

Consumer credit markets have yet to crash. The commercial property market has yet to collapse. Bankruptcies will move higher, as will unemployment.

According to Bloomberg, 16 percent of Alt-A mortgages issued since January of 2006 are at least 60-days late, and according to RealtyTrac, “defaults will accelerate next year and continue through 2011 as these loans hit their three- and five-year reset periods.”

There are $1 trillion in Alt-A mortgages out there. With a 16 percent default rate, that means at least $160 billion more losses to come, and this default rate could push higher. We shouldn’t be shocked to see 25 – 30% of these Alt-A mortgages go bad.

So you see, not only is this credit blow up nowhere near over, but the evaporation of credit will take money out of our money supply. As that happens, the economy will suffer, prices will move lower, and we’ll see some deflation occur.

Like I’ve said in previous articles – all of this makes bonds one of the most attractive investments right now. Not only can you find amazing yields (due to the market panicking), but you can find solid companies with bonds trading well under face value.

If you just get into a short-maturity bond with a good interest rate (and low default risk), you’ll probably make more money than most people playing stocks.

What is certain is that the massive credit bubble that is being unwound today will cause asset prices across the market to deflate.

That means we could be in a bear market for a long, long time.

Source: Staying Short in the Face of a Shrinking Money Supply