Montreal, Canada

If you're looking for an indicator to confirm the legitimacy of the bond market rally since April, then look no further than money-supply data. The U.S. economy is stuck in a rut; if the trend in loan contraction continues, a recession or a double-dip is almost unavoidable.

According to The Wall Street Journal (June 24), U.S. banks continue to rein in lending.

Since January 2010 bank holdings of Treasury securities have risen 3%. That's been a terrific trade this year for the banks as bond prices have rallied sharply following a dismal 2009.

Benchmark ten-year Treasury bonds are at the cusp of touching the 3% level – a psychologically important number for the markets. The recent thrust behind T-bonds is the apparent new bust now underway in distressed housing after a series of bearish data since earlier this month. The numbers are pretty bad; mortgage refinancing activity has collapsed, new and existing home sales have tanked and foreclosures are again rising.

Meanwhile, commercial and industrial loans have declined by 4% and real estate loans have contracted by 2% since the beginning of the year. This is not the kind of data that supports a sustainable economic expansion. In every post-WW II economic recovery coming off recession lows, the American economy was supported by credit growth as businesses and individuals consumed credit or grew debt. That's just not happening since the economy hit a trough in late 2008.

Over the last four weeks the much feared "deflation" word has surfaced again – the first time we're contemplating an environment of falling prices since early 2009. But the sad truth is that since 2000 we've been mobbed by bear markets deflating asset values across swaths of assets, including technology, real estate, commodities, collateralized mortgage-backed securities, global equities, distressed debt and convertible bonds. That's a pretty impressive list. From their respective all-time highs these and other risk-based assets remain 25% to 50% below their highest values over the last decade – some even deeper in the red. This, in a word, is deflation or the destruction of asset values.

Until banks start lending again and borrowers start demanding more credit, the broader monetary aggregates in the United States and in Europe will remain weak. There's no grease being applied to the wheels. Contracting money-supply means central banks are losing the battle against inflation – a commodity in desperately short supply. Central banks must print. Time is running out at exactly the same time they are being forced to withdraw fiscal stimulus. Increasingly, the bond market is correct as it discounts a deflationary scenario now unfolding in the West.

Have a nice weekend. See you on Monday.