Dysfunctional Markets

Dysfunctional Markets
by Doug Noland May 14, 2010

For the week, the S&P500 rallied 2.2% (up 1.8% y-t-d), and the Dow gained 2.3% (up 1.8%). The S&P 400 Mid-Caps jumped 4.3% (up 8.6%), and the small cap Russell 2000 recovered 6.3% (up 11.0%). The Morgan Stanley Cyclicals jumped 4.4% (up 7.0%), and the Transports gained 4.4% (up 9.5%). The Morgan Stanley Consumer index rose 1.8% (up 3.4%), and the Utilities gained 2.4% (down 3.9%). The Banks jumped 3.1% (up 24.7%), and the Broker/Dealers increased 1.5% (down 1.8%). The Nasdaq100 increased 3.1% (up 2.5%), and the Morgan Stanley High Tech index gained 2.1% (down 2.1%). The Semiconductors rose 2.1% (down 1.7%). The InteractiveWeek Internet index jumped 4.5% (up 4.1%). The Biotechs rallied 3.7%, increasing 2010 gains to 15.3%. With bullion jumping $22, the HUI gold index surged 7.9% (up 13.4%).

One-month Treasury bill rates ended the week at 14 bps and three-month bills closed at 14 bps. Two-year government yields declined 3 bps to 0.72%. Five-year T-note yields fell 3 bps to 2.10%. Ten-year yields increased 3 bps to 3.46%. Long bond yields rose 6 bps to 4.34%. Benchmark Fannie MBS yields declined 7 bps to 4.20%. The spread between 10-year Treasury and benchmark MBS yields narrowed 10 bps to 74 bps. Agency 10-yr debt spreads declined 3 bps to 44 bps. The implied yield on December 2010 eurodollar futures declined 4 bps to 0.855%. The 10-year dollar swap spread declined 1.25 to 3.5. The 30-year swap spread increased 2.25 to negative 18.5. Corporate bond spreads were mixed. An index of investment grade bond spreads narrowed 15 to 103 bps. An index of junk bond spreads widened 27 to 516 bps.

Debt issuance remained slow. Investment grade issuers included Enterprise Products $2.0bn, Morgan Stanley $1.75bn, Citigroup $1.5bn, CVS Caremark $1.0bn, Kinder Morgan $1.0bn, Burlington Northern $750 million, XCEL Energy $550 million, PNC Funding $500 million, Pearson Funding $350 million, Cigna $300 million, FPL Group $250 million, and San Diego G&E $250 million.

May 14 – Bloomberg (Shiyin Chen): “High-yield bond funds posted the largest outflows in five years and emerging-market equity funds had a second straight week of redemptions as Europe’s sovereign- debt crisis dented demand for riskier assets, EPFR Global said.”

Junk issuers included Mylan $1.25bn, MCE Finance $600 million, Omnicare $400 million, Wireco Worldgroup $275 million and Kratos $225 million.

I saw no converts issued.

International dollar debt sales included Inter-American Development Bank $1.0bn, Metinvest $500 million, Kazatomprom $500 million, and Renhe Commercial $300 million.

U.K. 10-year gilt yields declined 6 bps to 3.75%, while German bund yields rose 6 bps to 2.86%. Greek bond yields collapsed 470 bps to 7.70%, and 10-year Portuguese yields dropped 163 bps to 4.63%. The German DAX equities index rallied 6.0% (up 1.7% y-t-d). Japanese 10-year "JGB" yields rose 3 bps to 1.30%. The Nikkei 225 recovered 0.9% (down 0.8%). Emerging markets recovered some of last week's decline. For the week, Brazil's Bovespa equities index gained 0.9% (down 7.5%), and Mexico's Bolsa rose 1.0% (down 1.0%). Russia’s RTS equities index gained 4.8% (down 0.6%). India’s Sensex equities index gained 1.3% (down 2.7%). China’s Shanghai Exchange added 0.3% (down 17.7%). Brazil’s benchmark dollar bond yields dropped 17 bps to 4.83%, and Mexico's benchmark bond yields sank 43 bps to 4.78%.

Freddie Mac 30-year fixed mortgage rates dropped 7 bps last week to 4.93% (up 7bps y-o-y). Fifteen-year fixed rates fell 6 bps to 4.30% (down 22bps y-o-y). One-year ARMs declined 5 bps to 4.02% (down 69bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 15 bps to 5.63% (down 64bps y-o-y).

Federal Reserve Credit dipped $1.2bn last week to $2.310 TN. Fed Credit was up $90.3bn y-t-d (11.1% annualized) and $193.7bn, or 9.2%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 5/12) declined $11.8bn to $3.064 TN. "Custody holdings" have increased $108bn y-t-d (10.0% annualized), with a one-year rise of $380bn, or 14.2%.

M2 (narrow) "money" supply was up $34.3bn to $8.504 TN (week of 5/3). Narrow "money" has declined $8.1bn y-t-d. Over the past year, M2 grew 1.4%. For the week, Currency added $0.8bn, and Demand & Checkable Deposits surged $40.7bn. Savings Deposits declined $4.0bn, and Small Denominated Deposits fell $5.0bn. Retail Money Fund assets added $1.9bn.

Total Money Market Fund assets (from Invest Co Inst) jumped $24.2bn to $2.878 TN, the first rise since February. In the first 19 weeks of the year, money fund assets have dropped $416bn, with a one-year decline of $912bn, or 24.1%.

Total Commercial Paper outstanding added $0.9bn last week to $1.103 TN. CP has declined 67$bn, or 15.7% annualized, year-to-date, and was down $195bn from a year ago (15%).

International reserve assets (excluding gold) - as tallied by Bloomberg’s Alex Tanzi – were up $1.297 TN y-o-y, or 19.4%, to a record $7.986 TN.
Global Credit Market Watch:

May 12 – Bloomberg (Tim Catts and Pierre Paulden): “Europe’s sovereign debt crisis is punishing corporate borrowers, with bond issuance tumbling as investors doubt a $1 trillion bailout plan will be enough to bolster confidence in government finances for the region. Borrowers worldwide have sold $15 billion of corporate debt this month, a 62% decline from the same period in April and 83% less than the average for the past year… The extra yield investors demand to own corporate debt instead of government bonds soared last week to the highest in more than four months… ‘This is a fix and not a resolution,’ said Jason Brady, a managing director at Thornburg Investment Management… ‘Investors have seen volatility and that makes it harder to get excited about longer-dated assets paying a fixed return.’”

May 11 – International Herald Tribune (Andrew E. Kramer): “As the financial markets try to absorb news of a rescue package for Greece and other teetering euro-zone countries, some bankers and economists see parallels to Russia’s meltdown in 1998. A decade ago Russia was walking in the same shoes as Greece is today, striving to restore confidence in government bonds by seeking a huge loan from the International Monetary Fund and other lenders. Then, as now, the debt crisis was roiling global financial markets. And big hopes were pinned on a bailout — one that in Russia’s case did not work. ‘Greece creates a remarkable sense of déjà vu,’ Roland Nash, the head of research for Renaissance Capital, an investment bank in Moscow, wrote…”

May 11 – Finanacial Times (David Oakley and Ralph Atkins): “Investors on Tuesday warned that the European Central Bank would have to introduce quantitative easing to stave off the worst crisis in the eurozone since it was launched 11 years ago. The ECB has resisted following the Bank of England and the US Federal Reserve in expanding the money supply by buying government bonds because it fears that it could stoke inflation. Although eurozone central banks bought eurozone government bonds this week for the first time as part of the international rescue plan, this is not QE as the ECB is funding this by selling German bunds or using commercial bank deposits.”

May 11- New York Times (Landon Thomas Jr. and Jack Ewing): “Like the giant financial bailout announced by the United States in 2008, the sweeping rescue package announced by Europe eased fears of a market collapse but left a big question: will it work long term? Stung by criticism that it was slow and weak, the European Union surpassed expectations in arranging a nearly $1 trillion financial commitment for its ailing members over the weekend and paved the way for the European Central Bank to begin purchases of European debt on Monday... The premium that investors had been demanding to buy Greek bonds plunged… And as details crystallized of the package’s main component — a promise by the European Union’s member states to back 440 billion euros, or $560 billion, in new loans to bail out European economies — the wisdom of solving a debt crisis by taking on more debt was challenged by some analysts. ‘Lending more money to already overborrowed governments does not solve their problems,’ Carl Weinberg, chief economist of High Frequency Economics…said…"

May 12 – Bloomberg (Tim Catts and Pierre Paulden): “Europe’s sovereign debt crisis is punishing corporate borrowers, with bond issuance tumbling as investors doubt a $1 trillion bailout plan will be enough to bolster confidence in government finances for the region. Borrowers worldwide have sold $15 billion of corporate debt this month, a 62% decline from the same period in April and 83% less than the average for the past year…”

May 14 – Wall Street Journal (Ianthe Jeanne Dugan): “Federal regulators and state officials are examining Wall Street's role in trading derivatives that essentially bet the municipal bonds they sold would go bust. The Securities and Exchange Commission has launched a preliminary inquiry into banks' trades of municipal credit-default swaps that allow investors to short-sell, or bet against, municipal bonds… The probe is exploring potential conflicts of interest by banks that sell municipal bonds and then poise themselves to profit if those bonds fail, these people said. A main thrust of their investigation is whether firms use their own money to bet against the bonds they sell and, if so, whether that activity is properly disclosed to bond buyers.”

May 14 – Bloomberg (Christine Harper): “Goldman Sachs… is ceasing proprietary trading in one type of structured debt… A group of traders who were focused on making bets on collateralized loan obligations with the New York-based firm’s own money are now handling trades for clients…”

May 12 – Bloomberg (Takahiko Hyuga and Finbarr Flynn): “Morgan Stanley Chief Executive Officer James Gorman denied allegations the U.S. bank misled investors about mortgage derivatives it sold them. The firm is being probed by U.S. prosecutors over whether the bank misled clients when it sold them collateralized debt obligations as its own traders bet that the value of the securities would drop… Wall Street firms are facing unprecedented scrutiny from lawmakers and prosecutors over whether they missold CDOs linked to the subprime mortgages that caused the credit crisis.”
Global Government Finance Bubble Watch:

May 12 – Bloomberg (Abigail Moses and John Glover): “The cost of saving the world from financial meltdown has been bloated by ‘hyperinflation’ since Long Term Capital Management LP’s rescue in 1998… rising price of bailouts since the $3.5 billion pledged to hedge fund LTCM after it was crushed by Russia’s default, and the almost $1 trillion committed to halt the European Union’s sovereign debt crisis this week. It cost just $29 billion to sooth markets in March 2008 when Bear Stearns Cos. was taken over, and $700 billion for the Federal Reserve to save the banking system with the Troubled Asset Relief Program in October that year. ‘We haven’t had any kind of normal inflation in the last decade, but we’ve had hyperinflation in writedowns and the magnitude of bailouts,’ said Jim Reid, head of fundamental strategy at Deutsche Bank… ‘You have to do more to get a similar effect every time.’”

May 12 – Bloomberg (David Mildenberg and Dawn Kopecki): “Four of the largest U.S. banks, including Citigroup Inc., racked up perfect quarters in their trading businesses between January and March, underscoring how government support and less competition is fueling Wall Street’s revival. Bank of America Corp., JPMorgan Chase & Co. and Goldman Sachs Group Inc., the first, second and fifth-biggest U.S. banks by assets, all said in regulatory filings that they had zero days of trading losses in the first quarter… ‘The trading profits of the Street is just another way of measuring the subsidy the Fed is giving to the banks,’ said Christopher Whalen, managing director… Institutional Risk Analytics. ‘It’s a transfer from savers to banks.’
Currency Watch:

The dollar index jumped 2.1% this week to 86.249 (up 10.8% y-t-d). For the week on the upside, the South Korean won increased 2.2%, the Mexican peso 2.1%, the Brazilian real 2.0%, the South African rand 1.3%, the Canadian dollar 1.1%, and the Singapore dollar 0.6%. For the week on the downside, the euro declined 3.1%, the Danish krone 3.0%, the Swiss franc 2.2%, the British pound 1.8%, the Swedish krona 1.35, the New Zealand dollar 1.1%, the Japanese yen 0.9%, the Norwegian krone 0.3%, and the Australian dollar 0.2%.
Commodities Watch:

May 12 – Bloomberg (Stuart Wallace): “There has been a ‘significant’ surge in sales of gold coins and bars, particularly in Germany, Ross Norman, one of the founders of TheBullionDesk.com, said… ‘The last time we saw this level of grass-roots activity was in October 2008 when the economy was on the brink and the retail gold buying community effectively drained gold from the market,” the former bullion dealer said in the report.”

May 10 – Financial Times (Jack Farchy): “Silk ties and handkerchiefs are forecast to rise in price after the cost of silk jumped to its highest level in at least 15 years as rapid industrialisation in China, the world’s largest supplier, robs the sector of valuable farmland. The price of silk cocoons… has doubled since the start of 2009…”

The CRB index declined another 1.1% (down 8.8% y-t-d). The Goldman Sachs Commodities Index (GSCI) slipped 0.4% (down 4.4% y-t-d). Spot Gold jumped 1.8% to $1,230 (up 12.1% y-t-d). Silver surged 4.6% to $19.30 (up 14.6% y-t-d). June Crude sank $3.18 to $71.93 (down 9.4% y-t-d). June Gasoline 0.6% (up 4% y-t-d), and June Natural Gas jumped 7.7% (down 22% y-t-d). July Copper declined 0.8% (down 7% y-t-d). May Wheat sank 7.3% (down 14% y-t-d), and May Corn declined 2.2% (down 14% y-t-d).
China Bubble Watch:

May 11 – Wall Street Journal Asia: “The direction of China’s economy is set. The question troubling investors is whether policy makers have set their course, too. With consumer-price inflation rising to 2.8% in April, real interest rates have moved farther into negative territory… More inflation is in the pipeline. The producer-price index rose 6.8% year-to-year in April, up from 5.9% in March. Higher manufacturing costs should eventually feed through to consumers. The latest housing-market data adds to fears of overheating, with prices up 12.8% year-to-year across 70 of China's larger cities. New bank lending was up, too, with $113.3 billion more loans pumped into the economy in April -- back to around the average monthly level during 2009's credit bonanza. Against this backdrop, Beijing's tightening measures to date are inadequate.”

May 13 – Bloomberg (Peter Woodifield): “China is set to overtake Japan as the largest Asia-Pacific commercial real estate market next year following a surge in values, according to property adviser DTZ Holdings Plc.”
India Watch:

May 13 – Bloomberg (Unni Krishnan): “India’s food inflation rate climbed… An index measuring wholesale prices of agriculture products… rose 16.44% in the week ended May 1 from a year earlier…”

May 12 – Bloomberg (Kartik Goyal): “India’s industrial production grew more than 10% for a sixth straight month, adding to inflation pressures even as Europe’s debt crisis threatens to undermine the global economic recovery.
Asia Bubble Watch:

May 12 – Bloomberg (David Yong): “Asian interest-rate swaps show traders are betting central banks will be less aggressive in raising borrowing costs because of the European Union’s sovereign-debt crisis. ‘The euro crisis has hurt market confidence and liquidity,’ Matthew Huang, an interest-rate strategist… at Barclays Capital Plc, said… ‘If liquidity freezes up, Asian policy makers will likely choose to leave monetary conditions looser for longer.’”

May 10 – Wall Street Journal Asia (Alex Frangos): “The European bailout plan could be too much medicine for an overheating Asia. Before the Greece crisis intensified last week, policy makers in China and elsewhere in Asia said too much growth and an abundance of capital inflows were pushing real-estate and other asset prices dangerously high. While Asian markets welcomed the 750 billion euro ($955 billion) bailout plan, economists and analysts warned that the rescue package could end up bringing even more capital to Asian markets… Loose monetary policy in Europe and the U.S. has already helped to inflate assets prices in Asia, especially for emerging-market bonds and real estate.”

May 12 – Bloomberg (Eunkyung Seo): “South Korea’s unemployment rate declined in April for a third straight month… The jobless rate fell to 3.7% from 3.8% in March… ‘Jobs market conditions are improving on the economic recovery,’ Lee Sang Jae, an economist at Hyundai Securities... said… ‘But there remains some weakness, supporting policy makers’ views that the economy isn’t strong enough to endure higher borrowing costs.’”

May 13 – Bloomberg (Shamim Adam and Manirajan Ramasamy): “Malaysia’s economy grew at the fastest pace in at least 10 years last quarter… Gross domestic product increased 10.1% in the three months ended March 31 from a year earlier…”
Latin America Bubble Watch:

May 12 – Bloomberg (Jens Erik Gould): “Mexico’s industrial production rose the most in almost four years in March on surging demand for exports to the U.S. Output climbed 7.6% from a year earlier…”

May 12 – Bloomberg (Fabiola Moura and Drew Benson): “Argentine Economy Minister Amado Boudou said last week’s jump in bond yields may prompt the government to shelve plans to sell as much as $1 billion of bonds, its first international offer since defaulting in 2001.”
Unbalanced Global Economy Watch:

May 10 – Bloomberg (Bob Willis and Thomas R. Keene): “The fallout from the European debt crisis raises the risk of a ‘double dip’ recession for the global economy, said Stephen Roach, chairman of Morgan Stanley Asia Ltd. ‘When you have a vulnerable post-crisis economic recovery and crises reverberating in the aftermath of that, you have some very serious risks to the global business cycle,’ Roach said… ‘This concept of the global double dip which no one wants to talk about… is alive and well.’”

May 12 – Bloomberg (Svenja O’Donnell): “U.K. unemployment climbed to a 16- year high in the first quarter, underlining the fragility of the recovery as Conservative David Cameron begins his premiership.”

May 12 – Bloomberg (Simone Meier): “Europe’s economy expanded at a faster pace than economists forecast in the first quarter as a global recovery boosted exports… Gross domestic product in the 16 euro nations rose 0.2% from the fourth quarter…”

May 12 – Bloomberg (Christian Vits): “Germany’s economy unexpectedly grew in the first three months of the year as rising exports and company investment outweighed the effects of the cold winter. Gross domestic product… rose 0.2%..."

May 12 – Bloomberg (Maria Levitov): “Russia faces a ‘massive’ capital influx as investors look for alternatives to Europe’s crisis- ridden debt markets, said Mikhail Dmitriev, president of the Center for Strategic Development. That’s putting pressure on Russian policy makers to implement capital controls soon to stem the flows and avoid ruble volatility, Dmitriev, whose think tank conducts research for the government, said in an interview… ‘The government is unarmed against the distortions that may result from massive capital inflows,’ said Dmitriev, who is also a former First Deputy Economy Minister. ‘Russia’s balance of payments and internal macroeconomic stability would undoubtedly be at risk.’”

May 14 – Bloomberg (Paul Abelsky): “Russia’s economy expanded for the first time since 2008… Gross domestic product rose an annual 2.9% in the first quarter after contracting 3.8% in the last three months of 2009…”

May 13 – Bloomberg (Jacob Greber): “Australia’s job growth accelerated in April, propelled by full-time employment… The unemployment rate held at 5.4%.”

May 13 – Bloomberg (Tracy Withers): “New Zealand’s manufacturing industry expanded at the fastest pace in more than five years in April amid rising production and orders.”
U.S. Bubble Economy Watch:

May 12 – Bloomberg (Shobhana Chandra): “The trade deficit in the U.S. widened in March to the highest level in more than a year as imports climbed faster than exports, adding to evidence of the global recovery from the worst recession in the post-World War II era. The gap grew 2.5% to $40.4 billion…”

May 13 – Bloomberg (Ryan J. Donmoyer): “White House budget director Peter Orszag predicted Congress would approve higher taxes on managers of private equity firms, real estate funds and other investment partnerships in the coming weeks. Orszag, speaking yesterday…”

May 10 – Bloomberg (Terrence Dopp): “New Jersey’s Democratic lawmakers plan to introduce legislation to resurrect an income-tax surcharge on residents who earn $1 million a year or more…”
Derivatives Watch:

May 11 – Bloomberg (Phil Mattingly): “The Federal Deposit Insurance Corp. advanced a proposal aimed at overhauling part of the $4 trillion asset-backed securities market and introduced a rule that would require the biggest U.S. banks to submit ‘funeral plans’ to handle their possible collapse… ‘Now is the time to put some prudent controls in place to make sure we don’t get into some of the problems we saw in the past,’ Bair said…
Real Estate Watch:

May 13 – Bloomberg Dan Levy): “U.S. home repossessions rose to a record level in April while foreclosure filings dropped in a sign mortgage lenders are working off a backlog of seized properties, according to RealtyTrac… ‘Right now it appears that the banks are focusing on processing the loans already in foreclosure, and slowing down the initiation of new foreclosure proceedings as a way of managing inventory levels,’ Rick Sharga, RealtyTrac’s executive vice president, said… A record 92,432 bank repossessions were reported in April, up 45% from a year earlier…”
Central Bank Watch:

May 13 – DPA: “The European Central Bank (ECB) on Thursday defended its decision to intervene in European bond markets, rejecting claims that this threatened the bank’s independence. ‘These measures are designed not to affect the monetary policy stance,’ the ECB wrote in its monthly report of its decision to buy debt from troubled eurozone members. ECB chief economist Juergen Stark said this was a ‘temporary emergency measure,’ to which there was no alternative after the euro currency had come under attack. Stark said the bank was not responding to political pressures… ‘The credibility of the ECB does not just hinge on the question whether or not we buy government securities, but whether we fulfill our central task, which is ensuring price stability,’ Stark said. The economist said there was no doubt that ‘an attack’ on individual eurozone countries was being carried out by "anonymous market sources.’”

May 10 – Bloomberg (Mayumi Otsuma): “Central banks from the U.S., Japan and Europe will participate in temporary U.S. dollar swap agreements amid heightened tension in global financial markets, the Bank of Japan said. ‘In response to the re-emergence of strains in U.S. dollar short-term funding markets in Europe’ the central banks of Canada, England and Switzerland will also participate in the re- establishment of currency swaps that were implemented during the financial crisis, the BOJ said… ‘These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers.’ Central banks ‘will continue to work together closely as needed to address pressures in funding markets’ the BOJ said.”

May 10 – Bloomberg (Saburo Funabiki): “The Bank of Japan said it would pump 2 trillion yen ($21.7bn) into the financial system for a second day to help reassure markets after the Greek fiscal crisis set off a slump in stocks worldwide.”
GSE Watch:

May 10 – Bloomberg (Nick Timiraos): “Fannie Mae asked the U.S. government for an additional $8.4 billion in aid after posting an $11.5 billion net loss for the first quarter, the latest sign that the bailout of the mortgage investor and its main rival, Freddie Mac, is likely to be the most expensive legacy of the U.S. housing-market bust… The company has now racked up losses of nearly $145 billion, or nearly double its profits for the previous 35 years.”
Fiscal Watch:

May 13 – Bloomberg (Vincent Del Giudice): “The U.S. posted its largest April budget deficit on record as receipts declined in a month that typically sees an increase in individual income tax payments. The excess of spending over revenue rose to $82.7 billion last month compared with a $20.9 billion gap in April 2009… April marked a record 19th straight monthly shortfall… Deterioration in the government’s balance sheet in coming years raises the risk of higher interest rates even as an improving economy helps lift tax receipts. ‘With the recovery in place, we should be seeing higher revenue and lower outlays, not the other way around,’ said Win Thin, senior currency strategist at Brown Brothers Harriman… The government’s April budget deficit compares with a median forecast of $57.9 billion… The last time the U.S. had back-to-back April deficits was 1963-1964… For the fiscal year that began in October, the budget deficit totaled $799.7 billion compared with $802.3 billion during the same period last year.”

May 12 – Associated Press: “President Obama’s new health-care law could potentially add at least $115 billion more to government health care spending over the next 10 years, if Congress approves all the additional spending called for in the legislation, congressional budget referees said… That would push the 10-year cost of the overhaul above $1 trillion…”
California Watch:

May 11 – Bloomberg (Michael B. Marois and William Selway): “California Governor Arnold Schwarzenegger will seek ‘terrible cuts’ to eliminate an $18.6 billion budget deficit facing the most-populous U.S. state through June 2011… California’s revenue in April, when income-tax payments are due, trailed the governor’s estimates by $3.6 billion, or 26%.”

May 14 – Bloomberg (Michael B. Marois and William Selway): “California Governor Arnold Schwarzenegger proposed a new round of budget cuts, including eliminating the state’s main welfare program for families, to close a $19.1 billion budget deficit for the year starting July 1. The $83.4 billion plan calls for $12.4 billion in spending reductions, $3.4 billion in additional federal aid and $3.4 billion in fund shifts, fees and assessments…”
Speculator Watch:

May 14 – Bloomberg (Jody Shenn and Michael J. Moore): “In June 2006, a year before the subprime mortgage market collapsed, Morgan Stanley created a cluster of investments doomed to fail even if default rates stayed low -- then bet against its concoction. Known as the Baldwin deals, the $167 million of synthetic collateralized debt obligations had an unusual feature… Rather than curtailing their bets on mortgage bonds as the underlying home loans paid down, the CDOs kept wagering as if the risk hadn’t changed. That left Baldwin investors facing losses on a modest rise in U.S. housing foreclosures, while Morgan Stanley was positioned to gain. ‘I can’t imagine anybody would take that bet knowingly,’ said Thomas Adams, a former executive at bond insurers Ambac Financial Group Inc. and FGIC Corp… ‘You’re overriding the natural process of risk-mitigation.’”

May 12 – Bloomberg (Tomoko Yamazaki and Komaki Ito): “Japanese hedge funds, the world’s worst performers last year, returned 6.7% in the first four months of 2010, the best year-to-April return in six years, according to Eurekahedge Pte.”


Dysfunctional Markets:

It scrolled by quickly Wednesday afternoon on my Bloomberg screen: a one-line headline quoting ECB Executive Board member Jose Manuel Gonzalez-Paramo: “Central Banks Can’t Work if Markets Dysfunctional.” My efforts to located Mr. Gonzalez-Paramo’s full comments on the issue were unsuccessful; we’ll have to assume the context. I do believe strongly that many things these days can’t work because global markets are hopelessly dysfunctional.

I was never a big fan of the simplistic analytical fixation on the so-called “shadow banking system.” Key components of this “system” – i.e. the Wall Street securities firms, ABS, CDOs, SIVs, private-label MBS, etc. – have been reined in. This would imply a more stable financial backdrop, which is nowhere to been seen. I am similarly not a subscriber to a “new normal” thesis. Again, the focus seems to detract from today’s key issues. I have posited a “Newest Abnormal” thesis – that the long process of market distortions and economic imbalances has actually accelerated. Things go from bad to only worse. Things may look somewhat different, but there’s nothing new.

From my analytical perspective, the heart of the problem lies with this dysfunctional dynamic between global marketable debt and derivatives, policy-induced distortions, and unfettered speculative finance. Unique in history, we continue to operate with a global financial “system” functioning without limits to either the quantity or quality of new Credit created. There’s way too much Credit backed by little more than government assurances or perceptions of government insurance. And never before has an enormous global “leveraged speculating community” so dominated the markets for debt instruments and, in the process, so relied on faith in the efficacy of government market interventions. It’s global wildcat banking in its purest ever form.

These days, entities all over the world issue enormous quantities of tradable debt instruments. This debt, in large part, is purchased by sophisticated market operators earning unimaginable compensation for achieving “above market” returns. When market psychology is bullish, there is essentially unlimited demand for marketable debt – a significant portion acquired through the use of leverage. And as long as demand for new marketable securities remains robust, underlying positive fundamentals appear to support a high market valuation for this debt (irrespective of the quantity issued) - and the party lives on. But Katy bar the door whenever the crowd moves to cut exposure – either through liquidating positions or acquiring market “insurance.”

Eurozone policymakers look foolish these days for not having reined in profligate Greek borrowing and spending. To many, the ECB looks foolish for Sunday’s decision to purchase in the open market debt issued by Greece, Portugal, Spain and other troubled European countries. Others believe the ECB was foolish for not having had initiated a Federal Reserve-style monetization plan long before the debt crisis spiraled out of control. I sympathize with the ECB. Dysfunctional global markets placed them in a winless situation. Greek 10-year bond yields were below 5% for much of 2009. The market was happy to accommodate profligacy - until it wasn’t. If only well-functioning global markets disciplined borrowers rather than emboldening them.

The sea change in global finance gained unstoppable momentum in the early nineties. The Greenspan Federal Reserve nurtured marketable debt as a mechanism to help overcome severe banking system impairment. There was no stopping the historic boom in market-based Credit once unleashed. The problem was clear by the time of the 1994 bond and mortgage securities dislocation. But it was politically and monetarily expedient to allow GSE Credit (with its implicit government guarantee) to evolve into a mechanism for stabilizing the Credit system and spurring economic expansion.

The rapidly escalating scope of the problem was illuminated with the collapse of LTCM. Yet, the Greenspan Fed supported this new financial infrastructure with only more powerful words and deeds. Pegging short term interest rates and aggressively intervening to rectify market tumult incited unprecedented leveraged speculation throughout the Credit system. Dr. Bernanke’s 2002 “helicopter money” and “government printing press” speeches sealed the fate of runaway Bubbles in both marketable debt and leveraged speculation.

Especially during the Bubble years 2004 through 2007, massive U.S. current account deficits worked to unleash U.S. Credit Bubble dynamics upon the entire world. The more Bubbles became ingrained in the financial architecture the deeper market perceptions became that policymakers wouldn’t tolerate a bust. Worse yet, policymakers resorted to using the debt markets and the market’s propensity for leveraged speculation as mechanisms for increasingly aggressive monetary reflation.

Global policymakers and Credit markets have been fueling Bubbles and accommodating profligacy for years now. It would have taken a concerted effort by global central bankers to rein things in. The Greenspan/Bernanke Federal Reserve would have had no part of it. Quite the contrary. It was fundamental to Greenspan/Bernanke doctrine to deal with market and economic fragility through the aggressive reflation of system Credit. This doctrine of inflationism was instrumental in nurturing Credit and speculation excesses that worked over time to increasingly distort the pricing of finance, the quantity of Credit created, and the allocation of real and financial resources. The ECB’s big mistake was not to have forcefully fought the Fed.

We’re now two years into the greatest expansion of global government debt in the history of mankind. Manic-depressive debt markets have now pulled the rug out from under Greece and periphery Europe, but in the process have further accommodated profligate government borrowings here at home. It is frightening to think of how distorted the Treasury market has become - and how things might play out down the road.

My bearish thesis on our markets and economy is based upon the view that the financial fuel for our recovery has been unsound, unstable and unsustainable. This “Monetary Process” is now in jeopardy. The Global Government Finance Bubble, which lunged into its terminal phase of excess with the collapse of the Wall Street/mortgage finance Bubble, has been pierced. Greece’s debt crisis marks a momentous inflection point. And, yes, some government markets – certainly including Treasuries – are benefiting from Greek and periphery European debt woes. Yet key Bubble dynamics percolate under the surface.

I have argued that the Global Government Finance Bubble has been the biggest and most precarious Bubble yet. The incredible scope of global sovereign debt expansion over the past couple years has been rather obvious. Less apparent are related distortions - to the pricing and allocation of finance throughout international markets - based specifically upon the market's perception that politicians and central bankers would act aggressively and successfully to forestall future crises. This policy-induced market distortion fostered an incredible bout of risk-taking – especially considering the fundamental backdrop – and a resulting massive flood of finance out to the risk markets. This perception has been blown to smithereens in Europe and has quickly become vulnerable everywhere.

Global markets in sovereign Credit default swap (CDS) protection have flourished on the assumption that policymakers would thwart any debt crisis. In the post-Greek debacle era, writing insurance against a government default is no longer free money. New realities have profoundly changed the risk and reward profiles of operating in this key market - and I’ll assume some profoundly less attractive marketplace liquidity dynamics going forward. And a faltering market for sovereign debt insurance significantly changes the risk profile of owning the underlying sovereign debt. To be sure, changing perceptions in the market for government debt work to corrode market confidence in the capacity of policymakers to stem financial and economic crises generally. This implies a major adjustment in the markets’ perception of risk in various markets, including corporate, municipal and mortgage instruments.

But I’m getting somewhat ahead of myself. Thus far, dislocation in Greek debt has fed powerful contagion effects throughout European debt and CDS. This has forced a major market reassessment of the relative stability of the euro currency, which has unleashed bloody havoc throughout the currency and “carry trade” arena. Currency and “carry trade” tumult has forced market reassessment as to near-term prospects for both the dollar (upward) and global growth (downward). This has caused trading liquidation and de-leveraging havoc in the enormous global “reflation trade” and in risk markets more generally. And there’s nothing like liquidation and forced de-leveraging to really bring out the animal spirits for those seeking to make nice speculative profits from others’ misfortune.

The dollar and Treasuries have benefited. This has supported the bullish view that the unfolding crisis is largely a European issue. It has also helped dampen the impact to our markets from changing global perceptions with respect to the capacity of policymakers to stem crises. Here in the U.S., Credit spreads and risk premiums (corporates, MBS, municipals, etc.) have widened some. Yet faith still runs deep that Washington won’t allow a crisis. This confidence must hold for sufficiently loose U.S. finance to continue to support our fragile recovery.

The confluence of global financial crisis and intense financial sector scrutiny here at home will at some point prove confidence in Washington overly optimistic. For now, when it comes to pricing risk and disciplining profligate borrowers, our debt markets remain dysfunctional.
This has caused liquidation and de-leveraging havoc in the enormous global “reflation trade” and in risk markets more generally. And there’s nothing like liquidation and forced de-leveraging to really bring out the animal spirits for those seeking to make nice speculative profits from others’ misfortune.

The dollar and Treasuries have benefited. This has supported the bullish view that the unfolding crisis is largely a European issue. It has also helped dampen the impact to our markets from changing global perceptions with respect to the capacity of policymakers to stem crises. Here in the U.S., Credit spreads and risk premiums (corporates, MBS, municipals, etc.) have widened some. Yet faith still runs deep that Washington won’t allow a crisis. This confidence must hold for sufficiently loose U.S. finance to continue to support our fragile recovery.

The confluence of global financial crisis and intense financial sector scrutiny here at home will at some point prove confidence in Washington overly optimistic. For now, when it comes to pricing risk and disciplining profligate borrowers, our debt markets remain dysfunctional.
http://prudentbear.com/index.php/creditbubblebulletinview?art_id=10376

Misguided Monetary Mentalities ~ Nolan

Nobel Prize economist Paul Krugman – of Princeton and the New York Times – wrote a noteworthy piece this week: Misguided Monetary Mentalities (NYT 10/12/09).

“One lesson from the Great Depression is that you should never underestimate the destructive power of bad ideas. And some of the bad ideas that helped cause the Depression have, alas, proved all too durable: in modified form, they continue to influence economic debate today.

What ideas am I talking about? The economic historian Peter Temin has argued that a key cause of the Depression was what he calls the ‘gold-standard mentality’ By this he means not just belief in the sacred importance of maintaining the gold value of one’s currency, but a set of associated attitudes: obsessive fear of inflation even in the face of deflation; opposition to easy credit, even when the economy desperately needs it, on the grounds that it would be somehow corrupting; assertions that even if the government can create jobs it shouldn’t, because this would only be an ‘artificial’ recovery.

In the early 1930s this mentality led governments to raise interest rates and slash spending, despite mass unemployment, in an attempt to defend their gold reserves. And even when countries went off gold, the prevailing mentality made them reluctant to cut rates and create jobs. But we’re past all that now. Or are we? America isn’t about to go back on the gold standard. But a modern version of the gold standard mentality is nonetheless exerting a growing influence on our economic discourse. And this new version of a bad old idea could undermine our chances for full recovery.”


First of all, Dr. Krugman states that “the bad ideas that helped cause the Depression… continue to influence economic debate today.” Well, let’s say they were actually “bad ideas.” Even then his implication would be only somewhat true. There may be some feeble little impact on what has regressed to one lopsided “debate.” But, regrettably, ideas regarding sound money and Credit long ago lost their influence on actual economic policymaking.

Dr. Krugman, like so many economists of our time, is an inflationist. He, like so many before him, sees easy Credit and the government printing press as the solution to unemployment and other economic problems. And - in our age of electronic “money” and unbounded global finance - there are apparently no longer any bounds to U.S. fiscal and monetary stimulus.

Messrs. Greenspan and Bernanke are inflationists. The inflationists have been running the show since easy Credit was employed to juice the system after the 1987 stock market crash. The consequences of that bout of policy-induced excess led to a more potent inflationist policymaking elixir in the early-nineties to mop up the financial mess. Since then, ever more emboldened Credit inflation has been required to battle crisis after crisis after crisis. Easy money and Credit – the bane of Capitalism – were allowed to overwhelm the workings of the system. The point of Trillion dollar deficits and zero interest rates has been reached – with the undeterred inflationists now bent on this sorry state of affairs continuing indefinitely.

By now, one would hope the inflationists would challenge their own views, doctrines and Mentalities. Instead, they trumpet the same old failed policy responses – only in much larger dimensions and with greater conviction. And that is precisely the flaw in inflationist doctrine: once it gets rolling it becomes extremely painful to rein in the forces pushing for only greater inflation. The more spectacular the inflationary boom and bust - the more strident the inflationists become.

History is strewn with enough collapses, worthless currencies and social upheaval that I find it ridiculous that the inflationists would today be taking shots at sound money and Credit. It is the inflationists Clinging to Misguided Monetary Mentalities. The principle of sound money and Credit has no reason to have to defend itself.

Inflationism doctrine is riddled with failings: Easy Credit distorts system pricing mechanisms; foments destabilizing speculation; spurs societal wealth transfer; distorts the underlying economic structure; fosters financial fragility; and debases the currency – to name just a few. History – including recent history – validates this analysis.

Yet there are two particular facets of today’s inflationism that make “Keynesian” policymaking extraordinarily dangerous. First, the global backdrop is one of unchecked Credit and the absence of any disciplining global monetary regime. Policy mistakes are free to run longer and with enormous global financial and economic consequences. Second, policymakers and pundits herald incredible post-Bubble policy responses, while failing to recognize that aggressive stimulus is, once again, fostering problematic Bubbles. For too long the inflationists have been negligent in their disregard for Bubble dynamics.

From Dr. Krugman: “Consider first the current uproar over the declining international value of the dollar. The truth is that the falling dollar is good news. For one thing, it’s mainly the result of rising confidence…”

While confidence in the global reflationary backdrop may be rising, the dollar is in trouble. And many dollar apologists will claim the greenback has no immediate replacement and thus will retain its status as the world’s reserve currency. This line of reasoning misses the key point: the dollar reserve global monetary “regime” has broken down as a mechanism for supporting stable global Credit and economic performance. Unchecked global finance now rules, a consequence of the massive and ongoing devaluation of the world’s reserve currency.

Only the inflationists could argue the dollar’s current predicament is “good news.” I don’t see it. I don’t view a world economy rebalancing or becoming more stable. Instead, we’re witnessing the unleashing of another furious global boom and bust cycle. Crude oil traded above $78 this week as gold responded to the weak dollar by surging to an all-time record high. U.S. wealth is being shifted overseas, and Americans’ savings are being devalued. We are losing financial power by the day. Good news? More easy Credit to the rescue?

The inflationists are keen to argue that, with “inflation” remaining so low, policymakers enjoy unusual latitude to stimulate. By this point, haven’t we learned that rising CPI is not a primary contemporary risk associated with ultra-loose monetary policy? The mispricing of risk, unchecked speculation, asset-Bubbles, financial fragility, and economic maladjustment have already proven themselves as deleterious effects of loose money. I group these types of responses to unstable finance (“money and Credit”) as “Monetary Disorder.” Anyone watching global markets these days must recognize that Monetary Disorder remains powerfully entrenched.

Krugman Concludes: “We do seem to have avoided a second Great Depression. But giving in to a modern version of our grandfathers’ prejudices would be a very good way to ensure the next worst thing: a prolonged era of sluggish growth and very high unemployment.”

The first Great Depression was triggered by financial collapse – a historic boom and bust. The jury is still out on the second. The inflationists believe their policy prescriptions strengthen system underpinnings. I believe another bout of global Credit and speculative excess increases the likelihood of eventual financial meltdown. And I believe a dollar crash significantly increases the risk of a very problematic U.S. financial crisis. Worse than benign neglect won’t suffice. Dr. Krugman doesn’t think it makes any sense to consider raising rates. I don’t think it makes any sense to disregard the reality that fiscal and monetary policy went to dangerous extremes.

The time has come for a more level-headed and even-handed approach. As much as they abhor the notion of sound money and Credit, the inflationists need to back away from their dogma before it’s definitely too late. A prolonged period of slow growth and sluggish employment is not the worst-case scenario.

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10297

And No Dialing Back

Nolan says it still looks crook!@

And No Dialing Back:

CNBC's Steve Liesman: "Mr. Secretary, how much concern do you have right now - how much pressure are you under right now to dial back on these programs. Dial back spending. Dial back - getting to the audience question right there that I think is critical and that is really indicative of how Americans feel: Get the government out of the private sector. How much pressure are you under right now?"

Treasury Secretary Geithner: "No one is going to be more eager than I am. You're just not going to care about that more than me. We do not want to be in any of these institutions a day longer than is necessary. And look at what we have already done. We already have $80bn of capital coming back into the Treasury. If you look at what I said today in my testimony on the hill, we've seen these emergency programs we put in place already be used at a tiny fraction of their scale in emergency. We designed these things so that they would not be used a day longer than necessary.

But we're going to be careful not to withdraw too soon. Again, the classic mistake countries make in crisis is that they put on the brakes too early and reignite the recession, ultimately at much greater fiscal cost and much greater damage to the economy. So that's the balance we've got to get right. And we are not now at the point - even though the challenge is shifting - we're a bit moving now from emergency to the harder challenge, frankly, of repair and recovery. That's going to change the mix of what we do. We're going to get out and walk these things back as soon as we are confident we can get out of this thing."

September 10 - Bloomberg (Jody Shenn): "'Credibly' privatizing Fannie Mae and Freddie Mac... may be too difficult given the precedent set by the Treasury Department's financial assistance, according to a Government Accountability Office analysis. 'The financial markets likely would continue to perceive that the federal government would provide substantial financial support to the enterprises, if privatized as largely intact entities, in a financial emergency,' the GAO said... 'Consequently, such privatized entities may continue to derive financial benefits, such as lowered borrowing costs, resulting from the markets' perceptions.' The Treasury today reiterated that the government intends to make recommendations on Fannie Mae and Freddie Mac next year... 'Any transition to a new structure would need to consider the enterprises' still-dominant position in housing finance and be implemented carefully (perhaps in phases) to ensure its success," the GAO said."

My interest is not in taking shots at today's policymakers. They have been faced with incredible challenges, and proceed now on a course they hope and believe is best for returning the country to sound footing. And while I disagree strongly with the current path of policymaking, it has been predictable. From a policymaking perspective, the greatest error came with the Greenspan/Bernanke Fed's failure to act to rein in systemic Credit excess, asset inflation, and financial Bubbles. Many belatedly recognized the Fed's failings, yet few today appreciate that the costs and risks of flawed analysis and theories only keeps mounting.

I retain keen interest in debunking the Fed's thesis - articulated most clearly by then Fed governor Bernanke - that central banks should avoid the business of popping Bubbles and instead focus on post-Bubble "mopping up" strategies. It was, after all, post-Russia/LTCM "mopping up" that fueled the tech Bubble, and then the post-Tech and 9/11 mopping fostered the Wall Street/mortgage finance Bubble. And the latest big mop up job sets the stage for perhaps the greatest Bubble all them all - the Global Government Finance Bubble.

They appear as free lunches at the time, but there are myriad financial and economic costs associated with government intrusions into the marketplace. Most are subtle and tend to remain quiescent for years. When (market pricing, resource allocation and economic impairment) distortions do eventually manifest into a crisis, policymaking will have a strong proclivity to treat misdiagnosed ills with only greater government manipulations and intrusions. And the greater the degree of intrusion into the markets, the greater the ongoing costs involved. Huge intrusions ensure open-ended government involvement and increasing governmental command over the economic system.

As much as I believe Secretary Giethner is speaking earnestly, there is no way at this point government influence in the marketplace can be meaningfully dialed back. The damage has been done - historic distortions to both the financial system and real economy. The damage began with the activist Greenspan Fed manipulating interest rates, promising market liquidity, and pandering to the leveraged speculators. The damage worsened as the government-sponsored enterprises came to dominate our nation's market for housing finance. And the damage turned unmanageable when the markets listened back in 2002 to Dr. Bernanke profess the virtues of helicopter money and whatever other unconventional measures the central bank might deem worthwhile.

Federal government finance (Treasuries, agency debt and GSE MBS) has expanded about $2.0 TN over the past year. I expect it to inflate another $2.0 TN over the coming twelve months. The private sector Credit apparatus is simply not up to the task of generating the necessary $2.5 TN (or so) of total system Credit expansion necessary to sustain the current economic structure. In this post-Wall Street Bubble environment, only government and government-related Credit retains sufficient "moneyness" in the marketplace. Systemic reflation today depends on a massive inflation of this government helicopter "money."

This week's GAO analysis on the GSE's was spot on and certainly applies to more than just the GSEs: "The financial markets likely would continue to perceive that the federal government would provide substantial financial support to the enterprises, if privatized as largely intact entities, in a financial emergency." Over five Trillion - and counting - of GSE securities are valued and traded in the marketplace as (money-like) government-backed obligations. Policymakers would not today risk the negative financial and economic ramifications from dialing back from Washington's explicit and implicit guarantees.

And as much as moral hazard and "too big to fail" are recognized as fundamental facets of the previous Bubble excess, our policymakers have nonetheless been compelled to expand only further toward backstopping the entire Credit system. Obviously, the GSE's were too big to really fail, while markets appreciate that policymakers now believe it was a mistake to allow Lehman to collapse. The markets - more than ever before - operate with the view that policymakers have no tolerance for a major financial institution failure.

When one contemplates the issue of "getting the government out of the private sector," these various market liquidity support programs being wound down are an insignificant issue. Fundamentally, for the economy to move toward sounder and sustainable footing would require at least a semblance of a market-based Credit pricing mechanism. Regrettably, the vast majority of system Credit today is "public." Government intrusion chiefly dictates the cost of finance and the allocation of financial and real resources. Furthermore, I would argue that the limited amount of private sector debt being issued these days is dependent upon the system-stabilizing effects of massive government debt issuance and spending.

As I have stressed repeatedly, in the neighborhood of $2.5 TN of non-financial Credit growth is required to stem systemic implosion - a massive Credit expansion with only our federal government up to the challenge. It is this fundamental facet of Bubble economies - a maladjusted economic structure sustained only through ongoing Credit excess - that prohibits Washington from extricating itself from very public "private sector" intrusions. Fixated on the notion of sustainable recovery, policymakers will not be dialing back from massive borrowing, spending, or market backstopping endeavors. And this gets to the core of the unquantifiable costs of failing to rein in Credit and asset Bubbles.

As I have written over the years, the entire notion of "mopping up" is as flawed as it is dangerous. Clearly, the notion of inflationism remains as seductive as it has throughout history. If, God forbid, deflation ever becomes a risk the central bank must aggressively raise the price level to preclude a downward spiral. We heard this dogma in the early nineties, heard it again earlier this decade, and have had it repeated too often over the past year.

And the more intense the necessity to reflate - the greater the government's evolving role throughout both the financial and economic systems. This is a fact of life, human nature and politics. And at the end of the day inflationism tends toward socialism. And there is only one way to reverse this course; it is anything but painless. The economy must be weaned off of Credit and financial excesses and government intrusions - and allowed to proceed through the arduous task of adjustment and rebalancing. Choosing instead a course of sustaining current financial and economic structures implies a huge and ever-expanding role for the government. There will be no dialing back.

Many hope the private-sector can again rise to the occasion. It is expected that as recovery gains a foothold private sector borrowing and lending will increase, tax receipts will rise, and the government enjoy the luxury of dialing back as the system normalizes. I don't expect this dynamic to work as it has traditionally because of the confluence of Bubble economy Credit requirements, acute private sector Credit system impairment, and the government's predominant influence on the recovery.

The dynamic today is one of a shallow recovery induced by a flood of government borrowing and spending and marketplace intrusions. Rampant financial speculation has reemerged, which leaves the marketplace increasingly vulnerable to any serious move to dial back. In a normal recovery, the system tends to gain strength and stability over time. Credit requirements are manageable, and speculative excesses have been largely wrung out of the system. In stark contrast, today's combination of huge Credit expansion and a highly speculative financial backdrop ensures only more acute systemic fragilities over time. And the distorted marketplace will simply not function well at even the notion of fiscal and monetary exit strategies.

Conceptually, somewhere along the line there reaches a tipping point where government intrusions are no longer stabilizing. They become invariably destabilizing, as the quantity of government monetary inflation becomes massive and uncontrollable. This is the nature of inflationism, although this dynamic is nowhere to be found in Keynesian doctrine. It is my view that this tipping point was reached some time back. It is with this analysis in mind that I fear the emerging Government Finance Bubble risks destroying the creditworthiness of our entire economy.


Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10271

Reflation Contemplation ~ Nolan

Stock prices traditionally lead economic recoveries. Securities markets tend to react swiftly to loosened monetary conditions, while it takes some time for loose Credit to work its way through to the bowels of the real economy. Highly speculative markets react haphazardly, sloshing liquidity out and about. As is commonly understood, employment conditions are a somewhat lagging economic indicator. Most analysts have been content to read nothing of significance from ongoing poor jobs and housing data. Overwhelmingly, the bulls rely on faith - and history - that surging stock prices are discounting the usual “V” rebound.

Data this week should have those of the bullish persuasion on edge. July retail sales were much weaker-than-expected (down 0.1% vs. expectations of a rise of 0.8%). Retail Sales excluding auto sales were down 0.6% for the month (down 8.1% y-o-y), the largest drop since March’s 1.1% fall. Looking back, there was no mystery surrounding first quarter consumer weakness. But even after a dramatic stock market recovery, July’s Department store sales were down a dismal 1.6% for the month (down 9.6% y-o-y). Even Wal-mart management commented that their customers were “selective” and remained keenly focused on value.

Today’s preliminary report on August University of Michigan Consumer Confidence was also a big disappointment. The consensus called for this confidence reading to jump three points to 69. The actual report came in down to 63 - to the lowest level since those dark days of March. Readings on both “Economic Conditions” and “Economic Outlook” dropped to five-month lows.

Yesterday, RealtyTrac reported that U.S. foreclosures jumped to a record 360,149 in July. This was up almost 7% from June and 32% higher than the year ago level. And there’s no relief in sight. American Bankruptcy Institute data had 126,000 Americans filing for bankruptcy in July, up 34% from a year earlier. It is now expected that 1.4 million will file for bankruptcy this year.

Meanwhile, the economic optimists take comfort from this week’s readings on Non-farm Productivity, Wholesale Inventories, Industrial Production, and Capacity Utilization. Positive data out of Europe and Asia also seem to confirm that some type of global economic recovery has taken hold.

From my perspective, this week’s data confirm important aspects of Credit Bubble analysis. First, ongoing headwinds will restrain rebounds in U.S. housing markets and household consumption - for an extended period. Second, the overall U.S. consumption-based economy will lag those of most of our more manufacturing-oriented trading partners. In short, we are witnessing anything but typical reflation dynamics, and those expecting a typical U.S. recovery will be disappointed. Our economy remains overly exposed to U.S. consumption, while having insufficient manufacturing capacity (and resources) of the type to benefit significantly from heightened global demand.

Returning to the stock market, I see nothing typical going on there either. With the Morgan Stanley Retail Index and the Morgan Stanley Cyclical Index up 56% and 49%, respectively, the marketplace apparently has no issue with the recovery. I suspect these gains have been inflated by short covering. Indeed, market dynamics likely explain much of the divergence between ongoing weak underlying economic fundamentals and robust stock prices (especially in the consumer arena).

Unusually large bearish hedges and bets had been placed against the (consumer-driven) U.S. economy. Unprecedented fiscal and monetary policy crisis response stabilized the Credit system, setting in motion a self-reinforcing unwind of “bearish” positions. In the past, such a reflationary dynamic would have seen stock prices for the most part accurately discount the future direction of economic activity. Stated differently, the reversal of bearish positions (and resulting short “squeeze”) would traditionally have (reflating) stock prices portending recovery and a return to the previous trajectory of economic performance. In general, a rejuvenated Credit system - and the resulting recovery of financial flows - would ensure that the “bear” case was proved wrong.

This time may be different. I would not be surprised if the confluence of unusually large bearish positions, unprecedented policy response, and a resulting major “squeeze” created a backdrop where the stock market was turned into a rather poor foreteller of future prospects. From my vantage point, I certainly don’t believe stock prices today generally provide an accurate reflection of underlying company fundamentals. And from an economic perspective, I suspect the stock market is missing some key underlying dynamics that will shape future economic performance.

In particular, equities seem to be discounting a return to business as usual when it comes to the U.S. economy. Retail and the “consumer discretionary” sectors have been among this year’s stellar performers. And, yes, this does fly in the face of my analysis of new economic realities and a permanently downsized role for household consumption in the U.S. economy. At this point, I view this as an anomaly at least partially explained by the hastened reversal of bearish positions. But I also recognize that massive fiscal and monetary stimulus has been implemented with the policy goal of sustaining the existing economic structure. The market has been content to play this dynamic expecting policymaker success.

As I attempted to explain last week, I view the impairment of the stock market discounting mechanism as a key facet of Monetary Disorder. The reversal of bearish plays not only created huge buying power throughout the markets, it decisively reversed The Greed and Fear Factor. Notwithstanding today’s sell-off, the bulls are greedy and the bears are on the run. And the more that inflated stock prices entice shorting, the more games that can be played to “squeeze” the timid bears.

The end result is a highly speculative stock market increasingly detached from reality and vulnerable to wild swings in sentiment. Yet I don’t expect the emerging global reflation to this time disprove the U.S. bearish thesis, although it will no doubt be a wild market ride.

The bond market was happy with this week’s developments. The Fed confirmed it will be especially unhurried in raising rates and ending quantitative easing. Weak U.S. economic data was seen as confirming the bullish bond view. To be sure, low market yields at home and abroad are imperative for global reflation to gain a head of steam. And I would argue that (over-liquefied) bond markets are subject to their own pricing anomalies. In contrast to stocks, bonds have been fixated on U.S. economic vulnerabilities and the Fed, while content to downplay reflation risks. This week’s data doesn’t have me second-guessing the thesis of bond market vulnerability to global reflation dynamics. For bonds as well, the backdrop is set for a wild, speculative market ride.

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10259

The Stock Market and Monetary Disorder:

I’ll restate my thesis as concisely as I can (not my strong suit): The deeply maladjusted U.S. “Bubble” economy requires $2.5 Trillion or so of net new Credit creation to stem systemic (Credit and economic Bubbles) implosion. Only “government” (Treasury, agency debt, and GSE MBS) debt can, today, fill the gigantic void created with the bursting of the Wall Street/mortgage finance Bubble. The private sector Credit system is severely impaired, and there is as well the reality that the market largely lost trust (loss of “moneyness”) in Wall Street obligations (private-label MBS, CDOs, ABS, auction-rate securities, etc.). The $2.0 Trillion of U.S. “government” Credit creation coupled with the Trillion-plus expansion of Federal Reserve Credit over the past year has stabilized U.S. financial and economic systems.

The synchronized global expansion of government deficits, state obligations, and central bank Credit amounts to an historic government finance Bubble. Markets have thus far embraced the surge of debt issuance. This U.S. and global reflation will have decidedly different characteristics when contrasted to previous Fed and Wall Street-induced reflations.

First off all, the most robust inflationary biases are today domiciled in China, Asia and the emerging markets generally. The debased dollar has provided China and the “developing” world Credit systems unprecedented capacity to inflate (expand Credit/financial claims without fear of spurring a run on their currencies). Asian and emerging markets are outperforming, exacerbating speculative inflows. Things that the “developing” world need (energy/commodities) and want (gold, silver, sugar, etc.) should demonstrate increasingly strong inflationary pressures. Their overflow of dollars provides them, for now, the power to buy whatever they desire.

Here at home, the post-Wall Street Bubble financial landscape ensures the old days of the Fed slashing rates and almost instantaneously stoking mortgage Credit, home price inflation and consumption have run their course. Accordingly, the unfolding reflation will be of a different variety than those of the past – and, importantly, largely bypass U.S. housing. This sets the stage for a lackluster recovery in consumption and economic revival generally. Household sector headwinds will likely be exacerbated by higher-than-expected inflation (especially in energy and globally-traded commodities), higher taxes and rising interest rates.

There is a confluence of factors that expose the market to an upside surprised in yields. The bond market has been overly sanguine, emboldened by the prospect of the Bernanke Fed maintaining ultra-loose monetary policy indefinitely. Bond bulls have been further comforted by the deep structural issues overhanging both the U.S. financial system and economy. However, massive government Credit creation has, for now, put systemic issues on hold. Especially in Asia, unfettered Credit expansion creates the backdrop for a surprisingly speedy economic upsurge. The weak dollar plays a major reflationary role globally, while also raising the prospect for inflationary pressures here at home. Massive issuance, global economic resurgence, heightened inflation and a weak currency are offering increasingly tough competition to the bullish “forever loose policy” view.

Meanwhile, fixed income must gaze at the feverish equities market with disbelief – and rising trepidation. The bond market discerns incessant economic impairment, a historic debt overhang, 9.4% unemployment, and begrudging recovery. An intoxicated stock market ganders something altogether different, with the Morgan Stanley Retail Index up 61% y-t-d, the Morgan Stanley High Tech Index up 47%, the Morgan Stanley Cyclical Index up 52%, and the Broker/Dealers up 45%. The bond market has been content to laugh off the silly equities game. The chuckles may have ended today.

My secular bearish thesis rests upon a major assumption: The U.S. economy is sustained by $2.5 Trillion (or so) of new Credit. Only this amount will stem a downward spiral of asset prices, Credit, incomes, corporate cash flows and government finances. On the other hand, if forthcoming, the $2.5 Trillion of additional – chiefly government-directed and non-productive - Credit will foment problematic Monetary Disorder. In simplest terms, another bout of Credit inflation leads further down the path of unhinged market prices, destabilizing speculation, and unwieldy flows of finance.

The stock market has become illustrative of what we might experience in the way of Monetary Disorder. Speculation has returned with a vengeance, galloping blindly ahead of fledgling little greenish shoots. Those of the bullish persuasion contend that the marketplace is, as it should, simply discounting a rosy future. I would counter that problematic market dynamics have taken over, with prices increasingly disconnected from reality. In short, the market is in the midst of one major short squeeze.

There are myriad risks associated with the government’s unprecedented market interventions. Likely not well appreciated, policymaker actions have forced the destabilizing unwind of huge positions created to hedge against systemic risk (as well as to profit from bearish bets). This reversal of various bear positions has created enormous buying power, especially in the securities of companies (and sectors) most exposed to the Credit downturn. The reversal of bets in the Credit default swap (and bond) market has certainly played a role. Surging junk bond and stock prices have fed one another, as the highly leveraged and vulnerable companies provide phenomenal market returns. The markets are today throwing "money" at the weak and leveraged.

The resulting outperformance of fundamentally weak companies spurred short covering more generally, creating a dynamic whereby heavily shorted stocks became about the best performing sector in the equities market. This dynamic put significant pressure on so-called market neutral strategies that have proliferated over the past few years. The strategy of attempting to own the good companies and short bad ones is faltering, likely causing a flow out of these strategies - and a self-reinforcing unwind of positions. The “bad” stock soar and the “good” ones languish.

There’s nothing like a short squeeze panic to get the markets’ speculative juices flowing. Many will say all’s just fine and dandy – let the fun and games continue! My retort is that the stock market is indicative of the current dysfunctional financial backdrop. At the end of the day, the financial system must be capable of effectively allocating finance and real resources throughout the economy. I would argue that this is not possible for a system that congenitally misprices risk and distorts financial asset prices. Today’s stock market will inherently finance mainly speculative Bubbles and fragility. And the core systemic problem, the maladjusted "Bubble economy," well, the financial backdrop only worsens the situation.

I have great confidence that government finance Bubble dynamics ensure ongoing distortions in the markets’ pricing of risk and, as well, a continued misallocation of resources (financial and real). And it is increasingly clear that the stock market is embroiled in this problematic dynamic. But that is a dilemma for another day, as surging stocks fan optimism and risk embracement – not to mention forcing many into the stock market with both nostrils plugged. And speculative equities and Credit markets will spur increased economic output in the short-run.

Everything has been extraordinary; the boom, the bust, policymaker interventions, and now the bear market rally. I wish I could see some mechanism in the works that will help kick our system’s addiction to easy Credit and commence the inevitable process of economic adjustment and restructuring. Instead, I see confirmation everywhere that policy and market dynamics are working in concert to sustain the existing financial and economic structure. I have huge doubts it will work and no doubt about the risks of failure.


http://prudentbear.com/index.php/creditbubblebulletinview?art_id=10257

Tug-of-War

When will we see the inflation and dollar collapse...soonish

Chairman Bernanke committed another mistake this week. Removing monetary stimulus before inflation takes root was the focus of both his Wall Street Journal op-ed piece and this week’s congressional testimony. While I consider inflation to be a risk, it is definitely not the dominant systemic risk in play these days. Continuing its now traditional approach, the Federal Reserve is content to disregard unfolding asset Bubble risk. Today’s Bubble inflates rapidly throughout government finance – more specifically the enormous Treasury, agency debt and GSE MBS marketplace.

Actually, Dr. Bernanke did worse than ignore Bubble risk. The markets were promised the Fed would maintain its current ultra-loose monetary policy stance for an “extended period.” This is the same type of policy commitment that fostered speculative Bubbles in mortgages, housing, private-label MBS and CDOs. The Fed today is determined to peg short rates and market yields. Sure, there are obvious short-term reflationary benefits to such an approach. But such an endeavor also nurtures speculation and leveraging, especially in the Bubbling Treasury, agency and MBS markets. From my perspective, this is the most dangerous Bubble yet. It is addressed by no one.

I do appreciate that the Bernanke Fed has spent considerable time contemplating how to remove the past year’s unprecedented monetization. In a normal environment it would matter. But extraordinary circumstances would seem to completely rule out the possibility of Federal Reserve tightening. The risk of bursting the government finance Bubble is too great - and will become only greater. With Treasury, agency and GSE MBS now accounting for the vast majority of system Credit creation, economic and Credit system “recovery” would be stopped dead in its tracks by a surprising jump in market yields. The Fed has, once again, delegated itself to the role of Bubble enabler.

Tuesday, Bloomberg News went with the headline “Treasuries Rise as Bernanke Sees Limited Inflation…” The Sydney Morning Herald captured the true underpinnings of the Treasuries’ big gain: “Bernanke to Keep Easy US Credit Policy.” Dr. Bernanke did a nice job showcasing his inflation-fighting toolkit, although the markets really just needed reassurance he’s not going to back away from aggressive reflation anytime soon. And, here we are again, with Fed actions becoming a significant factor shaping/distorting market perceptions – hence the pricing and flow of finance throughout the economy. This becomes a critical dynamic with respect to the unfolding “government finance Bubble” because this Credit dynamic is capital markets driven (market perceptions of returns on securities dictating Credit expansion).

With U.S. inflation well in check, a strong bullish consensus sees prolonged loose monetary policymaking ensuring low and stable bond yields indefinitely. There is today a tremendous amount riding on this market view. At the same time, it is difficult to envisage a financial system and economy more acutely vulnerable to a spike in yields. How could the sanguine consensus view on rates be wrong?

First of all, it appears that global reflationary forces have reached critical mass. China and Asia are bouncing back. Loose financial conditions throughout the developing markets appear poised to spur robust economic recovery. Two important unknowns are how quickly inflationary pressures will reemerge and how soon foreign central bankers will begin feeling the heat. All eyes on China.

I am struck by a market disconnect. Each passing year finds market and economic forces increasingly globalized. Yet the view regarding favorable prospects for the U.S. fixed income market seems to be driven by favorable expectations of U.S. inflation and U.S. monetary policy. For the markets, Bernanke trumps international forces. The dollar hardly matters. And globally, the view seems to be that low U.S. market yields will continue to anchor global yields. But with financial and economic power having shifted markedly overseas, will there come a point in time when global factors play a much more significant role in determining our market yields. Has the Fed commenced a game of tug-of-war?

Listening to Chairman Bernanke this week, I couldn’t help but contemplate the prospect of waning Federal Reserve power. And I am not referring to regulatory power over our financial institutions. As I see it, the Fed is now locked into permanent monetary ease; they’ve let another Bubble get away from them. Resulting dollar devaluation traps the U.S. economy into a more inflationary backdrop. Meanwhile, the dynamic of massive flows of outbound dollar liquidity, coupled with unconstrained developing-economy Credit systems create powerful inflationary dynamics globally.

It would make sense to me that global forces increasingly tug U.S. yields upward. And we’ll have to wait and see how much the Fed is willing to use its balance sheet to try to tug them back down. Bernanke would clearly prefer to talk rates lower. It will be interesting to see how long talk suffices.

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10253

The Core to Periphery Dynamic: ~ Nolan

A very usefull paradigm for the ebb and flow of empires. For a country where "free enterprise" is the dominant justification for the status quo the extent to which the dollar system and financial innovation centered credit creation in the US investment banks and focused investments on what would pay commisions rather that real yeilds or even the actual needs of the real economy is a question worth asking. Capital was allocated on a command economy model chasing asset prices or arbitrage or whatever could be fit into guaranteed by a mortgage checkboxes.

Finance will be more small scale and local when this ends...




This week provided ample confirmation for the global reflation thesis. The dollar index dropped another 0.9%. Gold surged $22 to $979. Crude oil jumped $4.67 to a six-month high, posting the largest one-month percentage gain since 1999 (according to Bloomberg). The Goldman Sachs Commodities index rallied 5.5% to an almost 7-month high (up 27% y-t-d). Emerging markets remain on fire. And the Baltic Dry Index rose gain today, increasing its streak of consecutive gains to 19.

Leading the “bric” sweepstakes, Russia's RTS equities index jumped 7.3% this week, while India’s Sensex rose 5.3%. Russian stocks are now up 72% y-t-d, followed by India’s 52%, China’s 45%, and Brazil’s 42%. Elsewhere, stocks in Taiwan are up 50%, South Korea 24%, Argentina 47%, and Hungary 22%. The “commodity” currencies led the charge again this week. The South African rand gained 4.1%, the New Zealand dollar 3.3%, the Brazilian real 3.0%, the Australian dollar 2.4%, and the Canadian dollar 2.7%.

It was quite a week in U.S. interest rate markets. Ten-year Treasury yields jumped 29 basis points during the shortened week’s first two trading sessions (to 3.74%), before backing off to end the week up only 2 bps to 3.47%. The mortgage marketplace turned rather tumultuous, with benchmark Fannie MBS yields spiking 55 bps from last Friday’s close before ending the week 19 bps higher at 4.33%. Some interest-rate hedging markets seemed in disarray, with the dollar swaps market demonstrating price discontinuity. After closing last week at 14.4 bps, the 10-year dollar swap spread traded as high as 38.25 before ending the week at 19.50.

Importantly, at least for the week, mortgage-related market tumult didn’t broaden to other risk markets. Corporate Credit spreads were mostly narrower on the week, even as the company debt issuance boom ran unabated. The junk bond market enjoyed another week of strong fund inflows more than matched by huge issuance. It is also worth noting the resilience of the “emerging” debt markets. Brazilian benchmark dollar bond yields were down 14 bps to 5.86%. Mexican dollar bond yields fell 14 bps to 5.74%. Brazil’s Credit default swap (CDS) prices declined to the lowest level since early October (197 bps, down from the October high of 600 bps). It is no longer the case that when the Treasury market catches a cold others get really sick.

At this point, the markets’ sanguine attitude toward dollar and Treasury/MBS weakness is understandable. From a global perspective, a weaker dollar bolsters the inflationary bias that had prior to the Credit meltdown been driving robust economic performance throughout the energy and commodities-based economies. Dollar devaluation also works to reinforce already heady financial flows to “emerging” markets and non-dollar assets more generally. There are facets of inflation that seductively salve recovery.

The dramatic loosening of financial conditions globally is supporting an improvement in economic conditions. The optimists are looking for Asia and the developing world to lead a global recovery, and a sinking dollar on a short-term basis would seem to support such a scenario. Our weak currency also empowers the Global Government Finance Bubble. Amazingly, most countries today have unprecedented flexibility to issue debt without fear of negative market reaction or a run against their currencies.

I again want to emphasize the dramatic change in circumstances that is increasingly in view throughout global markets and economies. During the nineties – and stretching through the “King Dollar” period earlier this decade – there was an overarching inflationary bias that worked to direct flows TO the “Core” (the U.S. Credit system and securities markets). Whether it was a crisis that initially erupted in Mexico, SE Asia, Russia, Argentine or Brazil, the immediate market response was an abrupt reversal of financial flows from the developing countries to U.S. dollar securities. While there was an ongoing acceleration in speculative flows meandering about the globe in search of big returns, the first sign of trouble would incite a panic straight to the dollar.

The “Core” absolutely dominated the system, providing our policymakers (especially the Fed) extraordinary latitude. The Periphery to Core bias fostered financial crises, along with general Periphery financial and economic instability. This dynamic worked to keep global inflationary pressures in check. Or, better said, the nature of the inflationary flow of finance kept inflation pressures directed to U.S. dollar securities markets - as opposed to energy, commodities and more traditional inflation.

The global financial and economic backdrop has changed profoundly. Today, there exists a powerful inflationary bias working to direct flows away from the Core out to the Periphery. This dynamic helps to explain the dramatic change in the cost and availability of finance for the developed world over the past several years – the virtually unlimited cheap finance that funded historic booms in China and Asia.

Granted, this flow was abruptly interrupted by last year’s global Credit crisis. It is, however, my view that the dynamic of powerful Core to Periphery flows has resumed. Moreover, it is the nature of this type of dynamic that if such a trend recovers it will likely resume stronger-than-ever (think tech stock post-LTCM reflation or mortgages post-tech Bubble reflation). This analysis is supported by the Periphery’s recent dramatic economic and market outperformance relative to the Core.

So, is this bullish or bearish? Well, I believe The Core to Periphery Dynamic is supportive of a more rapid than expected global economic recovery. I definitely expect global inflation to surprise on the upside. Adherents to the global deflationary spiral thesis may be left wondering what the heck happened. The backdrop seems to be set for surprising revival in energy and commodities markets. And I would not be surprised if the global equities rally has some legs.

Yet I view The Core to Periphery Dynamic as profoundly bearish for the U.S. At its core, this historic redirection of global flows and inflationary pressures is the consequence of a breakdown in the dollar standard. Failed policies, a resulting deeply impaired economic structure, and massive ongoing devaluation have ended the dollar’s reign as the globe’s premier reserve currency and perceived stable store of value. There is today no sound currency to replace the dollar, so the global financial system operates rudderless and with great uncertainties.

It is more certain, however, that the great benefits commanded to our economy and markets over the decades from governing the world’s reserve currency are drawing to an end. Our policymakers still believe they can inflate Credit and manipulate interest rates - and not have to pay a price for it. But the new global reality may be that currency markets protest massive U.S. fiscal deficits and activist monetary policy, while global markets come to dictate U.S. market yields. Over the past two weeks we have seen the dollar and U.S. Treasuries/MBS come under significant pressure. Is this the beginning of global markets disciplining Washington?

A robust Core to Periphery Dynamic and the re-emergence of dollar vulnerability are a potent combination. U.S. markets to this point remain sanguine with the prospect of an expanding Federal Reserve balance sheet rectifying any spike in interest rates. But currency markets are no doubt increasingly fixated on our propensity to monetize current and prospective stimulus. At some point, increasingly unwieldy flows out of our currency may force the Fed’s hand. The scenario where the Fed is forced to choose between loose monetary policy and currency crisis sits out there as a potential big negative surprise for U.S. markets.


http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10234

The Greatest Cost ~ damage to the underlying economic structure

An astute analyst posed the following question yesterday: “The current debate is centered on whether the Fed can take back the liquidity in time in order to prevent inflation. Suppose it can. Suppose they execute this perfectly. But if the Fed is able to flood the system with the liquidity (thus reducing the severity of the downturn) and take it back before it causes inflation, it seems there is a free lunch. We get something for nothing. So, assuming a perfectly executed game plan by the Fed, is there a cost? Do they keep rates low for a time, only to raise them a lot a year down the road – is that the cost? Or is there another cost?”

I’m short on time today, so I’ll attempt a brief response.

First of all, while it often appears otherwise, finance provides no free lunch. The mispricing of Credit and misperceptions of risk in the marketplace have deleterious effects, although their true impact may remain unexposed for years. Indeed, the more immediate (and always seductive) consequences of loosened financial conditions tend to be reduced risk premiums, higher asset prices, and a boost to economic “output”. Conventional analysis of monetary policymaking still focuses on “inflation” and “deflation” risks. I would strongly argue that our contemporary world has already validated the analysis that acute financial and economic fragility are major costs associated with market pricing distortions.

When the Federal Reserve collapsed interest rates following the bursting of the technology Bubble, the results seemed constructive. Stock and real estate prices inflated; a robust economic recovery ensued. There was at the time some recognition of the potential for real estate excesses. But this was seen as such a small price to pay in the fight against the scourge of deflation. It was not until 2007 that the nature of the true costs of a massive “reflation” began to come to light.

Many would today argue that it was simply a case of the Fed’s failure to take the punchbowl away in time. Such analysis misses a key facet of Bubble dynamics. Once the Mortgage Finance Bubble gained a foothold there was absolutely no way policymakers were going to be willing to risk bursting such a consequential Bubble.

I see ample support for my view that Bubble dynamics have taken root throughout government finance. This unprecedented inflation includes Federal Reserve Credit, Treasury borrowings, Agency debt, GSE MBS guarantees, FHA and FDIC insurance, massive pension and healthcare obligations, the myriad new market support programs, etc. This Government Finance Bubble is domestic as well as global. Amazingly, the scope of the unfolding Bubble dwarfs even the Mortgage Finance Bubble. And, importantly, it is reasonable to presume that the Federal Reserve will find itself in the familiar position of being trapped by the risk of bursting a historic Bubble.

So I see the probabilities as very low that the Fed will reverse course and impose tightened liquidity conditions upon the marketplace. Actually, reflationary pressures may force the Fed to increase its Treasury holdings in an effort to maintain artificially low interest rates. At the same time, I don’t see higher inflation as the greatest cost associated with this predicament. Much greater risk lies with the acute systemic fragility that I believe is inherent to major Bubbles. Similar to mortgage finance 2002-2007, the marketplace is significantly mispricing the cost - and failing to recognize the risks - of a massive inflation of government finance. And while every Bubble has its own dynamics and nuances, the unfolding Government Finance Bubble has even more precarious Ponzi Finance dynamics than the Mortgage Bubble.

The markets are on tract to accommodate two Trillion or so of Treasury issuance this year. This incredible amount of debt creation is in the range I would expect necessary to temporarily stabilize the U.S. (“services”) Bubble Economy. Importantly, this amount of new finance both plugs financial holes and works to stabilize inflated income levels. From yesterday’s income data, one can see that Personal Income was up 0.3% y-o-y to $12.04 TN. And while 0.3% is very meager growth, without massive government fiscal and monetary expansion (inflation) the economy would have suffered a destabilizing income contraction. Keep in mind that personal income has inflated 65% since 1998 and 33% from 2003.

I’ll try to explain my belief that dangerous Ponzi Finance Dynamics are in play with the current course of policymaking. First, I view panicked policymakers as seeing no alternative than to try to sustain the current (deeply maladjusted) economic structure. A more natural course of economic adjustment – from finance and consumption-driven Bubble Economy to a more balanced system – was going to be much too painful to endure. So a massive government inflation was commenced in desperation - with the grandiose objective of revitalizing securities markets, housing prices, and the overall U.S. economy. I just don’t see how this reflation goes much beyond stoking a susceptible artificial recovery.

First and foremost, with government finance now completely dominating the Credit system, I can’t even begin to contemplate how this process might nurture an effective allocation of financial and real resources. Indeed, I see today’s manifestations of Credit Bubble Dynamics as an extension of similar mispricing, misperceptions, and over-issuance that led to last autumn’s near financial collapse.

Admittedly, the massive extension of government Credit and obligations works wonders in stabilizing a devastatingly impaired system. Inflationism is always seductive; Trillions worth is absurdly seductive. Yet this extra layer of debt does little to affect change to the underlying economic structure. Actually, a strong case can be made that it only delays and sidetracks the necessary adjustment process. And, importantly, this enormous additional layer of system debt exacerbates system vulnerability.

At the end of the day, a system is made or lost on the soundness of its underlying economic structure. I posit that a sound economic structure is reliant upon only moderate Credit growth and risk intermediation. Our system requires massive Credit expansion and intensive risk intermediation. I would also posit that there are no benefits – only escalating costs – to throwing massive Credit inflation upon an unhealthy economic structure. And, returning to Ponzi Dynamics, one of the major costs to such inflationism is a massive expansion of non-productive Credit – obligations that are created without a corresponding increase in real economic wealth producing capacity. The debt can only be serviced by the creation of more debt obligations.

The danger is that markets too easily and for too long accommodate massive Credit expansion during the boom. Federal Reserve policies are fundamental to this dynamic. But at some point and out of the Fed’s control, as Wall Street learned, greed inevitably turns to fear and a reversal of speculative flows marks the onset of the bust. And it’s the massive inflation of non-productive Credit that ensures the unavoidable crisis of confidence. Can the underlying economic structure service the mounting debt load or, instead, is it the massively inflating debt load that is sustaining a vulnerable economy? And it is in this vein that I fear the Government Finance Bubble is on track to destroy the Creditworthiness of the entire economy. And this Ponzi Dynamic is The Greatest Cost to what I fear is a continuation of unsound policymaking.

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10221

Nolan ~ Reflation appears to be working

Fan Gang stated that the Chinese government’s $585bn stimulus package would help support 2009 growth in the range of between 7% and 8%. Goldman Sachs economists this week raised their estimates of China GDP growth to 8.3% from 6.0%. CLSA Asia-Pacific Markets increased their China growth forecast to 7.0% from 5.5%.

Examining stock markets, China is leading exceptional performance by the “Bric” equities markets. Brazil’s Bovespa has posted 2009 gains of 24.6%, Russia’s RTS 31.6%, India’s Sensex 17.4%, and China’s Shanghai Composite 34.5%. Asia’s markets have been especially robust. Taiwan’s major index has posted a 2009 gain of 28.1%, South Korea's 20.4%, Indonesia's 17.4%, Malaysia's 13.2%, and the Philippines' 12.3%. It is also worth noting that Japan’s Nikkei (down 1.7%), Hong Kong’s Hang Seng (up 6.1%), and Australia’s S&P/ASX (down 0.3%) are among the world’s best performing major stock indices.

Currency markets also point toward a reflationary bias. The “commodities” currencies are among the strongest performers so far this year. The South African rand has gained 7.7%, the Norwegian krone 6.1%, the Brazilian real 5.5%, the Mexican peso 3.4%, the Australian dollar 2.4%, and the Canadian dollar 0.4%.

In commodities markets, industrial metals have bounced back meaningfully. Copper has gained about 45% so far this year. Platinum has jumped 25%, with strong gains also for lead and zinc. And let’s not forget silver, with its year-to-date gains of 9.1%. Overall, the CRB commodities index is down 2.9% y-t-d, while the Goldman Sachs Commodities index is up 5.6%. Now, if energy markets get going…

According to Dealogic, year-to-date global M&A activity has jumped to $449bn, a level now only 14% below comparable 2008. With PepsiCo’s acquisition of Pepsi bottling companies and Oracle’s purchase of Sun Microsystems, this past week was one of the strongest for M&A in months. Recall that first quarter “global debt capital issuance” was up 26% year-over-year to $1.53 TN (data from Dealogic). Asia issuance was up 55% year-on-year ($176bn). Here at home, there was record first quarter investment grade debt issuance ($298bn).

Companies are again able to raise finance through the junk bond market. Over the past two weeks, $5.5bn of high yield bonds have been sold. It is worth noting (citing AMG data) that high-yield funds attracted $532 million of inflows this week, up from last week’s $433 million. Notably, six-week inflows now stand at an impressive $3.38bn. Supported by various Washington-based programs, U.S. corporate debt issuance is on record pace.

Taking a look at U.S. debt market risk premiums, junk spreads are at the narrowest level since last October. Investment-grade spreads are at their tightest since February (from Merrill Lynch Credit indices). Corporate bonds have generally performed well for investors so far this year. Agency debt spreads have tightened all the way back to a pre-crises level 48 bps, and MBS spreads are now down to 98 bps. Muni bond yields have dropped to the lowest level since September in what has developed into a mini municipal issuance boom ($9.2bn issued this week inclusive of California’s “Build America Bonds”).

This week, inter-bank lending risk premiums tightened to levels not seen since before the failure of Lehman. According to Bloomberg, the “Libor-OIS” spread has narrowed to 0.87%, down from an October high of 3.64%. We’ll be learning much more about the “stress test” over the next couple weeks. Examining financial CDS prices, there remains extraordinary stress but apparently somewhat less of it as it pertains to bank defaults. JPMorgan CDS prices have dropped to about 170, down from as high as 240 bps last month. Morgan Stanley CDS is down about 120 to 360 bps. At 245 bps, Goldman Sachs CDS is down about 130 bps from March highs. Wells Fargo CDS is down about 60 from highs to 240 bps. The “problem child,” Citigroup, has seen its CDS prices come in a moderate 90 to a still high 575 bps.

This past Monday the U.S. Equities VIX index (expectations for future market volatility/risk) dropped below 34 to the lowest level since before the Lehman collapse. The S&P Homebuilding Index is now up 32% for the year. The Morgan Stanley Retail Index (35 companies) has now posted a 2009 gain of 31%. The Morgan Stanley High Tech index is up 24% y-t-d, and the InteractiveWeek Internet index is 31% higher.

It is worth noting that the Mortgage Bankers Association weekly application index is near the highest level since the summer of 2003. Of course, this boom is being driven by refinancings – which are now running about triple the year ago level. Mortgage rates are these days at historic lows. There are indications that Credit conditions are loosening meaningfully, with even jumbo mortgage rates dropping. As a disciplined analyst, I cannot disregard indicators that have many times in the past proven their worth.

The unfolding refi boom has the potential to significantly impact systemic reflation. For one, millions of households will be reducing their monthly mortgage payments. Many with adjustable-rate, shorter-term, or various “exotic” mortgages now have an opportunity to stretch things out to 30 years at quite favorable rates. While certainly a fraction of previous inflated levels, there will be meaningful equity extraction used to pay down higher cost debt and, perhaps even, buy things (weekly retail sales trends have stabilized). There is also the dynamic where holders of millions of old mortgages will receive early repayment in a process that works to reliquefy segments of the MBS marketplace. And I’ll assume that the GSE’s will increase their holdings of new MBS, perhaps creating a significant impetus for system reflation. At the minimum, Fannie, Freddie, and the FHA will be stamping their (I mean the taxpayers’) guarantee on hundreds of billions of MBS, creating more “money-like” debt instruments out of Wall Street’s previous “private-label” variety of (discredited) mortgage securities.

It’s my view that the markets generally lead the economy – not vice-versa. If this stock market rally is sustained, I would expect the summer home selling season to surprise on the upside in many locations. When some semblance of confidence returns to housing markets, I would not be surprised to see some pent up demand positively impact auto sales. Anecdotally, it appears consumer Credit conditions are beginning to loosen – even in auto finance.

If we step back and ponder the unprecedented scope of today’s global fiscal and monetary stimulus, we shouldn’t be all that surprised by the fledgling reflationary forces observable both at home and abroad. I have labeled emerging dynamics the “Government Finance Bubble.” There is mounting evidence that this Bubble is developing critical mass and should be taken seriously.

http://www.prudentbear.com/index.php/commentary/creditbubblebulletin