Page 1 of 3 CREDIT BUBBLE BULLETIN Kuroda's gambit
Commentary and weekly watch by Doug Noland
For centuries, economic thinkers have grappled with money and credit. Invariably, analytical interest ebbs and flows right along with boom and bust cycles. And during periods of keenest interest, there's a common recurring question that's been asked through the ages: "How could a period of economic advancement and prosperity that looked so promising and enduring come to such a dreadful end?" The answer too often is some variation of how money and credit run amuck over the course of the boom.
It's a challenge to place contemporary monetary analysis into historical context. After all, we're talking about extraordinary
financial and economic innovation; unmatched integration of global economic and financial systems; unprecedented global financial excess and imbalances; experimental central bank doctrine and unprecedented monetary stimulus. It's uncharted waters virtually across the board, which naturally evokes quite divergent views and analytical perspectives. Surging asset markets have largely squelched one side of the debate, while providing a fancy megaphone to the other.
Increasingly, "enlightened" is used to describe today's experimental central bank policymaking, especially in the context of using open-ended quantitative easing operations to support asset prices and economic activity. I'll take the other side of the analytical debate. I view contemporary central bank doctrine as essentially an experiment in attempting to contain the monetary instability that has consistently sealed the fate of boom-time prosperity over many generations. Especially during the past nine months, this whole endeavor of suppressing monetary disorder has begun to run amuck.
What began with the Alan Greenspan Fed's pegging of short-term rates and accommodating non-bank credit growth during the early-nineties has evolved into massive global central bank debt monetization of and the injection of Trillions of liquidity into international securities markets. What was a $40 billion hedge fund industry to begin the nineties has morphed into a multi-Trillion global pool of speculative finance and a remarkably sophisticated "leveraged speculating community".
Last month, I titled a Credit Bubble Bulletin "Things Have Gone Too Far," a week later "Kuroda Leapfrogs Bernanke". I and others view the Bank of Japan's "shock and awe" reflationary strategy as an historic gambit. Mr Kuroda seeks to jumpstart economic growth by using the prospect of an inflationary jolt to spur spending and investment. The Bank of Japan has appeared to support a much weaker yen, while believing its aggressive bond purchases would place an ongoing ceiling on bond yields. But with debt approaching 240% of gross domestic product and its financial institutions large (leveraged) holders of low-yielding government debt, a spike in market yields would both impair Japan's financial system and thrust its fiscal position into precarious debt trap dynamics. Playing with fire.
Initially, the global speculators were not too concerned with eventual outcomes. Their focus was on the BOJ's massive liquidity injections, yen weakness and prospects for Japanese institutions and retail investors to flee Japan in search of higher returns elsewhere. Suddenly, another $80 billion or so was combined with the Fed's $85 billion monthly quantitative easing for liquidity injections unlike anything ever experienced by booming global markets. Global equities went into melt-up mode, global sovereign yields in melt-down and risk premiums generally collapsed to multi-year lows - in the face of a weakening global economic backdrop and mounting fragilities. Corporate debt issuance, already at record pace, inflated to even greater extremes - including deteriorating quality at record low yields!
Well, financial euphoria too often proves fleeting. The current bout may have already begun to dissipate. Monetary policy that was to propel securities prices higher is suddenly viewed in somewhat different light. The Wall Street Journal went with the headline "Fed Leaves Market Guessing" for John Hilsenrath's take on Bernanke's testimony and the plethora of conflicting comments from various Fed officials.
Best I can tell, the Fed may begin to "taper" or they may instead choose to increase the size of QE. Could be soon but maybe not. It's "data dependent", although that data may be the unemployment rate or GDP or the Consumer Price Index or something else. When the Fed eventually decides to "taper" - it may then decide to reverse course depending, again, on various factors that no one can clearly articulate because there's no consensus view as to how to manage this phase of the monetary experiment.
And the higher stock prices climb, the more convinced participants are that the Fed will not allow a market accident. The more euphoric the market backdrop, the greater marketplace confidence that the securities markets are "too big to fail" - that the Fed will be there providing liquidity abundance irrespective of the data. As always, monetary inflations are as seductive as they are difficult to control.
I'll stick with the view that the Ben Bernanke Fed told a fib last summer when it tied QE to the unemployment rate. They were responding to heightened global financial and economic fragility, while justifying their astonishing "money printing" operation by linking it to the high jobless rate and the notion of lost economic potential. The Fed and global central banks fueled asset Bubbles that further diverged from weak economic fundamentals. As a result, monetary policy is now even more securely entrapped by financial and economic fragilities. And while the financial media was fixated on Bernanke and confusing Fed communications, perhaps a bigger near-term market risk began to unfold last week in Tokyo.
Japan's Nikkei equities index was hammered 7.3% on Thursday. After trading as high as 15,943 mid-week, the index briefly touched 14,000 on Friday before ending the week at 14,612. Notably, the Japanese government debt market has of late made their equity market appear relatively stable. Trading as low as 55 bps early in the month, Japan's 10-year JGB yields traded briefly at 1.0% Thursday before aggressive BOJ buying forced yields back down to 82 bps by week's end.
Some headlines were of the type that makes traders edgy. "Japan Economy Chief Warns Against Panic Over Stock Sell-off". "Kuroda Struggles with Communication as Japan Rates Rise". "Kuroda Promises to Stabilize Bond Market". The triggering of circuit breakers in the JGB market is becoming a hallmark of Kuroda's brief tenure, and I would not be surprised if extreme market volatility persists for some time to come.
When a fledgling central bank chief - in the midst of a radical and untested experiment in monetary inflation - promises to stabilize a nearly $14 trillion bond market, well, it is time to begin worrying. And my guess is that's exactly what some of the hedge funds and sophisticated leveraged players began to do last week. Time to begin taking some chips off the table.
The Kuroda gambit was seen unleashing enormous amounts of liquidity upon global markets. At least this perception was spurring a collapse of sovereign yields and risk premiums around the globe. Those caught short melting up risk markets were forced to run for cover - virtually everywhere. Those hedging various risks were forced to throw in the towel, while those cautiously underinvested in rapidly rising markets had little choice but to throw caution to the wind ("capitulate"). Radical BOJ measures pushed already over-liquefied, speculation rife and highly unsettled markets over the edge into speculative blow-off type dislocations.
If the Kuroda gambit does not live up to the advertised global liquidity bonanza, then some major market adjustments will be in order. Importantly, there have been indications that the sophisticated market operators (and others) moved to front-run the onslaught of Japanese liquidity. European markets, in particular, were viewed as likely to be on receiving end of a Japanese flight out of yen into higher yielding debt instruments. Italian and Spanish 10-year yields collapsed about 100 bps during April, in the face of ongoing economic deterioration. Sinking yields supported strong rallies in Italian, Spanish and European equity markets. Credit default swap (CDS) prices collapsed throughout Europe - for sovereigns, corporates and financials.
Notably, Italy sovereign CDS prices dropped from 308 on April 1st to 219 as of Wednesday (May 22). CDS for Spain sank from 307 to 204. But as JGB yields late in the week gyrated and Japanese stocks reversed sharply lower, the ill-effects were transmitted immediately to Europe. During Thursday's and Friday's sessions, Italy CDS surged 32 bps and Spain CDS jumped 31 bps. Portugal CDS jumped 37 bps in two sessions. In similarly sharp reversals, bank and financial CDS prices jumped sharply to end an unsettled week. Italian stocks were hit for 3.7% in two sessions and Spanish stocks fell 2.3% (3.7% for the week). And after spiking to record highs on Wednesday, Germany's DAX equities index reversed course and sank 2.6% in two sessions.
Financial euphoria-induced perceptions of endless liquidity are prone to abrupt market reassessment. As such, a few Friday Bloomberg headlines caught my attention: "Dealers Absorbing Junk Bonds as ETF Demand Drops"; "Corporate Bond Sales Slow in Europe on Fed Stimulus Speculation"; "Dollar Bond Sales Slump in Asia as Costs Leap on Stimulus Doubts". "Glencore Leads Company Bond Sales in US as Issuance Falls 36%".
No analysis of unsettled global markets would be complete without addressing ongoing currency market volatility. Thursday and Friday sessions saw the yen rally 2% against the dollar. Generally, the emerging currencies continue to trade poorly. The Colombian peso fell 2.0% last week, with the Chilean peso and Mexican peso 1.5% lower. The Indian rupee fell 1.4%, the South Korean won 0.9%, the Philippine peso 1.0% and the Peruvian new sol 1.4%. The so-called commodities currencies remained under pressure. The South African rand was hit for another 1.8%. The Brazilian real fell 0.8%, the Australian dollar 0.8% and the Canadian dollar 0.4%.
The unfolding Chinese slowdown and fragility story saw additional corroboration. China's Purchasing Managers' Index fell back below 50 (contracting) for the first time in seven months. There were, as well, several news items (see "China Bubble Watch" below) pointing toward an unfolding government crackdown on currency speculation and financial excess. Chinese government officials are now working on a tightrope as they attempt to contain runaway credit and speculative excesses while not pushing an already slowing (and deeply maladjusted) economy into a downward spiral.
Commodities prices generally remained under pressure. The Goldman Sachs Commodities index fell 1.2% last week, increasing 2013 declines to 3.4%. Crude oil dropped 2.2%. Curiously, Lumber futures declined another 2% last week, having now dropped about a third from March highs. Nickel, Soybeans, Cocoa, Palladium and Coffee all declined last week.
Here in the US, the stock market was resilient, while a few indicators pointed to tinges of heightened risk aversion. Ten-year Treasury yields jumped above 2.0% for the first time since March. Curiously, benchmark mortgage-backed securities (MBS) yields jumped 13 basis points (bps) to the highest level in a year. After beginning the month at 2.28%, MBS yields ended the week at 2.82%. And after dropping to the lowest level since 2007, junk bond CDS prices ended the week 29 bps higher.
There is little doubt that Fed policies have again fostered huge amounts of speculative leveraging throughout the US credit system. The spike in MBS yields and the widening of MBS spreads may portend a more cautious approach to risk in a very important segment of the US credit market. Moreover, a pronounced de-leveraging in MBS (and, potentially, other credit instruments) would counterbalance the Fed's $85 billion monthly injections.
It's no surprise that investors/speculators in US equities are determined to stick with the bullish thesis and disregard global macro issues (it's worked to this point!). Yet this unfolding Kuroda gambit drama could prove too significant to ignore. The perception holds firm that the Fed's $85 billion will ensure ample bull market liquidity for at least the next several months.
The overall bullish take on marketplace liquidity could prove too complacent if things begin to unwind in Tokyo. And by unwind I mean that Japanese bond market fragility forces a change of tack by the Kuroda BOJ. A spike in yields could prove highly destabilizing, with a bond and stock market crash not out of the question. Or perhaps the BOJ will work out an agreement with major Japanese institutions to ensure their support for low yields. The BOJ may need institutions to fall in line and stop selling bonds and the yen. Such an understanding might support a stronger yen, with less liquidity seeking higher yields overseas.
It would appear that there are now viable scenarios that are potentially problematic for the leveraged players - and for the financial euphoria that erupted around the globe. Perhaps an overdue bout of de-risking and de-leveraging actually commenced last week. At the minimum, the markets were reminded that there is as well a downside to all this central bank dependency and bubble-inducing liquidity.
The S&P500 declined 1.1% (up 15.7% y-t-d), and the Dow slipped 0.3% (up 16.8%). The Morgan Stanley Cyclicals were down 1.3% (up 16.6%), and the Transports fell 2.3% (up 20.5%). The Morgan Stanley Consumer index lost 1.3% (up 21.8%), and the Utilities sank 3.5% (up 10.2%). The Banks slipped 0.4% (up 18.7%), and the Broker/Dealers dropped 3.0% (up 28.7%). The S&P 400 MidCaps fell 1.9% (up 16.4%), and the small cap Russell 2000 declined 1.2% (up 15.9%). The Nasdaq100 lost 1.3% (up 12.4%), and the Morgan Stanley High Tech index dropped 1.8% (up 10.8%). The Semiconductors fell 1.9% (up 20.2%). The InteractiveWeek Internet index dropped 2.3% (up 16.1%). The Biotechs declined 1.2% (up 28.2%). With bullion recovering $27, the HUI gold index rallied 3.8% (down 42.5%).
One-month Treasury bill rates ended the week at two bps and 3-month rates closed at four bps. Two-year government yields were up slightly to 0.25%. Five-year T-note yields ended the week up 6 bps to 0.89%. Ten-year yields rose 6 bps to 2.01%. Long bond yields were little changed at 3.17%. Benchmark Fannie MBS yields jumped a notable 13 bps to 2.82% (12-month high). The spread between benchmark MBS and 10-year Treasury yields widened 7 to 81 bps. The implied yield on December 2014 eurodollar futures increased 3.5 bps to 0.525%. The two-year dollar swap spread rose one to 16 bps, and the 10-year swap spread increased about 2 to 15 bps. Corporate bond spreads widened. An index of investment grade bond risk increased 5 to 76 bps. An index of junk bond risk jumped 29 to 371 bps. An index of emerging market debt risk rose 15 to 282 bps.
Debt issuance remained fairly strong. Investment grade issuers included CF Industries $1.5bn, Glencore $5.0bn, PPL Capital Funding $1.15bn, Bank of America $1.0bn, Kimberly-Clark $850 million, International Lease Finance $550 million, Pricoa Global Funding $500 million, Analog Devices $500 million, Memorial Production Partners $400 million, Principal Life $300 million, National Rural Utility Cooperative $250 million, Entergy Arkansas $250 million and Helios Leasing $140 million.
Junk bond funds saw outflows of $123 million (from Lipper). Junk issuers included Concho Resources $1.55bn, B&G Foods $700 million, Midstates Petroleum $700 million, Commscope Holdings $550 million, Provident Funding $540 million, Cinemark $530 million, US Airways $500 million, SIWF $470 million, GETCO Financing $305 million, Springleaf Finance $300 million, Sabra Health Care REIT $200 million, Vantage Oncology $250 million, Century Aluminum $250 million and Legacy Reserves $250 million.
Convertible debt issuers included Sunpower Corp $300 million.
The long list of international dollar debt issuers included Intelsat Jackson $2.635bn, Morocco $2.25bn, Deutsche Bank $2.5bn, Caisse D'Amort $2.5bn, Vedanta Resources $1.7bn, Skandinaviska Enskilda $1.5bn, Westpac Banking $1.25bn, Kommunalbanken $1.15bn, Elan $850 million, MTS International Funding $500 million, AON $250 million, and Grupo Famsa $250 million.