Page 1 of 3 CREDIT BUBBLE BULLETIN One year of Draghi
Commentary and weekly watch by Doug Noland
The S&P might have been unchanged last week, but many individual stocks were wild, one year after European Central Bank (ECB) president Mario Draghi's "ad-libbed" comments (July 26, 2012) altered the course of financial history: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."
After trading above 7.50% just over a year ago, Spain's 10-year sovereign yields traded to as low as 4.04% (May 3) and closed
Friday at 4.61%. Italian yields dropped from 6.50% to 3.76% (May 2) and closed Friday at 4.40%. Spanish stocks posted a one-year gain of 31.1%, and Italian stocks were up 24.3%. The French CAC40 and German DAX jumped 23.8% and 25.3%. It's worth noting that the Eurozone economy has contracted in the face of rapidly rising stock and bond prices. After declining 0.1% during Q3 2012, real gross domestic product (GDP) dropped 0.6% during Q4 and another 0.3% during Q1 2013. And with the ECB having repressed financial crisis, politicians throughout the eurozone have relaxed measures to rein in deficits and restructure economies.
European and global investors agree with Mr Draghi's claim: "It's really very hard not to state that OMT has been probably the most successful monetary policy measure undertaken in recent times." [OMT, or Outright Monetary Transactions, is a program under which the ECB makes purchases ("outright transactions") in secondary, sovereign bond markets of bonds issued by Eurozone member-states.]
The Draghi Plan removed what was a very real risk of collapses in confidence in the euro, the Europe's banking system and European finance more generally. A potentially serious bout of capital flight - out of the Eurozone's periphery, out of Europe and away from emerging markets (EM) - was reversed. Draghi convinced the speculators to unwind bearish bets - and instead go long European debt and equities. With speculators adding leveraged holdings rather than selling and hedging, the market liquidity backdrop was altered profoundly. "Do whatever it takes" provided a green light for global speculation.
It was about a year ago that San Francisco Fed president John Williams talked openly of the benefits of open-ended QE. Not long afterward Federal Reserve chairman Ben Bernanke announced the Fed's intention to move forward with the largest non-crisis central bank balance sheet expansion in history. And then it wasn't many months later that the Bank of Japan implemented an even more radical experiment in central bank "money printing"/market liquidity injections. Japan's monetary base inflated 40% over the past year to 173 trillion yen (US$1.7 trillion). Japan's Nikkei equities index sports a one-year gain of 67.4%.
Here at home, the S&P500 enjoyed a one-year advance of 26.4%. The broader market has significantly outperformed. The small cap Russell 2000 has inflated 34.9% in 12 months and the S&P400 Mid-caps have jumped 32.1%. The Broker/Dealers were up 64.6% in 12 months, with the Banks up 45.3%. Biotech jumped 44.3% and the Internet stocks rose 37.3%. Speculation - and short squeezes - became only more intense.
In the past year, Netflix gained 332%, Green Mountain Coffee 320%, First Solar 240% and Gamestop 187%. After expanding 3.1% during Q3 2012, real GDP growth slowed to 0.4% in Q4 and then recovered somewhat to 1.8% in Q1 2013. GDP is forecast to have expanded at a 1.0% pace during Q2. As the economy slowed, corporate debt issuance jumped to a record pace - sold into a euphoric marketplace at record low yields. Only a few weeks after the Draghi Plan and Fed open-ended QE talk, benchmark mortgage - backed security (MBS) yields sank to a record low 1.68%.
I have argued against the conventional view of a favorable QE risk versus reward calculus. My thesis holds that there are extraordinary (and escalating) risks associated with QE-related "mis-priced finance" - debt that is being over-issued at exceptionally low yields, and stocks prices that are being grossly inflated by policy measures and speculation. Mis-pricing, misperceptions and systemic debt dependencies ensure latent market and economic fragilities.
Throughout its protracted bubble, I remained analytically fixated on the historic expansion of mortgage finance. There were key facets of the analysis: the nominal expansion in debt, the intermediation process that was transforming risky mortgage debt into perceived "money"-like debt instruments, associated distortions in the pattern of spending and investment, and the problematic systemic dependencies on ever-increasing amounts of (progressively risky) mortgage borrowings. I was convinced a problematic adjustment would inevitably unfold as soon as debt growth slowed. It was the timing that was unclear.
Intermediation risks were critical. Especially late in a credit cycle, there becomes a growing divergence between the perceived value of debt and the real underlying economic wealth supporting those inflating quantities of obligations. As they did throughout 2007 and much of 2008, Fed officials today believe expansionary monetary policies can sustain inflated securities prices irrespective of underlying economic fundamentals.
The government-sponsored enterprises (GSEs) were instrumental in the previous bubble. But late in the bubble period, so-called "private-label" mortgages were being intermediated through various sophisticated Wall Street instruments. These were categorized as asset-backed securities (ABS) in the Fed's Z.1 data. This late-cycle mis-priced debt relatively quickly came back to haunt the credit system.
For this cycle, Federal Reserve (and global central bank) measures have led to unappreciated financial asset mis-pricing. And I would see parallels as well as key differences to previous late-cycle excesses. Federal debt has doubled in four years. Risks associated with this debt bubble are mounting, yet unprecedented central bank buying has suppressed what should be increasing risk premiums. Meanwhile, massive ongoing fiscal and monetary stimulus has spurred a major increase in corporate borrowings at record low yields.
I would further contend that fiscal and monetary stimulus has boosted spending and corporate profits, while unprecedented loose financial conditions have spurred corporate borrowing, stock buybacks, special dividends, mergers & acquisitions, financial engineering and speculative excess that have led to major stock market overvaluation.
A quick look at some Z.1 data might be helpful. On a seasonally adjusted and annualized basis (SAAR), Q4 total non-financial debt (TNFD) expanded at a $2.585 trillion pace, more than double Q3 to the strongest credit expansion since Q3 2007. Total business debt growth jumped to SAAR $1.157 trillion. This was followed by SAAR Q1 2013 total non-financial debt growth of $1.851 trillion.
Total credit market borrowings surged to SAAR $2.524 trillion during Q4, up from Q3's $870 billion and Q2's $1.212 trillion, and then remained at an elevated SAAR $2.392 trillion during Q1. Over this six-month period, the federal government borrowed at about a $1.2 trillion annual pace, and corporate borrowings came in at about $850 billion annualized, the strongest since 2007. In a replay of late-cycle mortgage finance bubble dynamics, we're in the midst of a boom in marketable debt issued at highly inflated prices - in a marketplace distorted by major policy-induced misperceptions.
It is worth noting that mutual fund holdings of corporate debt jumped 22% in four quarters (Q1 through Q1) to a record $1.819 trillion. Mutual fund corporate debt holdings closed 2007 at $887 billion. After ending 2007 at $13.8 billion, exchange-traded Funds (ETF) holdings of corporate bonds ended Q1 2013 at $162 billion. ETF corporate bond holdings surged $39 billion, or 32%, in the four quarters ended March 31, 2013.
During the three quarters Q3 2012 to Q1 2013, outstanding corporate debt increased a notably large $645 billion. Who purchased this mis-priced debt? During this period, rest of world (ROW) holdings rose $137 billion. US life insurers boosted holdings $61 billion, and broker/dealers increased corporate debt holdings $10 billion. Meanwhile, household sector holdings surged $229 billion, mutual fund holdings $269 billion and ETF holdings $27 billion. As a proxy of total US household exposure to corporate debt, combined household, mutual fund and ETF holdings jumped $524 billion in nine months, accounting for 81% of the net issuance over that period. An indicator of an important market top?
Driving household savings into the risk markets has been integral to the Fed's monetary experiment. And, sure enough, surging asset prices inflated household net worth and no doubt spurred spending. The upshot has been an unprecedented expansion in household exposure to US and international stocks and bonds - securities prices that have been inflated to historic extremes throughout global markets.
Especially over the past year, unprecedented policy measures have goaded frustrated savers into unstable risk markets. This has accommodated a debt issuance bonanza, while the hedge funds have been incentivized into aggressive leveraged speculation. With China faltering, EM unraveling and the Fed talking tapering, global bubbles were looking increasingly vulnerable in June. The Fed and Chinese officials both moved quickly to calm markets. US stocks rallied to record highs and Japanese equities to five-year highs - further inflating powerful speculative bubbles. But what about the issues of mis-pricing and bubbles in fixed-income?
After trading at 2.28% in early May and as high as 3.68% on July 5, benchmark MBS yields ended Friday not far off highs at 3.40%. With the Detroit bankruptcy further weighing on confidence, municipal bonds have recovered little of the steep price declines suffered in May and June. Corporate debt has performed better. It is worth noting that many of the darling - and quite large - chiefly fixed-income "total return" mutual funds have struggled to recoup losses. And with investors hit with surprisingly quick losses throughout the fixed-income ETF complex, perhaps the bloom is off the rose in "bond" investing more generally.
The conventional bullish view holds that rising bond yields are a confirmation of a strengthening US economy. And there is this "great rotation" dynamic that sees waning enthusiasm for bonds drive strong fund flows into equities. For now - with QE at $85 billion a month - there may be adequate liquidity to both stabilize bond markets and fuel an inflating equities bubble.
Yet I can't help but to think that the marketplace remains too complacent with respect to what might be unfolding throughout global fixed-income. After years of bubble excess, more recent developments have had elements of "terminal phase" mis-pricing, misperceptions and speculation.
The yen rallied 2.6% last week. The big "macro" players are short the yen and long Japanese equities. The Nikkei was hit for 3.0% Friday. Yen strength seemed to play an important role in what was at the cusp of developing into a bout of global market de-risking/de-leveraging back in June. Markets reversed sharply on assurances from the Fed, along with support from global central Banks and Chinese officials. Short covering and the reversal of hedges helped fuel a speculative run in stocks, especially US and Japanese markets so favored by the global speculators.
As a whole, the global hedge fund community continues to struggle for performance. The volatile and policy-dominated "risk on, risk off" dynamic is tough on many trading strategies. Global risk markets - currencies, commodities, EM, bonds and equities - remain minefields, particularly for multi-asset class approaches. I believe enormous leverage has been employed by myriad strategies, certainly including global "carry trade," corporate, MBS and municipal debt. I'll assume there's no egregious Long-Term Capital Management-like leveraging, but I still worry a lot about global derivatives markets. I believe the world of speculative finance is full of problematic "crowded trades".
A few weeks back the markets were again indicating fragility - and the Fed once again demonstrated its market-pleasing low tolerance for market weakness. The flaw in aggressive QE is the notion that the Fed will be able to back away from market intervention without major consequences. Fed stimulus can spur debt issuance, market risk embracement and speculation.
But if that debt is mis-priced and predominantly non-productive, the system faces unavoidable debt problems. If speculative leverage is playing a prominent role in inflating securities and asset markets, the system face unavoidable de-leveraging issues. If the already vulnerable household sector continues to load up on mis-priced stocks and bonds, there will be negative consequences.
If there are major risk misperceptions endemic in the global marketplace - including with ETFs, the hedge funds, derivatives and perceived low-risk strategies - then there is latent market fragility that is only exacerbated by central bank liquidity injections and backstop assurances. I fully expect history to look back at the past year's Draghi Plan, Fed open-ended QE, and Bank of Japan "Hail Mary" monetary inflation as misguided market interventions that set loose historic market bubble excess.
I will posit that global systemic risk is significantly higher today than it was a year ago. And if the current trajectory of global central bank market intervention continues, systemic risk will be even more problematic one year from now.
The S&P500 was unchanged (up 18.6% y-t-d), while the Dow added 0.1% (up 18.7%). The Morgan Stanley Consumer index slipped 0.4% (up 24.2%), and the Utilities declined 0.6% (up %). The Banks dipped 0.1% (up 28.7%), and the Broker/Dealers declined 0.3% (up 42%). The Morgan Stanley Cyclicals were down 0.7% (up 20.0%), and the Transports fell 1.7% (up 22.0%). The S&P 400 MidCaps declined 0.5% (up 20.4%), and the small cap Russell 2000 slipped 0.2% (up 23.5%). The Nasdaq100 gained 1.0% (up 15.6%), and the Morgan Stanley High Tech index added 0.8% (up 14.2%). Semiconductors sank 2.7% (up 23.2%). The InteractiveWeek Internet index added 0.1% (up 23.8%). Biotechs fell 1.1% (up 38.6%). With bullion up $37, the HUI gold index rallied 6.4% (down 42.4%).
One-month Treasury bill rates ended the week at one basis point (bps) and three-month bill rates closed at two bps. Two-year government yields gained 1.5 bps to 0.315%. Five-year T-note yields ended the week up 7 bps to 1.37%. Ten-year yields jumped 8 bps to 2.56%. Long bond yields rose 6 bps to 3.62%. Benchmark Fannie MBS yields rose 6 bps to 3.40%. The spread between benchmark MBS and 10-year Treasury yields narrowed 2 to 84 bps. The implied yield on December 2014 eurodollar futures declined 1.5 bps to 0.595%. The two-year dollar swap spread declined one to 16 bps, and the 10-year swap spread declined one to 20 bps. Corporate bond spreads widened somewhat. An index of investment grade bond risk increased 2 bps to 74.5 bps. An index of junk bond risk jumped 14 to 365 bps. An index of emerging market debt risk rose 4 to 315 bps.
Debt issuance was strong. Investment grade issues included Daimler Finance USA $3.0 billion, American Airlines $1.4 billion, Citigroup $1.25 billion, American Express $1.2 billion, Bank of New York Mellon $1.1 billion, Nucor $1.0 billion, Pepsico $1.7 billion, Mass Mutual $600 million, Renaissance $575 million, Travelers $500 million, NYU Hospitals Center $350 million, Osprey Aircraft Leasing $160 million, GE Capital $250 million, and Gibson Brands $225 million.