Page 2 of 4 CREDIT BUBBLE BULLETIN The Fed goes too far
Commentary and weekly watch by Doug Noland
In my July 12, 2013 CBB, "Bernanke's Comment", I highlighted what I thought at the time was a comment for the history books: "If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that."
As someone who places "financial conditions" at the heart of market and economic analysis, I felt Bernanke had opened a real can of worms on the policy and communications front.
From Wednesday's Federal Open Market Committee statement: "The committee sees the downside risks to the outlook for the
economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market. The committee recognizes that inflation persistently below its 2% objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term."
Have financial conditions really tightened in recent months? Stock prices have surged to all-time record highs. The S&P500 has gained 7.7% in three months, with Nasdaq up 12.4%. The small cap Russell 2000 has surged 11.3% in three months. The Nasdaq Biotech index has jumped 24.8%, increasing its 2013 gain to 53.3% (two-year gain of 116%). Internet stocks enjoy a three-month gain of 12.6%. The average stock (value line arithmetic) is up 11.2% in three months. Stock prices indicate the opposite of tightening.
This month saw an all-time weekly record for corporate debt issuance. The year is on track for record junk bond issuance and on near-record pace for overall corporate debt issuance. At 350 basis points (bps), junk bond spreads are near five-year lows (5-yr avg 655bps). At about 70 bps, investment grade credit spreads closed on Thursday at the lowest level since 2007 (5-yr avg 114bps). It's a huge year for mergers and acquisitions. And with the return of "cov-lite" and abundant cheap finance for leveraged lending generally, US corporate debt markets are screaming the opposite of tightening.
August existing home sales were the strongest since February 2007. National home prices are now rising at double-digit rates. An increasing number of local markets - certainly including many in California - are showing signs of overheating. Prices at the upper-end in many markets are back to all-time highs. And despite a backup in mortgage borrowing costs from record lows, housing markets have yet to indicate a tightening of financial conditions. Clearly benefiting from loose lending conditions, August auto sales were the strongest since 2006.
Provide the marketplace a policy target for the unemployment rate and let the economic analysis and forecasting begin. Ditto for the Consumer Price Index and gross domestic product. But "financial conditions"? This is an altogether different animal, subjectively in the eye of the beholder - not easily quantified.
In my analysis of financial conditions, I talk of a broad global "mosaic". I closely examine scores of indicators, data and markets, doing my best to discern subtle changes in "financial conditions", and speculative and market liquidity dynamics. And within this mosaic, the pertinent and key indicators are in a constant state of flux. I discuss such challenging analysis in terms of a science and an art. How does the Fed define financial conditions? Does this imply a market liquidity backstop? Which markets? Under what circumstances? How?
Within my financial conditions analytical framework, I view the "leveraged speculating community" as the marginal source of marketplace liquidity. When the hedge funds and others are embracing market risk and leverage, this ensures abundant liquidity and resulting loose financial conditions. A move to de-risking/de-leveraging implies a tightening of financial conditions. QE only complicates already challenging analysis.
The initial QE chiefly involved accommodating speculative de-leveraging (a shifting of positions from the speculators to the Fed's balance sheet). As such, it actually had a much more muted impact on market liquidity than most appreciated at the time.
Non-crisis QE, on the other hand, has had a profound impact. It has directly injected liquidity into the marketplace, while at the same time inciting additional risk-taking and speculative leveraging. Moreover, this added liquidity and heightened speculation hit already highly speculative/overheated global markets. In short, recent QE had a major inflationary impact on global speculative bubbles. From this perspective, it's not too difficult to appreciate why global markets convulsed on the mere talk of even timid Fed tapering. On the margin, today's QE has unprecedented impact - and this market addiction will not be easily conquered.
So how is it possible that the Fed speaks of a tightening of financial conditions with stock prices at record highs, corporate debt yields near record lows and benchmark MBS yields at only 3.43% (10-yr avg. 4.60%)?
Here's how I see it. For going on five years now, experimental Fed policy purposely inflated bond and stock prices. Bond prices/yields were pushed to unprecedented extremes, with artificially low market yields now suppressed only through ongoing aggressive Fed buying. Similarly, securities and asset price bubbles have been inflated around the globe. Emerging markets and EM economies, in particular, have suffered from gross bubble-related excess and maladjustment. Trillions have flowed into various (inflated) markets at home and abroad with little appreciation for the risks monetary policies have created. Just the prospect of a gradual reduction in QE was enough to instigate a destabilizing reversal of speculator and investor flows.
What the Fed likely views as a tightening of financial conditions, I see as initial - and inevitable - cracks in the "global government finance bubble." The Fed wants to "push back" against a rise in mortgage borrowing costs, while likely content to "push back" on emerging-market fragility as well. A weaker dollar surely helps push back against the unwind of "carry trades" and other speculative de-leveraging. And the Fed surely would prefer to counter some of the tightening that has developed in municipal finance.
Bubble analysis plays prominently in my financial conditions analytical framework. Financial conditions will typically tighten first at the "periphery" - as the weakest ("marginal") borrower begins to lose access to cheap finance. This marks a key inflection point for bubbles - and the Fed would clearly want to push back against any risk of a bursting bubble. After all, faltering liquidity and heightened risk aversion at the fringes tend over time to have expanding contagion effects. May and June saw cracks, and Fed back-peddling continued through Wednesday's meeting.
After trading as high as 6.37% in July 2007, benchmark yields of mortgage-backed securities dropped all the way down to almost 5% by January 2008. The Fed's response to initial cracks at the periphery of mortgage finance (subprime) actually only extended the problematic inflation at the bubble's core (almost $1.1 trillion of risky mortgage credit growth in '07) - not to mention $145 crude and synchronized global risk market bubbles.
The initial European response to the Greek collapse extended the period of problematic excess and imbalances at Europe's core. The Fed's concern for the recent tightening of financial conditions at the "periphery" (EM, municipal credit and, perhaps, mortgages) ensures only more time for excess to build at the bubble's core (Treasuries, corporate debt, junk and leveraged lending, equities and, basically, anything with a yield).
My chronicling of the greatest bubble in history is going on five years now. This thesis is based upon the global nature of current credit and speculative excess, along with attendant financial imbalances and economic maladjustment. My thesis is premised upon bubble excess having, after decades, made it to the heart of government finance and contemporary "money." This implies acute - and intransigent - fragilities, which ensure policymakers won't have the grit to pull back.
As was made even clearer on Wednesday, the Fed is foremost determined to push back. And that's precisely the mindset that has allowed the "granddaddy of all bubbles" to get completely out of hand.
I believe the Bernanke Federal Reserve made yet another major blunder last week, and the likely price will be only greater market instability.
The S&P500 gained 1.3% (up 19.9% y-t-d), and the Dow added 0.5% (up 17.9%). The S&P 400 MidCaps gained 1.3% (up 22.1%), and the small cap Russell 2000 jumped 1.8% (up 26.3%). The Morgan Stanley Consumer index increased 0.9% (up 24.3%), and the Utilities advanced 1.8% (up 6.2%). The Banks slipped 0.1% (up 24.0%), while the Broker/Dealers gained 0.8% (up 48.1%). The Morgan Stanley Cyclicals were up 1.8% (up 27.1%), and the Transports jumped 2.6% (up 26.1%). The Nasdaq100 rose 1.5% (up 21.2%), and the Morgan Stanley High Tech index advanced 1.4% (up 21.0%). The Semiconductors gained 1.0% (up 28.4%). The InteractiveWeek Internet index increased 1.5% (up 28.8%). The Biotechs added 0.4% (up 43.3%). With bullion little changed, the HUI gold index was up 0.5% (down 47.5%).
One- and three-month Treasury bill rates ended the week at one basis point. Two-year government yields dropped 10 bps to 0.33%. Five-year T-note yields ended the week down 21 bps to 1.48%. Ten-year yields fell 15 bps to 2.74%. Long bond yields declined 7 bps to 3.76%. Benchmark Fannie MBS yields sank 20 bps to 3.43%. The spread between benchmark MBS and 10-year Treasury yields narrowed 7 to 69 bps. The implied yield on December 2014 eurodollar futures sank 17 bps to 0.56%. The two-year dollar swap spread was little changed at 16 bps, while the 10-year swap spread declined about one to 16 bps. Corporate bond spreads were mixed. An index of investment grade bond risk increased 3 to 80 bps. An index of junk bond risk fell 23 to 350 bps. An index of emerging market (EM) debt risk dropped 25 to 315 bps.
Debt issuance remained strong. Issuers included Union Bank $2.0bn, Spectra Energy Partners $1.9bn, Citigroup $1.75bn, SLM Corp $1.25bn, Cummins $1.0bn, HSBC USA $1.0bn, Hockey Merger $950 million, Branch Banking & Trust $750 million, Peco Energy $550 million, Bi-Lo Finance $475 million, Avalonbay Communities $400 million, Toyota Motor credit $350 million, EDR $300 million and TTX $250 million.
Junk bond funds enjoyed strong inflows of $1.39bn (from Lipper). Junk issuers this week included Hilton Worldwide $1.5bn, Springleaf Finance $950 million, Nissan Motor Acceptance $1.0bn, Nielsen Finance $625 million, Walter Energy $450 million, Nexstar Broadcasting $525 million, Reinsurance Group of America $400 million, Pinnacle $375 million, American Capital $350 million, Hercules Offshore $300 million, Geo Group $250 million and Prospect Holding $150 million.
Convertible debt issuers included BPZ Resources $125 million and Green Plains Renewable $100 million.