Page 1 of 3 CREDIT BUBBLE BULLETIN Face to face with reality Commentary and weekly review by Doug Noland
COMMENTARY
US consumer prices were up 4.3% year-on-year in November. The Producer Price
Index registered a 7.2% year-on-year surge. November import prices were up
11.4% from a year earlier. Eurozone inflation jumped to 3.1% year-on-year, the
strongest rate since May 2001. German consumer inflation rose to an 11-year
high (3.3%). Chinese inflation was at an 11-year high of 6.9% in November.
Score of countries and regions - including Australia, Russia, Eastern Europe,
and the Middle East - now confront
heightened inflationary pressures, in what has developed into a powerful global
phenomenon.
US financial markets traded dazed and confused - understandably. For some time
now, Wall Street has operated under a certain premise of how the Fed would
respond to financial crisis. Recent expectations had our central bankers poised
to lower rates to whatever level necessary to rekindle "animal spirits" and
spur the credit system and Wall Street risk intermediation more generally. The
overriding presumption has been that inflation was a moot issue: inflationary
pressures were well contained and, in any event, would rapidly dissipate in the
face of housing, credit and economic woes. Last week the market came face to
face with the reality that inflation is not only a major issue; inflation is in
the process of significantly limiting the Fed’s flexibility and capacity to
orchestrate another Wall Street bailout.
Markets boisterously protested the meagerness of the Fed’s 25 basis-point cut
in the Fed Funds and Discount Rate. Wednesday morning’s news of concerted
global central banks' unconventional liquidity injections garnered a curiously
lukewarm reception. This was likely due to its limited scope as well as the
recognition that such an approach indicated the Fed was exploring policy
instruments outside of Greenspan-style zealous rate slashing. Many on Wall
Street are calling the Fed’s handling of the situation a "fiasco", while some
are even asking for Ben Bernanke’s head. I would instead argue that unrealistic
Wall Street expectations were once again instrumental in fostering marketplace
instability.
There is certainly more than ample pontificating these days on the nuances of
central banking. Meantime, there remains scant attention paid to underlying
fundamental forces driving both the financial markets and monetary management.
Last week’s Z1 "flow of funds" data go far in illuminating today’s market and
Federal Reserve dilemma: the enormous scope of credit expansion necessary to
sustain Wall Street’s bloated securities markets - to keep the contemporary
credit mechanisms generally liquid and functioning - has become patently
inflationary for the system overall.
The third quarter demonstrated how, in spite of double-digit system credit
growth, an acutely fragile credit system came to the brink of imploding. In
particular, ongoing rampant financial sector expansion could not ameliorate
revulsion to Wall Street-backed securitizations. Double-digit expansion in
"money-like" debt instruments - including Treasuries, agencies debt, GSE MBS,
and bank and money fund deposits - had become powerless in providing liquidity
support for Wall Street’s asset-backed commercial paper, CDO, ABS, and
private-label (non-GSE guaranteed) MBS markets. Rapid expansion of financial
market credit (15.6% annualized!) was, at the same time, sufficient to
adequately (over-)finance the real economy, certainly including corporate
cash-flows and household incomes and attendant ongoing massive current account
deficits.
Back in 2001/02, some Wall Street analysts (the "inflationists") were keen to
argue that aggressive Fed reflationary policies were required to elevate "the
price level" to ensure that deflation was not allowed to take hold. Alluring,
yes, but this was dangerously flawed reasoning. There was not and is not today
an actual "price level" within the real economy to be manipulated by central
banks. Instead, inflationary policies ensured that the interrelated operations
of Wall Street’s asset-based lending, securitization, and leveraged securities
speculation ballooned in unimaginable excess. Resulting monetary disorder saw
wildly destabilizing price inflation and distortion, especially in housing,
securities and asset markets generally. US CPI may have remained tame, but
massive credit-induced current account deficits and the depreciating dollar set
in motion credit and asset bubble dynamics in economies around the globe.
Today, the Fed confronts bursting credit bubbles throughout Wall Street
finance, with resulting acute asset market vulnerability. Yet the unusual
structures that permeate the US financial sector at this time foster continuing
rampant inflationary credit creation. First of all, "money-like" financial
sector liabilities (ie, agencies, "repos", and bank/money fund deposits) are
proving thus far sufficient to sustain bubble economy excesses. Second, the
global recycling of ongoing massive current account deficits and speculative
outflows ensures over-liquefied markets (and artificially low interest rates!),
including key US debt instruments such as Treasuries, agencies and other
perceived low-risk securities. Bubble dynamics proliferate in the face of a
Wall Street bust.
The extreme divergence in liquidity conditions between bursting bubbles in Wall
Street finance and still rapidly inflating bubbles in "money-like" financial
sector liabilities poses both a major quandary and policy dilemma. Aggressive
rate cuts would definitely further stoke the powerful bubbles inflating in GSE,
"repo", money fund, and bank deposit liabilities. Such ongoing financial sector
debt expansion would likely sustain destabilizing liquidity outflows to the
world, further fueling myriad global bubbles and worsening an already
problematic global inflationary backdrop. A rapidly expanding US financial
sector (with the accompanying heavy risk intermediation burden associated with
transforming highly risky loans into perceived safe liabilities) also
significantly increases the risk of an eventual catastrophic breakdown in US
and international financial systems. Besides, it is likely that lower rates
would have only minimal effect on the investor and speculator revulsion that
has taken hold throughout the Wall Street securitization marketplace.
Those arguing for a Greenspan-style rate collapse fail to appreciate the
extraordinary circumstances and risks that have accumulated from years of
reckless credit bubble excess. The outcry for an audacious policy response to
avert a recession is misguided. Importantly, the current rampant financial
sector expansion is unsustainable. There are today acute inflationary risks to
go with major financial system stability issues. While the dislocation will be
substantial, the sooner the bubble in financial credit is reined in the better.
We are today in the midst of dangerous "blow-off" excesses in "money-like"
financial sector liability issuance. Few seem to appreciate that such a
circumstance places the stability of the "bedrock" of the entire US and global
financial system at considerable risk. Wall Street is clamoring for a rate
collapse and bold inflation in "money" to bail out its faltering securitization
markets. At this point, this would equate to throwing massive (relatively) good
"money" after bad - ensuring that a dreadful situation festers into a historic
calamity. The least bad course for central bank policymaking would be to hold
the line on rates, while injecting liquidity as necessary as part of a program
to check credit excess and permit the economy to commence its desperately
needed adjustment period.
WEEK IN REVIEW
Things turn only more unsettled by the day. For the week, the Dow declined 2.1%
(up 7.0% y-t-d) and the S&P500 2.4% (up 3.5%). Economically sensitive
stocks were hit hard. The Transports fell 4.1% (up 2.6%) and the Morgan Stanley
Cyclical index dropped 3.1% (up 10.6%). Yet even the Utilities were down 2.2%
(up 16.7%), and the Morgan Stanley Consumer index fell 1.7% (up 7.4%). The
broader market was under heavy selling pressure. The small cap Russell 2000
dropped 4% (down 4.3% y-t-d), and the S&P400 Mid-Caps were 3.4% lower (up
6.3%). The NASDAQ100 fell 2.7% (up 17.9%), and the Morgan Stanley High Tech
index declined 1.5% (up 9.7%). The Street.com Internet Index was hit for 2.6%
(up 13.6%), while the NASDAQ Telecommunications index was little changed (up
10%). The Semiconductors were down 3.5%, increasing 2007 loses to 11.5%. The
Biotechs sank 3.2% (up 6.2%). The Broker/Dealers dropped 3.4% (down 14.7%), and
the Banks were hammered for 6.9% (down 23.6%). And while Bullion was little
changed, the HUI Gold index sank 6.1% (up 14.4%).
Three-month Treasury bill rates fell 18 bps this week to an amazing 2.87%. At
the same time, two-year government yields jumped 20 bps to 3.30%. Five-year
T-Note yields rose 13 bps to 3.63%, and ten-year yields jumped 13 bps to 4.23%.
Long-bond yields increased 9 bps to 4.66%. The 2yr/10yr spread ended the week
at 97 bps. The implied yield on 3-month December ’08 Eurodollars jumped 15.5
bps to 3.78%. Benchmark Fannie MBS yields rose 7 bps to 5.755%, this week
under-performing Treasuries. The spread on Fannie’s 5% 2017 note narrowed 10 to
50, and the spread on Freddie’s 5% 2017 note narrowed 10 to 50. The 10-year
dollar swap declined 3.6 bps to 68.4. Corporate bond spreads generally narrowed
somewhat, with the spread on an index of junk bonds ending the week 7 bps
narrower.
Investment grade debt issuers included Wachovia $1.95bn, Great Atlantic &
Pacific $380 million, and CSX $380 million.
Junk issuers included NGPL Pipeco $3.0bn and Legends Gaming $220 million.
Convertible issuance included SPX Corp $500 million, Yingli Green $150 million
and Network Equipment $85 million.
Foreign dollar bond issuance included Diageo $2.0bn.
German 10-year bund yields rose 4 bps to 4.35%, while the DAX equities index
slipped 0.6% for the week (up 20.5% y-t-d). Japanese "JGB" yields dipped 2 bps
to 1.545%. The Nikkei 225 dropped 2.8%, increasing 2007 losses to 9.9%.
Emerging debt and equities markets were mostly lower. Brazil’s benchmark dollar
bond yields jumped 15 bps to 5.78%. Brazil’s Bovespa equities index sank 4.9%
(up 40.4% y-t-d). The Mexican Bolsa sank 4.0% (up 13.4% y-t-d). Mexico’s
10-year $ yields rose 3 bps to 5.45%. Russia’s RTS equities index dipped 0.7%
(up 18.1% y-t-d). India’s Sensex equities index added 0.3% (up 45.3% y-t-d).
China’s Shanghai Exchange declined 1.6%, lowering y-t-d gains to 87.3%.
Freddie Mac posted 30-year fixed mortgage rates jumped 15 bps this week to
6.11% (down 1 bps y-o-y). Fifteen-year fixed rates rose 13 bps to 5.78% (down
8bps y-o-y). One-year adjustable rates added 4 bps to 5.50% (up 5bps y-o-y).
Bank Credit increased $3.2bn during the week (12/5) to a record $9.209 TN. Bank
Credit has posted a 20-week gain of $565bn (17% annualized) and a y-t-d rise of
$912bn, a 11.7% pace. For the week, Securities Credit dropped $21bn. Loans
& Leases jumped $24.2bn to $6.752 TN (20-wk gain of $427bn). C&I loans
rose $9.0bn (2007 growth rate of 22%). Real Estate loans increased $7.3bn.
Consumer loans gained $4.2bn. Securities loans declined $5.0bn, while Other
loans rose $8.8bn. On the liability side, (previous M3) Large Time Deposits
jumped $15.3bn.
M2 (narrow) "money" supply dropped $24.4bn to $7.440 TN (week of 12/3). Narrow
"money" has expanded $397bn y-t-d, or 6.0% annualized. For the week, Currency
declined $2.4bn, while Demand & Checkable Deposits jumped $21.4bn. Savings
Deposits sank $55bn, while Small Denominated Deposits dipped $0.5bn. Retail
Money Fund assets rose $12.1bn.
Total Money Market Fund Assets (from Invest. Co Inst) gained $4.3bn last week
to a record $3.122 TN. Money Fund Assets have posted an unprecedented 20-week
surge of $538bn (54% annualized) and a y-t-d increase of $74obn (31.3%
annualized)..
Total Commercial Paper declined $5.4bn to $1.839 TN. CP is now down $385bn over
the past 18 weeks. Asset-backed CP fell another $10.2bn (18-wk drop of $404bn)
last week to $791bn. Year-to-date, total CP has contracted $136bn, with ABCP
down $253bn.
Asset-Backed Securities (ABS) issuance this week slowed to about nothing.
Year-to-date total US ABS issuance of $526bn (tallied by JPMorgan) is running
39% behind comparable 2006. At $224bn, y-t-d Home Equity ABS sales are off 58%
from last year’s pace. Year-to-date US CDO issuance of $291 billion is now 21%
below comparable 2006.
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