Page 1 of 4 CREDIT BUBBLE BULLETIN
Stage II predicaments
Commentary and weekly watch by Doug Noland
US Federal Reserve chairman Ben Bernanke set out his view of the risk to the
country's economy last week (June 9) in these terms:
Despite the
unwelcome rise in the unemployment rate that was reported last week, the recent
incoming data, taken as a whole, have affected the outlook for economic
activity and employment only modestly. Indeed, although activity during the
current quarter is likely to be weak, the risk that the economy has entered a
substantial downturn appears to have diminished over the past month or so.
I'll make just some brief comments as to why I believe Dr
Bernanke's view is too optimistic. First, since March, the Fed's Wall Street
bailout and the concurrent collapse in market yields played a significant role
in artificially bolstering the US economy. The unwind of market hedges also
worked to support marketplace liquidity and likely artificially boosted credit
availability - especially for conventional mortgages and the investment grade
corporate sector. I believe these forces have by now likely run their course.
The risk that our economy has entered a substantial downturn has actually
increased markedly over the past several weeks. Importantly, energy costs have
risen significantly to the point of being economically destabilizing. The
combination of spiking energy and food costs has created the worst global
inflationary backdrop since the 1970s - a dangerous predicament only belatedly
appreciated by global policymakers. Central banks across the globe have begun
to react, and vulnerable global bond markets are under heavy selling pressure.
There is today great uncertainty as to the consequences of a global spike in
bond yields.
Importantly, the Fed's aggressive "reflation" is being stopped dead in its
tracks by market forces. US market yields are moving sharply higher, with
benchmark mortgage-backed security (MBS) yields now all the way back to last
summer’s levels. This is forcing another round of speculative de-leveraging in
the highly leveraged mortgage credit market, which is tantamount to a further
tightening of already tight mortgage finance conditions. This is another huge
blow for the vulnerable bubble economy.
The University of Michigan Consumer Confidence index posted its high of 112
back in the first month of 2000. By the beginning of 2003, it had sunk all the
way down to 78. Yet during this period of weakening consumer sentiment and
general economic conditions, benchmark MBS yields dropped from over 8.0% in
mid-2000 all the way down to 4.2% by June 2003. Repeatedly over the past
("dis-inflationary") 20 years, waning economic activity has been bolstered by
sinking mortgage yields and resulting stimulus to housing and home-equity
withdrawal. It was like clockwork, but now this important cycle has been
broken. Since January, Consumer Confidence has plunged from 78.4 to 56.7, while
MBS yields have jumped from 5% or so to above 6%.
I have argued that the Fed’s latest reflation would prove problematic. On the
one hand, reflationary forces would bypass burst bubbles in Wall Street finance
and US real estate markets. On the other, an over abundance of cheap US and
global liquidity would further destabilize heightened inflationary pressures
globally and stoke acute monetary disorder. As has become clear of late, the
upshot is intensifying inflationary pressures in the face of a weakening US
economy. Indeed, one can look to spiking energy, food and borrowing costs and
make a strong case that Fed reflationary policies have become dangerous and
counterproductive.
From examining Q1 "Flow of Funds", one could identify how double-digit growth
in bank credit, agency MBS, and the money fund complex was carrying the load
for a busted Wall Street securitization credit apparatus. Recent developments,
however, have the sustainability of robust bank credit and MBS in serious
doubt. And while 9.7% fiscal year-to-date federal spending growth (see "Fiscal
Watch" below) has thus far played a meaningful role in supporting the economy,
the bond market for the first time in years must come to grips with the
confluence of surging yields and the prospect of massive federal deficits.
Similar to the Fed’s reflation policies, federal government stimulus is not
without significant costs and risks. Acute global inflationary pressures ensure
the old "free lunch" monetary and fiscal stimulus come these days with a hefty
price tag.
It has not taken long for Stage II of this unfolding historic crisis to
demonstrate some of the classic old financial and economic headaches. I’ve
always believed the most problematic scenario for the highly leveraged US
credit system and bubble economy would be an inflationary surge and resulting
spike in market yields. Curiously, just as the possibility of such a dismal
scenario gains momentum a bullish consensus develops that the worst of the
crisis is behind us.
WEEKLY WATCH
For the week, the Dow added 0.8% (down 7.2% y-t-d), while the S&P500 was
little changed (down 7.4%). The Transports were down 1.9% (up 12.7%), while the
Utilities rose 2.4% (down 3.6%). The Morgan Stanley Cyclicals added 0.2% (down
5.7%), and the Morgan Stanley Consumer index gained 0.5% (down 6.3%). The
broader market gave back some recent out-performance. Both the small cap
Russell 2000 (down 4.2%) and the S&P400 Mid-Caps (up 0.9%) declined 0.9%.
The NASDAQ100 declined 1.2% (down 5.7%) and the Morgan Stanley High Tech index
fell 1.1% (down 4.2%). The Semiconductors dropped 2.9% (down 3.5%). The
Street.com Internet Index dipped 0.2% (down 2.7%), while the NASDAQ
Telecommunications index added 0.2% (up 2.0%). The Biotechs lost 2.2% (down
4.6%). The Broker/Dealers added 0.4% (down 21.6%), while the Banks sank another
4.2% (down 24.8%). With Bullion sinking $32.30, the HUI Gold index was
clobbered for 7.7% (down 2.7%).
One-month Treasury bill rates increased 13 bps this week to 1.86%, and 3-month
yields rose 14 bps to 1.97%. Two-year government yields surged 66 bps to 3.03%,
according to Bloomberg the largest weekly gain in yields in 26 years. Five-year
T-note yields surged 55 bps to 3.73%, and 10-year yields jumped 34 bps to
4.26%. Long-bond yields gained 18 bps to 4.79%. The 2yr/10yr spread narrowed 22
to 123 bps. The implied yield on 3-month December ’09 Eurodollars shot 72.5 bps
higher to 4.555%. Benchmark Fannie MBS yields rose 36 bps to 6.07% (high since
Aug 20). The spread between benchmark MBS and 10-year Treasuries widened 2 bps
to 181. The spread on Fannie’s 5% 2017 note narrowed 3 bps to 70.5 bps, and the
spread on Freddie’s 5% 2017 note narrowed 2 bps to 71 bps. The 10-year dollar
swap spread declined 4.5 to 70. Corporate bond spreads were mixed to wider. An
index of investment grade bond spreads widened 1 to 111 bps, and an index of
junk bond spreads narrowed 15 to 579 bps.
Investment grade issuance included SLM $2.5bn, Florida Power $1.5bn, American
Express $500 million, Duke Energy $500 million, FPL Group $500 million,
Sotheby's $500 million, Sempra Energy $500 million, and Union Electric $450
million.
Junk issuers included Sequa Corp $500 million, and Targa Resources $250
million.
Convert issuance this week included Sotheby's $175 million.
International dollar bond issuance included Rabobank $3.4bn and Arantes
International $150 million.
German 10-year bund yields jumped 22 bps to an 11-month high 4.64%. The German
DAX equities index dipped 0.6% (down 16.1% y-t-d). Japanese 10-year "JGB"
yields gained 7.5 bps to an 11-month high 1.86%. The Nikkei 225 dropped 3.6%
(down 8.7% y-t-d and 21.2% y-o-y). Emerging debt markets were under pressure
and equities were mostly lower. Brazil’s benchmark dollar bond yields surged 27
bps to 6.33%. Brazil’s Bovespa equities index dropped 3.7% (up 5.2% y-t-d and
26.8% y-o-y). The Mexican Bolsa fell 2.4% (up 3.0% y-t-d). Mexico’s 10-year $
yields jumped 23 bps to 5.33%. Russia’s RTS equities index added 0.2% (up 2.9%
y-t-d). India’s Sensex equities index fell 2.5%, boosting y-t-d losses to
25.1%. China’s Shanghai Exchange index was clobbered for 14.4%, pushing 2008
losses to 45.5%.
Freddie Mac 30-year fixed mortgage rates surged 23 bps to a 7-month high 6.32%
(down 42bps y-o-y). Fifteen-year fixed rates jumped 28 bps to 5.93% (down 50bps
y-o-y). One-year adjustable rates increased 3 bps to 5.09% (down 66 bps y-o-y).
Bank Credit declined $4.2bn to $9.376 TN (week of 6/4). Bank Credit has
expanded $163bn y-t-d, or 4.0% annualized. Bank Credit posted a 52-week rise of
$821bn, or 9.6%. For the week, Securities Credit increased $7.9bn. Loans &
Leases declined $12.1bn to $6.899 TN (46-wk gain of $574bn, or 10.%
annualized). C&I loans fell $7.1bn, with one-year growth of 18.7%. Real
Estate loans dipped $1.6bn (up 3.4% y-t-d). Consumer loans were little changed,
and Securities loans declined $2.2bn. Other loans decreased $1.0bn. Examining
the liability side, Deposits sank $36.4bn and "Borrowings" rose $11.6bn.
M2 (narrow) "money" supply declined $11bn to $7.694 TN (week of 6/2). Narrow
"money" has expanded $231bn y-t-d, or 7.3% annualized, with a y-o-y rise of
$466bn, or 6.4%. For the week, Currency added $1.1bn, and Demand &
Checkable Deposits increased $17.8bn. Savings Deposits dropped $26.2bn, and
Small Denominated Deposits declined $2.4bn. Retail Money Funds slipped $1.2bn.
Total Money Market Fund assets (from Invest Co Inst) declined $5.0bn last week
to $3.515 TN, reducing the y-t-d rise to $402bn, or 29% annualized. Money Fund
assets have posted a one-year increase of $985bn (38.9%).
Asset-Backed Securities (ABS) issuance increased this week to $6.3bn.
Year-to-date total US ABS issuance of $100bn (tallied by JPMorgan's Christopher
Flanagan) is running at 27% of the
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