Page 1 of 4 CREDIT BUBBLE BULLETIN Riddle of the burst bubble
Commentary and market watch by Doug Noland
Here's how I see it. Many are celebrating the bursting of the
energy/commodities bubble. Rapidly declining oil and resource prices are now
expected to alleviate inflationary pressures while bolstering household
purchasing power. There'll be no pressure on the US Federal Reserve to raise
rates, while their global central bank compatriots can soon begin cutting. The
consensus view is that this is bullish for the US economy and stock market and,
if nothing else, market action did take attention away from troubling financial
and economic news.
I am not one to easily dismiss notions of bursting bubbles, and perhaps there
is something to the energy-bust thesis. I'm just skeptical of the idea that a
slumping global economy is behind
recent stunning price declines. Examining the global market backdrop, I sense
different dynamics at play - important dynamics. And I tend to believe rapidly
retreating commodities markets should be viewed in the context of a bursting
leveraged speculating community bubble.
The leveraged speculators have struggled since this year's initial trading
sessions. "Quant" and "market neutral" strategies in particular have foundered,
although wild market volatility, illiquidity, and weak global securities
markets have been an impediment for virtually all strategies. The hedge-fund
industry has been trying to adapt to tighter credit conditions from the Wall
Street firms and generally less-liquid markets. Overall, leveraged strategies
have been problematic, whether the underlying positions were in residential
mortgages, commercial mortgages or corporate loans. The easy days of leveraged
spread trades ("borrow cheap and lend dear") quickly became quite difficult.
And the easy returns in emerging markets turned abruptly into painful losses.
Overall, global equities have performed quite poorly and global bonds somewhat
poorly. Not many things have performed well and, worse yet, various trades that
were supposed to offer diversification all became too tightly correlated.
Crude ended the first half at US$140. Major commodities indices concluded June
at record highs - sporting spectacular year-to-date gains. There's no doubt
that the speculator community had all crowded into the energy/commodities
trade, one of a rapidly narrowing menu of speculations offering juicy (and
desperately needed) returns. At the same time, the long energy/short financials
"pairs trade" was also put on in great excess. The speculator community likely
crowded as well further into dollar short positions, for years now an almost
surefire winner. The more the crowded industry struggled for performance, the
more they were forced to crowd into the same crowded trades. I would argue that
the bubble in the leveraged speculating community played a significant role in
fueling energy/commodities prices inflation beyond what was justified by
exceptionally bullish fundamentals. I wouldn't, however, write off energy and
commodities as burst bubbles.
A lot of things had to go right for the vulnerable leveraged speculator
community not to be pushed over the edge. Of course, markets tend not to
accommodate the impaired - and the current market is particularly ruthless in
this regard. The energy trade has unraveled badly. Commodities markets have
been in near freefall. The dollar has mustered its most ferocious rally in
quite some time. At the same time, spreads on agency debt and mortgage-backed
securities (MBS) have widened, while global bond prices have offered little
performance help. Corporate debt prices have performed poorly, while
"private-label" MBS and various mortgage-related derivatives have traded
dismally. Meanwhile, the financial stocks and other heavily shorted equities
have rallied significantly. In short, a whole host of popular trades have gone
wrong at the same time - a huge problem for the fragile industry.
We're now in the midst of another one of these precarious periods. I believe
global markets - equities, debt, currencies, and commodities - are all in some
stage of dislocation (perhaps not emerging debt, at least yet). Trading
conditions across the spectrum of markets are as chaotic as I've ever
witnessed, a dislocation chiefly related to the now forced unwinds of
speculative positions. Recent extreme global market volatility is part and
parcel to the heightened monetary disorder I have been addressing for months
now. The massive global pool of speculative finance has run amuck. The bulls
will celebrate the rally, yet markets this unstable are prone to "melt-ups"
that lead to breakdowns.
Earnings reports last week from Freddie Mac, Fannie Mae and AIG - three of our
largest financial institutions - were horrendous. Financial sector hemorrhaging
has actually accelerated, and definitely do not underestimate the impact of
tightened credit in the pipeline from Fannie, Freddie and others. With limited
"capital" quickly evaporating, Freddie stated that its aggressive retained
portfolio growth has come to a conclusion. Fannie intimated about the same.
Fannie will curtail purchases of alt-A loans, and it is clear that both
companies have lost the capacity to provide the speculators a "backstop bid" in
the MBS marketplace. This major additional tightening of mortgage credit
availability and marketplace liquidity will further depress housing markets and
bolster the headwinds buffeting our vulnerable economy.
Yet it is not the nature of dislocated markets to let fundamentals get in the
way of price movement. Markets, after all, live on fear and greed. Sinking
energy prices and a short squeeze ignited US stocks this week. And surging
stock prices always entice the optimistic viewpoint, with many viewing runs in
stocks and the dollar as confirmation that the worst of the financial and
economic crisis is behind us. The bursting of the so-called energy/commodities
bubble is also viewed in positive light.
Yet if the key dynamic is instead a bursting leveraged speculating community
bubble, entirely different dynamics are now in play. Enormous short positions
have built up, the vast majority as part of "market neutral," "quant" and
myriad risk hedging strategies. If today's dislocation develops into a
significant unwind of these positions, the market immediately then becomes
vulnerable to a disorderly "melt-up" followed almost inevitably by a sharp
reversal and disorderly decline. The unwind of bearish speculations and hedges
would be a most problematic market development, unleashing a final bout of
speculative excess and disorder that would set the stage for a major market
It is not difficult to envision the backdrop for problematic market liquidation
and deepening financial crisis. The hedge-fund community is now susceptible to
huge year-end redemptions, generally poor performance, shrinking assets and
tighter credit - all taking place in a climate of inhospitable market
conditions that dictate ongoing credit system de-leveraging.
The pool of players willing and able to acquire US risk assets is being
depleted by the week. To be sure, the unfolding change of fortunes for the
leveraged speculating community is one more key facet of tighter system credit
and faltering marketplace liquidity - extremely problematic financial
conditions for the finance-driven US bubble economy. And this makes the current
market dislocations in the face of rapidly deteriorating fundamentals such a
For the week, the Dow jumped 3.6% (down 11.5% y-t-d) and the S&P500 gained
2.9% (down 11.7%). The Transports surged 5.4%, increasing 2008 gains to 14.1%.
The Morgan Stanley Cyclicals rose 4.0% (down 11.1%). The Morgan Stanley
Consumer index jumped 4.4% (down 5.2%), and the Utilities added 1.2% (down
12.3%). The small cap Russell 2000 increased 2.5% (down 4.1%), and the
S&P400 Mid-Caps gained 1.6% (down 5.2%). Technology stocks were strong. The
NASDAQ100 surged 5.5% (down 7.6%), and the Morgan Stanley High Tech index rose
5.1% (down 6.4%). The Semiconductors jumped 8.6% (down 10%). The Street.com
Internet Index surged 7.2% (down 4.7%), and the NASDAQ Telecommunications index
advanced 5.8% (down 1.2%). The Biotechs increased 1.0% (up 9.1%). The
Broker/Dealers rallied 2.0% (down 25.4%), and the Banks gained 1.6% (down
22.9%). With Bullion sinking $54, the HUI Gold index sank 14.4% (down 18.4%).
One-month Treasury bill rates rose 4 bps this week to 1.60%, while 3-month
yields were little changed at 1.70%. Two-year government yields were unchanged
at 2.50%. Five-year T-note yields slipped one basis point to 3.19%, and 10-year
yields were little changed at 3.94%. Long-bond yields declined 2 bps to 4.54%.
The 2yr/10yr spread was little changed at 144 bps. The implied yield on 3-month
December '09 Eurodollars declined one basis point to 3.80%. Benchmark Fannie
MBS yields rose 5 bps to 5.99%. The spread between benchmark MBS and 10-year
Treasuries widened 5 to 206 bps. The spread on Fannie's 5% 2017 note widened 2
bps to 73 bps, and the spread on Freddie's 5% 2017 note widened 2 bps to 74
bps. The 10-year dollar swap spread increased 0.75 to 73.0. Corporate bond
spreads were mixed to wider. An index of investment grade bond spreads widened
2 to 142 bps, while an index of junk bond spreads was little changed at 560
Investment grade issuance this week included XTO Energy $3.0bn, CME Group
$1.3bn, Caterpillar $850 million, Northern Trust $700 million, Public Service
Colorado $600 million, and Ryder Systems $300 million.
Junk issuers included Texas Industries $300 million and Aeroflex $225 million.
Convert issuers this week included Massey Energy $690 million.
International dollar bond issuance included Trans-Canada Pipeline $1.5bn.
German 10-year bund yields dropped 9 bps to 4.26%. The German DAX equities
index rallied 2.6% (down 18.7% y-t-d). Japanese 10-year "JGB" yields declined 4
bps to 1.47%. The Nikkei 225 added 0.6% (down 14% y-t-d and 22.7% y-o-y).
Emerging markets mostly underperformed. Brazil's benchmark dollar bond yields
rose 4 bps to 5.94%. Brazil's Bovespa equities index declined 1.8% (down 11.4%
y-t-d). The Mexican Bolsa added 0.6% (down 8.1% y-t-d). Mexico's 10-year $
yields declined 4 bps to 5.46%. War worries pushed Russia's RTS