Page 1 of 5 CREDIT BUBBLE BULLETIN Dysfunctional pricing backdrop
Commentary and market watch by Doug Noland
The divergence between underlying fundamental developments and market trading
dynamics became only more striking last week. July consumer prices were
reported up 5.6% from a year earlier, the largest year-on-year increase since
January 1991. July import prices were up a record 21.6% year-on-year (data
going back to 1982). Despite much worse-than-expected inflation readings, the
bond market rallied on Thursday.
Understandably, the market is rather confident the US Federal Reserve will
ignore inflationary pressures as long as employment trends remain weak. And
weak they were. Thursday's report had continuing claims for unemployment
jumping another 114,000 last
week to 3.417 million - the highest since November 2003. Continuing claims were
up a notable 320,000 in three weeks, increasing the year-to-date gain to
727,000.
The Treasury market is similarly content to disregard what will now be massive
ongoing supply of new government debt issues. The federal deficit surged to a
record $102.8 billion during July. Spending for the month was up 27.2%
year-on-year, pushing fiscal year-to-date spending growth to a positive 8.5%.
Receipts were down 5.8% from last July, with fiscal year-to-date receipts now
running 1.0% below a year ago. With two months to go, the fiscal year-to-date
deficit has surged to $371 billion, more than double last year’s comparable
$157 billion.
And despite troubling developments in the Caucasus and heightened geopolitical
tensions, the energy and commodities rout ran unabated. Sure, the global
economy is slowing. Yet the dramatic price moves being witnessed are indicative
of panic liquidations. It is now clear that many within the leveraged
speculating community have suffered huge losses over the past few weeks. For a
"community" that was already suffering a difficult year, blowups in the popular
energy, commodities and short dollar trades were a decisive backbreaker. Huge
rallies in heavily shorted stocks and sectors have added further pain. One can
now expect major redemptions at quarter- and year-ends, a dynamic that likely
ensures recent near-chaotic market conditions become the norm for awhile.
I could go on and on with a discussion on deteriorating fundamentals. The
economy is rapidly sinking into what will prove a deep and protracted downturn.
Mortgage problems are broadening and worsening, ushering in another leg of
financial system and housing market tumult. Financial sector spreads widened
meaningfully again this week, and it is worth noting that American Express
issued five-year debt on Friday afternoon at an eye-opening 425 basis points
above Treasuries. Fannie and Freddie debt spreads also widened significantly in
the week, as did benchmark agency MBS spreads. A severe credit crunch is now
tightening its noose around much of the real economy.
But, for now, fundamentals are not driving market prices. As I wrote last week,
markets are about greed and fear - and right now fear dominates. Those that
packed into the already crowded energy and commodities trade are having their
heads handed to them. It is also my sense that the scores of long/short funds
are likely struggling as well, as many popular longs are performing poorly and
popular shorts are in many cases rising spectacularly. The proliferation of
"market neutral" and "quant" strategies created too many players all working
cleverly to play the same game. Those ranks will be thinned over the coming
months.
Friday's Wall Street Journal chronicled the pain suffered by one particular
hedge fund. Launched in September 2006 by a hot UBS trader, the fund
immediately raised $3.0 billion. Performance has not met expectations. The fund
dropped 34% in 2007 and was down 77% year-to-date through July. Worse yet,
investors had agreed to up to a five-year lockup. So, even the small amount of
their remaining investment is inaccessible.
A lot has been written about all the crazy mortgage and derivative products
that were peddled during the bubble. The incredible mania that engulfed the
hedge fund community has not yet received it due. It’s simply hard to believe
the days of new fund managers raising billions with extended lockups isn’t
coming to an abrupt end. And this is an industry that has for the past few
years luxuriated in enormous investment inflows.
While I still read articles noting increased hedge fund investments (see "Muni
Watch" below), I can’t believe the more sophisticated money is not running or
at least considering heading for the exits. At the minimum, the industry
appears to have passed a major inflection point, and one should contemplate
that acute Ponzi dynamics could easily materialize.
As long as the industry was posting strong returns, inflows remained
predictably huge. And robust flows ensured that favored positions could be
increased and additional leverage employed - self-reinforcing bull market
dynamics. These inflows worked to mark up the value of previous investments, as
global securities and commodities markets soared. Investors were completely
enamored, while "genius" fund managers raked in billions.
This bubble will not function well in reverse. And I know the argument that
most hedge funds are still outperforming the major equities indices. This just
doesn’t matter much. I expect the entire dynamic of this industry to change now
that the majority of funds face "high water marks" (losses that have to be
recovered before incentive fees can again be collected). After suffering
losses, many managers will be tempted to role the dice with investors’ money:
"Heads I win and get my head above the high water mark; tails investors lose
and I close the fund and enjoy time at the beach." More responsible managers
will operate under intense pressure for performance, forced to place bets but
with little room for error. This is a particularly grueling endeavor, and you
can rest assured that markets won’t cooperate.
Such significantly altered trading dynamics - not to mention all the burst
global speculative bubbles - create a backdrop where it becomes extremely
difficult for speculators to perform. And resulting wild market volatility
significantly compounds the pressure and angst. At the same time, many managers
had expected to implement various strategies to play the markets’ downside -
including shorting, buying put options, writing calls, and certainly playing
CDS (credit default swaps) and various other derivatives.
Yet because the global leveraged speculating community ballooned to
unimaginable dimensions, these various systemic "hedges" and bearish
speculations all became one big crowded trade. Things are just not going work
as expected, a huge problem for investors with grossly inflated expectations.
Wall Street and global speculator community travails are today at the heart of
acute monetary disorder. Global pricing mechanisms have turned dysfunctional.
Crude oil, the most important commodity in the world, now sees its price
fluctuate 30% over a few short weeks - to the upside and then to the downside.
Currency values have become similarly unhinged. At the same time, liquidity
conditions throughout the global debt markets have turned quite spotty at best.
All these factors are working corrosively on the global economy.
The consensus view holds that the Fed should maintain today’s (grossly
inequitable) negative real interest rates indefinitely. This, as the thinking
goes, is how the financial sector will repair itself. Everything will then
return to normal - eventually. Besides, inflation won’t be much of an issue.
I contend that global financial and economic systems will not begin to
"normalize" until this massive global pool of speculative finance deflates.
Speculators have for some time been the marginal price setters for global
securities, energy, commodities and many other asset markets. This is a
precarious dynamic, especially considering that large numbers of speculators
are impaired and will now be fighting to save their businesses.
Things both financial and economic have become hopelessly unstable. And this
dysfunctional pricing backdrop has become the major impediment to unavoidable
US and global economic adjustment.
WEEKLY WATCH
For the week, the Dow dipped 0.6% (down 12.1% y-t-d), while the S&P500
added 0.1% (down 11.6%). The Morgan Stanley Cyclical index added 0.6% (down
10.6%), and the Morgan Stanley Consumer index gained 1.2% (down 4.1%). The
Utilities (down 13.3%) and Transports (up 12.8%) each declined 1.2%. The
broader market was much stronger. The small cap Russell 2000 jumped 2.6% (down
1.7%), and the S&P400 Mid-Caps rose 1.0% (down 4.2%). Technology continues
to outperform. The NASDAQ100 gained 1.6% (down 6.1%), and the Morgan Stanley
High Tech index added 0.6% (down 5.8%). The Semiconductors jumped 2.5% (down
7.7%). The Street.com Internet Index increased 1.2% (down 3.6%), and the NASDAQ
Telecommunications index gained 1.0% (down 0.2%). The Biotechs jumped 3.0%,
increasing y-t-d gains to 12.3%. The Broker/Dealers dropped 2.8% (down 27.5%),
and the Banks fell 3.1% (down 25.3%). With Bullion sinking $70, the HUI Gold
index fell 5.7% (down 22.9%).
One-month Treasury bill rates rose 6 bps this week to 1.72%, and 3-month yields
jumped 10 bps to 1.83%. Two-year government yields fell 11 bps to 2.39%.
Five-year T-note yields declined 10 bps to 3.10%, and 10-year yields dropped 9
bps to 3.84%. Long-bond yields declined 7 bps to 4.47%. The 2yr/10yr spread
widened 2 bps to 145 bps. The implied yield on 3-month December'09 Eurodollars
sank 15 bps to 3.66%. Benchmark Fannie MBS yields declined 3 bps to 5.96%. The
spread between benchmark MBS and 10-year Treasuries widened a notable 6 to 212
bps. The spread on Fannie’s 5% 2017 note widened 5 bps to 81 bps, and the
spread on Freddie’s 5% 2017 note widened 6 bps to 82 bps. The 10-year dollar
swap spread increased 0.25 to 74.25. Corporate bond spreads were mostly wider.
An index of investment grade bond spreads widened one to 145 bps, and an index
of junk bond spreads widened 17 bps to 577 bps.
August 13 - Bloomberg (Dawn Kopecki): "Fannie Mae sold $3.5 billion of
three-year benchmark notes, paying investors the
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