Page 1 of 3 CREDIT BUBBLE BULLETIN UK sets pace for US woes
Commentary and weekly watch by Doug Noland
The UK is in trouble. Last week, it was reported that the British economy
contracted a much worst-than-expected 1.5% during the fourth quarter (not
annualized!), the steepest economic decline since the dark days of 1980.
Manufacturing activity sank a dismal 4.6%, while services contracted by 1%.
Some forecasts now have the British economy this year suffering the most severe
economic contraction since 1946. There's now a strong case for using
"depression" when describing this deepening financial and economic malaise.
The pound today traded at the lowest level against the dollar since 1985. This
currency has depreciated 30% against the dollar over the past 12 months.
Against the yen, the pound has collapsed
42% during the past a year. There is little room left for conventional monetary
policy. At 1.50%, the Bank of England's (BofE) base lending rate is today at
the lowest level since 1694.
Curiously, the British pound has declined 6.5% against the dollar so far this
month, while the dollar index has gained about 6%. I say "curiously", as I
would argue that in key aspects of financial and economic structuring, the UK
provides a microcosm of our own systemic vulnerabilities. In a recent Bloomberg
interview, Jim Rogers stated, "The pound sterling is going to be under
pressure. The UK hasn't got much to sell the world anymore." His comments to
the Financial Times were even harsher. "I don't think there is a sound UK bank
now, at least, if there is one I don't know about it ... The City of London is
finished, the financial center of the world is moving east. All the money is in
Asia. Why would it go back to the west? You don't need London."
Following the US direction, the UK over the past decade gutted its already
shrunken manufacturing base as it shifted headlong into "services" and finance.
While this finance and asset inflation-driven bubble economy seemed to work
miraculously during the boom, the post-bubble reality is a severely impaired
financial system and an economic structure incapable of sufficient real wealth
creation.
I feel for British policymakers. Just five short quarters ago, overheated
nominal gross domestic product (GDP) was expanding at about a 6% pace. With
inflation surging to the 5% level, the Bank of England pushed its base lending
rate to 5.75% (summer of '07). I'll give the BofE credit for trying to tighten
financial conditions. It was, however, in vain, as acute global monetary
disorder overwhelmed domestic policymaking. BofE tightening only widened
interest-rate differentials, especially compared to near zero borrowing rates
in Japan. Finance inundated the City of London in a finale of unwieldy
speculative excess, setting the stage for a reversal of flows, de-leveraging
and today's collapse.
On Thursday, US insurance company Aflac dropped 37% on concerns for its
exposure to European "hybrid" securities - in particular preferred-type
instruments issued by the large UK banks. According to research by Morgan
Stanley (Nigel Dally), "When it comes to capital adequacy and investment
portfolio strength, Aflac has historically been viewed as the gold standard
across the industry."
Accordingly, the Street responded violently to the report highlighting the
company's potentially significant exposure to securities that have suffered
huge losses in market value (Aflac rallied sharply on Friday). According to the
Morgan Stanley report, some of the hybrid securities issued by UK lenders Royal
Bank of Scotland (RBS), HBOS, and Barclays are now trading at between 15 and 45
cents on the dollar.
Not long ago during the boom's heyday, these types of securities were viewed as
low-risk instruments. They were, after all, issued by major - and at the time
well-capitalized - banking institutions. In the worst-case scenario, these
institutions (and their hybrid securities) were viewed as too big to fail. In
reality, these banks were issuing a most dangerous class of securities - higher
yielding ("money-like") instruments appealing to even the more conservative
investors. Today, the entire UK banking system is enveloped in a vicious
downward spiral. Tens of billions of securities that only a short time ago were
perceived as safe are being heavily discounted for the possibility the issuing
institution will be "nationalized".
On Wednesday, troubled Royal Bank of Scotland promised to lend $8.7 billion in
exchange for various lines of government support. The market took the news as a
huge leap toward nationalization and governmental control over the UK banking
sector. Even RBS's chief executive was quoted as saying, "We'll be one the
first guinea pigs." The markets now view that UK policymakers will have few
available options other than borrowing hundreds of billions to recapitalize
their banks and support the securities markets.
Ten-year government "gilt" yields spiked 29 basis points (bps) higher this week
to 3.68%, with a two-week gain of 55 bps. On Tuesday, Britain reported a $20.5
billion (14.9 billion pounds) fiscal deficit for the month of December.
Spending was up 6%, while tax receipts were down 5.5%. The European Commission
is now forecasting the UK deficit to surpass 8% of GDP this year. After trading
at about 20 bps this past June, the cost of UK credit default swap protection
has spiked to 147 bps (traded as high as 165bps Wednesday).
The UK gilt market seemed to lead global bond rates higher this week. As the
scope of global financial sector capital shortfalls and forthcoming economic
stimulus become clearer, bond market nervousness grows. US 10-year yields ended
the week 31 bps higher at 2.59%, about 110 bps below comparable gilts. There
should be little doubt that the administration of Barack Obama will move
quickly and decisively to try to bolster the financial sector and stabilize the
real economy.
I fully expect that the US the post-bubble financial and economic predicament
will parallel that of Britain. At some point, our problems will likely be of
much greater scope due to, among other things, our system's larger size. So
far, the UK has suffered a more acute crisis due to its inability to stabilize
its troubled financial sector. For one, it is suffering through a more
destabilizing outflow of speculative finance (unwind of carry trades). Also,
the UK financial structure has traditionally been less government-influenced -
leaving it today more vulnerable to a crisis of confidence. Outside of
government debt instruments, confidence has faltered for large cross-sections
of the UK's financial claims ("moneyness") has been lost.
Our system has to this point proved relatively more stable due primarily, I
believe, to the instrumental role played by government and quasi-government
institutions such as the Federal Housing Authority, mortgage-guarantors Fannie
Mae and Freddie Mac, and the Federal Home Loan Banks. The market's perception
of "moneyness" is retained for multi-trillions of US claims - a dynamic that
bolsters the view that the US dollar retains its "reserve currency" and
safe-haven status.
As long as this confidence holds, faith in the government's capacity for system
"reflation" endures. But it all has the look of a fragile confidence game, and
I fully expect the invaluable attribute of "moneyness" to be tested at some
point.
There is absolutely no doubt that a massive inflation of US financial claims is
in the offing. One would suspect it is only a matter of when market perceptions
of "moneyness" adjust. Last week's jump in gilt yields could portend a
troubling new phase in the UK financial crisis. It could also be a harbinger of
a more general crisis of confidence for global currencies and debt markets. The
long-bond suffered its worst week since 1987 (according to Bloomberg). Gold was
up $43 on Friday and $56 for the week.
WEEKLY WATCH
For the week, the S&P500 declined 2.2% (down 7.9% y-t-d) and the Dow fell
2.5% (down 8%). The Morgan Stanley Cyclicals fell 6.1% (down 10.5%), and the
Morgan Stanley Consumer index declined 1.7% (down 5.3%). The Utilities slipped
0.6% (down 1.7%), and the Transports sank 6.1% (down 16.2%). The S&P400
Mid-Caps fell 3.1% (down 6.9%), and the Russell 2000 small caps declined 5.0%
(down 11%). The Nasdaq100 declined 1.9% (down 3%) and the Morgan Stanley High
Tech index 1.8% (down 1.3%). The Semiconductors fell 2.9% (down 1.8%), the
InteractiveWeek Internet index slipped 0.4% (down 1.0%), and the Nasdaq
Telecommunications index gained 0.8% (up 1.7%). The Biotechs lost 4.2% (down
2.6%). The Broker/Dealers rallied 1.0% (down 6.2%), while the Banks were
slammed for 11.0% (down 35.8%). With bullion rallying $56, the HUI Gold index
gained 9.6% (up 0.5%).
January 20 - Bloomberg (Lynn Thomasson and Adam Haigh): "The S&P 500 Index
is off to its second-worst start, shattering the biggest rally since World War
II, as analysts cut earnings estimates by a record 83 percentage points and
companies signal worse to come."
One-month Treasury bill rates ended the week at 3 bps and three-month bills at
10 bps. Two-year government yields gained 10 bps to 0.77%. Five-year T-note
yields jumped 17 bps this week to 1.58%. Ten-year yields surged 31 bps to
2.585%. Long-bond yields jumped 45 bps to 3.38%, in what Bloomberg is calling
the worst week for the 30-year bond since 1987. The implied yield on 3-month
December '09 Eurodollars rose 13 bps to 1.325%. Benchmark Fannie MBS yields
gained 11 bps to 3.97%. The spread between benchmark MBS and 10-year T-notes
narrowed 20 to 136 bps. Agency 10-yr debt spreads narrowed 9 to 84 bps. The
2-year dollar swap spread increased 7.4 to 65.4 bps; the 10-year dollar swap
spread increased 5.7 to 15 bps, while the 30-year swap spread declined 8.6 to
negative 20 bps. Corporate bond spreads were mostly narrower. An index of
investment grade bond spreads narrowed 7 to 208 bps, while an index of junk
bond spreads narrowed 26 to 1,259 bps.
January 19 - Bloomberg (Wes Goodman): "A rally that sent US Treasuries to their
best year since 1995 is coming to an end, South Korea's National Pension
Service, the country's biggest investor, said ... 'It's time to sell US
Treasuries,' said Kim [Heeseok], who took over as head of investments at the
start of the year. 'The stimulus plan may cause inflation. The US will raise
the benchmark interest rate.'"
Investment grade issuance included Duke Energy $750 million, Duke University
$500 million, Lubrizol $500 million, Jersey Central P&L $300 million, and
Puget Sound Energy $250 million.
January 20 - Bloomberg (Jack Kaskey and Shannon D. Harrington): "Ineos Group
Holdings, Georgia Gulf Corp. and Chemtura Corp. are crashing on a mountain of
takeover debt and may follow Lyondell Chemical Co. into bankruptcy, trading in
their bonds shows ... A glut in supplies that drove prices of polypropylene
down by half since October will make it even harder for plastics makers to meet
debt payments, just as manufacturers in the Middle East add millions of tons of
new supplies."
January 23 - Bloomberg (Bryan Keogh and Gabrielle Coppola): "Sales of
high-yield bonds surged to $1.83 billion, the biggest weekly total since July,
as companies took advantage of a six-week market rally to refinance debt. Sales
almost doubled last week's $1.05 billion and compare with a weekly average of
about $200 million since July ... "
Junk issuers included Crown Castle $900 million, Petrohawk Energy $600 million,
Nielsen $330 million, and Tennessee Gas Pipeline $250 million.
International issuers included Electricite de France $5.0bn and Codelco $600
million.
UK 10-year gilt yields surged 29 bps to 3.68%, and German bund yields jumped 31
bps to 3.24%. The German DAX equities index sank 4.3% (down 13.1% y-t-d).
Japanese 10-year "JGB" yields ended the week 1.5bps higher at 1.23%. The Nikkei
225 dropped 5.9% (down 12.6% y-t-d). Emerging bonds and equities were mostly
weak, although bonds did ok considering the rise in global bond yields.
Brazil's benchmark dollar bond yields rose 9 bps to 6.66%. Brazil's Bovespa
equities index declined 3.1% (up 1.6% y-t-d). The Mexican Bolsa dropped 4.8%
(down 13.5% y-t-d). Mexico's 10-year $ yields rose 12 bps to 6.25%. Russia's
RTS equities index sank 12.1% (down 21.2% y-td). India's Sensex equities index
fell 7.0% (down 10.1% y-t-d). China's Shanghai Exchange gained 1.9% (up 9.3%
y-t-d).
Freddie Mac 30-year fixed mortgage rates jumped 16 bps to 5.12% (down 36bps
y-o-y), with a notable 12-wk decline of 134 bps. Fifteen-year fixed rates rose
15 bps to 4.80% (down 15bps y-o-y). One-year ARMs added 3 bps to 4.92% (down
7bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr
fixed jumbo rates up a notable 21 bps this week to 7.0% (up 52bps y-o-y).
Bank Credit surged $68.3bn to $9.864 TN (week of 1/14). Bank Credit expanded
$605bn year-over-year, or 6.5%. Bank Credit jumped $472bn over the past 19
weeks. For the week, Securities Credit surged $72.3bn. Loans & Leases
dipped $3.9bn to $7.087 TN (52-wk gain of $244bn, or 3.6%). C&I loans
gained $4.7bn, with 52-wk growth of 8.1%. Real Estate loans added $3.7bn (up
4.7% y-o-y). Consumer loans jumped $13.2bn, while Securities loans dropped
$20.8bn. Other loans fell $4.7bn.
M2 (narrow) "money" supply gained $8.0bn to a record $8.223 TN (week of 1/12).
Narrow "money" jumped $793bn over the past year, or 10.7%. For the week,
Currency added $1.5bn, while Demand & Checkable Deposits sank $37.9bn.
Savings Deposits jumped $45.0bn, while Small Denominated Deposits dipped
$2.9bn. Retail Money Funds increased $2.4bn.
Total Money Market Fund assets (from Invest Co Inst) dropped $28.9bn to $3.893
TN, with a 52-wk expansion of $641bn, or 19.7% annualized.
Total Commercial Paper outstanding dropped $30.2bn this week to $1.688 TN, with
CP down $159bn over the past year (8.6%). Asset-backed CP fell $22.2bn to
$749bn, with a 52-wk decline of $86bn (10.3%).
Federal Reserve Credit dropped $19.9bn to $2.049 TN, with a
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