Page 1 of 3 CREDIT BUBBLE BULLETIN The government finance bubble
Commentary and weekly watch by Doug Noland
What are we really dealing with here? First of all, the system is suffering
through the breakdown in contemporary Wall Street finance. As wrenching and
destabilizing as it continues to be, this process should be differentiated from
outright financial collapse. Confidence in Wall Street "money" (their
previously perceived safe and liquid securities/instruments) has been
shattered. Myriad sophisticated credit instruments have been discredited and
thus will no longer provide a viable mechanism for system credit expansion.
Importantly, however, confidence has been sustained for system "money" more
generally.
As I've noted in previous writings, analysts made a momentous blunder earlier
this decade when they mistook the collapse of the
technology bubble (and attendant recession and corporate debt problems) for the
onset of "deflation". Reflationary policymaking without regard to the nature of
inflationary consequences proved disastrous. We're about to repeat this error.
Ignoring the acute inflationary bias unfolding in mortgage finance was the
greatest mistake in both analysis and policymaking from the ill-fated 2001-2004
period. It should have been clear at the time that rates were way too low and
mortgage finance way too loose. This was especially the case when compared with
the rapid pace of home price inflation. Most regrettably, the strong
inflationary biases that had taken hold in the mortgage and housing
marketplaces ("bubbles") were too easily exploited as a monetary policy
expedient for systemic reflation. Excess in some local housing markets was
viewed as a small price to pay for thwarting systemic deflationary pressures.
Despite today's histrionic fixation on "deflation", current dynamics have some
similarities to the post-tech bubble period. Granted, the collapse of Wall
Street finance is of much greater scope and consequence than the bursting of
the tech bubble. Yet I would counter that the burgeoning bubble in government
finance is poised to make the mortgage finance bubble appear tiny in
comparison.
There has been no run on bank deposit "money", not with the Federal Deposit
Insurance Corporation, the Treasury, and the Federal Reserve there to backstop
confidence. The marketplace's love affair with agency debt runs unabated -
compliments of federal government receivership and guarantees. Money market
fund assets are right at record levels, confidence bolstered by Fed and
Treasury assurances. And despite the prospect of a US$1 trillion borrowing
requirement this year, the Treasury can still tap liquid markets for short-term
funds at about 20 basis points.
The Fed's balance sheet has ballooned, although nothing to compare with the
unfolding explosion of trillions of Treasury borrowings, obligations and
guarantees (both implied and explicit).
The government finance bubble is enormous and powerful - and should be anything
but underestimated. Akin to the previous bubble in Wall Street finance, the
epicenter of this bubble is in the US. But I would argue that this unfolding
bubble dynamic has greater potential to engulf the entire world than even US
-style mortgages and derivatives did starting back around 2002. Welcome to the
new world of synchronized stimulus, deficits, and reflationary policymaking. I
don't believe true systemic deflation (as opposed to collapsing asset bubbles)
is a high probability scenario as long as the government finance bubble is
rapidly inflating. All bets are off, however, if confidence in government debt
falters. The worst case scenario - that should be avoided at all costs - is a
massive inflation of government claims that sets the stage for a devastating
bust.
It is imperative for policymakers to ensure that the government finance bubble
does not follow in the footsteps of the runaway excess associated with Wall
Street/mortgage finance. Yet it's clear that policymaking (monetary and fiscal)
is setting a course to guarantee just such an outcome. And, as has been the
case for some time now, markets are keen to fall in love with - and
aggressively accommodate - whatever might be the bubble of the day.
The Wall Street/mortgage finance bubble ran to such incredible extremes that
its subsequent implosion has created the near ideal backdrop for the explosion
of government finance (as the tech implosion did for mortgage finance). Some
notable pundits espouse throwing "trillions" at the problem in hopes of finding
a solution. They fail to be appreciated that trillions today will only create
the need for ongoing trillions. But this is the nature of vulnerable
inflationary booms. The solution is always incorrectly gauged as a shortage of
money, credit and spending.
There is hope that massive government reflation will reinvigorate the asset
markets and resuscitate Wall Street finance. I view this as highly unlikely -
and these lofty goals incredibly dangerous. It is more likely that the historic
bubble in private-sector credit creation - with its focus on myriad
sophisticated instruments, structures and leveraging - will recover little of
its former power and glory.
In past episodes of financial turmoil, our policymakers would simply entice
private sector financial operators (notably the Wall Street firms, hedge funds
and bond fund managers) with alluring borrowing costs, spreads and speculative
profits. Strong inflationary biases permeated Wall Street finance, the
leveraged speculating community, and US asset prices more generally.
Accordingly, almost on demand, private-sector credit creation would quickly
evolve into the main source for fueling system (that is asset) reflation.
Moreover, asset price inflation was the focal point for perceived wealth
creation and economic stimulus.
Today's post-credit bubble backdrop and the nature of the government finance
bubble ensure quite atypical dynamics (and analytical surprises). For one, the
flow of finance to the asset markets will be insufficient to reinvigorate asset
inflation (post-bubble realities of burst confidence, altered market
psychology, impaired credit mechanisms and economic angst/dislocation).
This is critical analysis. It was the strong inflationary biases throughout the
asset markets that fostered the self-reinforcing bubble in private-sector
credit. And private-sector credit was behind past inflationary financial and
economic bubbles - that have left the system today so fragile (and pundits
clamoring for more inflation!). Structural realities dictate that government
finance cannot simply enter the fray and miraculously make things right. A
moderate amount of stimulus would be expected to assist the post-bubble
economic adjustment, while inordinate government credit inflation and market
intervention will only work to compound systemic fragility.
The public sector is now essentially on its own when it comes to stoking this
bout of reflation. Moreover, it is being called upon after a couple of decades
where private-sector credit grossly inflated home prices, securities values,
various other asset prices, household incomes, consumer borrowing and spending,
corporate profits, and government receipts and expenditures. The government
finance bubble is being called upon to reflate with little assistance from
private credit, while at the same time it is faced with a deeply maladjusted
economic structure still overly dependent upon inflationary credit expansion.
Throwing mega-trillions at our distorted economy is just asking for trouble.
It is in this context that I fear that the trillions of government finance
spent to save the world from "deflation" will, in the end, require perpetual
needs for trillions more. There will be no kick-starting asset bubbles or a
return of private-sector credit excess. Instead, it will be a case of throwing
repeated doses of government-directed finance/purchasing power at the system.
Temporary but fleeting economic boosts will then require only stronger doses of
artificial stimulus.
We've commenced a new cycle dominated by government electronic printing presses
in all their various forms. The inflationary consequences will be a different
variety than we've grown accustomed to from previous reflations. But the bottom
line is - and there's ample history to support this view - that once the
"printing presses" get humming along it's going to be darn difficult to slow
them down.
WEEKLY WATCH
For the week, the Morgan Stanley High Tech index jumped 10.6% (up 8.6% y-t-d),
and the Nasdaq100 rose 8.2% (up 5.4% y-t-d). The Interactive Week Internet
index increased 9.0% (up 9.0%), and the Semiconductors jumped 10.0% (up 8.0%).
The Biotechs surged 12.0% (up 9.8%). The Securities Broker/Dealers gained 11.2%
(up 4.1%). The Banks gained 11.9% today, with a one-week advance of 5.7% (down
31.5%). The S&P Homebuilding index jumped 31.8% this week (up 13.4%), and
the Morgan Stanley Retail index gained 8.2% (down 1.4%). As for the broader
market, the S&P500 rallied 5.2% (down 3.8%), and the Dow rose 3.5% (down
5.6%). The Morgan Stanley Cyclicals advanced 4.7% (down 9.3%), and the
Transports jumped 8.0% (down 9.4%). The Utilities increased 3.3% (up 2.0%), and
the Morgan Stanley Consumer index recovered 3.3% (down 3.4%). The small cap
Russell 2000 rallied 6.2% (down 5.8%), and the S&P400 Mid-Caps recovered
6.4% (down 1.4%). Although Bullion fell $16, the HUI Gold index mustered a 2.3%
advance (up 1.5%).
One-month Treasury bill rates ended the week at 22 bps, and three-month bills
ended the week at 28 bps. Two-year government yields jumped 8.5 bps to 0.93%.
Five-year T-note yields rose 12 bps this week to 1.92%. Ten-year yields jumped
14 bps to 2.97%. Long-bond yields gained another 10 bps to 3.73% (up 120bps
from Dec. lows). The implied yield on 3-month December '09 Eurodollars declined
11.5 bps to 1.435%. Benchmark Fannie MBS yields rose 8 bps to 4.35%. The spread
between benchmark MBS and 10-year T-notes narrowed 6 to 136 bps. Agency 10-yr
debt spreads narrowed a notable 13 to 76 bps. The 2-year dollar swap spread
declined 8.75 to 61 bps; the 10-year dollar swap spread declined 0.25 to 23
bps, and the 30-year swap spread declined 2.25 to negative 23.5 bps. Corporate
bond spreads were narrower. An index of investment grade bond spreads narrowed
5 to 194 bps, and an index of junk bond spreads narrowed 43 to 1,235 bps (8-wk
low).
Investment grade issuance included Fannie Mae $7.0bn, Novartis $5.0bn, Altria
$4.5bn, Procter & Gamble $3.0bn, Morgan Stanley $3.0bn, Caterpillar $3.0bn,
CME Group $750 milliion, Goldman Sachs $600 million, Wellpoint $1.0bn, Georgia
Power $500 million, and Sunoco Logistics $175 million.
Junk issuers included El Paso Corp $500 million, Landry's Restaurant $295
million, and American Media Operation $300 million.
International issuers included Petrobras $1.5bn and Swedbank $1.45bn.
U.K. 10-year gilt yields added 3 bps to 3.73%, and German bund yields jumped 7
bps to 3.37%. The German DAX equities index surged 7.1% (down 3.4%). Japanese
10-year "JGB" yields ended the week up 4 bps at 1.33%. The Nikkei 225 rallied
1.0% (down 8.8%). Emerging markets were mixed to higher. Brazil's benchmark
dollar bond yields jumped 20 bps to 6.83%. Brazil's Bovespa equities index
surged 8.8% (up 13.9% y-t-d). The Mexican Bolsa rallied 4.6% (down 8.7% y-t-d).
Mexico's 10-year $ yields rose 37 bps to 6.68%. Russia's RTS equities index
declined 2.6% (down 17.6%). India's Sensex equities index fell 1.3% (down
3.6%). China's Shanghai Exchange surged 9.6% (up 19.8%).
Freddie Mac 30-year fixed mortgage rates jumped 15 bps to 5.25% (down 42bps
y-o-y). Fifteen-year fixed rates rose 12 bps to 4.92% (down 23bps y-o-y).
One-year ARMs dipped two bps to 4.92% (down 13bps y-o-y). Bankrate's survey of
jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 8 bps this week
to 6.95% (up 37bps y-o-y).
Federal Reserve Credit dropped $149bn to $1.841 TN. Fed Credit expanded $979bn
over the past 52 weeks (114%). Liquidity swaps with foreign central bank
counterparts fell $78bn this past week to $387bn. Elsewhere, Fed Foreign
Holdings of Treasury, Agency Debt last week (ended 2/4) increased $6.4bn to a
record $2.555 TN. "Custody holdings" were up $437bn over the past year, or
20.6%.
Bank Credit dropped $54.8bn to $9.749 TN (week of 1/28). Bank Credit expanded
$459bn year-over-year, or 4.9%. Bank Credit jumped $356bn over the past 21
weeks. For the week, Securities Credit sank $42bn. Loans & Leases declined
$12.8bn to $7.057 TN (52-wk gain of $179bn, or 2.6%). C&I loans dipped
$2.7bn, with 52-wk growth of 7.9%. Real Estate loans gained $6.3bn (up 4.7%
y-o-y). Consumer loans added $2.4bn, while Securities loans fell $13.2bn. Other
loans declined $5.5bn.
M2 (narrow) "money" supply rose $19.8bn to a record $8.277 TN (week of 1/26).
Narrow "money" has now inflated at a 20.3% rate over the past 19 weeks and has
jumped $771bn over the past year, or 10.3%. For the week, Currency jumped
$5.9bn, while
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