Page 1 of 3 CREDIT BUBBLE BULLETIN
Asia reflation moves to the wild side
Commentary and weekly watch by Doug Noland
Key indicators of global reflation were released last week. China's official
reserve holdings jumped to a record US$2.132 trillion. Importantly,
second-quarter reserve growth surged to a record $178 billion. This was up
dramatically from Q1 2009's $7.7 billion increase and Q4 2008's growth of $40.0
billion. It is worth also noting that the most recent quarter exceeded even the
$154 billion increase near the height of the "hot money" bubble period back in
early 2007. China began 2004 with $400 billion of reserves.
China is central to my macro global reflation thesis. And I believe the
core-to-periphery" flow of funds dynamic (that is, dollar outflows to China,
Asia and emerging markets) will fundamentally shape unfolding reflationary
dynamics. I view the enormous
increase in China's reserves as confirmation both that global speculative flows
have been largely rejuvenated and that China and the emerging markets retain
the most robust inflationary bias. On the margin, speculative flows will prefer
Asia to the US - providing reflationary crosscurrents/headwinds here at home.
Meanwhile, things that Asia needs and wants will demonstrate upward price
pressures over time.
There were also a slew of strong economic reports out of China last week.
Second-quarter growth was reported at a stronger-than-expected 7.9% rate,
boosting China's first-half expansion to an impressive 7.1%. Fixed investment
was up 33.6% year on year during the quarter, while industrial production rose
10.7%. First-half steel production increased to a record. Another report had
China's fiscal spending up 21.5% y-o-y in June, with receipts up 19.6%.
Accounts have it that real estate prices are bubbling again. June M2 money
supply expanded at a 28.5% pace. And after posting a 75% gain so far this year,
Chinese stocks have again surpassed Japan's to take second place globally in
terms of market capitalization. Economists are quickly raising second-half and
2010 growth estimates.
The emerging markets and commodities rallied strongly this week. The EMBI+
emerging market bond index traded this week to a record high. The Goldman Sachs
Commodities Index surged 6.3%, increasing 2009 gains to 23.3%. Brazilian dollar
bond yields dropped to 5.80%. Copper jumped 9.6% this week, silver was up 5.7%,
and gold rallied 2.7%. It is also worth nothing that the Indonesian rupiah
declined only two-thirds of one percent following last week's terrorist
attacks.
The massive scope of China's bank lending and "hot money" inflows ensures a
historic policy challenge. There are indications that Chinese monetary
authorities (the People's Bank of China) are now attempting to tap the brake a
bit, as somewhat reduced inter-bank liquidity puts pressure on short-term
borrowing costs to go higher. But don't expect central bank tinkering to have
much more impact in China than it did in the United States during the 2004-2007
bubble period. I would expect the rejuvenated Chinese boom to be largely
impervious to cautious policymaking. Or, stated differently, bubble dynamics
would seem to dictate that increasingly unwieldy financial and economic bubbles
will keep policymakers on their heels and unwilling to decisively face growing
risks. And as ultra-loose financial conditions in the US and elsewhere spur a
rebound in credit growth (and attendant financial flows), the Chinese
predicament will turn even more problematic.
Financial reports in the US also confirm a rejuvenation of speculative and
global reflation dynamics. Goldman Sachs reported record quarterly net revenues
($13.76 billion) and net earnings ($3.44 billion). "Net revenues in trading and
principal investments were $10.78 billion, 93% higher than the second quarter
of 2008 and 51% higher than the first quarter of 2009 ... Fixed income,
currency and commodities (FICC) generated record quarterly revenues ... Equity
underwriting produced record quarterly net revenues…" Investment banking
revenues were up 75% from the first quarter to $1.44 billion. Second-quarter
debt underwriting revenues of $336 million compare to Q1's $248 million and the
year-ago $269 million. Second quarter equity underwriting revenues of $736
million compare to Q1's $48 million and the year ago $616 million.
At JPMorgan Chase, "Record firmwide revenue of $27.7 billion ... Net income of
$2.721 billion was up 27% from the first quarter and 36% from the year ago
period. ... The investment bank reported record overall revenue for the first
half of the year, which included record fees and fixed income. ... Fixed income
markets revenue was a record $4.9 billion, up by $2.6 billion from the prior
year, driven by strong results across all products ... Extended approximately
$150 billion in new credit to consumers, corporations, small businesses,
municipalities, and non-profits." JPMorgan approved 138,000 loan modifications
during the second quarter.
While clearly struggling, Bank of America "funded $110.6 billion in first
mortgages ... Credit extended during the quarter ... was more than $211
billion, compared to $183 billion in the first quarter ... " BofA "earned" $3.4
billion in the quarter, "results driven by continued strong revenue performance
in the wholesale capital markets businesses as well as in home loans ... Bank
of America Merrill Lynch ranked No 1 in high-yield debt and leveraged loans ...
Sales and trading revenue ... rose to a record $6.7 billion." BofA provided
rate relief/modification to 150,000 customers.
Of course, Goldman and JPMorgan benefit greatly from their competitors'
travails. But their greater advantage is that policymakers desperately need
them to expand credit. With bank lending stagnant, domestic reflation today
depends chiefly upon the revival of the capital markets. And there are clearly
no two institutions better positioned to profit from ultra-loose financial
conditions than Goldman and JPMorgan. One can argue that the concentration of
financial power to a few Wall Street firms played a major role in the credit
boom and bust. Ironically, reflationary policymaking is today fostering only
greater concentration of power and market influence.
So far, I don't really see many surprising developments pertaining to reflation
dynamics. Thing seem largely on track in Asia, while the struggling US credit
system is regaining some fire power. At this point, I see little justification
for revising my expectation for lagging US asset markets and economic
performance.
At the same time, one can see the makings of future bouts of acute fragility. I
see great risk in the system's increasing reliance on capital markets as the
primary source for credit expansion and liquidity creation. It is unfortunate -
but not unexpected - that reflation requires a further concentration of
financial power. Moreover, it is dangerous that Washington policymakers now
completely hold sway over the credit markets. "Federal" credit - Treasury,
agency, and mortgage-backed securities (MBS) related to government-sponsored
enterprises (GSEs) - remains the vast majority of system credit creation. It is
worth noting that May and June GSE MBS issuance totaled almost $450 billion
(from Bloomberg). There is an enormous amount of mortgage credit and
interest-rate risk being bundled and transferred to Washington - to a
government that already has too much of it.
The problem only seems to get clearer. The maladjusted US bubble economy is
sustained by $2.0 trillion to $2.5 trillion of new credit - credit that must
largely be issued or guaranteed in Washington. This reflation (also known as
credit inflation/currency devaluation) drives massive flows to China, Asia and
the emerging markets that have few takers other than the central banks. And as
economies recover and inflationary distortions reemerge, these enormous dollar
flows can be expected to foment increasing policymaker angst.
Asian reflation is poised to take on a wild life of its own, forcing
policymakers at some point to confront today's reality that dollar flows are
destabilizing and unmanageable. China, in particular, faces tough choices when
it comes both to managing its bubble and the massive accumulation of IOUs of
deteriorating quality.
WEEKLY WATCH
For the week, the S&P500 jumped 7.0% (up 4.1% y-t-d), and the Dow rallied
7.3% (down 0.4% y-t-d). The Morgan Stanley Cyclicals surged 12.3% (up 23.8%),
and the Transports increased 6.5% (down 6.3%). The Banks surged 8.2% (down
16.3%), and the Broker/Dealers gained 5.9% (up 27.2%). The Morgan Stanley
Consumer index rose 5.2% (up 3.0%), and the Utilities increased 3.7% (down
4.6%). The broader market was quite strong. The S&P 400 Mid-Caps jumped
7.3% (up 9.4%), and the small cap Russell 2000 rallied 8.0% (up 4.0%).
Technology is putting up some big numbers. The Nasdaq100 gained 7.6% (up
26.0%), and the Morgan Stanley High Tech index surged 8.7% (up 38.8%). The
Semiconductors surged 12.1% (up 36.9%), and the InteractiveWeek Internet index
rallied 8.3% (up 45.2%). The Biotechs rose 5.3% (up 5.3%). With Bullion
rallying $24.25, the HUI gold index jumped 10.9% (up 15.1%).
One-month Treasury bill rates ended the week at 14 bps, and three-month bills
closed at 17 bps. Two-year government yields rose 9.5 bps to 0.915%. Five-year
T-note yields jumped 28 bps to 2.46%. Ten-year yields surged 35 bps to 3.66%.
Long bond yields were 34 bps higher at 4.53%. Benchmark Fannie MBS yields were
28 bps higher to 4.63%. Agency 10-yr debt spreads narrowed 2 to 11 bps. The
implied yield on December eurodollar futures were little changed at 0.755%. The
2-year dollar swap spread increased 8.5 to 47.5 bps; the 10-year dollar swap
spread increased 6.5 to 24.0 bps; and the 30-year swap spread increased 6.5 to
negative 18.75 bps. Corporate bond spreads were mostly tighter. An index of
investment grade bond spreads narrowed 10 to 186 bps, and an index of junk
spreads narrowed 8 to 859 bps.
Investment grade issuers included Carefusion $1.4bn, Goldman Sachs $1.0bn,
Rowan Companies $500 million, and USAA Capital $200 million.
Junk bond funds saw inflows of $162 million (from AMG). The list of junk
issuers included Freedom Group $200 million.
I saw no convert issuance this week.
International dollar debt issuers included Ras Laffan LNG $2.23bn, Ecopetrol
$1.5bn, Virgin Media $1.35bn, Kazmunaigaz $1.25bn, Lloyds Bank $835 million,
BNP Paribas $775 million, Philippines $750 million, Korea Electric Power $500
million, Yonkers Racing $225 million, and Atlas Energy $200 million.
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