Page 1 of 3 CREDIT BUBBLE BULLETIN Bubble hazards mount
Commentary and weekly watch by Doug Noland
I received an email a couple years back from a unimpressed reader with the
following message: "Doug, when you're a hammer everything looks like a nail."
He was referring to my thesis back then that bubbles had sprung loose from the
US credit system and had begun propagating around the world.
Months back I posited that a government finance bubble had emerged from the
smoking ashes of the Wall Street/mortgage finance bubble. I understand why some
might see me as a dreary hammer out searching for nails. All the same, the
backdrop merits further discussion of facets of bubble analysis.
Many see bubbles in terms of an unsustainable overvaluation of
asset prices. And many would view today's "post-bubble" landscape and find my
ongoing bubble premise borderline ridiculous. But I've always viewed bubbles as
a credit phenomenon. Inflating assets prices are actually only one of many
consequences of an overexpansion of credit. Rapid asset inflation is almost a
sure sign of underlying credit excess, though analysts should downplay asset
prices while focusing keenly on underlying credit and speculative dynamics.
Huge credit growth, market price distortions (especially the under-pricing of
risk), highly speculative markets, and prolonged asset inflation are inevitably
indicative of some underlying monetary/credit disorder.
I want policymakers out of the business of targeting or tinkering with the
asset markets and market yields. Instead, the focus should be on creating a
backdrop of stable money and credit. The problem today is that central bankers
for years ignored a historic expansion of credit (much of it directed to the
asset markets) and the resulting monetary disorder.
Now, to avert systemic implosion central bankers at home and abroad have
resorted to unprecedented measures to expand credit and intervene in the
markets' pricing of credit. Instead of a movement toward constructing a more
stable global credit system and backdrop, policymakers have instead jumped
farther into the uncharted waters of unconstrained credit expansion. Such a
backdrop is ultra-conducive for ongoing speculation, bubbles, and general
disorder.
Again, bubbles are first and foremost a credit phenomenon. Fundamental to the
nature of credit, expansion generally fosters more expansion. Credit excess
begets only greater credit excess. And credit excess notoriously begets
speculative excesses. Importantly, credit is inherently self-reinforcing - both
on the upswing and downswing. In today's "system" of unrestrained credit,
rising demand for borrowings does not dictate an increasing price for this
credit. Indeed, an unlimited supply of credit will tend to satisfy rising
demand at a lower price. And this gets right to the heart of a huge bubble -
and policymaking - dilemma.
The bottom line is that unrestrained credit is inherently unstable, and few
seem to appreciate the unique nature of today's unfettered global credit
environment. There is no international gold monetary regime for which to
discipline lenders, central banks, governments or economies. The dollar reserve
system self-destructed over decades of undisciplined credit expansion. And the
breakdown of US discipline - and the resulting massive dollar devaluation - has
unleashed domestic credit systems from China to Brazil. Never have "developing"
credit systems (and currencies) enjoyed such freedom to inflate financial
claims.
It's with this backdrop in mind that I contemplate the likelihood that we have
entered an especially dangerous period of credit excess and attendant bubbles.
Fundamentally, the massive intrusion of the US Treasury and Federal Reserve
into the marketplace has only further distorted the pricing of finance
throughout our economy - as well as globally.
Despite record debt issuance, the market will lend the Treasury three-month
money at about 11 basis points (bps), or 0.11%. Two-year borrowings come at
cost of about 100 bps. The price of Treasury notes and bonds inflates in spite
of enormous deficits as far as the eye can see. Moreover, the marketplace is
happy to lend to mortgage guarantors Fannie Mae and Freddie Mac at only a
slight premium to the US Treasury, with the prices of their obligations
inflating in the face of these institutions' ongoing financial implosions.
Today's price distortions go right to the heart of system "money".
Fannie Mae's Book of Business (mortgage holdings and mortgage-backed securities
guaranteed) jumped $43.9 billion during June to $3.194 trillion. This was the
biggest growth since December 2007. Freddie's Book of Business increased $12.2
billion last month. According to Bloomberg's issuance tally, the
government-sponsored enterprises (Fannie, Freddie and Government National
Mortgage Association, or Ginnie Mae) issued $168 billion of MBS in July, down
somewhat from June's huge $236 billion and May's $212 billion. At $1.102
trillion, year-to-date agency MBS issuance has already almost matched 2008 and
2007. The government is quietly accumulating dangerous credit and interest rate
risk in its ongoing mortgage operations.
During the Wall Street/mortgage finance bubble, seemingly no amount of credit
creation and debt issuance would place upward pressure on the cost of
borrowings (or reduced the price of the underlying debt instruments).
Importantly, the bigger this bubble inflated, the more confident the savvy
market operators became that an inevitable crisis would force policymakers to
explicitly back GSE obligations and aggressively slash interest rates. Market
yields remained artificially low and increasingly detached from escalating
risks. Fundamentally, a market trapped in bubble dynamics had lost is capacity
for adjustment and self-regulation.
The massive expansion of GSE obligations, coupled with a speculative
marketplace's anticipation of yet another major government-induced reflation,
severely distorted the marketplace and provided the bedrock for a historic
mortgage finance bubble. Today, the government's intrusion into the marketplace
is greater than ever. The markets readily accommodate a couple trillion of
annual issuance - as if the US economy and credit system were on solid footing.
And I would argue that today's mispricing of government finance reinforces the
market's perception that US policymakers will successfully reflate the economy.
This bubble distortion, then, fosters a problematic explosion of government
debt issuance - and a most dangerous case Minskian "Ponzi finance".
There are a number of reasons why the government finance bubble is even more
dangerous than the Wall Street/mortgage finance bubble. First of all, the $2
trillion or so of "government" issuance over the past year is greater than the
$1.4 trillion peak total mortgage credit growth during 2005 and 2006. I would
expect another $2 trillion next year and the year after.
Government debt enjoys the attribute of "moneyness" in the marketplace to a
much greater capacity than mortgage securities did during the boom. The risks
associated with debasing this "moneyness" are momentous. There is, as well, the
dynamic where the greater the government finance bubble inflates the more
convinced the marketplace becomes that the Federal Reserve will do everything
within its power to accommodate the debt markets (ultra-loose monetary
conditions for the duration). And destabilizing speculation can return to all
markets ...
The government finance bubble is a global dynamic. There were pertinent
bubble-related comments out of China last week:
July 30 - Dow Jones (JR Wu): "China's central bank will emphasize market-based
systems, rather than administrative controls, in guiding the appropriate growth
of credit, People's Bank of China Vice Governor Su Ning said. The statement ...
came just hours after Chinese shares posted their biggest one-day percentage
fall in over eight months on fears that loan growth may start to pull back ...
'We should pay attention to the use of market-oriented means - rather than
controlling the size - and flexibly use various monetary policy tools to guide
the appropriate growth of credit,' Su said ... He said 'the mind and action' of
all financial institutions should 'be as one' with the government's goal, and
financial institutions should properly handle the relationship between
supporting the economy's development and preventing financial risks. Su's
comments appeared to signal the PBOC wasn't about to set loan curbs in the
second half of this year to cool explosive lending growth, as it did in 2008
when it used the blunt tool of loan quotas for banks to hold down inflationary
pressures that were building at the time ... But Su said the central bank will
resolutely maintain its moderately loose monetary policy. He said the
foundation for China's economic recovery isn't firm yet and many uncertain
factors still exist in both the external and domestic environment."
Similar to the Federal Reserve, I see Chinese authorities increasingly held
hostage to bubble dynamics. I found it fascinating that a top People's Bank of
China official would mention emphasizing "market-based systems" for guiding
credit growth. I suspect this may be a most inopportune time to begin relying
on market mechanisms. As we have witnessed, market-based processes can be
particularly unreliable credit regulators after bubbles have reached an
overheated state.
It is my view that only decisive action by Chinese policymakers will at this
point have much impact at restraining excess. Central to the analysis of
unfolding precarious bubble dynamics is my view that few, if any, policymakers
anywhere around world will be willing to act decisively to tighten credit
conditions and address increasingly speculative financial markets.
WEEKLY WATCH
For the week, the S&P500 added 0.8% (up 9.3% y-t-d), and the Dow gained
0.9% (up 4.5% y-t-d). The Morgan Stanley Cyclicals surged 5.5% (up 43.7%), and
the Transports added 0.9% (up 4.5%). The Morgan Stanley Consumer index slipped
0.3% (up 6.1%), and the Utilities declined 2.4% (down 1.7%). The Banks jumped
8.4% (down 8.8%), and the Broker/Dealers rose 3.7% (up 40.7%). The S&P 400
Mid-Caps increased 1.0% (up 16.7%), and the small cap Russell 2000 gained 1.5%
(up 11.5%). The Nasdaq100 added 0.3% (up 32.3%), while the Morgan Stanley High
Tech index dipped 0.2% (up 44.7%). The Semiconductors increased 0.3% (up
42.2%), while the InteractiveWeek Internet index fell 1.3% (up 50.4%). The
Biotechs added 0.7% (up 34.5%). With Bullion gaining $2.10, the HUI gold index
slipped 0.2% (up 19.2%).
One-month Treasury bill rates ended the week at 11 bps, and three-month bills
closed at 17 bps. Two-year government yields rose 5 bps to 1.01%. Five-year
T-note yields declined 4 bps to 2.47%. Ten-year yields dropped 18 bps to 3.48%.
Long bond yields were 24 bps lower at 4.29%. Benchmark Fannie MBS yields sank a
notable 23 bps to 4.37%. The spread between 10-year Treasuries and benchmark
MBS narrowed 5 to 89. Agency 10-yr debt spreads declined 4.5 to a tiny 7 bps.
The implied yield on December eurodollar futures dipped 3 bps to 0.715%. The
2-year dollar swap spread declined 9 to 35.5 bps; the 10-year dollar swap
spread increased 1.75 to 24.25 bps; and the 30-year swap spread increased 7.5
to negative 13.25 bps. Corporate bond spreads tightened further. An index of
investment grade bond
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