Page 1 of 3 CREDIT BUBBLE BULLETIN
Old addiction untouched
Commentary and weekly watch by Doug Noland
I'll restate my thesis as concisely as I can (not my strong suit): the deeply
maladjusted US "bubble" economy requires US$2.5 trillion or so of net new
credit creation to stem systemic (credit and economic bubbles) implosion. Only
government (Treasury, agency debt, and government-sponsored enterprises'
mortgage-backed securities - GSE MBS) debt can today fill the gigantic void
created with the bursting of the Wall Street/mortgage finance bubble.
The private sector credit system is severely impaired, and there is as well the
reality that the market largely lost trust (loss of "moneyness") in Wall Street
obligations (private-label MBS, collaterlized debt obligations, or CDOs,
asset-backed securities, or ABS, auction-rate securities). The $2 trillion of
US
"government" credit creation coupled with the trillion dollar-plus expansion of
Federal Reserve credit over the past year has stabilized US financial and
economic systems.
The synchronized global expansion of government deficits, state obligations,
and central bank credit amounts to an historic government finance bubble.
Markets have thus far embraced the surge of debt issuance. This US and global
reflation will have decidedly different characteristics when contrasted with
previous Fed and Wall Street-induced reflations.
First off all, the most robust inflationary biases are today domiciled in
China, Asia and the emerging markets generally. The debased dollar has provided
China and the "developing" world credit systems unprecedented capacity to
inflate (expand credit/financial claims) without fear of spurring a run on
their currencies. Asian and emerging markets are outperforming, exacerbating
speculative inflows. Things that the "developing" world need
(energy/commodities) and want (gold, silver, sugar, and so forth) should
demonstrate increasingly strong inflationary pressures. Their overflow of
dollars provides them, for now, the power to buy whatever they desire.
Here at home, the post-Wall Street bubble financial landscape ensures that the
old days of the Fed slashing rates and almost instantaneously stoking mortgage
credit, home price inflation and consumption have run their course.
Accordingly, the unfolding reflation will be of a different variety than those
of the past, and, importantly, will largely bypass US housing. This sets the
stage for a lackluster recovery in consumption and economic revival generally.
Household sector headwinds will likely be exacerbated by higher-than-expected
inflation (especially in energy and globally-traded commodities), higher taxes
and rising interest rates.
There is a confluence of factors that expose the market to an upside surprise
in yields. The bond market has been overly sanguine, emboldened by the prospect
of the Ben Bernanke Fed maintaining ultra-loose monetary policy indefinitely.
Bond bulls have been further comforted by the deep structural issues
overhanging both the US financial system and economy. However, massive
government credit creation has, for now, put systemic issues on hold.
Especially in Asia, unfettered credit expansion creates the backdrop for a
surprisingly speedy economic upsurge. The weak dollar plays a major
reflationary role globally, while also raising the prospect for inflationary
pressures here at home. Massive issuance, global economic resurgence,
heightened inflation and a weak currency are offering increasingly tough
competition to the bullish "forever loose policy" view.
Meanwhile, fixed income must gaze at the feverish equities market with
disbelief - and rising trepidation. The bond market discerns incessant economic
impairment, a historic debt overhang, 9.4% unemployment, and begrudging
recovery. An intoxicated stock market ganders something altogether different,
with the Morgan Stanley Retail Index up 61% year to date, the Morgan Stanley
High Tech Index up 47%, the Morgan Stanley Cyclical Index up 52%, and the
Broker/Dealers up 45%. The bond market has been content to laugh off the silly
equities game. The chuckles may have ended today.
My secular bearish thesis rests upon a major assumption: The US economy is
sustained by $2.5 trillion (or so) of new credit. Only this amount will stem a
downward spiral of asset prices, credit, incomes, corporate cash flows and
government finances. On the other hand, if forthcoming, the $2.5 trillion of
additional - chiefly government-directed and non-productive - credit will
foment problematic monetary disorder. In simplest terms, another bout of credit
inflation leads further down the path of unhinged market prices, destabilizing
speculation, and unwieldy flows of finance.
The stock market has become illustrative of what we might experience in the way
of monetary disorder. Speculation has returned with a vengeance, galloping
blindly ahead of fledgling little greenish shoots. Those of the bullish
persuasion contend that the marketplace is, as it should, simply discounting a
rosy future. I would counter that problematic market dynamics have taken over,
with prices increasingly disconnected from reality. In short, the market is in
the midst of one major short squeeze.
There are myriad risks associated with the government's unprecedented market
interventions. Probably not well appreciated, policymaker actions have forced
the destabilizing unwind of huge positions created to hedge against systemic
risk (as well as to profit from bearish bets). This reversal of various bear
positions has created enormous buying power, especially in the securities of
companies (and sectors) most exposed to the credit downturn.
The reversal of bets in the credit default swap (and bond) market has certainly
played a role. Surging junk bond and stock prices have fed one another, as the
highly leveraged and vulnerable companies provide phenomenal market returns.
The markets are today throwing "money" at the weak and leveraged.
The resulting outperformance of fundamentally weak companies spurred short
covering more generally, creating a dynamic whereby heavily shorted stocks
became about the best performing sector in the equities market. This dynamic
put significant pressure on so-called "market-neutral" strategies that have
proliferated over the past few years. The strategy of attempting to own the
good companies and short bad ones is faltering, probably causing a flow out of
these strategies - and a self-reinforcing unwind of positions. The "bad" stocks
soar and the "good" ones languish.
There's nothing like a short squeeze panic to get the markets' speculative
juices flowing. Many will say all's just fine and dandy - let the fun and games
continue! My retort is that the stock market is indicative of the current
dysfunctional financial backdrop.
At the end of the day, the financial system must be capable of effectively
allocating finance and real resources throughout the economy. I would argue
that this is not possible for a system that congenitally misprices risk and
distorts financial asset prices. Today's stock market will inherently finance
mainly speculative bubbles and fragility.The core systemic problem, the
maladjusted "bubble economy", well, the financial backdrop only worsens the
situation.
I have great confidence that government finance bubble dynamics ensure ongoing
distortions in the markets' pricing of risk and, as well, a continued
misallocation of resources (financial and real). And it is increasingly clear
that the stock market is embroiled in this problematic dynamic. But that is a
dilemma for another day, as surging stocks fan optimism and risk embracement -
not to mention forcing many into the stock market with both nostrils plugged.
And speculative equities and credit markets will spur increased economic output
in the short-run.
Everything has been extraordinary; the boom, the bust, policymaker
interventions, and now the bear market rally. I wish I could see some mechanism
in the works that will help kick our system's addiction to easy credit and
commence the inevitable process of economic adjustment and restructuring.
Instead, I see confirmation everywhere that policy and market dynamics are
working in concert to sustain the existing financial and economic structure. I
have huge doubts it will work and have no doubt about the risks of failure.
WEEKLY WATCH
For the week, the S&P500 rose 2.3% (up 11.9% y-t-d), and the Dow gained
2.2% (up 6.8%). With AIG up 107%, MBIA 41%, Ambac 39% and Citigroup 21% - all
this week! - some may question the quality of the rally. The S&P
Homebuilding index jumped 13.4% (up 43.0%) this week, and the Morgan Stanley
Retail Index rose 7.5% (up 62.9%). The Banks surged 12.4% (up 2.6%), and the
Broker/Dealers jumped 2.9% (up 44.6%). The Morgan Stanley Cyclicals ran another
5.7% (up 51.9%), and the Transports jumped 4.7% (up 6.0%). The broader market
remained strong, with the S&P 400 Mid-Caps jumping 4.3% (up 21.7%) and the
small cap Russell 2000 advancing 2.8% (up 14.6%). The Morgan Stanley Consumer
index increased 2.2% (up 8.5%), and the Utilities added 0.2% (down 1.5%). The
Nasdaq100 added 1.0% (up 33.7%), and the Morgan Stanley High Tech index gained
1.2% (up 46.3%). The Semiconductors slipped 1.1% (up 40.7%), while the
InteractiveWeek Internet index gained 1.2% (up 52.2%). The Biotechs declined
1.1% (up 33.2%). Although Bullion was down about a buck, the HUI gold index
increased 1.6% (up 21.1%).
One-month Treasury bill rates ended the week at 14 bps, and three-month bills
closed at 17 bps. Two-year government yields jumped 20 bps to 1.20%. Five-year
T-note yields surged 31 bps to 2.79%. Ten-year yields jumped 37 bps to 3.86%.
Long bond yields were 31 bps higher at 4.61%. Benchmark Fannie MBS yields
surged 42 bps to 4.80%. The spread between 10-year Treasuries and benchmark MBS
widened 5 to 94. Agency 10-yr debt spreads narrowed slightly to 6 bps. The
implied yield on December eurodollar futures rose 8.5 bps to 0.795%. The 2-year
dollar swap spread increased 10.75 to 46.0 bps; the 10-year dollar swap spread
increased 8.25 to 32.75 bps; and the 30-year swap spread increased 9.5 to
negative 3.75 bps. Corporate bond spreads were mostly tighter. An index of
investment grade bond spreads widened one basis point to 166, while an index of
junk spreads collapsed 53 to 757 bps (low since September).
Investment grade issuers included Dow Chemical $2.75bn, Citigroup $2.5bn, GE
Capital $2.0bn, Firstenergy Solutions $1.5bn, Simon Properties $1.1bn,
International Paper $1.0bn, Niagara Mohawk $750 million, Nationwide Mutual $700
million, Magellan Midstream $550 million, and Coca-Cola Enterprises $250
million.
Junk bond fund inflows were strong again at $583 million (from AMG). The list
of junk issuers included Smithfield Foods $850 million, Iron Mountain $550
million, Duke Realty $500 million, Hospitality Properties $300 million,
Mack-Cali Realty $250 million, Affinia Group $225 million, Global Aviation $175
million and Inverness Medical $150 million.
Convert issuance included Rayonier $170 million.
International dollar debt issuers included Petronas $4.5bn, BP Capital $2.0bn,
Majapahit Holding $750 million, Macquarie Group $500 million, CCL Finance $350
million, Westpac Banking $250 million, and Alestra $200 million.
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