Page 1 of 3 CREDIT BUBBLE BULLETIN Party like it is 1991
Commentary and weekly watch by Doug Noland
On CNBC last Thursday, Richard Bernstein commented on some of the similarities
he's seeing between 2009 and 1991. I have been rambling for months now how this
year brings back memories of 1991. Going into the first Iraq war, bearish
sentiment was extreme. The bears had made a killing in 1990, while the bulls
were downtrodden and depressed. The US banking system was a bloody mess, and
the economy was sinking fast. As the war approached, the market feared Saddam
Hussein's military had the capacity to both put up a fight and strike at Saudi
oil fields.
But with the January 17, 1991, launch of Operation Desert Storm it became
immediately clear that Iraq was no match whatsoever
for the highly sophisticated and well-equipped US armed forces. The S&P500
rallied 3.7% on the 17th and didn't look back.
The 1991 market rally caught the bulls underinvested and the bears highly
exposed. Both camps waited anxiously for a pullback to get their positions in
order. Not uncharacteristically, Mr Market was in no mood to accommodate.
Bernstein noted that the riskier stocks gained 90% during 1991, only somewhat
ahead of the 85% gain he said this category has gained so far this year.
Indeed, a huge short squeeze led the 1991 market rally. This dynamic severely
punished the bears, while the generally cautious bulls were for awhile left
unsatisfied.
Throughout 1991, there were ample reasons for the bears to maintain bearishness
and the bulls to stay cautious. The economic recovery was anemic, with Q2's
2.7% gross domestic product (GDP) recovery followed by weak reports in 1991's
Q3 (positive 1.7%) and Q4 (positive 1.6%). Unemployment began the year at 6.3%,
only to rise to 7.3% by year end - on its way to the cycle peak of 7.8% posted
in June 1992. Personal income and spending both lagged. The fiscal situation
was dismal (a US$269 billion deficit in 1991) and projected to get even worse
($290 billion in 1992). Ten-year bond yields began 1991 at about 8% and were
above 8.2% at the year's midpoint. The thrill of watching the Fed collapse
interest rates had yet to be experienced - and wasn't yet even contemplated.
After beginning 1991 at 7.0%, the Fed funds rate was cut repeatedly to an - at
that time - extraordinary 3.0% by September 2002. The Alan Greenspan Federal
Reserve fashioned a very steep yield curve to ensure the impaired banking
system easy profits - a dynamic that also provided easy speculative returns to
Wall Street firms and the fledgling hedge fund industry. It wasn't long until
speculation was running rampant throughout the stock and bond markets.
It is my view that this past year's unprecedented fiscal and monetary policy
response has unleashed powerful speculative forces throughout the global
markets. Recalling 1991, a major short squeeze has again propelled the general
market higher. The unwind of systemic risk hedges has also surely played a
major role in newfound marketplace liquidity abundance - both in equities and
fixed income. And there is absolutely nothing like the confluence of extended
ultra-cheap "money", highly liquid markets, and speculative froth to keep the
marketplace focused beyond the valley to the hopeful return of prosperity.
It is with this in mind that it is worth mentioning the market's inattention to
terrible budget data released last week. This year's deficit is now slated at
$1.58 trillion, or 11.2% of GDP (the largest since World War II). Spending will
increase 24%, the strongest increase since the Korean War (from the Wall Street
Journal). The White House increased its estimate for the 2010 shortfall by $200
billion to $1.50 trillion (40% of federal revenues). Worst of all, the estimate
for 10-year deficits was raised $2.0 trillion to a staggering $9.0 trillion. It
was difficult to gauge who cared less - bonds or stocks.
I understand the fundamental case for disregarding these types of long-term
budget forecasts. The Congressional Budget Office (CBO) saw deficits as far as
the eye could see back in the early 1990s. Actual deficits turned to nice
surpluses by the end of the decade. Looking back at year 2000 projections, the
CBO penciled in a $400 billion surplus for 2009 and better than $3.0 trillion
of cumulative surplus for this decade. A speculative marketplace easily ignored
this week's projections.
I have my own explanation for why the CBO projections were so off in both the
early nineties and earlier this decade: the historic expansion of "Wall Street
finance". The securities brokers/dealers began the nineties with assets of $237
billion, ended 1999 at $1.0 trillion, and peaked at $3.1 trillion in 2007. The
government-sponsored enterprises (Fannie Mae, Freddie Mac and others) started
1990 with assets of $454 billion, ended the decade at $1.732 trillion and
concluded 2008 at $3.458 trillion. The asset-backed securities market began the
nineties at $210 billion, ended 1999 at $1.313 trillion and peaked in 2007 at
$4.5 trillion. I don't have data for hedge fund positions, "repos", or the
collateralized debt obligation (CDO) market - but all would have the same
bubble trajectory.
While the US banking system was severely impaired to begin the nineties, this
fact did not prove bearish for the economy, the markets or federal government
finances. A historic Wall Street credit bubble was cultivated and then
championed by the Greenspan Fed. This massive expansion of credit created
abundant liquidity for spectacular asset bubbles, a dramatic inflation in
government receipts and spending, and a consumption boom like the world had
never experienced. And, importantly, the reflationary boom in Wall Street
finance worked to repair and rejuvenate the bank credit-creating mechanism -
until last year's collapse left everyone (but the federal government) starved
for credit and liquidity.
So what about today? It's not difficult for an increasingly speculative stock
market to dream it's 1991 all over again. Many believe the economy's previous
growth trajectory can be reestablished and the great bull market resumed.
Others simply see a very fruitful speculative backdrop. Most believe that the
recovering markets are a reflection of growth prospects and that the buoyant
stock market is discounting the return of the economy to sound footing. The
bullish consensus believes economic recovery will work to cure housing and
financial sector ills, as it did during the nineties.
I believe the bullish consensus is misguided. First and foremost, it is the
credit system driving the real economy - not vice-versa. Only massive fiscal
and monetary stimulus was capable of stabilizing the system. Total
non-financial credit expanded $470 billion 1991. It is my view that the
maladjusted US bubble economy will require non-financial credit growth of at
least $2.0 trillion this year. With the banking system and Wall Street finance
severely impaired, "federal" (Treasury, agency, GSE mortgage-backed securities)
credit will account for the vast majority of system credit growth this year.
The unprecedented expansion of federal credit has stabilized the system and
incited a speculative run in the stock market. But I just don't see the
mechanism for private-sector credit to recover to the point of carrying the
heavy load necessary to sufficiently finance the gluttonous US economy. I don't
see a new boom in Wall Street credit instruments in the offing, and it's
difficult to see how bank credit can recover adequately on its own. So, as far
as the eye can see, the system is left with "federal" credit.
I expect this week's dire deficit projections from the White House and CBO this
time to be much more on the mark. I also believe it matters greatly to both the
US economy and markets that our government has become the predominant source of
system finance. Granted, it may not matter so much right now as artificial
recoveries flourish in the markets and economy. But those believing the stock
market is forecasting a happy ending to this, the latest stage of the bubble,
will again be disappointed. I haven't forgotten how the Wall Street boom
papered over a lot of problems and structural issues.
WEEKLY WATCH
For the week, the S&P500 added 0.3% (up 13.9% y-t-d), and the Dow gained
0.4% (up 8.7% y-t-d). The Morgan Stanley Cyclicals slipped 0.3% (up 51.2%), and
the Transports declined 1.2% (up 5.3%). The Banks increased 0.8% (up 7.2%), and
the Broker/Dealers rose 2.2% (up 46.5%). The Morgan Stanley Consumer index rose
another 1.9% (up 13.5%), while the Utilities declined 0.8% (down 0.1%). The
S&P 400 Mid-Caps added 0.5% (up 23.2%), while the small cap Russell 2000
slipped 0.3% (up 16.1%). The Nasdaq100 gained 0.3% (up 35.6%) and the Morgan
Stanley High Tech index gained 0.8% (up 49.4%). The Semiconductors jumped 3.3%
(up 46.7%). The InteractiveWeek Internet index slipped 0.2% (up 53.4%). The
Biotechs surged 4.8% (up 42.3%). With Bullion up $1.70, the HUI gold index
increased 1.8% (up 20.6%).
One-month Treasury bill rates ended the week at 11 bps, and three-month bills
closed at 14 bps. Two-year government yields dropped 14 bps to 0.91%. Five-year
T-note yields fell 14 bps to 2.40%. Ten-year yields were down 13 bps to 3.44%.
Long bond yields were 18 bps lower to 4.19%. Benchmark Fannie MBS yields fell 7
bps to 4.48%. The spread between 10-year Treasuries and benchmark MBS widened 6
to 104. Agency 10-yr debt spreads widened 2 to 21 bps. The implied yield on
December eurodollar futures sank 12.5 bps to 0.465%. The 2-year dollar swap
spread declined 7.5 to 36 bps; the 10-year dollar swap spread declined 4 to
22.75 bps; and the 30-year swap spread increased 1 to negative 8.75 bps.
Corporate bond spreads were narrower. An index of investment grade bond spreads
narrowed 5 bps to 168, and an index of junk spreads narrowed 14 to 694 bps.
Corporate debt issuance has been in late-summer slowdown. Investment grade
issuers included WEA Finance $2.0 billion, Duke Energy $1.0 billion, Procter
& Gamble $500 million, Roper Industries $500 million, and Spectra
Industries $300 million.
Junk bond funds saw inflows of $275 million (from AMG). Junk issuers included
Vector Group $85 million.
I saw no convert issues.
International dollar debt issuers included Westpac Banking $1.5bn.
UK 10-year gilt yields dropped 8 bps to 3.55%, and German bund yields declined
6 bps to 3.25%. The German DAX equities index gained 1.0% (up 14.7%). Japanese
10-year "JGB" yields were unchanged at 1.305%. The Nikkei 225 jumped 2.9% (up
18.9%). Emerging markets were mixed to higher. Brazil's benchmark dollar bond
yields declined 2 bps to 5.55%. Brazil's Bovespa equities index was little
changed (up 53.7% y-t-d). The Mexican Bolsa gained 1.0% (up 27.8% y-t-d).
Mexico's 10-year $ yields jumped 17 bps to 5.85%. Russia's RTS equities index
surged 7.2% (up 72.8%). India's Sensex equities index rallied 4.5% (up 65.0%).
China's Shanghai Exchange fell 3.4%, lowering 2009 gains to 57.1%.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
