Page 1 of 4 CREDIT BUBBLE BULLETIN First Dubai
Commentary and weekly watch
by
Doug Noland
The latests non-farm payroll data provide fodder for those believing a US
recovery is on track. I'll stick with the view that a 10% unemployment rate
after more than a year of extraordinary fiscal and monetary stimulus is
indicative of deep underlying structural impairment. Recent housing, household
spending, mortgage delinquency, and state and local finances data all confirm
our secular bearish prognosis.
I want to commend David Malpass for his spot-on op-ed piece in Friday's Wall
Street Journal, "Near-Zero Rates are Hurting the Economy". From the article:
"The Federal Reserve implemented an emergency monetary policy after the 2008
Lehman bankruptcy to salvage the world financial system. In his testimony
yesterday ... Ben Bernanke said, 'We must be prepared to withdraw the
extraordinary policy support in a smooth and timely way as markets and the
economy recover.' This leaves all-out emergency monetary stimulus in place, but
with a different, much weaker justification. With the system stabilized, the
Fed hopes that artificially low interest rates and its purchases of
mortgage-backed securities [MBS] will spur growth. Instead they are pushing
dollars abroad and wasting precious growth capital in asset and commodity
bubbles ... more than a year after the heart of the panic, the Fed is still
promising near-zero interest rates for an extended period and buying over $3
billion per day of expensive mortgage securities ... Capital is being rationed
not on price but on availability and connections. The government gets the most,
foreigners second, Wall Street and big companies third, with not much left
over. The irony of the zero-rate policy, coupled with Washington's preference
for a weak dollar, is a glut of American capital in Asia (as corporations and
investors shun the weakening US currency) and a shortage at home ... Much of
its current stimulus is being diverted to commodities and foreign economies -
hence Asia's complaint about bubbles ... Wall Street will threaten a tantrum if
the Fed even thinks about damping the air-raid sirens. The Street utterly loves
the Fed's largess ... "
Mr Malpass and others have recognized the dangerous flaws inherent in Federal
Reserve doctrine. It became the Alan Greenspan Fed's crisis management modus
operandi to call upon Wall Street credit creation and leveraging to lead
systemic market liquidity and reflationary efforts. For more than two decades,
this proved history's most powerful monetary mechanism. Dominant "monetary
processes" provided the key to "success". With the Fed guaranteed to slash
rates and government-sponsored enterprises (GSEs) such as Fannie Mae and
Freddie Mac guaranteed to buy and back hundreds of billions of mortgages at the
first sign of trouble, the mortgage and mortgage-related securities arena
attracted a massive and reinforcing influx of funds (what Mr Malpass would
refer to as "capital").
From my analytical framework, mortgage finance demonstrated a powerful
"inflationary bias." Related forces inflated the GSEs, Wall Street firms, the
hedge funds, home prices, household net worth, equity extraction,
over-consumption, and malinvestment. The inflationary bias inherent in US
mortgage securities (and related instruments) was instrumental to two decades
of major US structural transformation to a de-industrialized "services"
economy. Distortions in the pricing of mortgage finance fostered a massive
misallocation of financial and real resources - both at home and abroad. It
also fueled a historic housing mania and attendant acute financial and economic
fragility.
Mr Malpass recognizes that the world has changed in fundamental ways. Today,
"capital" flows first and foremost to Asia and commodities rather than to
job-creating US businesses. The more liquidity created here, the more things
inflate there. In my nomenclature, predominant inflationary biases and related
monetary processes have been radically altered. Importantly, mania has given
way to US housing depression, while faith in sophisticated Wall Street credit
instruments has been shattered. The dollar has been severely impaired. There is
no returning to previous cycle dynamics.
The reliable old monetary process - where Federal Reserve and GSE reflationary
measures would immediately stoke rapid (and self-reinforcing) mortgage credit
growth, housing inflation, inflating household net worth, equity extraction,
spending and booming government receipts - is no longer operable. Reflationary
liquidity that for years gravitated predictably to our MBS and agency debt now
prefers "undollar" asset classes, including emerging debt and equities, gold
and metals, and commodities more generally.
The Fed's capacity for domestic monetary stimulus has been greatly diminished,
with US and global economic systems these days responding altogether
differently to reflationary policymaking. Yet the Fed, now under Ben Bernanke,
refuses to respond to the altered landscape. Dangerously, the Fed adheres
steadfastly to its old policy approach - only implementing it more radically.
Our central bank balloons its balance sheet with mortgage-backed securities,
while pegging interest rates all the way down to zero. Worse yet, the Fed has
signaled that the markets can bank on near zero percent for a protracted
period. Global dynamics have changed, yet the Fed has locked itself into a
precarious policy approach. Dr Bernanke testifies that US asset prices don't
appear overvalued. Meanwhile, price distortions and bubble dynamics engulf the
world.
Discussions of what went wrong in Dubai are quite interesting. Some want to
simplistically blame a combination of a lack of transparency and stupid
bankers. Yet Dubai's debt problems are complex and really are a microcosm of
global credit and economic woes. Market price distortions are the essence of
financial bubbles. In Dubai, lenders assumed implicit government backing for
corporate debt obligations. In a region seeing more than its share of liquidity
excess, intoxicated lenders saw little reason for looking through to underlying
project economics. And the bigger the bubble inflated the more convinced the
market became that wealthy local governments would have no stomach for a
regional crisis of confidence.
The Dubai debt crisis appears at this point largely contained and may not prove
a catalyst for a new crisis phase. But it certainly highlights crucial and
ongoing global issues. Market distortions fostered by global liquidity excess
and market perceptions of implicit government backing recalls our own GSE
fiasco. Superfluous and mispriced finance fed bubbles and precarious Ponzi
finance dynamics. The Wall Street and Dubai miracles worked until they didn't.
As we witnessed firsthand with the Wall Street/mortgage finance bubble, the
scheme lasted as long as sufficient new cheap speculative finance was enticed
to play. It became a confidence game.
For months now, I have posited the emergence of a global government finance
bubble. Global liquidity excess and market perceptions of implicit government
backing are, once again, playing an instrumental role in fostering Ponzi
dynamics. The Fed and most observers are seemingly oblivious to bubble risk
here at home. Yet the Treasury and agency markets are the epitome of
dangerously distorted bubble markets. Unprecedented global imbalances,
ballooning central bank balance sheets, pegged ultra-low rates, and unwieldy
speculative financial flows foment liquidity excesses and market price
distortions - especially in the enormous US Treasury and agency markets. At the
same time, the markets perceive an implicit guarantee: that China, Japan,
"emerging" Asia and the Middle East can be counted on to support Treasury
prices and ensure dollar weakness doesn't turn disorderly. Moreover, markets
perceive that Federal Reserve rate and monetization policies will continue to
underpin US corporate, municipal and household debts.
Markets have thus far been content to largely overlook underlying economic
fundamentals when it comes to valuing US government debt obligations.
Importantly, the multi-trillion dollar expansion of (mispriced) Treasury and
agency securities has been instrumental in rejuvenating the US credit system,
markets and the real economy. Markets have readily accommodated a massive
expansion of US government debt and perceive that ongoing Treasury and Fed
credit creation will bolster recovery.
This perception - built into collapsing credit spreads and increased credit
availability - has been instrumental in stabilizing domestic incomes, corporate
cash flows, and asset prices (homes, stocks, debt and "risk assets" more
generally). I would argue that only the emergence of a government finance
bubble held much greater debt problems - along with necessary economic
adjustment - at bay.
While perhaps not obvious from an asset price perspective, there are
unmistakable bubble and Ponzi dynamics at work. The entire US financial and
economic recovery rests on a flimsy foundation of a highly distorted Treasury
and agency market bubble. I am the first to appreciate that bubbles notoriously
survive longer and grow larger than we bubble analysts would expect. At the
same time, the world has moved up the bubble analysis learning curve. I find it
disconcerting that many who recognize the unfolding bubble landscape still
believe they have plenty of time to profit and then get out before the bust. I
also sense the more sophisticated players are following developments with an
increasing degree of angst.
WEEKLY WATCH
For a volatile week in global markets, the S&P500 gained 1.3% (up 22.4%
y-t-d), and the Dow added 0.8% (up 18.4% y-t-d). The Banks rallied 2.7% (down
0.2%), and the Broker/Dealers jumped 3.9% (up 48.9%). The Morgan Stanley
Cyclicals gained 2.8% (up 68.7%), and Transports jumped 4.6% (up 16.0%). The
Morgan Stanley Consumer index added 0.8% (up 23.0%), and the Utilities gained
3.8% (up 3.0%). The broader market was strong. The S&P 400 Mid-Caps rallied
2.7% (up 30.4%), and the small cap Russell 2000 surged 4.4% (up 20.7%). The
Nasdaq100 increased 1.5% (up 47.9%), and the Morgan Stanley High Tech index
gained 2.3% (up 63.4%). The Semiconductors surged 8.2% (up 58.0%). The
InteractiveWeek Internet index rose 2.4% (up 70.4%). The Biotechs gained 2.7%
(up 40.5%). Although bullion ended the week down $16, the volatile HUI gold
index ended the week little changed (up 55.7%).
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