Page 1 of 3 CREDIT BUBBLE BULLETIN Confidence wearing thin
By Doug Noland
"I favor being much clearer and specific about the economic markers that it
would take to alter [the course of policymaking]... In fact, I argued for
something like this just recently... We could allow rates to remain low until
the unemployment rate fell to a certain level or if inflation became
tremendously unacceptable at a higher rate." - Chicago Federal Reserve president
Charles Evans (interviewed by CNBC's Steve Liesman)
On September 1, Marc Jones of Reuters reported: "Bundesbank President Jens
Weidmann said... that trust in the European Central Bank could be lost if the
euro zone central bank persists with crisis-fighting policies that go beyond
its conventional role... He said the lines between central bank monetary policy
and
governments' fiscal policy had been blurred as a result of the financial and
euro zone debt crises. 'In the long run this strains the trust in the central
banks, and therefore for monetary policy it matters that the additional risks
that have been taken on [are] reduced again... ' Noting that the debt problems
of weaker euro zone countries had been shared by the bloc's stronger states, he
said this was not the way to maintain incentives for solid fiscal policy. 'Such
a solution is not suitable to curtail the uncertainty on financial markets.
Moreover, it exposes monetary policy to pressure to have a loose bias.'"
Global monetary policymaking is a complete mess. As for the US Federal Reserve,
I won't this week be profiling Chicago Federal Reserve president Evans'
interview with CNBC's Steve Liesman. In what is a really wacky idea, a dovish
Evan's suggested the Fed could consider targeting a specific unemployment rate
when setting monetary policy. Fed chairman Ben Bernanke has been a long-time
advocate of having monetary policy target a pre-determined inflation rate
("inflation targeting"), and I have fully expected that such a mechanism at
some point would be used to justify additional "accommodation"/monetization.
However, at 3.6% year-on-year current elevated consumer price inflation creates
an inopportune backdrop for proposing such a targeting mechanism. So, then, why
not the unemployment rate - or home values or stock prices?
In Europe, the European Central Bank (ECB) now confronts a very serious
dilemma. Ongoing (and evolving) financial crisis has forced the central bank to
sidestep its policymaking doctrine, circumvent rules and dangerously expose
itself to market, political and capital pressures. They today hold enormous
quantities of securities and loans to European periphery governments and banks,
exposure they had no intention of holding for anything other than for
short-term liquidity-supporting purposes. Not only are they now stuck with
these "trades-turned-long-term investments", they face overwhelming pressure
for ongoing liquidity injections. In particular, they are left holding the bag
filled with big exposure to Greek debt, as Greece Bailout II unravels and
two-year Greek yields surge to 47%.
More problematically for the ECB, the European banking system, and global
financial markets, a side deal struck early last month between the ECB and
Italian President Silvio Berlusconi's government appears in peril. Apparently,
the ECB agreed to support Italian debt in the marketplace in exchange for a
commitment to more aggressive austerity measures from the Italians. After
surging to a high of 6.20% on August 4, ECB buying was instrumental in pressing
Italy's 10-year yields below 5% by mid-month.
Now, under intense political pressure, the Berlusconi government has backed
away from key austerity measures. Complicating matters, Berlusconi leadership
is jeopardized by ongoing criminal investigations and rising unpopularity. ECB
president Jean-Claude Trichet on Friday warned that Italian fiscal and economic
reform commitments were "extremely important" and "it is therefore essential
that the objectives announced for the improvement of public finances be fully
confirmed and implemented".
The ECB is said to have purchased almost $55 billion of Italian and Spanish
bonds in the open market over the past few weeks. This has elicited strong
rebuke from the German Bundesbank, especially after the ECB-induced bond rally
took the pressure off Italian politicians. Italy's 10-year yields jumped 21
basis points (bps) last week to 5.27%, with Friday afternoon's 397 bps a record
close for five-year Italian Credit Default Swap (CDS) prices. Having
aggressively intervened in the marketplace, the ECB now faces the risk of
market tumult if it shies away from its bond-buying program. At home and
abroad, central bankers have allowed themselves to be taken hostage by
(increasingly desperate) markets.
Come to the markets' rescue and there will be no turning back, especially in a
bubble backdrop. Global central bankers will more vocally protest the state of
fiscal mismanagement and "dysfunctional" markets, yet they largely have
themselves to blame. For too long, central bankers have accommodated both
reckless sovereign borrowing and highly speculative markets, which ensures a
fateful day of reckoning. To be sure, experimental monetary policy has been
instrumental in promoting the increasingly vulnerable global government finance
bubble.
"Activist" central banking has been the nucleus for overstating the
effectiveness - and over-promising - with respect to both monetary and fiscal
policymaking. Markets and citizens alike had over years been conditioned to
believe that enlightened policy ensured economic stability and rising asset
prices. Accordingly, risk and leverage were readily embraced. These days,
central bankers are trapped - the markets fully appreciate that they have them
trapped - and it's going to be fascinating and unnerving to watch how this all
plays out.
And while the ECB has badly deviated from its core principles, it does at least
have some to anchor policymaking. The Bernanke Fed is completely lost at sea.
Markets will now anxiously anticipate the rate-setting Federal Open Market
Committee's September 20/21 meeting. A divided Fed will contemplate additional
stimulus measures, including more quantitative easing. There will be intense
pressure to do more to support a faltering "jobless" recovery, with the
expectation that chairman Bernanke will carry the day and ensure a backdrop
sufficiently loose to accommodate additional fiscal stimulus.
Unlike in Europe, the markets have yet to impose austerity on Washington. And
while both European and American economies have demonstrated recent weakness,
in contrast to Europe our feeble recovery will continue to be underpinned by
lavish federal spending. US stocks have significantly outperformed European
bourses this year, and there remains considerable confidence that our monetary
and fiscal measures can support economic expansion and higher stock prices. As
I wrote a few weeks back, it is not difficult for most US investors to remain
complacent.
At the same time, the global financial system comes under added stress each
passing week. The euro again came under pressure this week. The euro has been
notably resilient for the past several months, but I worry that this has only
provided an opportunity for additional hedging in the marketplace to protect
against potential euro weakness. Part of my analysis is that huge derivative
protection (put options and such) has accumulated that would tend to increase
the vulnerability of the euro to an abrupt and destabilizing decline (if key
technical support levels are broken).
It has been part of my thesis that the global financial system has been
especially vulnerable to de-risking and de-leveraging dynamics. I believe
markets have absorbed the first phase of de-risking/de-leveraging, with
meaningful stock market declines, surging Treasury prices, a widening of credit
spreads, a tightening of general financial conditions and a downshift in
economic activity. Importantly, this "first phase" was accompanied by
significant currency market volatility - but not dramatic changes in most
currency values. In particular, the euro and US dollar have traded in
relatively tight trading ranges for several months now, at least partially
explained by ongoing market faith that global central bankers are keen to
ensure liquid and stable markets.
If current financial tumult evolves more into a 2008-style event, I would
expect the next phase of de-risking/de-leveraging to be accompanied by
increasing signs of dislocation in currency markets more generally. The big
question remains unanswered: how big are global currency "carry trades" (short
low-yielding dollar instruments to fund higher-returning assets abroad)?
An important part of the thesis is that we've reached the point where
reflationary policymaking will tend to only increase uncertainty and further
destabilize unsettled financial markets. Both the Fed and ECB are at respective
policy crossroads and markets have ample reason to fret. Confidence is wearing
thin.
WEEKLY WATCH
For the week, the S&P500 slipped 0.2% (down 6.7% y-t-d), and the Dow lost
0.4% (down 2.9%). The S&P 400 Mid-Caps declined 0.4% (down 8.2%), and the
small cap Russell 2000 declined 1.2% (down 12.8%). The Banks declined 2.0%
(down 28.4%), and the Broker/Dealers fell 2.2% (down 28.9%). The Morgan Stanley
Cyclicals dipped 0.2% (down 19.9%), and the Transports slipped 0.3% (down
13.0%). The Morgan Stanley Consumer index gained 0.7% (down 6.8%), and the
Utilities added 0.7% (up 4.9%). The Nasdaq100 gained 0.3% (down 2.3%), and the
Morgan Stanley High Tech index increased 0.1% (down 14.7%). The Semiconductors
declined 1.2% (down 17.1%). The InteractiveWeek Internet index rallied 1.6%
(down 10.1%). The Biotechs added 0.6% (down 11.5%). With bullion rallying $55,
the HUI gold index gained 3.5% (up 7.8%).
One month Treasury bill rates ended the week at one basis point and 2-month
bills at 2 bps. Two-year government yields were up one basis point to 0.20%.
Five-year T-note yields ended the week down 8 bps to 0.86%. Ten-year yields
dropped 20 bps to 1.99%. Long bond yields sank 24 bps to 3.30%. Benchmark
Fannie MBS yields fell 12 bps to 3.18%. The spread between 10-year Treasury
yields and benchmark MBS yields widened 8 to 119 bps. Agency 10-yr debt spreads
increased 5 to 6 bps. The implied yield on December 2012 eurodollar futures was
little changed at 0.51%. The 10-year dollar swap spread increased 3 to 20 bps.
The 30-year swap spread increased 5 to negative 30.5 bps. Corporate bond
spreads narrowed. An index of investment grade bond risk declined 4 bps to 122
bps. An index of junk bond risk dropped 50 bps to 675 bps.
Debt issuance has slowed to almost a trickle. Investment-grade issuers included
Coca-Cola $3.0bn, Commonwealth Edison $600 million, Praxair $500 million and
USAA Capital $250 million.
Junk bond funds saw outflows of $96 million (from Lipper). I saw no junk
issuance again this week.
I saw no convertible debt issued.
International dollar bond issuers included America Movil $4.0bn.
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