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3 CREDIT BUBBLE
spreads Commentary and weekly
watch by Doug Noland
For more than a year
now, I have posited the thesis that unstable
global finance is highly vulnerable to a
problematic bout of de-risking and de-leveraging.
The unfolding European debt crisis was viewed as
the likely catalyst.
Importantly, as this
thesis began to play out during 2011's
second-half, it was my view back then that
"developing" financial systems and economies would
prove more susceptible than generally anticipated.
The consensus viewed China and the developing
world as robust - and that, in the unlikely event
of an expanding European crisis, they would prove
a source of stability, much as they did back in
It's been my view that several
years of extreme financial excess
and resulting imbalances
created latent fragilities throughout the
"developing" world, certainly including China,
India, and Brazil, as well as more generally
throughout Latin America, Asia and Eastern Europe.
The rally in global risk markets induced
by Europe's long-term refinancing operations
pushed out the resolution of this thesis. Yet with
the European debt crisis now spiraling out of
control, the markets have turned increasingly
focused on the health of the "developing" world.
There are global elements that recall the
environment heading into the collapse of Asian
currency pegs and economies back in 1997/98.
For the week, the Indian rupee declined
1.7%, the Philippine peso 1.4%, the Indonesian
rupiah 1.1%, the South Korean won 1.1%, and the
Thai baht declined 0.8%. Over the past month, the
rupee is down 5.1%, the South Korean won 3.7%, the
Malaysian ringgit 3.0%, the Singapore dollar 2.8%,
and the Thai baht 2.5%. Curiously, the Chinese
yuan declined 0.3% this week, increasing its
one-month loss to 0.6%.
May 25 -
Bloomberg: "China's biggest banks may fall short
of loan targets for the first time in at least
seven years as an economic slowdown crimps demand
for credit, three bank officials with knowledge of
the matter said. A decline in lending in April and
May means it's likely the banks' total new loans
for 2012 will be about 7 trillion yuan (US$1.1
trillion), less than an estimated government goal
of 8 trillion yuan to 8.5 trillion yuan, said one
of the officials ... "
referenced Bloomberg article was one more piece of
evidence that a major Chinese credit slowdown has
commenced. The article noted comments from the
director of the Chinese Academy of Social
Sciences, who stated that lending from China's
four largest banks (40% of lending) had increased
a meager $5 billion during the first 20 days of
May. This follows April's weaker-than-expected
loan growth that was fully 30% below March
Sinking demand for credit is
consistent with data pointing to rapidly slowing
demand for apartments and autos, as well as
mounting inventories and excess capacity
throughout the economy.
So far this month,
the Shanghai Composite has declined 2.6%. South
Korea's Kospi is down 8.0%, with stocks down 13.9%
in Hong Kong, 5.7% in Taiwan, 6.4% in India, 6.7%
in Indonesia, and 5.3% in the Philippines. Credit
default swap prices are up 22 basis points (bps)
so far this month in South Korea, 23 bps in China,
56 bps in Indonesia, 25 bps in Malaysia, 24 bps in
Thailand and 44 bps in the Philippines.
Europe, the situation last week went from bad to
worse. The 18th emergency European Union summit
was acrimonious and unproductive. It is clear that
with its new Socialist president, the political
landscape has shifted dramatically in France.
Importantly, the breakdown of the German and
French policymaking axis has only made the
policymaking backdrop more dysfunctional.
In a quote worthy of note, French
President Francois Hollande asked: "Is it
acceptable that some sovereigns can borrow at 6%
and others at zero in the same monetary union?"
Not surprisingly, this line of thinking - and his
hard line approach with the Germans - has been
warmly embraced in Spain and Italy. We'll see if
the Germans can be bullied.
The thought is
that, with Greece at the precipice and Chancellor
Angela Merkel under intense political pressure
internationally, throughout Europe and even within
Germany, the German position must soften. Indeed,
there were reports that Germany is working on a
"six-point plan" to stimulate European growth.
Reports (Spiegel), however, suggest that the focus
is on fostering targeted growth through the
creation of "special economic zones". There is no
indication the Germans are softening their stance
against eurobonds, the European Stability
Mechanism borrowing from the European Central
Bank, or European-wide deposit guarantees.
Importantly, officials from Germany's
Bundesbank have taken a harder line. Strong
comments were heard on Friday from Bundesbank
president Jens Weidmann. From MarketNews
International: "The European Central Bank has
reached the limit of its mandate, especially in
the use of its non-conventional measures, ECB
Governing Council member Jens Weidmann said ...
'In the end, these [measures] are risks for
taxpayers, most notably in France and Germany,'
the Bundesbank chief told France's daily Le
Monde." In reference to Eurobonds, Mr Weidmann
stated (from Reuters) that 'this debate irritates
me a bit ... You cannot give someone your credit
card without having the means to control the
Earlier in the week, it was the
Bundesbank that was taking a hard line with
respect to Greece living up to its EU commitments.
As capital flight and bank solvency become
critical issues, it's the ECB that controls the
While it remains obvious
that Greece is Europe's and the euro's weakest
link, it is also apparent that the financial and
economic situation in Spain is weakening rapidly.
With the Spanish economy faltering and the banking
system hemorrhaging, the situation has turned
perilous. Spanish 10-year yields ended the week at
6.27%, as fears of a massive bank capital
shortfall and stressed regional governments
weighed further on market confidence.
Trading in Bankia, the struggling Spanish
lender, was halted on Friday ahead of another
government recapitalization plan. Only two weeks
after the government took a 45% stake with a 4.5
billion euro (US$5.6 billion) capital injection,
the Financial Times is reporting that the Spanish
government "is poised to invest up to 19bn euro in
its most troubled lender ... in a bold attempt to
end market skepticism about the health of the
country's banking sector."
We'll see to
what extent such a move actually bolsters
confidence and slows deposit and capital flight.
It will surely give more credence to estimates for
a capital shortfall as high as $250 billion for
Spain's faltering banking system.
things weren't bad enough, on Friday from Reuters
(Fiona Ortiz): "Spain's wealthiest autonomous
region, Catalonia, needs financing help from the
central government because it is running out of
options for refinancing debt this year, Catalan
President Artur Mas said on Friday. 'We don't care
how they do it, but we need to make payments at
the end of the month. Your economy can't recover
if you can't pay your bills,' Mas told a group of
reporters ... "
When Spain imposed a level
of "austerity" at the federal level to rein in
out-of-control deficits, regional governments just
kept borrowing and spending. They've now
apparently hit the wall. Reuters noted that 17
regions have $45 billion of debt to refinance this
Over the past two years, Catalonia
has borrowed through the issuance of "patriot
bonds", although with "a quarter of all Catalan
savings ... already in patriot bonds" retail
demand is apparently sated. Bank borrowing is
expensive - and risky for the banking system.
Invoking a term becoming troublingly common
throughout Europe, officials in Catalonia are
calling for the "mutualization" of region debt
Wednesday was one of those days
that left a bad feeling in the pit of my stomach.
European shares were getting hammered. Spanish,
Italian and periphery bonds were under heavy
selling pressure. Emerging equities were under
pressure, and key "developing" currencies were
under heavy selling pressure.
Interestingly, credit default swap prices
were rising meaningfully for key "developing"
countries such as Brazil and Mexico. US stock
prices began sinking, with the S&P 500 falling
below the 1,300 level. There was notable weakness
in the stocks of major multinational companies
with significant exposure to the developing
economies. Things looked bleak. Miraculously, US
stocks rallied sharply to lead recoveries in
global risk markets.
I think I understand
the bullish view for US stocks and our economy. I
am the first to point out how the US economic
system, predominantly fueled by Treasury credit,
is these days strangely immune to stress
associated with global de-risking/de-leveraging.
Yet we live these days in highly
integrated global financial and economic systems.
"Risk on, risk off" is a global dynamic; the hedge
funds, leveraged speculators, international
financial conglomerates and global derivatives
markets link all markets and economies tightly
It is not a low probability that
a cataclysmic event is unfolding in Europe. Over
the past 20 years, cataclysms have been anything
but rare occurrences (1995, '97, '98, 2000, '01,
and '08 come quickly to mind).
finance is not functioning effectively;
policymaking is dysfunctional; confidence is
breaking down; and the region's economies are in
serious trouble (I know, "markets are oversold").
It is also apparent that major credit bubbles in
China, India, Brazil and elsewhere are showing
While talk of capital flight
from Greece, Spain and Italy garners most of the
focus, there are maladjusted economic/financial
systems round the globe that are quite susceptible
to de-risking/de-leveraging dynamics and attendant
reversals in "hot money" flows. Heightened global
market stress, bouts of financial dislocation and
a resulting global economic slowdown now appear
The extent to which dollar carry
trades (shorting/selling dollar instruments to
finance the purchase of higher-returning global
risk assets) have accumulated over the years
remains an important unknown.
credit-centric framework analyzes the situation in
terms of a series of interrelated global bubbles.
Developing economy bubbles appear increasingly
vulnerable to the bursting of the European credit
Speculators, investors and
corporations have over recent years positioned for
ongoing dollar devaluation versus emerging
currencies. Hedge funds have enjoyed spectacular
windfall returns, while US multinationals have
benefited from an international profits bonanza.
And while I appreciate the notion of US
stocks and our economy as today's so-called "least
dirty shirts", I at the same time see the
potential for major disappointment and
The US bubble may very well
prove resilient - but I don't expect our risk
markets to avoid what is potentially a radical
change in the global financial and economic
backdrop. And when things looked like they might
spiral out of control mid-week, market excitement
was almost palpable: "Here comes the policy
WEEKLY WATCH The
S&P500 rallied 1.7% (up 4.8% y-t-d), and the
Dow increased 0.7% (up 1.9%). The S&P 400
Mid-Caps surged 3.2% (up 6.3%), and the small cap
Russell 2000 rallied 2.6% (up 3.4%). The Morgan
Stanley Cyclicals surged 3.6% (up 4.3%), and the
Transports jumped 4.2% (up 1.2%). The Morgan
Stanley Consumer index gained 1.3% (up 2.3%), and
the Utilities increased 0.7% (down 1.3%). The
Banks were up 2.3% (up 11.9%), and the
Broker/Dealers were 1.2% higher (up 3.3%). The
Nasdaq100 was up 2.0% (up 10.9%), and the Morgan
Stanley High Tech index added 0.5% (up 7.8%). The
Semiconductors rallied 2.1% (up 2.1%). The
InteractiveWeek Internet index increased 1.5% (up
5.2%). The Biotechs rose 3.3% (up 34.5%). Although
bullion was down $19, the HUI gold index rallied
8.0% (down 14.2%).
One-month Treasury bill
rates ended the week at 6 bps and three-month
bills closed at 8 bps. Two-year government yields
were down about a basis point to 0.29%. Five-year
T-note yields ended the week up one basis point to
0.76%. Ten-year yields increased one basis point
to 1.74%. Long bond yields rose 3 bps to 2.84%.
Benchmark Fannie MBS yields jumped 5 bps to 2.72%.
The spread between benchmark MBS and 10-year
Treasury yields widened 4 to 98 bps. The implied
yield on December 2013 eurodollar futures declined
2.5 bps to 0.725%. The two-year dollar swap spread
declined 1.5 to 35.5 bps. The 10-year dollar swap
spread increased 3 to 15 bps. Corporate bond
spreads reversed course for the week. An index of
investment grade bond risk ended the week down 5
to 118 bps. An index of junk bond risk fell 52 to