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2 CREDIT BUBBLE
BULLETIN Diverging like it's
1929 Commentary and weekly
watch by Doug Noland
Spanish 10-year
yields dropped 123 basis points (bps) last week to
5.57%. Yields are now down 194 bps from July 24
highs (7.51%). Italian 10-year bond yields sank 80
bps last week to 5.02%, and are down 153 bps from
July highs (6.55%). Spanish
stocks (IBEX) have rallied
34% off July lows, slashing its 2012 loss to only
8%. And after its 32% rally from July lows,
Italian stocks (MIB) now sport a 6.8% year-to-date
gain. The German DAX has gained 14% from July
lows, increasing its 2012 gain to 22.3%.
Here in the US, tens of trillions of
(government, corporate, and mortgage-related)
bonds are priced at or near record high levels
(low yields). The S&P 400 Mid-Cap equities
index, up 14.3% y-t-d, is only 0.4% below its
all-time high. The small cap Russell 2000 (up
13.7% y-t-d) is 0.6% below its record high. The
S&P 500 traded this week to the highest level
since May 2008. The Nasdaq ("NDX") 100 now enjoys
a 2012 gain of 24.0% - and traded this week to its
highest level going all the way back to 2000. Junk
bond spreads traded this week to a 13-month low.
As regional and global economic downturns
gain momentum, the European Central Bank (ECB)
last week significantly lowered its forecasts for
eurozone growth. ECB staff now project 2012
economic activity to contract in the range of
between 0.2% and 0.6%. Thursday the Organization
for Economic Cooperation and Development revised
downward its estimates for Group of Seven economic
growth.
The German economy is now
projected to slip into recession, with Q3 GDP
forecast at an annualized negative 0.5%. Economic
activity is expected to weaken further to negative
0.8% in Q4. The French economy is expected to
contract 0.4% in Q3, before recovering for 0.2%
growth in Q4. The Italian economy is forecast to
contract 2.9% during Q3 and 1.4% in Q4. The
British economy is seen contracting 0.7% in Q3,
before recovering for 0.2% growth in Q4. Japan's
economy is now expected to contract 2.3%
(annualized) in Q3. US growth is expected to
improve mildly to a 2.0% rate during Q3 and 2.4%
in Q4. Outside of the G7, the Greek and Spanish
economies are unmitigated disasters.
With
the financial world fixated on ECB president Mario
Draghi, the Federal Reserve chairman Ben Bernanke
and endless quantitative easing, global markets
now wildly diverge from economic fundamentals.
Many are content to celebrate, holding firm to the
view that financial conditions tend to lead
economic activity. Markets discount the future, of
course. And, traditionally, an easing of monetary
policy would loosen credit and financial
conditions - spurring lending, spending, investing
and stronger economic activity.
Importantly, traditional rules and
analysis no longer apply. Monetary policy has been
locked in super ultra-loose mode now entering an
unprecedented fifth year. Here in the US,
financial conditions can't get meaningfully
looser. The Federal Reserve has pushed corporate
and household borrowing costs to record lows.
Liquidity abundance will ensure near-record 2012
corporate debt issuance.
"Loose money" has
already had too long a period to impact decision
making throughout the economy - with decidedly
unimpressive results. Arguably, previous
unfathomable monetary measures some time ago
created dependencies and addictions that are
increasingly difficult to satisfy.
Clearly, monetary policy is exerting a
much greater impact on the financial markets than
it is on real economic activity. In the US and
globally, market gains are in the double-digits,
while economic growth is measured in dinky
decimals. The vulnerability associated with
elevated securities markets has tended to only
compound the issue of systemic fragility, and
policymakers have responded to heightened stress
with only more extraordinary policy measures.
Recent weeks have provided important confirmation
of the bubble thesis.
Amazingly, in the
face of exceptionally buoyant securities markets
and an expanding economy, the Federal Reserve is
apparently about to embark on yet another round of
quantitative easing ("money printing"). Few expect
this to have much impact on the real economy, but
it is clearly having a major impact on already
speculative financial markets.
I've always
feared such a scenario: severely maladjusted
bubble economies responding poorly to aggressive
monetary stimulus, spurring policymakers into only
more aggressive stimulus measures. Meanwhile,
financial fragility mounts, as credit systems
continue to rapidly expand non-productive debt.
Securities markets become dangerously speculative
and detached from underlying fundamentals.
Students of the late-1920s appreciate how
late-cycle policy-induced market and economic
distortions laid the groundwork for financial
collapse and depression. Especially in 1928 and
early-1929, highly speculative financial markets
diverged from faltering global economic
fundamentals. Our nation's business came to be
precariously dominated by "money changers",
financial leveraging and market speculation.
But we don't have to look back to
late-cycle "Roaring Twenties" excess for examples
of the danger of markets disconnecting from
fundamentals. From April 1997 to July 1998 the
Nasdaq Composite jumped 90%. The marketplace had
turned quite speculative, although excesses were
beginning to be wrung out during the
August-October 1998 Russian collapse and Long-Term
Capital Management (LTCM) crisis. Fatefully, the
Federal Reserve bailed out LTCM and the leveraged
speculating community, while orchestrating a
liquidity backstop for financial markets
generally. The consequences continue - and they're
no doubt momentous.
Rather than chastened,
the speculator community was emboldened back in
late-1998. Not surprisingly, loose monetary policy
combined with a central bank market backstop had
the greatest impact on the fledging bubble at the
time gathering momentum in technology stocks. The
Nasdaq Composite then rose from about 1,000 in
early-October 1998 to its historic March 2000 high
of 4,816.
It's certainly not uncommon for
individual stocks - or markets - to enjoy their
most spectacular gains right as they confront
rising fundamental headwinds. Indeed, whether it
was the Dow Jones Industrial Average in 1929 or
technology stocks in late-99/early-2000,
deteriorating fundamentals actually played an
instrumental role in respective dramatic market
rallies.
In each case, bearish short
positions had been initiated in expectation of
profiting from the wide gulf between inflating
stock prices and deflating fundamental backdrops.
In each case, short squeezes played a prevailing
role in fueling "blow off" speculative rallies.
Actually, the most precarious backdrops
unfold during a confluence of serious fundamental
deterioration, perceived acute systemic
fragilities, aggressive monetary policy easing and
an already highly speculative market environment.
This was the backdrop during 1929 and 1999, and I
would argue it is consistent with the current
environment.
Excess liquidity and rampant
speculation drove prices higher in '29 and '99, as
the unwinding of short positions (and the
attendant speculative targeting of short squeezes)
created rocket fuel for a speculative melt-up.
Over time, intense greed and fear and episodes of
panic buying overwhelmed the marketplace. Would-be
sellers moved to the sidelines and markets
dislocated (extraordinary demand and supply
imbalances fostered dramatic spikes in market
pricing and emotions).
Market dislocations
- and resulting price jumps - were only
exacerbated when those watching prudently from the
sidelines were forced to capitulate and jump
aboard.
The technology bubble was
spectacular - but it was also more specific to an
individual sector than it was systemic. Today's
bubble is unique in the degree to which it
encompasses global markets and economies. Systemic
fragilities these days make 1999 appear
inconsequential in comparison. The backdrop has
more similarities to 1929 - and, not
coincidentally, policymakers are absolutely
resolved to avoid a similar fate. Thus far, policy
measures have notably succeeded in fostering
over-liquefied and highly speculative markets on a
manic course divergent from troubling underlying
fundamentals.
The Draghi Plan was unveiled
last week, and expectations have the Fed coming
imminently with QE3. I don't anticipate measures
from the ECB or the Fed to have much effect on
economic fundamentals. At the same time, Draghi
and Bernanke already have had huge impacts on
global risk markets. Their policies have
dramatically skewed the markets in the direction
of rewarding the "bulls" and severely punishing
the "bears". History will not be kind. Policies
have, once again, incentivized speculation and
emboldened speculators. Policymakers have further
energized the expansive global "government
finance" bubble.
There are many articles
discussing the details of the Draghi Plan. I will
instead focus my attention on the interplay
between ECB and Federal Reserve policymaking and
dysfunctional global markets.
The markets'
immediate response to Friday's weak US payrolls
report was telling: bonds rallied strongly, the
dollar weakened, gold jumped, and the stock market
melt-up ran unabated - as markets readied for QE3.
Ongoing dollar devaluation is critical for
sustaining the inflationary bias throughout global
commodities and non-dollar securities markets -
not to mention incredibly inflated bond and fixed
income prices.
Fed policymaking seemingly
ensures ongoing enormous trade deficits that expel
liquidity around the globe. Fed-induced weakness
also works to stem "safe haven" and speculative
inflows to the dollar, flows that have risked
inciting problematic capital flight and risk
aversion in markets around the world.
For
some time now, the global speculator community has
been successfully positioned for ongoing dollar
liquidity abundance and devaluation. For the past
two years, the unfolding European debt crisis has
repeatedly been at the precipice of unleashing
powerful global de-risking/de-leveraging dynamics.
The Draghi Plan is being crafted specifically to
backstop troubled Spanish and Italian debt,
faltering markets that were in the process of
inciting a catastrophic crisis of confidence in
the euro currency.
In unsubtle terms, the
Draghi Plan has directly targeted those with
bearish positions in European debt instruments and
the euro. In this respect, it has been both
effective and destabilizing. Draghi has
dramatically skewed the marketplace to the benefit
of the longs and to the detriment of the shorts -
throughout European debt, equity and currency
markets.
With simultaneous "open-ended QE"
rhetoric from the Bernanke Federal Reserve, shorts
have suddenly found themselves in the crosshairs
worldwide. A huge short squeeze has unfolded,
fomenting market dislocation - and an only wider
divergence between inflating market prices and
deteriorating underlying fundamentals. Panicked
covering of short positions and the unwind of
derivative hedges has thrown gasoline on already
wildly speculative securities markets.
In
previous Credit Bubble Bulletins I have noted how
asymmetrical central bank policymaking and market
backstops over the past two decades nurtured a
multi-trillion global leveraged speculating
community. I have also explained how massive
central bank liquidity injections have bypassed
real economies on their way to be part of an
increasingly unwieldy global pool of speculative
finance. I have further noted how global markets
have regressed into one big dysfunctional "crowded
trade".
And now the Draghi and Bernanke
Plans have dealt a severe blow to those positioned
bearishly around the globe. We can now contemplate
the behavior of highly speculative and
over-liquefied markets perhaps operating without
the typical checks and balances provided by
shorting and bearish positioning.
Draghi
and European policymakers must be giddy watching
the bears get completely run over. The truth of
the matter, however, is that the shorts are in no
way responsible for what ails Europe. Indeed, the
deep financial and economic structural
deficiencies were created during environments
where long-side debt market speculation was rife -
and the resulting over-abundance of mispriced
finance sowed the seeds for future crises.
Regrettably, this process remains very much alive,
as policymaking ensures bubble dynamics become
further embedded in all corners of the world.
From my perspective, the key issue is not
whether the ECB finally has a (Draghi) plan that
will resolve Europe's debt crisis - the coveted
big bazooka. Monetary policy won't solve Europe's
deep structural problems anymore than QE will
resolve US economic maladjustment and global
imbalances.
Indeed, there is little doubt
that the Draghi and Bernanke plans will only
exacerbate global systemic fragilities. They have
bought some additional time, but at rapidly
inflating costs. We desperately needed global
policymakers to work assiduously to extricate
themselves from market interventions and
manipulations. They've again done the very
opposite.
WEEKLY WATCH The
S&P500 jumped 2.2% (up 14.3% y-t-d), and the
Dow gained 1.6% (up 8.9%). The broader market
outperformed. The S&P 400 Mid-Caps jumped 3.4%
(up 14.3%), and the small cap Russell 2000 rose
3.7% (up 13.7%). The Morgan Stanley Cyclicals
rallied 3.6% (up 11.7%), and the Transports gained
1.1% (up 1.1%). The Banks surged 4.4% (up 25.1%),
and the Broker/Dealers jumped 5.7% (up 3.0%). The
Morgan Stanley Consumer index rose 1.5% (up 9.1%),
and the Utilities gained 0.5% (down 0.3%). The
Nasdaq100 was up 1.9% (up 24%), and the Morgan
Stanley High Tech index gained 2.3% (up 17.4%).
The Semiconductors increased 1.3% (up 10.1%). The
InteractiveWeek Internet index jumped 3.2% (up
13.7%). The Biotechs gained 3.3% (up 38.5%). With
bullion surging $44, the HUI gold index jumped
5.5% (down 3.1%).
One-month Treasury bill
rates ended the week at 9 bps and three-month
bills closed at 10 bps. Two-year government yields
were up 3 bps to 0.25%. Five-year T-note yields
ended the week 5 bps higher to 0.64%. Ten-year
yields gained 12 bps to 1.67%. Long bond yields
jumped 15 bps to 2.82%. Benchmark Fannie MBS
yields increased 2 bps to 2.29%. The spread
between benchmark MBS and 10-year Treasury yields
narrowed 10 to 62 bps. The implied yield on
December 2013 eurodollar futures increased a basis
point to 0.415%. The two-year dollar swap spread
declined 3 to 15 bps, while the 10-year dollar
swap spread was little changed at 11 bps.
Corporate bond spreads narrowed meaningfully. An
index of investment grade bond risk sank 9 to a
5-month low 93 bps. An index of junk bond risk
sank 45 to a 13-month low 499 bps.
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