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May 29, 2009

The Core to Periphery Dynamic
by Doug Noland

For the week, the S&P500 gained 2.6% (up 1.8% y-t-d), and the Dow jumped 3.5% (down 3.2% y-t-d). Economically-sensitive stocks led the charge. The Morgan Stanley Cyclicals jumped 4.1% (up 15.7%), and the Transports surged 6.1% (down 9.4%). Financial stocks were also strong. The Banks rose 4.6% (down 15.6%), and the Broker/Dealers gained 4.0% (up 28.5%). The broader market posted big gains. The S&P 400 Mid-Caps advanced 4.2% (up 6.9%) and the small cap Russell 2000 rose 4.8% (up 0.4%). The Nasdaq100 surged 5.0% (up 18.5%), and the Morgan Stanley High Tech index rose 5.3% (up 28.8%). The Semiconductors surged 7.7% (up 27.9%), and the InteractiveWeek Internet index jumped 5.3% (up 39.8%). The Biotechs increased 4.4% (up 0.3%). Somewhat lagging, the Morgan Stanley Consumer Index gained 2.1% (up 2.2%), and the Utilities rallied 3.3% (down 9.7%). With Bullion jumping $22, the HUI gold index gained 4.8% (up 31.6%).

One-month Treasury bill rates ended the week at 14 bps, and three-month bills closed at 15 bps. Two-year government yields declined 3 bps to 0.82%. Five year T-note yields rose 10 bps to 2.29%. By week's end, ten-year yields had only increased 2 bps to 3.47%. The long-bond saw yields end the week down 4 bps to 4.34%. The implied yield on 3-month December '09 Eurodollars slipped 2 bps to 0.935%. Benchmark Fannie MBS yields jumped 19 bps to 4.33%. The spread between benchmark MBS and 10-year T-notes widened 17 bps to 87 bps. Agency 10-yr debt spreads narrowed 5 bps to 32 bps. Interest-rate derivative markets were wildly volatile. The 2-year dollar swap spread ended little changed at 40.75 bps; the 10-year dollar swap spread increased 5 to 19.5 bps; and the 30-year swap spread declined 1.0 to negative 31.5 bps. Corporate bond spreads mixed. An index of investment grade bond spreads tightened 3 to 194 bps, while an index of junk spreads widened 4 to 940 bps.

The corporate debt issuance boom runs unabated. Investment grade issuers included Morgan Stanley $5.5bn, Citigroup $5.0bn, Goldman Sachs $3.0bn, Bank of America $2.5bn, Metlife $1.25bn, Mass Mutual $750 million, Travelers $500 million, Norfolk Southern $500 million, Pride International $500 million, and Public Service Colorado $400 million.

Junk bond funds saw inflows of $472 million this past week (from AMG), 11 straight weeks of positive flows. Junk issuers included Harrahs $1.375bn, Cricket Communications $1.1bn, Ford $1.1bn, Virgin Media $750 million, CBS $600 million, AMC Entertainment $600 million, Verso Paper $325 million, Allegheny Technologies $350 million, Terex $300 million, and American Tower $300 million.

I saw no convert issuance this week.

International dollar debt issuers included Corp Andina de Fomento $1.0bn and Westpac Banking $350 million.

U.K. 10-year gilt yields rose 3 bps to 3.75%, and German bund yields gained 4 bps to 3.59%. The German DAX equities index added 0.5% (up 3.6%). Japanese 10-year "JGB" yields jumped 5 bps to 1.48%. The Nikkei 225 rose 3.2% (up 7.5%). Emerging markets remain quite strong. Brazil's benchmark dollar bond yields dropped 14 bps to 5.86%. Brazil's Bovespa equities index jumped 5.2% (up 41.7% y-t-d). The Mexican Bolsa gained 1.0% (up 8.7% y-t-d). Mexico's 10-year $ yields dropped 14 bps to 5.74%. Russia's RTS equities index surged 7.3% (up 72%). India's Sensex equities index gained 5.3% (up 51.6%). China's Shanghai Exchange added 1.3% in a shortened week (up 44.6%).

Freddie Mac 30-year fixed mortgage rates jumped 9 bps to 4.91% (down 117bps y-o-y). Fifteen-year fixed rates gained 3 bps to 4.53% (down 113bps y-o-y). One-year ARMs dropped 13 bps to 4.69% (down 53 bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 26 bps to 6.48% (down 57bps y-o-y).

Federal Reserve Credit dropped $90.7bn last week to $2.074TN. Fed Credit has declined $172 y-t-d, although it expanded $1.196 TN over the past 52 weeks (136%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 5/27) jumped another $14.7bn to a record $2.724 TN. "Custody holdings" have been expanding at an 20.4% rate y-t-d, and were up $431bn over the past year, or 18.8%.

Bank Credit increased $7.4bn to $9.772 TN (week of 5/20). Bank Credit was up $341bn year-over-year, or 3.6%. Bank Credit was down $141bn y-t-d (3.7% annualized). For the week, Securities Credit declined $9.3bn. Loans & Leases jumped $16.6bn to $7.095 TN (52-wk gain of $185bn, or 2.7%). C&I loans dropped $7.9bn, with one-year growth of 2.7%. Real Estate loans fell $9.1bn (up 6.2% y-o-y). Consumer loans jumped $15.2bn, and Securities loans rose $13.4bn. Other loans increased $5.2bn.

M2 (narrow) "money" supply increased $12.2bn to $8.328 TN (week of 5/18). Narrow "money" has expanded at a 4.2% rate y-t-d and 9.1% over the past year. For the week, Currency was unchanged, while Demand & Checkable Deposits declined $5.8bn. Savings Deposits jumped $30.8bn, while Small Denominated Deposits fell $4.2bn. Retail Money Funds decreased $8.6bn.

Total Money Market Fund assets (from Invest Co Inst) rose $15.4bn to $3.789 TN. Money fund assets have declined $41bn y-t-d, or 2.7% annualized. Money funds have expanded $309bn, or 8.9% over the past year.

Total Commercial Paper outstanding sank $35.9bn this past week to $1.248 TN. CP has declined $433bn y-t-d (63.8% annualized) and $506bn over the past year (28.8%). Asset-backed CP declined $8.7bn to $566bn, with a 52-wk drop of $188bn (24.9%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were down $100bn y-o-y to $6.709 TN. Reserves have declined $237bn over the past 37 weeks.

Global Credit Market Dislocation Watch:

May 29 - Bloomberg (Lester Pimentel and Michael Patterson): "Emerging-market bonds are headed for their biggest three-month rally in seven years, led by Argentina and Ukraine... Bonds sold by developing countries returned 3.4% in May, extending their gain since March 1 to 12%..."

May 28 - Bloomberg (Jeff Green and Mike Ramsey): "General Motors Corp., the world's largest automaker until its 77-year reign ended in 2008, plans to file for bankruptcy protection on June 1 and sell most of its assets to a new company, people familiar with the matter said."

May 28 - Bloomberg (Oliver Suess): "Credit insurers, including Euler Hermes SA, Atradius NV and Coface SA, have raised premiums by as much as 20 percent this year in Germany and may increase them more as defaults climb amid the financial crisis. 'Credit insurers have been scrutinizing their contracts very carefully' and raising rates, Joerg Mielke, head of credit risk at the German unit of...Marsh & McLennan Cos. in Munich, said... 'They currently might feel like fire insurers when half of the world is on fire.'"

May 28 - Bloomberg (Radoslav Tomek): "Eastern Europe no longer faces the threat of a financial crisis as private investors and banks will continue their financing in the region, Moody's... said. Still, eastern European economies are in 'dire shape' and their recovery depends on a revival of global output, said Dietmar Hornung, Moody's senior analyst... 'The imminent feeling of a financial crisis has faded,' Hornung said... 'There are assurances that foreign banks remain committed' to the region."

Government Finance Bubble Watch:

May 28 - Bloomberg (Craig Torres): "The Federal Reserve may step up asset purchases to prevent its balance sheet from contracting until policy makers are convinced an economic recovery has taken hold, Fed officials and analysts said. Demand for some of the Fed's emergency programs has waned as the grip of the credit crunch loosens, with loans to banks shrinking 38% since Jan. 1. The main tool to keep the central bank's holdings from falling from the current $2.1 trillion would be more purchases of Treasuries, said analysts including former Fed Governor Laurence Meyer. Until now, policy makers' balance-sheet decisions have been driven by the emergency liquidity needs of banks, bond dealers, money markets and failing financial institutions."

May 27 - Bloomberg (Alan Bjerga): "Cargill Inc., Archer Daniels Midland Co. and Bunge Ltd. are benefiting from the most government support for farm exports since 1992 as the U.S. steps up loan guarantees for foreign buyers unable to get credit. About $4.35 billion was allocated to countries from Jamaica to Turkey through April 6 in the year that started Oct. 1... That's 40% more than in all of fiscal 2008 and almost triple 2007's total."

Currency Watch:

May 27 - Bloomberg (Chen Shiyin and Bernard Lo): "The U.S. economy will enter 'hyperinflation' approaching the levels in Zimbabwe because the Federal Reserve will be reluctant to raise interest rates, investor Marc Faber said. Prices may increase at rates 'close to' Zimbabwe's gains, Faber said... Zimbabwe's inflation rate reached 231 million percent in July, the last annual rate published by the statistics office. 'I am 100% sure that the U.S. will go into hyperinflation,' Faber said. 'The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate.'"

The dollar index declined 0.9% this week to 79.29 (down 2.5% y-t-d). For the week on the upside, the South African rand increased 4.1%, the New Zealand dollar 3.3%, the Brazilian real 3.0%, the Canadian dollar 2.7%, the Australian dollar 2.4%, the Swiss franc 1.6%, the British pound 1.6% and the Euro 1.0%. On the downside, the Swedish krona declined 1.4%, the South Korean won 0.6%, the Japanese yen 0.5%, and the Singapore dollar 0.2%.

Commodities Watch:

May 28 - Bloomberg (Heather Walsh): "Coffee prices may return to a 10-year high this year after rainfall harmed crops in Colombia, the world's third-largest supplier, a farming group said. Prices may more than double this year's 21% gain and 'probably' exceed $1.70 a pound, said Rafael Mejia, president of the Colombian Agriculture Society..."

Gold ended the week up 2.3% to $979 (up 11% y-t-d). Silver jumped 4.9% to $15.69 (up 38.3% y-t-d). July Crude surged $4.67 (2-wk gain of $9.45) to $66.45 (up 30% y-t-d). June Gasoline rose 4.9% (up 82% y-t-d), and June Natural Gas jumped 6.5% (down 31% y-t-d). Copper rallied 4.0% (up 49% y-t-d). July Wheat surged 6.1% (up 0.3% y-t-d), and July Corn gained 3.1% (up 5.7% y-t-d). The CRB index jumped 3.7% (up 10.2% y-t-d). The Goldman Sachs Commodities Index (GSCI) surged 5.5% (up 26.9% y-t-d).

China Reflation Watch:

May 29 - Bloomberg (Kevin Hamlin): "China's growth prospects have improved from three months ago... The world's third-largest economy will expand 7.5% this year, according to the median estimate of 14 economists surveyed by Bloomberg..."

May 27 - Bloomberg (Tom Kohn): "China, the world's second-biggest energy consumer, views global warming as more serious than the world financial crisis, President Hu Jintao's special representative on climate change wrote... 'The global financial crisis has, no doubt, exacerbated the challenge of climate change,' Xie wrote. 'But since climate change is a more far-reaching and serious challenge, the world must not waver in its determination and commitment to address it.'"

May 29 - Bloomberg (John Duce): "China, the world's second-biggest energy user, may raise gasoline and diesel prices by about 10% by next weekend as higher oil prices are leading to losses at the nation's refiners, according to an analyst."

Japan Watch:

May 29 - Bloomberg (Jason Clenfield and Toru Fujioka): "Japan's industrial output surged the most in 56 years in April as a rebound in exports helped the economy emerge from its worst recession since World War II. Production rose 5.2% from March..."

India Watch:

May 29 - Bloomberg (Cherian Thomas): "India's economy grew more than estimated in the last quarter... Asia's third-largest economy expanded 5.8% in the three months to March 31, led by government spending and construction..."

May 28 - Bloomberg (Kartik Goyal): "India's credit rating may come under pressure if Prime Minister Manmohan Singh's government is not able to rein in a widening budget deficit, Moody's Investors Service said. 'The stable outlook on the ratings has recently faced growing pressure, mainly due to substantial deterioration in the fiscal position,' Aninda Mitra, a senior analyst at Moody's...said... 'Inability of the newly re-elected government to meaningfully adjust fiscal policies and push ahead with reforms could pressurize the foreign currency credit rating."

Asia Bubble Watch:

May 27 - Bloomberg (Stephanie Phang): "Malaysia's economy contracted for the first time since 2001... Southeast Asia's third-largest economy shrank 6.2% in the first quarter from a year earlier..."

Latin America Watch:

May 26 - Bloomberg (Iuri Dantas and Joshua Goodman): "Brazil posted a current account surplus for the first time in 19 months on growing demand for the country's commodities, rising foreign investment and fewer remittances of profits and dividends abroad."

May 28 - Bloomberg (Matthew Walter): "Brazil's state-run development bank will loan Venezuela as much as $4 billion to finance projects, Venezuelan President Hugo Chavez said. Brazil and Venezuela signed a letter of intent for the financing earlier this week..."

Unbalanced Global Economy Watch:

May 28 - Bloomberg (Greg Quinn): "Canadian home prices fell in March, the Teranet-National Bank National Composite House Price Index showed. Prices fell 5.8% from March 2008..."

May 27 - Bloomberg (Svenja O'Donnell): "The U.K.'s millionaire club has shriveled by half because of the slump in property prices, falling stock prices and smaller bonuses, the Centre for Economics and Business Research said. There are currently 242,000 people living in Britain with assets of at least 1 million pounds ($1.6 million), compared with 489,000 estimated in the CEBR's previous report in 2007..."

May 29 - Bloomberg (Christian Vits): "Loans to households and companies in Europe grew at the slowest pace on record in April... Loans to the private sector rose 2.4% from a year earlier after increasing an annual 3.2% in March..."

Bursting Bubble Economy Watch:

May 28 - Bloomberg (Brian Louis): "JPMorgan Chase & Co. Chairman and Chief Executive Officer Jamie Dimon cut the asking price for his Chicago mansion to $10.5 million last month..."

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

May 28 - Bloomberg (Kathleen M. Howley): "Mortgage delinquencies and foreclosures rose to records in the first quarter and home-loan rates jumped to the highest since March this week as the government's effort to fix the housing slump lost momentum. The U.S. delinquency rate jumped to a seasonally adjusted 9.12% percent from 7.88%, the biggest-ever increase, and the share of loans entering foreclosure rose to 1.37%, the Mortgage Bankers Association said... Both figures are the highest in records going back to 1972."

Speculator Watch:

May 28 - Bloomberg (Larry Edelman): "Arthur Samberg, once the world's biggest hedge-fund manager, said a federal insider-trading investigation is forcing him to shut Pequot Capital Management Inc. more than two decades after starting its first fund... Pequot oversees $3.47 billion, according to a May 15 regulatory filing, down from $4.3 billion in November and $15 billion in 2001..."

May 26 - Bloomberg (Gillian Wee): "The New York state pension fund, the third largest in the U.S., is pulling its money out of 10 money-management companies to eliminate the use of middlemen when investing in hedge funds."

The Core to Periphery Dynamic:

This week provided ample confirmation for the global reflation thesis. The dollar index dropped another 0.9%. Gold surged $22 to $979. Crude oil jumped $4.67 to a six-month high, posting the largest one-month percentage gain since 1999 (according to Bloomberg). The Goldman Sachs Commodities index rallied 5.5% to an almost 7-month high (up 27% y-t-d). Emerging markets remain on fire. And the Baltic Dry Index rose gain today, increasing its streak of consecutive gains to 19.

Leading the "bric" sweepstakes, Russian RTS equities index jumped 7.3% this week, while India's Sensex rose 5.3%. Russian stocks are now up 72% y-t-d, followed by India's 52%, China's 45%, and Brazil's 42%. Elsewhere, stocks in Taiwan are up 50%, South Korea 24%, Argentina 47%, and Hungary 22%. The "commodity" currencies led the charge again this week. The South African rand gained 4.1%,the New Zealand dollar rising 3.3%, the Brazilian real 3.0%, the Australian dollar 2.4%, and the Canadian dollar 2.7%.

It was quite a week in U.S. interest rate markets. Ten-year Treasury yields jumped 29 basis points during the shortened week's first two trading sessions (to 3.74%), before backing off to end the week up only 2 bps to 3.47%. The mortgage marketplace turned rather tumultuous, with benchmark Fannie MBS yields spiking 55 bps from last Friday's close before ending the week 19 bps higher at 4.33%. Some interest-rate hedging markets seemed in disarray, with the dollar swaps market demonstrating price discontinuity. After closing last week at 14.4 bps, the 10-year dollar swap spread traded as high as 38.25 before ending the week at 19.50.

Importantly, at least for the week, mortgage-related market tumult didn't broaden to other risk markets. Corporate Credit spreads were mostly narrower on the week, even as the company debt issuance boom ran unabated. The junk bond market enjoyed another week of strong fund inflows more than matched by huge issuance. It is also worth noting the resilience of the "emerging" debt markets. Brazilian benchmark dollar bond yields were down 14 bps to 5.86%. Mexican dollar bond yields fell 14 bps to 5.74%. Brazil's Credit default swap (CDS) prices declined to the lowest level since early October (197 bps, down from the October high of 600 bps). It is no longer the case that when the Treasury market catches a cold others get really sick.

At this point, the markets' sanguine attitude toward dollar and Treasury/MBS weakness is understandable. From a global perspective, a weaker dollar bolsters the inflationary bias that had prior to the Credit meltdown been driving robust economic performance throughout the energy and commodities-based economies. Dollar devaluation also works to reinforce already heady financial flows to "emerging" markets and non-dollar assets more generally. There are facets of inflation that seductively salve recovery.

The dramatic loosening of financial conditions globally is supporting an improvement in economic conditions. The optimists are looking for Asia and the developing world to lead a global recovery, and a sinking dollar on a short-term basis would seem to support such a scenario. Our weak currency also empowers the Global Government Finance Bubble. Amazingly, most countries today have unprecedented flexibility to issue debt without fear of negative market reaction or a run against their currencies.

I again want to emphasize the dramatic change in circumstances that is increasingly in view throughout global markets and economies. During the nineties - and stretching through the "King Dollar" period earlier this decade - there was an overarching inflationary bias that worked to direct flows to the "Core" (the U.S. Credit system and securities markets). Whether it was a crisis that initially erupted in Mexico, SE Asia, Russia, Argentine or Brazil, the immediate market response was an abrupt reversal of financial flows from the developing countries to U.S. dollar securities. While there was an ongoing acceleration in speculative flows meandering about the globe in search of big returns, the first sign of trouble would incite a panic immediately to the dollar.

The "Core" absolutely dominated the system, providing our policymakers (especially the Fed) extraordinary latitude. The Periphery to Core bias fostered financial crises, along with general Periphery financial and economic instability. This dynamic worked to keep global inflationary pressures in check. Or, better said, the nature of the inflationary flow of finance kept inflation pressures directed to U.S. dollar securities markets - as opposed to energy, commodities and more traditional inflation.

The global financial and economic backdrop has changed profoundly. Today, there exists a powerful inflationary bias working to direct flows away from the Core out to the Periphery. This dynamic helps to explain the dramatic change in the cost and availability of finance for the developed world over the past several years - the virtually unlimited cheap finance that funded historic booms in China and Asia.

Granted, this flow was abruptly interrupted by last year's global Credit crisis. It is, however, my view that the dynamic of powerful Core to Periphery flows has resumed. Moreover, it is the nature of this type of dynamic that if such a trend recovers it will likely resume stronger-than-ever (think tech stock post-LTCM reflation or mortgages post-tech Bubble reflation). This analysis is supported by the Periphery's recent dramatic economic and market outperformance relative to the Core.

So, is this bullish or bearish? Well, I believe The Core to Periphery Dynamic is supportive of a more rapid than expected global economic recovery. I definitely expect global inflation to surprise on the upside. Adherents to the global deflationary spiral thesis may be left wondering what the heck happened. The backdrop seems to be set for surprising revival in energy and commodities markets. And I would not be surprised if the global equities rally has some legs.

Yet I view The Core to Periphery Dynamic as profoundly bearish for the U.S. At its core, this historic redirection of global flows and inflationary pressures is the consequence of a breakdown in the dollar standard. Failed policies, a resulting deeply impaired economic structure, and massive ongoing devaluation have ended the dollar's reign as the globe's premier reserve currency and perceived stable store of value. There is today no sound currency to replace the dollar, so the global financial system operates rudderless and with great uncertainties.

It is more certain, however, that the great benefits commanded to our economy and markets over the decades from governing the world's reserve currency are drawing to an end. Our policymakers still believe they can inflate Credit and manipulate interest rates -and not have to pay a price for it. But the new global reality may be that currency markets protest massive U.S. fiscal deficits and activist monetary policy, while global markets come to dictate U.S. market yields. Over the past two weeks we have seen the dollar and U.S. Treasuries/MBS come under significant pressure. Is this the beginning of global markets disciplining Washington?

A robust Core to Periphery Dynamic and the re-emergence of dollar vulnerability are a potent combination. U.S. markets to this point remain sanguine with the prospect of an expanding Federal Reserve balance sheet rectifying any spike in interest rates. But currency markets are no doubt increasingly fixated on our propensity to monetize our massive debt. At some point, increasingly unwieldy flows out of our currency may force the Fed's hand. The scenario where the Fed is forced to choose between loose monetary policy and currency crisis could be a potential big negative surprise for U.S. markets.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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