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August 21, 2009

The Depressed U.S. Consumer and Global Reflation
by Doug Noland

For the week, the S&P500 gained 2.2% (up 13.6% y-t-d), and the Dow rose 2.0% (up 8.3% y-t-d). The Banks jumped 2.8% (up 6.3%), and the Broker/Dealers added 1.2% (up 43.4%). The Morgan Stanley Cyclicals increased 1.5% (up 51.7%), and the Transports gained 1.7% (up 6.5%). The Morgan Stanley Consumer index jumped 3.0% (up 11.4%), and the Utilities rose 2.0% (up 0.7%). The S&P 400 Mid-Caps rallied 2.1% (up 22.5%), and the small cap Russell 2000 surged 3.1% (up 16.4%). The Nasdaq100 gained 1.6% (up 35.2%) and the Morgan Stanley High Tech index rose 1.7% (up 48.3%). The Semiconductors increased 2.3% (up 42.0%), and the InteractiveWeek Internet index gained 1.6% (up 53.7%). The Biotechs jumped 2.4% (up 35.9%). With Bullion up $5.60, the HUI gold index added 0.3% (up 18.5%).

One-month Treasury bill rates ended the week at 10 bps, and three-month bills closed at 16 bps. Two-year government yields rose 4 bps to 1.05%. Five-year T-note yields increased 5 bps to 2.54%. Ten-year yields were little changed at 3.57%. Long bond yields were bps at 4.4%. Benchmark Fannie MBS yields rose 4 bps to 4.55%. The spread between 10-year Treasuries and benchmark MBS widened 4 to 98. Agency 10-yr debt spreads widened 9 to 19 bps. The implied yield on December eurodollar futures was little changed at 0.59%. The 2-year dollar swap spread increased 3.75 to 43.75 bps; the 10-year dollar swap spread increased 4.75 to 26.75 bps; and the 30-year swap spread increased 5.5 to negative 10.0 bps. Corporate bond spreads were mixed. An index of investment grade bond spreads widened 2 bps to 173, while an index of junk spreads dropped 20 to 692 bps.

Investment grade issuers included American Express $1.5bn, Watson Pharmaceutical $850 million, Viacom $850 million, Yum Brands $500 million, Air Products & Chemicals $400 million, Baxter Intl $400 million, Meadwestvaco $400 million, and Boardwalk Pipeline $350 million.

Junk bond funds saw outflows of $130 million (from AMG). Junk issuers included Donnelley & Sons $350 million.

I saw no convert issues.

International dollar debt issuers included Royal Bank of Scotland $2.0bn and BNP Paribas $1.7bn.

U.K. 10-year gilt yields declined 4 bps to 3.64%, while German bund yields were little changed at 3.31%. The German DAX equities index gained 2.9% (up 13.6%). Japanese 10-year "JGB" yields sank 7 bps to 1.305%. The Nikkei 225 fell 3.4% (up 15.6%). Emerging markets were mixed to higher. Brazil's benchmark dollar bond yields rose 4 bps to 5.62%. Brazil's Bovespa equities index increased 1.9% (up 53.7% y-t-d). The Mexican Bolsa rallied 1.6% (up 26.5% y-t-d). Mexico's 10-year $ yields jumped 9 bps to 5.70%. Russia's RTS equities index slipped 0.9% (up 66.2%). India's Sensex equities index declined 1.1% (up 58.0%). China's Shanghai Exchange fell another 2.8%, lowering 2009 gains to 62.6%.

Freddie Mac 30-year fixed mortgage rates sank 17 bps to 5.12% (down 135bps y-o-y). Fifteen-year fixed rates fell 12 bps to 4.56% (down 144bps y-o-y). One-year ARMs declined 3 bps to 4.69% (down 60bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 12 bps to 6.17% (down 136bps y-o-y).

Federal Reserve Credit jumped $45bn last week to a nine-week high $2.035 TN. Fed Credit has declined $212bn y-t-d, although it expanded $1.147 TN over the past 52 weeks (129%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 8/19) declined $1.5bn to a record $2.814 TN. "Custody holdings" have been expanding at an 18.6% rate y-t-d, and were up $408bn over the past year, or 17.0%.

M2 (narrow) "money" supply dipped $5.6bn to $8.318 TN (week of 8/10). Narrow "money" has expanded at a 2.5% rate y-t-d and 7.9% over the past year. For the week, Currency added added $0.9bn, while Demand & Checkable Deposits fell $14.4bn. Savings Deposits jumped $26.2bn, while Small Denominated Deposits declined $7.2bn. Retail Money Funds dropped $11.1bn.

Total Money Market Fund assets (from Invest Co Inst) fell $12.1bn to $3.581 TN. Money fund assets have declined $249bn y-t-d, or 10.2% annualized. Money funds expanded $8.2bn, or 0.2%, over the past year.

Total Commercial Paper outstanding jumped $35.9bn to $1.111 TN. CP has declined $571bn y-t-d (54% annualized) and $677bn over the past year (38%). Asset-backed CP declined $6.2bn to $416bn, with a 52-wk drop of $334bn (45%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $116bn y-o-y to $7.089 TN. Reserves have increased $324bn year-to-date.

Global Credit Market Watch:

August 18 - Wall Street Journal (Sara Murray and Jon Hilsenrath): "Banks continued to tighten lending standards to businesses and households, but there are hints that the credit crisis is beginning to ease, according to the Federal Reserve's periodic survey of banks... Meanwhile, the Fed said it would extend a program aimed at bolstering consumer-loan and commercial-real-estate markets into 2010, even as it allows other recovery programs to expire. The Fed's Term Asset Backed Securities Loan Facility, or TALF, was set to expire at the end of the year. But Fed and Treasury officials said in a statement that consumer- and business-loan and commercial-real-estate markets were still 'impaired' and were likely to remain so for some time."

August 20 - Bloomberg (Caroline Hyde and Paul Armstrong): "Corporate defaults worldwide rose in 2009, surpassing the number for the whole of 2008, Standard & Poor's said... A total of 201 issuers defaulted through Aug. 12, affecting $453.1 billion of debt, S&P said. That's up from 126 defaults totaling $433 billion for all of last year..."

Government Finance Bubble Watch:

August 17 - Bloomberg (Brian Swint): "Bank of England Governor Mervyn King and two other policy makers were overruled in a push to expand the bank's bond-purchase program to 200 billion pounds ($329bn)... 'All members agreed that substantial further asset purchases were needed over the next three months,' the minutes said."

Currency Watch:

August 17 - Bloomberg (Shamim Adam): "The U.S. must address the massive amounts of 'monetary medicine' that have been pumped into the financial system and now pose threats to the world's largest economy and its currency, billionaire Warren Buffett said. The 'gusher of federal money' has rescued the financial system and the U.S. economy is now on a slow path to recovery, Buffett wrote in a New York Times commentary... While he applauds measures adopted by the Federal Reserve and officials from the Bush and Obama administrations, Buffett says the U.S. is fiscally in 'uncharted territory.'"

August 20 - Bloomberg (Rich Miller): "Federal Reserve Chairman Ben S. Bernanke and fellow central bankers gathering in Jackson Hole, Wyoming, are showing scant signs of reprising the coordinated stance they took fighting the worst financial crisis since the Great Depression... The danger is that such a disjointed approach will lead to volatile financial markets, a damaging drop of the dollar and slower global growth, Mohamed El-Erian, chief executive officer of... Pacific Investment Management Co., said... 'The question is not whether the dollar will weaken over time, but how it will weaken... The real risk is that you will get a disorderly decline."

August 18 - Bloomberg (Alexandre Deslongchamps): "Foreigners bought a net C$10.5 billion ($9.5 billion) of Canadian securities in June, investing in the country's securities for a sixth straight month and increasing their position in all asset types... Economists surveyed by Bloomberg said the report would show non-residents bought a net C$2 billion of Canadian securities during the month..."

The dollar index declined 1.0% this week at 78.07 For the week on the upside, the South African rand increased 3.6%, the Swedish krona 2.2%, the Canadian dollar 1.5%, the Norwegian krone 1.4%, the Swiss franc 1.3%, the Brazilian real 1.0%, the Euro 0.9% and the Japanese yen 0.6%. On the downside, the South Korean won declined 0.9% and the British pound 0.2%.

Commodities Watch:

Gold ended the week up 0.6% to $954 (up 8.2% y-t-d). Silver declined 3.9% to $14.19 (up 25.6% y-t-d). October Crude surged $4.39 to $73.99 (up 66% y-t-d). September Gasoline rose 3.4% (up 89% y-t-d), while September Natural Gas sank 13.7% (down 50% y-t-d). September Copper added 1.5% (up 105% y-t-d). September Wheat fell 4.5% (down 25% y-t-d), while September Corn increased 0.8% (down 20.9% y-t-d). The CRB index added 0.7% (up 12.9% y-t-d). The Goldman Sachs Commodities Index (GSCI) jumped 2.6% (up 34.7% y-t-d).

China Bubble Watch:

August 18 - Bloomberg: "Shanghai Mayor Han Zheng has every intention of fulfilling his mandate to enable China's financial capital to overtake Hong Kong, Singapore and Tokyo as preeminent in Asia, as long as bankers don't get in the way. 'Financiers have the least conscience in the world when it comes to making money,' Han, 55, said... 'By saying that, I would have offended many bankers and financiers, but this is my personal experience.' The mayor's misgivings mirror a wider dilemma for leaders in China, where a centuries-old Confucian disdain for the merchant class gave way to outright hostility when the communists seized power in 1949."

August 17 - Bloomberg: "Foreign direct investment in China fell for a tenth straight month in July as companies stalled expansion plans amid the global financial crisis. Investment declined 35.7% from a year earlier to $5.36 billion, the Commerce Ministry said..."

August 17 - Bloomberg: "Some Chinese banks are accelerating mortgage loans for buyers who already own at least one residential property on speculation the government will tighten rules on lending for second-home purchases, the Securities Times reported..."

August 17 - Bloomberg: "Shanghai will more than double the supply of land this year for housing projects to help cool rising real-estate prices, the Shanghai Daily said, citing the city's mayor Han Zheng."

August 20 - Wall Street Journal (David Walker): "China is making its presence felt by the hedge-fund industry, replacing London as the most popular base for Asia-focused managers and replacing Japan as the focus for Asian hedge funds. Data provider Hedge Fund Research said in a report Tuesday on the $68.2 billion Asian hedge-fund industry that 24% of Asia-focused hedge funds now are located in China..."

Japan Reflation Watch:

August 17 - Bloomberg (Jason Clenfield and Tatsuo Ito): "Japan's economy emerged from its deepest postwar recession as exports and consumer spending rebounded... Gross domestic product expanded at an annual 3.7% pace in the three months to June 30, the first growth in five quarters..."

India Watch:

August 18 - Bloomberg (Kartik Goyal): "India's government won't need to borrow more than estimated in the year to March 2010 even as a drought-like situation threatens its budget targets, Finance Secretary Ashok Chawla said... Finance Minister Pranab Mukherjee on July 6 unveiled plans to borrow a record 4.51 trillion rupees ($93.3bn) to fund spending ... Higher borrowing is expected to widen the budget deficit to a 16-year high of 6.8% of gross domestic product, putting pressure on the nation's sovereign ratings."

Asia Bubble Watch:

August 18 - Bloomberg (Van Nguyen): "Vietnam's gross domestic product may expand between 5% and 5.2% this year as stimulus packages have helped boost the country's economy, State Bank Governor Nguyen Van Giau said. Vietnam's economy began to grow in March after four months of applying different economic packages..."

Latin America Watch:

August 17 - Bloomberg (Iuri Dantas and Joshua Goodman): "Brazilian companies last month created jobs at their fastest pace this year, providing more evidence that Latin America's largest economy may have emerged from its first recession since 2003. The Labor Ministry said today that it registered 138,402 jobs in July..."

Unbalanced Global Economy Watch:

August 18 - Bloomberg (Svenja O'Donnell): "The U.K. inflation rate unexpectedly held at 1.8% in July..."

August 20 - Bloomberg (Josiane Kremer): "Norway's economy grew last quarter as investment in its energy industry and the biggest government stimulus in more than three decades jolted the world's fifth- largest oil exporter out of recession. The mainland economy... expanded 0.3% in the second quarter from the previous three months..."

August 17 - Bloomberg (Daryna Krasnolutska and Kateryna Choursina): "Ukraine's economy shrank an annual 18% last quarter, the second-deepest slump on record, after industrial production and retail spending plunged."

Bursting Bubble Economy Watch:

August 20 - Wall Street Journal (Sara Murray): "In the depths of the recession, the tiniest private firms accounted for a disproportionate share of the job losses, the Labor Department said... Companies that employed fewer than five workers -- where 5.1% of the private-sector work force is employed -- accounted for 14.5% of the job losses in the fourth quarter of 2008."

Central Banker Watch:

August 17 - Bloomberg (Jennifer Ryan and Brian Swint): "Lehman Brothers'... collapse in 2008 surprised former Bank of England Deputy Governor John Gieve because the rescue of Bear Stearns Cos. led him to assume U.S. officials would save investment banks. 'I remember being alarmed and surprised,' Gieve, the central bank's financial stability chief at the time, told BBC Radio 4... The U.S. government's actions on Bear had 'established a strong presumption that it would do what was necessary to prevent a collapse of an investment bank as well as a commercial bank.' U.S. officials didn't share much information with the Bank of England as they struggled to save Lehman, Gieve said..."

August 17 - Bloomberg (Christian Vits): "European Central Bank Governing Council member Axel Weber said the bank will start withdrawing stimulus measures once the economy recovers and financial markets stabilize... The ECB will exit the measures 'once the economic recovery becomes sustainable an the situation on financial markets gets sufficiently stable,' he was quoted as saying. 'With this assessment we mustn't only focus on strong banks, we also have to keep an eye on situation of the weaker ones,' Weber said..."

August 18 - Bloomberg (Jacob Greber): "The Australian central bank says its decision on when to raise borrowing costs from a half-century low will need to balance the risk of stoking inflation with prematurely killing off confidence and demand. 'A particular source of uncertainty was whether the recent growth in household spending was due mainly to temporary' government handouts, 'in which case it would probably soon fade,' policy makers said..."

Fiscal Watch:

August 20 - Wall Street Journal (John D. McKinnon): "The Obama administration next week will project a federal budget deficit for fiscal 2009 of about $1.58 trillion, slightly less than previously predicted... The administration earlier this year predicted the deficit for fiscal 2009 -- which ends Sept. 30 -- would be about $1.84 trillion. The improvement since then reflects the lowered cost of the financial-sector bailout, officials said. In particular, the Obama administration is dropping the $250 billion cost of additional aid for the financial industry."

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

August 21 - Los Angeles Times (E. Scott Reckard and Ronald D. White): "Widespread joblessness is causing more Americans to fall behind on their house payments... A mortgage trade group reported... that more than 13% of the nation's mortgage holders were delinquent on their mortgages or in the process of having their homes repossessed during the second quarter of this year. That's the highest figure since tracking began in 1972. California's rate, 15.2%, was among the highest of all states."

Real Estate Bust Watch:

August 17 - Dow Jones (A.D. Pruitt): "The ruins of Washington Mutual's aggressive and unorthodox growth strategy is no more apparent than in the Windy City, where roughly 75% of the bankrupt bank's branches have gone dark. It's a stark harbinger of what looms ahead for recession-battered retail real estate. A growing number of vacant branches being dumped on the market due to mergers and Chapter 11 filings are poised to push vacancy rates higher and exacerbate weak property values.

Muni Watch:

August 18 - Bloomberg (Martin Z. Braun): "New York's Dormitory Authority and the Dallas Convention Center plan to sell $1.1 billion of taxable Build America Bonds today, taking advantage of a federal subsidy to lower borrowing costs... Under the program, part of the $787 billion federal stimulus package, municipalities have issued $22.6 billion since public offerings began in mid-April... The federal government, which budgeted $90 million for the program this fiscal year ending Sept. 30, has vastly underestimated its cost, which Ciccarone projected to be at least $863 million. The price tag should be even greater next year, he said."

Speculator Watch:

August 17 - Bloomberg (Tomoko Yamazaki): "Hedge fund assets increased by $10.6 billion in July, rising for a third straight month... according to Eurekahedge Pte. Net inflows into the industry totaled $2.1 billion, while gains through performance were $8.5 billion, bringing total assets under management to $1.35 trillion..."

August 17 - Dow Jones (Natasha Brereton): "There are 37 sovereign wealth funds internationally with assets worth $1 billion or more each and collectively they are worth $3.2 trillion, new research from State Street Global Advisors shows."

August 17 - Bloomberg (Poppy Trowbridge): "Sovereign wealth funds are seeking safer investments after facing 'vehement' domestic criticism over losses linked to the credit crisis and a plunge in oil prices, analysts at State Street Corp. said. 'Criticism by the national media for their high-profile losses might even jeopardize their ability to take the long-term investment positions that have given them such a comparative advantage,' John Nugée, managing director...at...State Street, told reporters... Sovereign funds, together worth about $3.2 trillion, operate as government-owned, special purpose investment vehicles."

Crude Liquidity Watch:

August 17 - AFP: "Just one year ago, property prices in Dubai were surging to record peaks undeterred by a real estate slump in major markets, but they have since gone into freefall... Market watchers in the former Gulf boomtown differ slightly on the magnitude of the decline so far, but all seem to agree that the prices of Dubai property, which was selling unchecked over the past three years, should drop further."

The Depressed U.S. Consumer and Global Reflation

The global reflation thesis has been somewhat under fire of late. Chinese stocks dropped about 25% from trading highs set earlier this month. An abrupt slowdown in bank lending - and even discussion of more stringent bank capital requirements - has many now questioning the underpinnings of Chinese recovery. Here at home, a bevy of data on household spending, confidence, and job losses point to stubborn consumer frugality. Can global reflation make headway without a recovery in U.S. consumption?

As the year has progressed, optimistic adherents to the global reflation/recovery thesis have multiplied. Of late, however, the reflation protagonists have been roused. Many hold the view that the Chinese situation is much more tenuous than advertised. Moreover, this camp views global recovery as impossible in the era of the stingy American consumer. Talk of deflation risk has turned more boisterous.

My view differs from both the bullish consensus reflation viewpoint and that of the protagonists/ "deflationists." And, to cut to the chase, I do believe a period of global reflation can evolve in the face of weak U.S. consumption. And while a troubled bond market would likely stop reflation in it tracks, a downtrodden American consumer is an impediment to be hurdled with a powerful boost from ultra-easy global "money." Indeed, deep underlying U.S. fragility - and resulting market assurance that the Fed is indefinitely wedded to ultra-loose policy - is a critical facet of my global reflation thesis.

Fundamentally, it is my view that the nexus of global reflation emanates from irreparable structural impairment to the international dollar reserve system. The global dollar monetary "regime" some time back stopped functioning as a disciplining or restraining force for Credit systems around the world. Today, even in this nervous post-crisis landscape, the prospect of an unending expansion of dollar reserves works to foment synchronized Credit and speculative excesses. And the deeply maladjusted U.S. "Bubble" economy ensures heavy ongoing non-productive U.S. debt issuance that manifests as enormous trade and speculative dollar financial flows - to further inundate the saturated world. The unfolding breakdown in this dollar "system" is the genesis of global inflationary forces.

I've read and listened to the view that an imminent dollar rally will rejuvenate global deflation. And while the dollar and currency markets will surely fluctuate, I view nothing on the horizon that will alter the fundamental issue of massive outgoing dollar flows. Policymaking is now trapped in a scheme of promoting excess in the name of system stabilization. The Fed is poised to again retain a loose policy stance for a far too extended period, and there will be no let up in the massive issuance of federal (Treasury, agency, and GSE MBS) debt.

A central aspect of my global reflation thesis holds that China, Asia and the "emerging" economies are this cycle's "asset class" with the strongest inflationary biases - hence the areas most prone to immediate and spectacular inflationary manifestations. These "hot money" magnets then work to rejuvenate animal spirits throughout the global leveraged speculating community, with rapidly recovering Credit systems and economies spurring a more general rebound in global activity. The more commodity-oriented and manufacturing-driven economies are the first to benefit. The "services" and housing-centric U.S. economy badly lags in this reflationary scenario.

Many analysts that do recognize U.S. vulnerability also see troubling aspects to the Chinese economy and financial system. I see them also; they just don't alter my fear that China has likely entered a precarious period where Credit, speculation, and spending excesses tend to really run amuck.

Expect increasing concern from China's policymakers - and lots of tinkering (bank capital requirements, lending restraint pronouncements, warnings against speculation, interest-rate adjustments, etc.). And expect markets in China and around the world to grapple mightily with the course of Chinese policy responses. Keep in mind that the "terminal phase" of Credit Bubble excess is notorious for outflanking fainthearted policymaking. And it is indeed the acute financial, economic and social vulnerabilities that I suspect will restrain Chinese policymakers from applying the type of tough measures necessary to rein in (traditionally unwieldy) late-cycle excesses.

It is the combination of deep structural issues/vulnerabilities in the U.S. and China that have the reflation antagonists and deflationists energized. They see confirmation in their view from recent U.S. economic data and Chinese developments. Yet it remains a preeminent challenge of Credit Bubble analysis to recognize that fundamental issues can inhibit, repress and check excess - but there are circumstances when system maladjustment and fragility instead tend to cultivate a backdrop of policymaking and market tolerance.

As I've written over the years, major Credit Bubbles invariably evolve from some underlying source of Monetary Disorder. Stable and sound Credit systems are simply not breeding grounds for Bubbles. And the greatest Bubbles are fashioned when profound money and Credit distortions meld with policymaker confusion and acquiescence. As we've witnessed - at home, in China and around the world - acute financial and economic fragility has engendered a backdrop of unprecedented global policymaking accommodation. And predictably accommodating policymakers have cultivated an environment of synchronized global marketplace reflation accommodation.

It is with this analysis in mind that I am analytically forced to give global reflation a strong benefit of the doubt. I will be dismissive of deflation chatter as long as the markets readily accommodate Trillions of U.S. debt issuance here at home and tolerate excesses within domestic Credit systems across the globe. Today, the dollar index traded below 78 and crude traded above $74. The bond market is understandably unsettled. Ten-year yields traded at 3.72% on July 27, dropped to 3.48% on July 31, jumped to 3.85% on August 7, sank to 3.43% yesterday and closed today at 3.56%.

I'll posit that artificially low interest rates everywhere are global reflation's greatest champion. It is the nature of Bubbles that the longer markets misprice risk the greater the pain when the Bubble eventually bursts. Credit and market analysis could not be more challenging or fascinating.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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