The Beginning of Tightening?

By: Doug Noland | Fri, Feb 19, 2010
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For the week, the S&P500 jumped 3.0% (down 0.5% y-t-d), and the Dow rose 3.0% (down 0.3% y-t-d). The broader market continues to outperform. The S&P 400 Mid-Caps jumped 3.3% (up 1.9%), and the small cap Russell 2000 rose 3.3% (up 1.0%). The Banks surged 4.2% (up 9.2%), and the Broker/Dealers increased 2.9% (down 0.1%). The Morgan Stanley Cyclicals jumped 4.2% (unchanged), and Transports gained 3.5% (down 1.0%). The Morgan Stanley Consumer index gained 2.8% (up 0.6%), and the Utilities rose 3.6% (down 4.8%). The Nasdaq100 gained 2.4% (down 2.0%), and the Morgan Stanley High Tech index rose 2.8% (down 2.2%). The Semiconductors rallied 3.1% (down 4.5%). The InteractiveWeek Internet index rose 3.3% (down 1.3%). The Biotechs gained 3.2%, increasing 2010 gains to 8.8%. With bullion jumping $25, the HUI gold index rose 2.2% (down 4.5%).

One-month Treasury bill rates ended the week at 6 bps, and three-month bills closed at 10 bps. Two-year government yields jumped 9 bps to 0.87%. Five-year T-note yields rose 12 bps to 2.41%. Ten-year yields increased 8 bps to 3.78%. Long bond yields increased 5 bps to 4.70%. Benchmark Fannie MBS yields rose 13 bps to 4.47%. The spread between 10-year Treasury and benchmark MBS yields widened 5 to 69 bps. Agency 10-yr debt spreads narrowed 2 to 36 bps. The implied yield on December 2010 eurodollar futures rose 4 bps to 1.005%. The 10-year dollar swap spread increased 0.75 to 10.5, and the 30-year swap spread increased 1.5 to negative 12.5. Corporate bond spreads were mixed. An index of investment grade bond spreads narrowed 7 to 91 bps, while an index of junk spreads widened 15 to 537 bps.

Debt issuance was very light. Investment grade issuers included Hanover Insurance $200 million.

Junk bond funds saw outflows of $614 million. The list of junk issuers included Treehouse Foods $400 million.

I saw no converts issued.

International dollar debt issuers included UBS $2.0bn, Nationwide Building Society $1.5bn and Scotiabank Peru $125 million.

U.K. 10-year gilt yields jumped 13 bps to 4.17%, and German bund yields rose 9 bps to 3.28%. Bond yields in Greece surged 31 bps to 6.45%. The German DAX equities index rallied 4.0% (down 4.0% y-t-d). Japanese 10-year "JGB" yields were little changed at 1.33%. The Nikkei 225 increased 0.3% (down 4.0%). Emerging markets were mixed to higher. For the week, Brazil's Bovespa equities index jumped 3.9% (down 1.4%), and Mexico's Bolsa gained 3.8% (up 0.2%). Russia's RTS equities index jumped 3.6% (down 1.4%). India's Sensex equities index added 0.2% (down 7.3%). China's Shanghai Exchange was closed for Chinese New Year (down 7.9%). Brazil's benchmark dollar bond yields declined 3 bps to 5.15%, while Mexico's benchmark bond yields rose 2 bps to 5.12%.

Freddie Mac 30-year fixed mortgage rates declined 4 bps to a 10-week low 4.93% (down 11bps y-o-y). Fifteen-year fixed rates slipped one basis point to 4.33% (down 35bps y-o-y). One-year ARMs sank 10 bps to 4.23% (down 57bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 2 bps to 5.90% (down 115bps y-o-y).

Federal Reserve Credit jumped $31.0bn last week to a record $2.264 TN. Fed Credit was up $357bn, or 18.7%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 2/17) increased $2.8bn to $2.959 TN. "Custody holdings" expanded $383bn, or 14.9.%, over the past year.

M2 (narrow) "money" supply increased $14bn to $8.485TN (week of 2/8). Narrow "money" has declined $27bn y-t-d. Over the past year, M2 expanded 1.9%. For the week, Currency added $1.8bn, and Demand & Checkable Deposits increased $3.2bn. Savings Deposits rose $11.1bn, while Small Denominated Deposits declined $2.7bn. Retail Money Funds were up $0.5bn.

Total Money Market Fund assets (from Invest Co Inst) dropped $37bn to $3.161 TN. In the first seven weeks of the year, money fund assets have declined $133bn, with a one-year drop of $718bn, or 18.5%.

Total Commercial Paper outstanding increased $3.9bn last week to $1.138 TN. CP dropped $384bn over the past year (25.2%).

International reserve assets (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.091 TN y-o-y, or 16.2%, to $7.816 TN.

Global Credit Market Watch:

February 18 - Bloomberg (Tony Czuczka): "German Chancellor Angela Merkel said it would be a 'scandal' if banks helped Greece massage its budget, as European officials investigate Goldman Sachs Group Inc.'s role in Greek efforts to conceal the size of its deficit. 'It's a scandal if it turned out that the same banks that brought us to the brink of the abyss helped fake the statistics,' Merkel said... Greece 'falsified statistics for years.'"

February 16 - Bloomberg (Elisa Martinuzzi and Maria Petrakis): "A Greek government inquiry uncovered a series of swaps agreements with securities firms that may have allowed it to mask its growing debts. Greece used the swaps to defer interest repayments by several years, according to a Feb. 1 report commissioned by the Finance Ministry in Athens... The government turned to Goldman Sachs Group Inc. in 2002 to obtain $1 billion through a swap agreement, Christoforos Sardelis, head of Greece's Public Debt Management Agency between 1999 and 2004, said... 'While swaps should be strictly limited to those that lead to a permanent reduction in interest spending, some of these agreements have been made to move interest from the present year to the future, with long-term damage to the Greek state,' the Finance Ministry report said. The 106-page dossier is now being examined by lawmakers."

February 19 - Bloomberg (Sonja Cheung and Caroline Hyde): "Corporate bond sales in Europe declined to the lowest level this year as concern governments are struggling to control spiralling budget deficits prompted borrowers and investors to sit on the sidelines."

February 17 - Bloomberg (Wes Goodman): "China sold a record amount of U.S. debt, raising speculation it is turning bearish as President Barack Obama increases borrowing to unprecedented levels to sustain economic growth. The Asian nation's investment in U.S. government securities dropped by $34.2 billion in December to $755.4 billion... The decline is the most since Treasury data start in 2000. Japan's holdings rose 1.5% to $768.8 billion, making it America's largest creditor. China is reducing the amount of Treasuries in its record currency reserves after expressing concern about the amount the U.S. is borrowing to fund growing budget deficits."

February 18 - Bloomberg (Bryan Keogh and Patricia Kuo): "Debt used to fund buyouts is lagging behind the rest of the high-yield market as a slump in demand for initial public offerings thwarts efforts by private-equity firms to pare borrowings... At least 15 IPOs were postponed or withdrawn this year, bolstering concern private-equity firms won't be able to raise equity and slash debt from some of the $2 trillion of deals made since 2004."

February 16 - Bloomberg (Bryan Keogh): "Companies are pulling bond sales at the fastest pace since the credit markets seized up 2 1/2 years ago on concern that the inability of European governments to trim their budget deficits will threaten a global recovery. At least 16 borrowers including Montreal-based airplane maker Bombardier Inc. and Italian betting company Snai SpA have postponed or withdrawn $7.3 billion of debt sales over the past month... That's the most since more than 50 were canceled in the months after financial markets began to freeze in July 2007."

Global Government Finance Bubble Watch:

February 19 - Bloomberg (Paul Abelsky and Maria Levitov): "Russia's central bank cut its benchmark interest rate for the 11th time since April after earlier cuts proved insufficient to spur lending growth... Bank Rossii cut the refinancing rate a quarter of a point to a record low 8.5%..."

Currency Watch:

The dollar index added 0.4% this week to 80.575 (up 3.5% y-t-d). For the week on the upside, the Brazilian real increased 2.9%, the Australian dollar 1.2%, the Mexican peso 1.1%, the Canadian dollar 1.1%, the Swedish krona 0.5%, the South African rand 0.4%, and the New Zealand dollar 0.2% For the week on the downside, the Japanese yen declined 1.7%, the British pound 1.5%, the South Korean won 0.8%, the Norwegian krone 0.5%, and the Euro 0.1%.

Commodities Watch:

February 17 - Bloomberg (Katherine Burton and Glenys Sim): "Billionaire George Soros's Soros Fund Management LLC more than doubled its holding in the biggest gold exchange-traded fund in the fourth quarter... The $25 billion... firm became the fourth- largest holder in the SPDR Gold Trust, adding 3.728 million shares valued at $421 million... Soros joined China Investment Corp. and central banks including those in China and India in acquiring gold."

February 16 - Bloomberg: "China's iron ore imports from Australia rose 42.9% in 2009 to 260 million tons and imports from Brazil rose 41.5% to 140 million tons from a year earlier, the official Xinhua News Agency reported..."

The CRB index rallied 3.7% (down 2.0% y-t-d). The Goldman Sachs Commodities Index (GSCI) surged 5.3% (down 0.5% y-t-d). Gold gained 2.3% to $1,118 (up 1.9% y-t-d). Silver jumped 5.5% to $16.325 (down 3.1% y-t-d). March Crude jumped $5.79 to $79.92 (up 0.7% y-t-d). March Gasoline rose 8.4% (up 1.8% y-t-d), while March Natural Gas deflated 7.7% (down 9.5% y-t-d). May Copper rallied 8.6% (up 0.7% y-t-d). March Wheat increased 0.7% (down 9.6% y-t-d), while March Corn slipped 0.4% (down 13.1% y-t-d).

China Bubble Watch:

February 16 - UPI: "Expanding domestic demand and reducing reliance on exports will be part of the Chinese government's economic restructuring this year, state media said. A report... said the world's third largest economy will become a 'real tiger' as the country heralds the Chinese new lunar Year of the Tiger. The country faces mounting international pressure to appreciate its undervalued currency... The report said authorities have made the task of restructuring the economy a priority as called for by President Hu Jintao..."

February 16 - Bloomberg: "China's economy... may expand at a faster pace in 2010 even as officials cool lending to restrain inflation and avert asset bubbles. Goldman Sachs Group Inc. maintained its forecast for 11.4% growth after the central bank raised reserve requirements for lenders on Feb. 12. That compares with an 8.7% expansion last year."

Japan Watch:

February 16 - Bloomberg (Keiko Ujikane and Tatsuo Ito): "Japan's economy grew faster than economists anticipated last quarter, reducing the risk of falling back into a recession even as deflation intensifies. Gross domestic product rose at an annual 4.6% pace in the three months ended Dec. 31... Exports led the expansion, aided by a global recovery..."

India Watch:

February 18 - Bloomberg (Kartik Goyal): "India's food-price inflation climbed to the highest level in six weeks... An index measuring wholesale prices of lentils, rice, vegetables and other food articles compiled by the commerce ministry increased 17.97%... from a year earlier..."

February 16 - Bloomberg (Kartik Goyal): "India's inflation accelerated to a 15-month high in January... The benchmark wholesale-price index, measuring prices of rice, oil and manufactured products, climbed 8.56% from a year earlier..."

Asia Bubble Watch:

February 16 - Bloomberg (Shinhye Kang): "Industrial electricity sales in South Korea, Asia's fourth-biggest energy consumer, rose the most in almost 34 years after factories boosted output as the global economic recovery spurred demand for cars and steel. Sales jumped 24% by volume in January from a year earlier..."

Latin America Bubble Watch:

February 19 - Bloomberg (Jens Erik Gould): "Mexico's central bank kept its benchmark interest rate unchanged for a sixth straight meeting, saying that policy makers aren't seeing second-round inflation effects... The bank's five-member board... maintained borrowing costs at 4.5%..."

Unbalanced Global Economy Watch:

February 16 - Bloomberg (Alaric Nightingale and Alistair Holloway): "The fastest expansion in world trade in three years is clogging up ports from Australia to Brazil, driving a 32% jump in charter rates by December. The rate for leasing capesizes, boats three times the size of the Statue of Liberty, will average $39,000 a day in the fourth quarter, from $29,649 now, according to the median in a Bloomberg survey..."

February 17 - Bloomberg (Jennifer Ryan): "U.K. jobless claims unexpectedly jumped in January to the highest level since Tony Blair led the ruling Labour Party to power almost 13 years ago as the recession destroyed work at businesses from carmakers to banks."

February 16 - Bloomberg (Scott Hamilton): "U.K. inflation accelerated in January to the fastest pace in 14 months... Consumer prices rose 3.5% from a year earlier..."

U.S. Bubble Economy Watch:

February 18 - Bloomberg (Ryan J. Donmoyer): "The 400 highest-earning U.S. households reported an average of $345 million in income in 2007, up 31% from a year earlier, IRS statistics show. The average tax rate for the households fell to the lowest in almost 20 years... Each household in the top 400 of earners paid an average tax rate of 16.6%, the lowest since the agency began tracking the data in 1992..."

Central Bank Watch:

February 18 - Bloomberg (Vivien Lou Chen): "Federal Reserve Bank of St. Louis President James Bullard said he doesn't see a high probability the central bank will lift the federal funds rate this year and that the move may be put off until 2011. 'The idea that's in markets that there's a high probability that we'll raise rates later this year is overblown," Bullard said... 'There's a little bit of probability' and 'there's also some probability, maybe more, that this will extend into 2011.'"

February 18 - Bloomberg (Craig Torres): "Federal Reserve officials set a long-term goal to keep only U.S. government securities in their portfolio as they debated how and when to pull back on the most aggressive monetary policy in U.S. history. Central bankers are planning to eventually remove $1.43 trillion of housing debt from the balance sheet... Philadelphia Fed President Charles Plosser said... that the Fed's purchases of housing debt expose it to demands from politicians to support other industries. Some of the Fed's emergency actions 'blurred the line between monetary policy and fiscal policy, thereby increasing the risk to the Fed's independence,' Plosser said... 'These policies have veered toward deciding how public money should be allocated across firms and sectors of the economy.'"

February 15 - Bloomberg (Gabi Thesing): "European Central Bank Governing Council member Athanasios Orphanides said the bank will continue to support the economy even as it unwinds its emergency lending measures, suggesting interest rates may remain at a record low for some time. 'The phasing out of some unconventional measures should not be misinterpreted as a desire to remove policy accommodation from the economy,' Orphanides, who heads the central bank of Cyprus, said... 'Policy accommodation continues to be needed in light of the very subdued inflation outlook and the unevenness and weakness of the economy.'"

February 16 - Bloomberg (Jana Randow and Christian Vits): "Germany's Axel Weber leads the race to succeed Jean-Claude Trichet as president of the European Central Bank and Portugal's Vitor Constancio is likely to be his deputy, a survey of economists shows."

Real Estate Watch:

February 19 - Bloomberg (Kathleen M. Howley): "A record number of Americans were in danger of losing their homes in the fourth quarter... Loans in foreclosure rose to 4.58% of all mortgages, while those more than 90 days overdue... climbed to 5.09%..."

GSE Watch:

February 16 - Bloomberg (Jody Shenn): "Yields on Fannie Mae and Freddie Mac mortgage securities that guide U.S. home-loan rates fell to the lowest on record relative to Treasuries amid speculation that the government-supported companies' plan to buy delinquent loans out of their bonds will lead to reinvestment in the market. The difference between yields...narrowed about 0.01 percentage point to 0.64 percentage point..."

Fiscal Watch:

February 18 - Bloomberg (Darrell Preston and Nanette Byrnes): "U.S. states must contend with a more than $1 trillion gap between what they have saved and what they have promised to retired workers for pension and health-care benefits, the Pew Center on the States said... States have saved $2.35 trillion of the $3.35 trillion owed to workers as of mid-2008... The Washington-based group expects the deficit to grow..."

Muni Watch:

February 19 - Bloomberg (Christine Richard and Darrell Preston): "Forewarned bankruptcies linked to infrastructure projects from Las Vegas to Harrisburg, Pennsylvania, may prove Warren Buffett's conclusion that insuring municipal bonds is a 'dangerous business.' ...With state tax collections last year through September showing the biggest drop since at least 1963... local governments are seeking concessions from creditors of public projects, including bond insurers. The moves further threaten companies backing $1.16 trillion of public debt that already face $11.6 billion of claims on collapsed securities backed by mortgages."

February 18 - Bloomberg (Terrence Dopp): "New Jersey Transit riders may face fare increases of as much as 30% by May as the third- busiest U.S. transit system confronts a $300 million deficit for the coming year, Executive Director James Weinstein said... The agency is also examining the elimination of bus and rail routes, as well as staff and salary reductions to limit the boost in ticket prices..."

Crude Liquidity Watch:

February 18 - Bloomberg (Henry Meyer): "Qatar's gross domestic product will grow by 18.5% this year as gas exports increase, leaving the economy at risk of overheating in the medium term, the International Monetary Fund said."

February 15 - Bloomberg (Jeran Wittenstein and Shamim Adam): "Saudi Arabia's credit rating was raised by Moody's... which cited 'strong' government finances that have withstood volatile oil prices and the global recession."

 

The Beginning of Tightening?

The Bernanke Fed surprised the markets with a Thursday, late-afternoon hike/"normalization" in the Discount Rate. The marketplace had been forewarned, yet participants weren't sure what to make of such unconventional timing. Markets are unsettled and leery of uncertainty. In after-market trading, stock futures retreated, the dollar rallied, and fixed-income instruments were under some pressure. The immediate market reaction was to assume that this was the beginning of "tightening." Focusing on what they do rather than what they say, there isn't much to indicate any intention on the Fed's part to actually tighten financial conditions.

Around the time of its discount rate announcement, the Federal Reserve released its February 18, 2010 "H.4.1" statistical release. Examining the data, the Fed certainly did not retreat from its aggressive securities market interventions. For the week ended February 18, 2010, "Averages of daily figures" for "[Federal] Reserve Bank Credit" jumped a notable $30.99bn to a record $2.264 TN. "Securities held outright" jumped $53.633bn for the week to a record $1.967 TN, with "Mortgage-backed securities" up $53.2bn to a record $1.025 TN.

Year-over-year, Fed Credit was up "only" $356.9bn. Take note, however, of the major changes to the composition of Fed holdings. Over the past year, emergency "Term auction Credit" dropped $432.1bn to only $15.4bn. "Net holdings of Commercial Paper Funding Facility LLC" fell $242.6bn to $7.7bn. And "Central bank liquidity swaps," another crisis-induced arrangement, shrank $379.7bn to almost zero. The Fed has wound down these emergency liquidity support programs.

Meanwhile, Federal Reserve security holdings have ballooned in historical fashion over the past year. "Securities held outright" jumped an incredible $1.397 TN from a year earlier. "Mortgage-backed securities" accounted for $961.5bn of this expansion, followed by a $296.0bn increase in U.S. Treasury "Notes and bonds...", and a $133.3bn increase in "Federal Agency debt securities." Since September 2008, Fed holdings of agency (debt and MBS) securities have grown from zero to $1.119 TN.

One advantage of announcing its move after the U.S. market close was that it afforded various Fed officials extra hours to comfort the markets before the resumption of trading. Federal Reserve Bank President Dennis Lockhart said "not to interpret this action as a tightening or even a sign that a tightening is imminent." James Bullard, President of the St. Louis Fed, commented that the announcement "does not indicate anything one way or another about what we might eventually do with the fed funds rate." He added: "The idea that's in markets that there's a high probability that we'll raise rates later this year is overblown."

The markets don't seem all that worried about imminent tightening. The December 2010 fed funds futures contract closed today with an implied yield of 0.615%, up 3.5 bps on the week but still down considerably from where it began the year (1.095%). The December 2011 contract closed today at 2.53% - not exactly discounting "tight money."

I find it difficult to take talk of an "exit strategy" seriously when the Fed continues to purchase tens of billions of marketable securities. Why can't they wind down the MBS purchases early (scheduled to end in March at $1.25 TN)? Apparently, the Fed's immediate objective remains to ensure that markets remain highly liquid. They may discuss various future methods to ensure that the massive liquidity pool does not turn inflationary, but the marketplace is not really fooled. Markets see ultra-easy "money" indefinitely.

With gold back above 1,100 and crude in the neighborhood of $80, perhaps the Fed felt compelled to do something. My own view (shared by many) is that they have no intention of implementing true tightening. Their massive securities purchases have injected unprecedented liquidity into the system - and it will likely be years before these positions are reversed.

I'll assume that the Bernanke Fed is enthralled with the idea of an enormous liquidity cushion backstopping the system against future runs on banks, financial institutions, short-term financing markets, etc. With over a Trillion dollars of "excess reserves," there is today little fear of a renewed liquidity crisis. Rather, worry revolves around the ramifications of the Fed moving to withdraw this liquidity bonanza or that these "reserves" might somehow fuel an inflationary lending boom. It seems to me that the "academics" worry more about an inflationary surge while the markets worry more about the Fed reversing course and emptying the punchbowl. So the innovative Bernanke Fed confronts an interesting challenge and delicate balancing act.

My hunch is that the Fed's primary objective is to design new monetary doctrine and strategy that provides somewhat the appearance of traditional tightening but without any meaningful impact on its New Age Systemic Liquidity Backstop. The Fed wants to maintain excessively liquefied markets, but at the same time convince the marketplace that they have this liquidity very well contained. It's there as a protective measure, and the Fed will ensure it doesn't turn problematic. The marketplace, generally fixated on liquidity and sanguine on inflation, is these days unusually receptive to avant-garde policymaking.

The Fed has signaled that it is essentially scrapping its previous policy of carefully managing a targeted "fed funds rate" - or essentially the overnight rate for the inter-bank/financial institution lending market. Traditionally, the Fed would manage the fed funds rate to its target level by adding or subtracting system liquidity. With the Trillion or so of Fed-induced excess reserves, it is no longer practical for the Fed to manage the overnight rate as it has in the past. Time for new doctrine.

The Fed certainly wants to avoid being in a position where it would have to withdraw huge amounts of liquidity to force the fed funds rate up to some targeted level. And our central bank is very focused on not putting the funds market in a situation where imminent Fed liquidity withdrawal causes a fearful market to preempt the Fed. At the same time, the Bernanke Fed certainly doesn't want to get out of the business of manipulating market expectations.

So the Bernanke Fed has apparently devised a new rate target - the rate it will pay banks on excess reserve holdings. We'll have to wait for additional details, as well as to see how this new monetary regime works in practice. From what I've read so far, it has the appearance of a handy expedient; a tool similar in form to the fed funds target rate - but without the baggage of an implied policy of managing the rate through the addition or, more importantly, removal of Fed liquidity. The Fed hopes to have the luxury of raising the rate it pays on reserves held at the Federal Reserve, without forcing the system-wide overnight funds rate higher. The Fed would today certainly prefer to separate the tasks of raising rates and removing system liquidity and, once apart, implement respective "tightenings" at varying paces (rates up very slowly... liquidity removal even slower).

Certainly not without justification, the markets came to the recognition that yesterday's increase in the discount rate did not signal any imminent tightening of financial conditions. It will be interesting to see if the markets eventually end up calling a bluff on Fed "exit" policies more generally.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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