A Prominent Indicator of Financial Conditions

By: Doug Noland | Sat, Jun 19, 2010
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For the week, the S&P500 jumped 2.4% (up 0.2% y-t-d), and the Dow gained 2.3% (up 0.2%). The S&P 400 Mid-Caps rallied 2.1% (up 6.6%), and the small cap Russell 2000 jumped 2.7% (up 6.6%). The Morgan Stanley Cyclicals gained 2.4% (up 4.0%), and the Transports jumped 2.6% (up 8.1%). The Morgan Stanley Consumer index increased 1.7% (up 1.7%), and the Utilities surged 4.0% (down 3.1%). The Banks rose 2.3% (up 17.2%), while the Broker/Dealers slipped 0.4% (down 7.7%). The Nasdaq100 surged 3.6% (up 2.9%), and the Morgan Stanley High Tech index gained 3.1% (down 1.6%). The Semiconductors jumped 6.2% (up 3.1%). The InteractiveWeek Internet index gained 2.4% (up 4.4%). The Biotechs rose 2.9%, boosting 2010 gains to 16.6%. With bullion surging $29.50 to a new record high, the HUI gold index jumped 6.8% (up 14.8%).

One-month Treasury bill rates ended the week at 2 bps and three-month bills closed at 9 bps. Two-year government yields slipped 2 bps to 0.68%. Five-year T-note yields declined 2 bps to 1.98%. Ten-year yields dipped one basis point to 3.23%. Long bond yields were little changed at 4.15%. Benchmark Fannie MBS yields declined 2 bps to 3.95%. The spread between 10-year Treasury yields and benchmark MBS yields narrowed one to 72 bps. Agency 10-yr debt spreads narrowed 3 bps to 30 bps. The implied yield on December 2010 eurodollar futures declined one basis point to 0.80%. The 10-year dollar swap spread dropped 4.75 to 5.25. The 30-year swap spread declined 4.0 to negative 19.5. Corporate bond spreads were mixed. An index of investment grade spreads narrowed 10 to 114 bps, while an index of junk bond spreads widened 42 to 652 bps

Debt issuance pickup up a little. Investment grade issuers included Bank of America $3.0bn, JPMorgan Chase $1.25bn, Prudential $1.0bn, Genzyme $1.0bn, Lincoln National $750 million, Donnelley & Sons $400 million, Caterpillar $300 million, Pall Corp $375 million, Avnet $300 million, Western Union $250 million and San Clemente Leasing $190 million.

Junk issuers included TMX Financial $250 million and Citco Petroleum $300 million.

Converts issues included Health Care REIT $300 million.

International dollar debt sales included Total Capital $2.5bn, Teva Pharma $2.5bn, Toyota Motor Credit $2.0bn, International Bank of Reconstruction & Development $2.0bn, and MTS International $750 million.

U.K. 10-year gilt yields jumped 8 bps to 3.54%, and German bund yields surged 16 bps to 2.73%. Greek 10-year bond yields jumped 124 bps to 9.42%, and 10-year Portuguese yields rose 50 bps to 5.59%. The German DAX equities index rallied 2.8% (up 4.4% y-t-d). Japanese 10-year "JGB" yields declined 3 bps to 1.20%. The Nikkei 225 jumped 3.0% (down 5.2%). Emerging markets were mostly higher. For the week, Brazil's Bovespa equities index increased 1.3% (down 6.1%), and Mexico's Bolsa rose 2.1% (up 2.2%). Russia's RTS equities index surged 4.1% (down 2.2%). India's Sensex equities index gained 3.0% (up 0.6%). China's Shanghai Exchange fell 2.2% (down 23.3%). Brazil's benchmark dollar bond yields dropped 20 bps to 4.74%, while Mexico's benchmark bond yields fell 13 bps to 4.70%.

Freddie Mac 30-year fixed mortgage rates increased 3 bps last week to 4.75% (down 63bps y-o-y). Fifteen-year fixed rates rose 3 bps to 4.20% (down 69bps y-o-y). One-year ARMs sank another 9 bps to 3.82% (down 113bps y-o-y), the lowest level since 2004. Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up one basis point to 5.58% (down 99bps y-o-y).

Federal Reserve Credit expanded $8.3bn last week to $2.322 TN. Fed Credit was up $102bn y-t-d (9.9% annualized) and $267bn, or 13.0%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 6/16) increased $4.0bn to a record $3.080 TN. "Custody holdings" have increased $125bn y-t-d (9.1% annualized), with a one-year rise of $328bn, or 11.9%.

M2 (narrow) "money" supply increased $7.3bn to $8.602 TN (week of 6/7). Narrow "money" has increased $90bn y-t-d. Over the past year, M2 grew 2.0%. For the week, Currency added $0.4bn, while Demand & Checkable Deposits declined $10.5bn. Savings Deposits jumped $19bn, while Small Denominated Deposits fell $3.7bn. Retail Money Fund assets gained $2.2bn.

Total Money Market Fund assets (from Invest Co Inst) dropped $34.5bn to $2.806 TN. In the first 24 weeks of the year, money fund assets sank $488bn, with a one-year decline of $869bn, or 23.6%.

Total Commercial Paper outstanding jumped $18.8bn last week to $1.083 TN. CP has declined $87bn, or 16.1% annualized, year-to-date, and was down $119bn from a year ago (9.9%).

International reserve assets (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.535 TN y-o-y, or 22.6%, to $8.328 TN.

Global Credit Market Watch:

June 15 - Bloomberg (Meera Louis): "Spain and Portugal need additional budget cuts to meet deficit targets announced a month ago even as their efforts to tame their shortfalls threaten to choke growth and produce a 'snowball' effect on their debt levels, according to a draft European Commission document... Spain pledged to cut the EU's third-highest deficit to 9.3% of gross domestic product this year and 6% in 2011. Portugal said it would reduce its shortfall to 7.3% of GDP in 2010 and 4.6% in 2011."

June 15 - Bloomberg (Abigail Moses): "Greek credit swaps signal a 48% probability the nation will default within five years after its debt was cut to junk by Moody's... The cost of insuring $10 million of Greece's bonds for five years jumped $43,500 to $799,000 a year, making the nation's debt the third most expensive to protect after Venezuela and Argentina, according to CMA DataVision."

June 14 - Bloomberg (Gavin Finch and John Glover): "European banks at risk of writedowns from the sovereign debt crisis face a funding squeeze that may depress earnings, curb lending and imperil economic recovery in the region. Investors are shunning bank securities on concern Greek, Portuguese and Spanish bonds held by the lenders will plunge in value. Bank bond sales slowed in May to the lowest since Lehman Brothers Holdings Inc.'s failure in 2008... 'There is a lot of mistrust,' said Christoph Rieger, co- head of fixed-income strategy at Commerzbank... 'Banks are trading with the ECB rather than with each other.' The central bank is preventing a crisis by providing banks with unprecedented funding. In substituting long-term money with shorter-maturity ECB cash, policymakers are making it harder to wean banks off life support as well as the short-term financing that regulators blame for the credit crisis."

June 14 - Bloomberg (Ben Moshinsky): "National regulators may be given 'emergency powers' to 'prohibit or restrict' naked credit- default swaps trades, under proposals being considered by the European Union in the wake of the region's debt crisis. The measures would be 'temporary in nature and subject to coordination' by the European Securities and Markets Authority, the European Commission said... The European Parliament is also scheduled to vote tomorrow on separate proposals to restrict trading in credit-default swaps. French President Nicolas Sarkozy and German Chancellor Angela Merkel called on the commission last week to speed up curbs on financial speculation..."

June 17 - Bloomberg (Maria Petrakis and Paul Tugwell): "Greece's unemployment rate rose in the first quarter to a 10-year high... The jobless rate rose to 11.7%... from 9.3%..."

June 14 - Financial Times (Kerin Hope): "China is eyeing investments valued at several billion euros in Greek shipping, logistics and airport projects to be discussed during the second visit to Athens in four weeks by a high-ranking Beijing official... A delegation led by Zhang Dejiang, a Chinese vice-premier, will seal a series of agreements on Tuesday with local companies, a Greek government official said."

June 16 - Bloomberg (Gregory Viscusi and Helene Fouquet): "French President Nicolas Sarkozy's government said it will raise the retirement age and increase taxes on capital, seeking to stem losses in the pension system and safeguard the nation's top credit rating. The retirement age will rise to 62 by 2018 from 60... The government will increase taxes on stock options, dividends and capital gains, and will raise the top income-tax rate a percentage point to 41%... 'There is no trick,' Woerth told reporters... 'We can't promise to work less, raise pensions and erase deficits.'"

June 16 - Bloomberg (Katrina Nicholas): "A wave of maturing debt may 'wash away' some speculative-grade U.S. companies as Europe's sovereign crisis pushes up borrowing costs and credit markets freeze, according to Standard & Poor's. Junk-rated borrowers led by 'consumer-dependent companies' will struggle to 'refinance at the rates they'll need for long-term survival, if they can find financing at all,' S&P said... U.S. non-financial corporate borrowers have more than $1.7 trillion of bonds and loans due from 2011 through 2014, and those rated BB+ or below may 'encounter serious hurdles to their refinancing needs,' S&P managing director John Bilardello said..."

June 16 - Bloomberg (Jesse Westbrook and Otis Bilodeau): "Congress's proposed overhaul of U.S. bank regulation wouldn't have averted the 2008 financial crisis and does too little to prevent a recurrence, two former chairmen of the Securities and Exchange Commission said.... Congress failed to address emerging threats, such as abuses in the municipal-bond market, that might trigger the next meltdown, said Arthur Levitt, who was SEC chairman from 1993 to 2001. 'There was massively too much leverage within the financial system,' Breeden said... 'Regulators had the authority to control that and eliminate it. We can keep passing laws, but if the regulators don't have the backbone to enforce the rules and to be realistic, then that's a different problem.'"

Global Government Finance Bubble Watch:

June 15 - Bloomberg (Esteban Duarte): "The European Central Bank increased funding for Spanish lenders to a record 85.6 billion euros ($104.6bn) in May as investors shun the nation's banks."

Currency Watch:

June 16 - Bloomberg (Paul Abelsky and Maria Levitov): "Russia may add the Australian and Canadian dollars to its international reserves for the first time after fluctuations in the U.S. dollar and euro. 'Adding the Australian dollar is being discussed,' Alexei Ulyukayev, the central bank's first deputy chairman, said... 'There are pros and cons. We have added the Canadian dollar but haven't yet begun operations' with the currency."

The dollar index dropped 2.2% to 85.58 (up 9.9% y-t-d). For the week on the upside, the Swiss franc increased 3.7%, the South Korean won 3.6%, the Australian dollar 2.6%, the New Zealand dollar 2.5%, the South African rand 2.4%, the Swedish krona 2.4%, the Euro 2.3%, the Danish krone 2.3%, the Brazilian real 2.2%, the British pound 1.9%, the Norwegian krone 1.5%, the Singapore dollar 1.2%, the Canadian dollar 1.1%, the Japanese yen 1.1%, the Mexican peso 0.8% and the Taiwanese dollar 0.7%.

Commodities Watch:

June 18 - Bloomberg (Pham-Duy Nguyen): "Gold futures rose to a record $1,263.70 an ounce in New York as Europe's fiscal woes and dimming prospects for the U.S. economy prompted investors to step up purchases of bullion as an alternative asset... 'The problems over in Europe are just as pernicious over here in the U.S.,' said Michael Pento, the chief economist at Delta Global Advisors Inc. 'You can't trust sovereign debt and sovereign currency. Gold is the only real honest money that we have.'"

June 15 - Financial Times (Javier Blas): "Food commodity prices will increase more than previously expected in the next decade because of rising energy prices and developing countries' rapid growth, two leading organisations said... Higher crude oil prices would add force to rising agricultural commodities prices, particularly in those regions... where energy inputs such as fertilisers were used intensively..."

June 15 - Bloomberg (Tony C. Dreibus): "Oat futures soared the most in five years on speculation that heavy rain will result in reduced acreage and lower yields in Canada... Prices surged 41% in the past six sessions... Wet weather will cut the area planted with all spring crops by as much as 12.5 million acres, the Canadian Wheat Board said last week. The excessive precipitation may also cause yields to fall..."

The CRB index rallied 2.7% (down 7.2% y-t-d). The Goldman Sachs Commodities Index (GSCI) jumped 3.5% (down 2.7% y-t-d). Spot Gold gained 2.4% to $1,256 (up 14.5% y-t-d). Silver surged 5.2% to $19.175 (up 13.8% y-t-d). July Crude rose $3.53 to $77.31 (down 2.6% y-t-d). July Gasoline gained 5.2% (up 5% y-t-d), and July Natural Gas rose 4.9% (down 10% y-t-d). July Copper slipped 0.3% (down 13% y-t-d). July Wheat rallied 4.8% (down 15% y-t-d), and July Corn increased 3.2% (down 13% y-t-d).

China Watch:

June 15 - Bloomberg: "China's banking regulator said it sees growing credit risks in the nation's real-estate industry and warned of increasing pressure from non-performing loans. Risks associated with home mortgages are growing and a 'chain effect' may reappear in real-estate development loans, the China Banking Regulatory Commission said... Property-price gains spurred concerns that a record 9.59 trillion yuan ($1.4 trillion) of loans extended last year to combat the effects of the global financial crisis may be causing asset bubbles."

June 17 - Bloomberg (Simon Packard): "China overtook Hong Kong as the world's hottest housing market in the first quarter, with prices rising at more than double the rate of anywhere else, property adviser Knight Frank LLP said. Values soared 68% in China's main cities from a year earlier..."

Japan Watch:

June 15 - Bloomberg (Mayumi Otsuma and Keiko Ujikane): "Bank of Japan Governor Masaaki Shirakawa widened efforts to support economic growth even as he signaled that the export-led recovery is beginning to feed through to households and companies. 'We are seeing signs that the increase of exports and output is starting to spread to private domestic demand,' Shirakawa said... after his policy board unveiled a 3 trillion yen ($33 billion) program aimed at encouraging lending to businesses."

India Watch:

June 15 - Bloomberg (Unni Krishnan): "India's inflation unexpectedly accelerated in May... The benchmark wholesale-price index advanced 10.16% from a year earlier..."

Asia Bubble Watch:

June 17 - Bloomberg (Shamim Adam and Malcolm Scott): "From Shanghai to Singapore, policy makers are struggling in their efforts to curb property bubbles that threaten to derail the world's fastest growing region. In China, home prices are surging at a record pace even after authorities set price ceilings, demanded higher deposits, and limited second-home purchases. In Hong Kong... a site auctioned on June 8 fetched the most since the market peak of 1997. It's a similar story in Singapore and Taiwan as prices defy cooling measures. 'Governments allow the property bubble to get so big and then try to use administrative measures to keep out speculators,' said Andy Xie, former Morgan Stanley chief economist for Asia-Pacific... 'It creates the risk of a very hard landing. The right thing to do is raise interest rates.'"

Latin America Watch:

June 16 - Bloomberg (Eliana Raszewski): "Argentine labor leaders are demanding the biggest wage increases in more than 15 years to compensate for inflation they say is running at more than three times the official rate of 10.7% a year. In the past month, sugar-cane harvesters won a 43% pay rise, cafeteria employees 35% and janitors 28%. Union leader Osvaldo Iadarola, who represents 20,000 telephone workers... said he is seeking a 35% increase, along with the right to ask for more in six months if prices continue to rise."

June 14 - Bloomberg (Jens Erik Gould): "Mexican production of cars and light trucks rose in May from the same month a year earlier... Output of vehicles increased 65% to 178,738 units last month..."

Unbalanced Global Economy Watch:

June 16 - Financial Times (Ben Hall): "The French government... unveiled plans to raise the retirement age from 60 to 62 and increase taxes on business and the wealthy to eliminate a gaping hole in France's pay-as-you-go pension system... President Nicolas Sarkozy hopes the move will help to reassure financial markets and key partners, especially Germany, about France's commitment to long-term fiscal discipline."

June 14 - Bloomberg (Johan Carlstrom): "Swedish unemployment fell for a fourth month in May... The non-seasonally adjusted rate, as measured by the number of people claiming benefits, fell to 4.5% from a revised 4.8% the previous month..."

U.S. Bubble Economy Watch:

June 16 - Bloomberg (Hugh Son): "Warren Buffett... said he's giving [his wealth] away because he benefited from a U.S. economy that produces 'wildly capricious' results... 'My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well... I've worked in an economy that rewards someone who saves the lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect the mispricing of securities with sums reaching into the billions. In short, fate's distribution of long straws is wildly capricious.'"

Central Bank Watch:

June 18 - Bloomberg (Christian Vits, Jana Randow and Richard Tomlinson): "On May 10, just hours after the European Central Bank stepped into government bond markets for the first time, Axel Weber broke ranks with most of his colleagues on the ECB's Governing Council -- including his boss, President Jean-Claude Trichet. 'The purchase of government bonds poses significant stability risks, and that's why I'm critical of this part of the ECB council's decision,' said Weber, president of Germany's Bundesbank."

June 15 - Wall Street Journal (Jon Hilsenrath): "Federal Reserve officials are beginning to debate quietly what steps they might take if the recovery surprisingly falters or if the inflation rate falls much more. Fed officials... believe a durable recovery is on track and their next move -- though a ways off -- will be to tighten credit, not ease it further. Fed Chairman Ben Bernanke has played down the risk of a double-dip recession and signaled guarded confidence in the recovery."

GSE Watch:

June 14 - Bloomberg (Lorraine Woellert and John Gittelsohn): "The cost of fixing Fannie Mae and Freddie Mac... will be at least $160 billion and could grow to as much as $1 trillion after the biggest bailout in American history... 'It is the mother of all bailouts,' said Edward Pinto, a former chief credit officer at Fannie Mae..."

June 16 - Bloomberg (Lorraine Woellert): "Fannie Mae and Freddie Mac were told by their regulator to delist their common and preferred stock from the New York Stock Exchange... The U.S. Treasury had injected $145 billion into the companies to keep them solvent as of the first quarter of this year."

Fiscal Watch:

June 18 - Bloomberg (Jacob Greber): "Former Federal Reserve Chairman Alan Greenspan said the U.S. may soon face higher borrowing costs on its swelling debt and called for a 'tectonic shift' in fiscal policy to contain borrowing. 'Perceptions of a large U.S. borrowing capacity are misleading,' and current long-term bond yields are masking America's debt challenge, Greenspan wrote in an opinion piece posted on the Wall Street Journal's website. 'Long-term rate increases can emerge with unexpected suddenness,' such as the 4 percentage point surge over four months in 1979-80, he said."

June 15 - Bloomberg (Brian Faler): "Voters are forcing Democrats into an election-year equation they may be unable to solve: How to spend more money to create jobs and at the same time reduce the deficit. Democrats have abandoned billions of dollars in proposed jobs initiatives to avoid adding to the deficit, risking that a pending bill may now seem ineffective to the 15 million unemployed. To further cut costs, they added more than $50 billion in taxes on buyout managers, oil companies and other businesses, seized upon by Republicans as job killers. Yet there are few signs Democrats' contortions to avoid adding to the deficit are winning over voters, especially when the savings are compared with this year's $1.5 trillion shortfall. 'We're in a vise,' said Representative Gerald Connolly... 'It's a real dilemma.'"

California Watch:

June 16 - Bloomberg (Michael B. Marois): "California lawmakers are poised to miss a constitutional deadline to send a fiscal 2011 budget to Governor Arnold Schwarzenegger as they remain at odds on erasing a $19.1 billion deficit."

June 16 - Bloomberg (Michael B. Marois): "California, already facing a $19.1 billion budget deficit, will have to pay 18% more in retirement costs for government workers to the California Public Employees' Retirement System... The fund's 13-member board voted today to boost the state's contribution by $600.7 million, to $3.9 billion... Fund managers said an increase is needed after a 24% drop in asset value in the past fiscal year and because of higher benefit costs as retirees live longer."

New York Watch:

June 16 - Bloomberg (Michael Quint): "New York Governor David Paterson set a June 28 deadline for an accord on the state's overdue budget and said if lawmakers don't cooperate he will submit an emergency bill that would have to be passed or else government would shut down...Lawmakers, under pressure from Paterson, have passed 11 consecutive weekly spending bills that trimmed the $9.2 billion deficit in the governor's $135.2 billion budget to about $8.1 billion."

Muni Watch:

June 16 - Bloomberg (Allison Bennett): "Illinois, whose projected deficit equals half its proposed $25.9 billion budget, sold $455.1 million in sales tax-backed bonds yesterday, as investors demanded higher yields from the state... The state's debt servicing on the bonds has priority over the general fund for the sales-tax revenue."

June 14 - Wall Street Journal (Ianthe Jeanne Dugan): "Investors are ignoring warning signs in the $2.8 trillion municipal-bond market, raising the risk of a reckoning, according to some market specialists. Numerous municipalities are struggling financially. A Rhode Island city recently said it faces insolvency. Harrisburg, the capital of Pennsylvania, is considering a municipal-bankruptcy filing. And famed investor Warren Buffett recently warned of a 'terrible problem' ahead for municipal bonds. But municipal-bond prices aren't reflecting much concern."

Speculator Watch:

June 18 - Bloomberg (Bradley Keoun): "Citigroup Inc. plans to raise more than $3 billion for its private-equity and hedge funds, even as U.S. lawmakers consider banning banks from owning and investing in so-called alternative funds, people with direct knowledge of the plan said. Citi Capital Advisors, which oversees about $14 billion, may seek $1.5 billion for private equity this year and $750 million for hedge funds, said the people, who declined to be identified because the plans aren't public. An additional $1 billion is targeted next year for hedge funds, the people said."


A Prominent Indicator of Financial Conditions

I would like to follow up on last week's examination of the Fed's "flow of funds" data with more focus on Financial Conditions. Over the past seven quarters (back to Q2 2008), Federal borrowings have increased $3.274 TN, or 49%, to $9.972 TN. Over the same period, GDP increased $104bn, or 0.7%, to $14.601 TN. This massive fiscal expansion was instrumental in stabilizing the economy. It certainly wasn't the only factor.

In just 21 months, Federal Reserve assets expanded $1.387 TN, or 146%, to $2.339 TN. Of course, the Fed also stoked ultra-loose financial conditions when it dropped short-term interest-rates to near zero. From the high in January 2009, Money Market Fund Assets declined $1.1 TN, an unprecedented outflow of finance upon global risk markets. Renewed Risk Embracement by the global leveraged speculating community played a pivotal role in loosening Financial Conditions, although there is little transparency when it comes to securities leveraging, "carry trades," sophisticated derivatives and other global sources of finance for speculation.

From crisis lows to this past April's highs, the S&P500 rallied more than 80%. The broader market was even stronger, with the S&P400 Mid-caps and Russell 2000 small cap indices more than doubling. The Morgan Stanley Retail Index almost tripled from lows, and the S&P Regional bank index surged 250%. Commodities indices rallied almost 50%. Synchronized fiscal and monetary stimulus propelled spectacular equity and debt market reflation across the globe. Confidence, right along with faith in policymakers, skyrocketed.

I have posited that the policy response to the bursting of the Wall Street/mortgage finance Bubble unleashed the Global Government Finance Bubble. It now appears that the Greek debt crisis will mark a key Bubble inflection point.

From a market perceptions point of view, it's a changed world. Faith in government policymaking has been badly shaken. Confidence that fiscal and monetary stimulus ensures ongoing global reflationary forces has waned. Markets now appreciate that massive stimulus can't assure market stability. Indeed, further deterioration in government finances is now recognized as creating instability, uncertainty, and heightened systemic risk throughout the markets. The world will now look at structural debt issues in a much less positive light.

From a flow of funds perspective, one can identify four key sources of finance that propelled the recent 18-month reflationary period. First, recall that federal liabilities increased about $340bn in 2007. This debt growth ballooned to $1.63 TN annualized during the first quarter and averaged about $1.60 TN annualized over the past six quarters. Second, reflation was fueled by Federal Reserve monetization - especially the $1.2 TN increase in agency debt/MBS holdings over the past five quarters. Third, zero rates encouraged a massive flow out of relative safety in search of higher returns. Fourth, there was the critical - if not transparent - re-risking and leveraging for the hedge funds, sovereign wealth funds and other global speculators.

All four of these critical sources of reflationary finance now have issues. Alan Greenspan's op-ed piece in today's Wall Street Journal - "U.S. Debt and the Greece Analogy" - highlights the newfound attention to our nation's structural debt predicament. Though I'll somewhat reserve judgment until the next crisis or economic downturn, the political pendulum appears to have swung decisively against additional bailouts, stimulus measures or other programs that would worsen our dismal fiscal situation. Staggering amounts of government spending stabilized the system, while it increasingly appears we will garner few additional "benefits" from double-digit percentage-to-GDP deficits.

Similarly, caution is the watchword when it comes to anticipating additional benefits from monetary policy. Granted, the Fed is likely stuck in the vicinity of zero indefinitely. I am nonetheless skeptical that this necessarily equates to ongoing ultra-loose financial conditions. I would argue that the Trillion-plus purchases of MBS had a momentous impact on marketplace liquidity, especially when it came to unfreezing the private-label MBS marketplace. I expect a divided Fed to approach any additional monetization of MBS cautiously. Slashing rates certainly has a powerful impact when it comes to inciting Risk Embracement and asset inflation. I don't, however, anticipate that zero rates will have a great expansionary influence in a period of renewed risk aversion and faltering markets. Looking at this issue from the Household sector perspective, zero rates can have varying benefits as well as costs. On the back of surging securities prices, Household net worth jumped $6.30 TN over the past year (ended 3/31). Previous low rate environments saw households enjoy huge housing wealth effects, including the free-flowing extraction of (inflating) home equity. Near zero returns on household savings may not be a big issue when assets markets are rapidly inflating and households are tapping cheap sources of borrowings. But that's not the likely backdrop going forward. Instead, zero rates may prove an impediment to consumption after this cycle's atypical (especially in regard to housing and private-sector Credit expansion) reflationary dynamics have run their course.

I'll be surprised if the wall of liquidity fleeing low returns isn't in the process of slowing toward a trickle - or perhaps even reversing. Especially with the continued drag from weak housing and jobs markets, the household sector is not favorably positioned to take on additional market risk.

I would find it very surprising if the European debt crisis did not mark a key inflection point for the global leveraged speculating community. Painful (and highly correlated) losses in debt, currency, equities and commodities markets would seem to ensure heightened risk aversion going forward. Clearly, sovereign debt has a greater degree of risk than was perceived in the marketplace prior to the Greek eruption. A more cautious approach to "carry trades" (i.e. borrowing in yen or dollars to purchase higher-yielding instruments in other currencies) and leverage more generally seems certain. This equates to more challenging marketplace liquidity and tighter financial conditions.

Prior to Greece, market perceptions held that aggressive global fiscal and monetary stimulus ensured highly-liquid markets that would demonstrate strong inflationary biases. Virtually across the board, global risk assets were robust. Not surprisingly, seemingly endless financial flows into the speculative markets distorted risk perceptions. Nowhere was this more apparent than in the markets for Credit default protection.

Prior to Greece, risk insurance was cheap - insurance protecting against sovereign debt, corporate and municipal bonds, Credit instruments generally, equities and overall systemic risk. Importantly, the perception of inexpensive and highly liquid market insurance spurred risk-taking and self-reinforcing leveraged speculation. The abrupt dislocation in Greek and, only somewhat later, European Credit default swap (CDS) protection put an immediate end to inexpensive market protection. And the subsequent synchronized decline in global risk markets illuminated inherent liquidity issues throughout. It is my view that the end of the misperception of readily-available insurance protection marks an inflection point for the Global Government Finance Bubble.

While most view Greece and European tumult as of only minor consequence to the U.S., I believe it marks an inflection point for U.S. financial conditions. Risk premiums have risen and non-government debt issuance has slowed. Moreover, the cost of financial insurance has increased markedly. Changes in insurance market dynamics could have the most profound impact on risk-taking - hence financial conditions - in the coming weeks and months.

June 18 - Financial Times (Brendan A. McGrail and Allison Bennett): "Illinois sold $300 million of Build America Bonds at a yield premium over Treasuries about 40% higher than two months ago after lawmakers failed to close a $13 billion budget deficit for the year starting July 1. The fifth most-populous U.S. state sold the taxable debt maturing in 2035 priced to yield 7.1%... or 297 bps over... Illinois offered Build Americas of similar maturity at spreads of 205 bps and 210 bps in two April issues... Risk aversion among investors amid Greece's efforts to impose austerity measures contributed to swell the state's borrowing costs, said Tom Boylen, a managing director... for BMO Capital Markets. 'A lot of this is a global thing,' Boylen said. 'There's a bigger magnifying glass on credit."

June 17 - Bloomberg (Allison Bennett): "The cost of insuring bonds issued by Illinois against default rose to a record high as lawmakers sought to close a $13 billion budget deficit... The cost of a five-year credit-default swap to insure Illinois obligations rose 6 bps to 308.61 bps today, or $308,610 to insure $10 million of debt... The gain makes insuring bonds from the fifth-most populous state the most costly among municipal issuers and puts it 66 bps above Spain."

State of Illinois (five-year) CDS traded at about 160 bps to begin the month of May (closed today at 312 bps). The cost of insuring against a default by the state was 25 bps back in May 2008. State of California CDS this week also jumped above 300 bps, this after beginning May below 200 (traded about 60 bps in the summer of '08). After starting May at 140 bps, State of New York CDS closed today at 249 bps (traded most of 2008 below 50 bps). Since the Greece crisis, the cost of State of New Jersey default protection has jumped about 70% to 249 bps.

As a Prominent Indicator of Financial Conditions, I will be closely monitoring developments throughout municipal debt markets. State and local finances are stretched and vulnerable. The weak link? This susceptibility has become more acute post-Greece, with the marketplace now reassessing the efficacy of policymaking and the sustainability of reflationary forces. Akin to Greece, state and local officials lack the luxury of Washington's electronic printing press and helicopter "money." And, again like Greek debt, things deteriorate rather rapidly when the market turns nervous and demands significantly higher yields. Meanwhile, the market's faith is waning with respect to the ability of recovery to cure structural state and local deficits, as well as in the federal government's capacity to move forward with numerous additional bailouts.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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