Trichet Challenges Inflationism
For the week, the S&P500 jumped 3.5% (down 1.1% y-t-d), and the Dow gained 3.2% (unchanged). The broader market was quite strong. The S&P 400 Mid-Caps jumped 5.0% (up 5.1%), and the small cap Russell 2000 surged 6.6% (up 4.0%). The Banks rose 1.8% (up 12.2%), and the Broker/Dealers jumped 3.1% (down 8.9%). The Morgan Stanley Cyclicals surged 7.1% (up 4.3%), and the Transports gained 6.1% (up 6.6%). The Morgan Stanley Consumer index rose 2.9% (up 1.2%), and the Utilities increased 2.3% (down 1.9%). The Nasdaq100 gained 4.0% (up 0.8%), and the Morgan Stanley High Tech index increased 3.4% (down 2.5%). The Semiconductors rose 4.4% (up 1.3%). The InteractiveWeek Internet index jumped 5.1% (up 5.6%). The Biotechs increased 3.6%, increasing 2010 gains to 11.7%. Although bullion declined $5.50, the HUI gold index rallied 1.8% (up 5.1%).
One-month Treasury bill rates ended the week at 14 bps and three-month bills closed at 14 bps. Two-year government yields slipped one basis point to 0.56%. Five-year T-note yields jumped 6 bps to 1.695%. Ten-year yields gained 8 bps to 3.00%. Long bond yields rose 8 bps to 4.02%. Benchmark Fannie MBS yields jumped 13 bps to 3.65%. The spread between 10-year Treasury yields and benchmark MBS yields widened 5 bps to 65 bps. Agency 10-yr debt spreads declined 2 bps to 25 bps. The implied yield on December 2010 eurodollar futures fell 5.5 bps to 0.525%. The 10-year dollar swap spread was little changed at 1.5. The 30-year swap spread declined 1.5 to negative 24.25. Corporate bond spreads were mixed. An index of investment grade spreads declined 4 to 109 bps, while an index of junk bond spreads rose 14 to 702.
Debt issuance has picked up. Investment grade issuers included Goldman Sachs $4.25bn, Morgan Stanley $3.0bn, Noble International $1.25bn, US Bancorp $1.0bn, Ralcorp $750 million, and Charles Schwab $600 million.
Junk issuers included Wynn Las Vegas $1.3bn, Calpine $1.1bn, Interactive Data Corp $700 million, Entravision Communications $400 million, Accuride $310 million, and Esterline Technologies $250 million.
Converts issuers included Genco Shipping $110 million.
International dollar debt sales included European Investment Bank $3.0bn, Toronto Dominion Bank $2.0bn, Quebec $1.5bn, Banco Votorantim $1.1bn, State Bank India $1.0bn, Braskem Finance $750 million, JBS $700 million, Myriad International $700 million, Indosat Palapa $650 million, Bancocolombia $620 million, National Agriculture $500 million and Banco Mercantile $250 million.
U.K. 10-year gilt yields jumped 10 bps to 3.43%, and German bund yields jumped 10 bps to 2.71%. Greek 10-year bond yields rose 13 bps to 10.37%, and 10-year Portuguese yields increased 9 bps to 5.53%. The German DAX equities index gained 2.1% (up 3.5% y-t-d). Japanese 10-year "JGB" yields declined 2 bps to 1.065%. The Nikkei 225 declined 2.6% (down 10.6%). Emerging markets moved higher. For the week, Brazil's Bovespa equities index jumped 6.4% (down 3.3%), and Mexico's Bolsa gained 3.2% (up 2.1%). Russia's RTS equities index jumped 4.8% (up 0.8%). India's Sensex equities index gained 1.0% (up 3.8%). China's Shanghai Exchange jumped 6.1% (down 21.5%). Brazil's benchmark dollar bond yields fell 8 bps to 4.29%, and Mexico's benchmark bond yields sank 16 bps to 4.30%.
Freddie Mac 30-year fixed mortgage rates dipped another basis point last week to 4.56% (down 64bps y-o-y). Fifteen-year fixed rates declined 3 bps to 4.03% (down 65bps y-o-y). One-year ARMs dropped 4 bps to 3.70% (down 107bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 3 bps to 5.43% (down 95bps y-o-y).
Federal Reserve Credit was little changed last week to $2.316 TN. Fed Credit was up $95.8bn y-t-d (7.7% annualized) and $305bn, or 15.2%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 7/21) surged $18.1bn to a record $3.132 TN. "Custody holdings" have increased $176bn y-t-d (10.7% annualized), with a one-year rise of $345bn, or 12.4%.
M2 (narrow) "money" supply expanded $14.0bn to $8.603 TN (week of 7/12). Narrow "money" has increased $90.4bn y-t-d, or 2.0% annualized. Over the past year, M2 grew 2.0%. For the week, Currency was unchanged, while Demand & Checkable Deposits dropped $21.4bn. Savings Deposits surged $40.0bn, while Small Denominated Deposits declined $3.4bn. Retail Money Fund assets dipped $0.9bn.
Total Money Market Fund assets (from Invest Co Inst) dropped $17.8bn to $2.798 TN. In the first 29 weeks of the year, money fund assets fell $496bn, with a one-year decline of $858bn, or 23.5%.
Total Commercial Paper outstanding increased $2.5bn to $1.100 TN. CP declined $70bn, or 10.8% annualized, year-to-date, while it was up $6.0bn from a year ago.
International reserve assets (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.425 TN y-o-y, or 20.3%, to a record $8.442 TN.
Global Credit Market Watch:
July 23 - Bloomberg (Jann Bettinga and Charles Penty): "Seven of the 91 European Union banks subject to stress tests failed with a combined capital shortfall of 3.5 billion euros ($4.5bn), stirring concern the evaluations were too lenient... The banks are in 'close contact' with national authorities over the results and the need for more capital, said the Committee of European Banking Supervisors... 'The amount of capital needed is much lower than the market expected,' said Mike Lenhoff... chief strategist at Brewin Dolphin Securities... 'The amount does seem quite trivial considering the concerns about losses from the sovereign crisis.'"
July 20 - Bloomberg (Chan Tien Hin): "Emerging-market equity fund inflows jumped to more than $3 billion in the week to July 14 as the start of the U.S. earnings season prompted a rebound in optimism, according to EPFR Global."
July 20 - Bloomberg (Edith Balazs and Balazs Penz): "Hungary's short-term borrowing costs rose to a 19-week high at its first debt sale since international creditors suspended talks, weakening the forint and stoking concern that interest rates may increase."
July 21 - Bloomberg (Steve Scherer): "The mafia has cranked up money laundering activities in Italy after the credit crunch prompted banks to stop lending, leaving a funding gap that criminal capital has filled, according to the Bank of Italy. 'The crisis has given organized crime room to thrive because access to credit has become more difficult,' said Anna Maria Tarantola, the central bank's deputy general director... 'Whoever holds large amounts of cash, like crime groups, can make investments that aren't possible for others. They can now invest in fully legal businesses.'"
Global Government Finance Bubble Watch:
July 22 - Bloomberg: "Chinese banks face rising credit risks and their non-performing loan ratios are likely to climb as the nation's economy slows and lending for government projects comes due for repayment, according to Standard & Poor's. It's 'highly likely' that some loans to local government financing vehicles will turn bad over the next few years... Loans to these entities account for about 18% to 20% of total lending... Chinese policy makers are grappling with risks from last year's $1.4 trillion credit boom that fueled the nation's comeback from the global recession. The banking regulator aims to cap new loans at 7.5 trillion yuan ($1.1 trillion) this year, down 22% from 2009..."
July 22 - Bloomberg (David Welch): "General Motors Co., the automaker 61% owned by the U.S., is buying subprime lender AmeriCredit Corp. for $3.5 billion to help it reach more customers with leases and loans to borrowers with faulty credit records."
July 19 - Bloomberg: "China should reduce its holdings of U.S. dollar assets to diversify risks of 'sharp depreciation,' Yu Yongding, a former adviser to the central bank, wrote in a commentary in the China Securities Journal. The nation should convert some holdings currently in U.S. dollars into assets denominated in other currencies, commodities and direct investments overseas, he recommended. China's dollar assets are surplus to requirements and the proportion is too high, Yu said. 'It's completely possible and also necessary for China to expand direct investments in Asia, Africa and Latin America,' he wrote. 'It's also a rare opportunity for Chinese companies to acquire businesses overseas.'"
The dollar index was unchanged at 82.49 (up 5.9% y-t-d). For the week on the upside, the Australian dollar increased 3.2%, the New Zealand dollar 2.4%, the South African rand 2.3%, the Canadian dollar 2.1%, the Mexican peso 1.7%, the Brazilian real 1.5%, the Norwegian krone 1.4%, the British pound 0.8%, the Singapore dollar 0.4%, and the Swedish krona 0.4%. For the week on the downside, the Japanese yen declined 0.9%, the Swiss franc 0.4%, the Danish Krone 0.2%, and the euro 0.2%.
July 19 - Wall Street Journal (Spencer Swartz): "Powered by years of rapid economic growth, China is now the world's biggest energy consumer, knocking the U.S. off a perch it held for more than a century, according to... the International Energy Agency."
The CRB index gained 1.7% (down 5.9% y-t-d). The Goldman Sachs Commodities Index (GSCI) surged 2.6% (down 1.7% y-t-d). Spot Gold was down 0.5% to $1,187 (up 8.2% y-t-d). Silver added 1.8% to $18.10 (up 7.5% y-t-d). September Crude jumped $2.59 to $78.97 (unchanged y-t-d). August Gasoline rose 3.4% (up 3.2% y-t-d), and August Natural Gas increased 0.6% (down 18.4% y-t-d). September Copper surged 9.1% (down 4% y-t-d). September Wheat added 1.5% (up 10% y-t-d), while September Corn declined 6.0% (down 10% y-t-d).
July 23 - Bloomberg: "China's stocks rose, capping the benchmark index's best week in seven months, on speculation the government won't introduce more measures to curb bank loans and property prices after leaders pledged policy stability... 'The macro adjustment will be very modest in the second half and you won't see any draconian measures like what the government did in the first half,' said Li Jun, a strategist at Central China Securities... 'Sentiment is improving and very favorable for a rebound in stocks.'"
July 23 - Bloomberg: "Chinese banks may struggle to recoup about 23% of the 7.7 trillion yuan ($1.1 trillion) they've lent to finance local government infrastructure projects, according to a person with knowledge of data collected by the nation's regulator. About half of all loans need to be serviced by secondary sources including guarantors because the ventures can't generate sufficient revenue..."
July 19 - Bloomberg (Kartik Goyal): "India's economy may expand faster than 8.5% in the financial year that began April 1, Finance Minister Pranab Mukherjee said..."
July 22 - Bloomberg (Tushar Dhara): "India's food inflation rate stayed above 10% for a 14th straight month, increasing pressure on the central bank to raise interest rates..."
Asia Bubble Watch:
July 19 - Bloomberg (Kyung Bok Cho): "South Korea will 'soon' announce plans to stimulate the nation's property market, Yonhap News reported... The nation's land ministry is drawing up measures to boost real-estate prices, and the ruling Grand National Party may begin discussions on easing debt-to-income restrictions on homeowners..."
Latin America Watch:
July 22 - Bloomberg (Matthew Bristow): "Brazil's unemployment rate fell to the lowest level for the month of June since at least 2002. Unemployment fell to 7.0% in June..."
July 23 - Bloomberg (Andre Soliani and Cecilia Tornaghi): "Brazil's government is considering tax breaks to stimulate long-term lending for infrastructure investment, helping to reduce the lending burden on the state development bank, Finance Minister Guido Mantega said. Mantega... said that among the measures being considered is to cut income taxes for investment in debentures and to develop a secondary market for them."
Unbalanced Global Economy Watch:
July 22 - Bloomberg (Emma Ross-Thomas and Simone Meier): "Growth in Europe's services and manufacturing industries unexpectedly accelerated in July as concern over the sovereign-debt crisis eased and an increase in global trade spurred exports. A composite index based on a survey of euro-area purchasing managers in both industries rose to 56.7 from 56 in June..."
July 23 - Bloomberg (Svenja O'Donnell): "The U.K. economy grew almost twice as much as economists forecast in the second quarter in the fastest expansion for four years... Gross domestic product rose 1.1% in the three months through June after increasing 0.3% in the previous quarter..."
July 23 - Bloomberg (Christian Vits and Simon Berberich): "German business confidence unexpectedly surged to a three-year high in July after exports boomed and economic growth accelerated. The Ifo institute said its business climate index, based on a survey of 7,000 executives, jumped to... the highest since July 2007... the biggest monthly increase since records for a reunified Germany began in 1990."
U.S. Bubble Economy Watch:
July 23 - Bloomberg: "China's trade surplus with the U.S. is set to remain 'persistently large' even as the Asian nation's imbalance with the world narrows, according to International Strategy & Investment Group. U.S.-China trade tensions will pose 'the most serious economic threat to the world for the next five years,' Donald Straszheim, senior managing director for China research at International Strategy, said... 'China and the Americans are the Group of Two, and if the G-2 are at each other's throats, that's troubling.'"
July 23 - Bloomberg (William Selway): "Most U.S. states cut government jobs last quarter as cities, counties and public agencies coped with falling tax revenue in the wake of the recession, a study found. State government payrolls dropped in 28 states in April through June... while employment in local government fell in 30 states, according to... the Nelson A. Rockefeller Institute of Government..."
July 22 - Bloomberg (Bob Willis): "Sales of U.S. previously owned homes fell in June for a second month, adding to evidence the market will slump as the effects of a federal tax credit fade... The number of transactions will be 'very low' in coming months, reflecting the end of the government incentive..."
Central Bank Watch:
July 20 - Bloomberg (Sandrine Rastello): "Central banks should have policies that are 'the first defense against' asset bubbles without losing their focus on price stability, an International Monetary Fund official said. 'There is still much work to be done in developing a new policy framework to marry monetary and financial stability,' Jose Vinals, who heads the IMF's Monetary and Capital Markets department, said... 'Tools should be sharpened to counter the build-up of financial imbalances at their root.'"
July 20 - Bloomberg (Greg Quinn): "The Bank of Canada increased its benchmark lending rate for a second month... Governor Mark Carney raised the target rate... a quarter point to 0.75%..."
July 21 - Bloomberg (Jody Shenn): "Fannie Mae and Freddie Mac's regulator may identify as much as $30 billion of debt included in mortgage bonds that the companies can force sellers to repurchase, according to Joshua Rosner, an analyst who in 2007 predicted the collapse in the market for the securities. The Federal Housing Finance Agency this month said it issued 64 subpoenas seeking loan files and other documents related to so-called non-agency mortgage securities bought by the two government-supported companies."
July 23 - Bloomberg (Roger Runningen): "President Barack Obama's budget office said this year's federal deficit will be a record $1.47 trillion, about $84 billion less than forecast in February because of lower spending for unemployment and some government programs. The administration predicted in its mid-session review that the deficit for the 2011 spending year, which begins Oct. 1, will be $1.42 trillion, $150 billion more than estimated at the beginning of this year, mostly because of lagging tax receipts."
July 20 - Bloomberg (William Pesek): "Moody's..., Standard & Poor's and Fitch... can't be happy. Last week, the world's credit-rating giants got scooped on the biggest rating decision: whether to strip the U.S. of AAA status. Worse, the U.S. was downgraded by a company that few people have ever heard of, and a Chinese one at that. While Moody's and S&P ignore the wreckage that America's finances have become, Beijing-based Dagong Global Credit Rating Co. is uncorrupted by the system that enables developed-world debt addicts to appear fiscally clean. It rates U.S. debt AA, two levels below the top grade."
July 23 - Bloomberg (Andy Fixmer and Christopher Palmeri): "U.S. cities and states may need more than $1 trillion of federal assistance in the next three years to stave off financial failure, former Los Angeles Mayor Richard Riordan said. Local governments are in a 'race to the bottom' and U.S. taxpayers will inevitably be called on to bail them out, Riordan said... The federal government should make pension, health-care and school reform a condition of receiving the aid, he said... 'It's not just L.A., it's not just California, it's all over the country, you're going to see all these entities become totally insolvent,' Riordan said. 'I think the federal government has to come in and have a list of what the states have to do to be saved.'"
July 20 - Bloomberg (Terrence Dopp): "New Jersey, the third-most indebted U.S. state, faces a $10.5 billion deficit next year, nearly matching the one Governor Chris Christie closed in his current $29.4 billion budget, the Office of Legislative Services said."
Crude Liquidity Watch:
July 21 - Bloomberg (Zainab Fattah): "A dearth of Dubai home sales and foreclosure auctions is stalling a recovery because buyers aren't able to gauge how far prices have fallen... 'There are very few transactions at the moment,' said Craig Plumb, head of Middle East research at... Jones Lang LaSalle... 'We are not going to see the bottom of the market until we see transactions through the foreclosure process.' Home prices in the sheikhdom have dropped about 50% from their peak two years ago..."
July 20 - Bloomberg (Saijel Kishan): "Investments in hedge funds slowed by 30% in the second quarter, according to Hedge Fund Research... Investors added a net $9.5 billion to hedge funds in the three months ended June... down from $13.7 billion in the prior period. The industry's assets declined 1.2% to $1.65 trillion in the second quarter. Hedge funds posted an average decline of 2.5% in the three months ended June..."
Trichet Challenges Inflationism
"The acute fiscal challenges across all industrial economies are no surprise. Our economies are emerging from the worst economic crisis since the second world war, and without the swift and appropriate action of central banks and a very significant contribution from fiscal policies, we would have experienced a major depression. But now is the time to restore fiscal sustainability. The fiscal deterioration we are experiencing is unprecedented in magnitude and geographical scope. By the end of this year, government debt in the euro area will have grown by more than 20 percentage points over a period of only four years, from 2007-2011. The equivalent figures for the US and Japan are between 35 and 45 percentage points. The growth of public debt has been driven by three phenomena: a dramatic diminishing of tax receipts due to the recession; an increase in spending, including a pro-active stimulus to combat the recession; and additional measures to prevent the collapse of the financial sector." European Central Bank President Jean-Claude Trichet, Financial Times, July 23, 2010
The title of Mr. Trichet's remarkable op-ed piece in today's FT was direct and to the point: "Stimulate No More - It Is Now Time For All To Tighten." The head European central banker has spoken publicly and in no uncertain terms: unrelenting government stimulus is today fraught with great risk. Mr. Trichet should be commended for courageously taking to the next level one of the most important debates of our time.
From Mr. Trichet: "...Given the magnitude of annual budget deficits and the ballooning of outstanding public debt, the standard linear economic models used to project the impact of fiscal restraint or fiscal stimuli may no longer be reliable. In extraordinary times, the economy may be close to non-linear phenomena such as a rapid deterioration of confidence among broad constituencies of households, enterprises, savers and investors. My understanding is that an overwhelming majority of industrial countries are now in those uncharted waters, where confidence is potentially at stake. Consolidation is a must in such circumstances."
Perhaps his stern message was directed at Dr. Bernanke, the Federal Reserve and the Administration. More likely, it was in response to the recent chorus of calls for even more extreme government stimulus and intervention. Especially from some notable American economists, there has been a movement afoot to press Washington (and global policymakers) to completely throw caution to the wind in a crusade of further government spending programs and monetization. From the astute Mr. Trichet: "With hindsight, we see how unfortunate was the oversimplified message of fiscal stimulus given to all industrial economies under the motto: 'stimulate', 'activate', 'spend'!"
Meanwhile, the markets this week seemed to demand that our Fed Chairman arrive for his Congressional testimony with a lengthy list of additional measures our central bank is prepared to immediately implement to ensure buoyant markets and a robust recovery. Over the years, top European central bankers argued against U.S.-style "activist" central banking. The ECB decisively won this debate, yet the Fed is today under intense pressure to become only more radically "activist." Mr. Trichet must have been compelled to interject.
With today's noon release of the European bank "stress test," Mr. Trichet's message didn't garner the attention it deserved. Not unexpectedly, "test" results were met with skepticism. The most popular complaint seemed to be that they lacked credibility because the tests didn't factor in the banks' capital exposure to sovereign debt risk. Well, I doubt there are many banking systems around the world these days that would perform satisfactorily in the event of a domestic sovereign debt crisis. Our banking system would surely not function well in the event of a crisis of confidence - and spike in yields - throughout our Treasury, agency debt and MBS markets.
These days, the marketplace can fixate on deflation risk and feel comfortable holding our debt instruments. With perceptions of scant inflation risk and a Fed predisposed toward additional monetization, bonds are viewed as a low-risk proposition. And, of course, with market yields at historic lows it is especially easy to dismiss the seriousness of today's unfolding fiscal problems.
I'm of the view that our fiscal predicament has been decades in the making and is much worse than generally appreciated. At about 66% of GDP, most believe our federal government's fiscal position is quite manageable - and is certainly better than many others. At worst, market participants perceive there are still a few years before they must concern themselves with U.S. debt service issues. There is, as well, faith in the prospect of economic recovery rectifying our massive deficits. I fear we have reached the stage where our deficits are unmanageable: in this post-mortgage/Wall Street finance Bubble backdrop, economic recovery will disappoint and prospective governmental receipts and expenditures will really disappoint.
Hear me out on this. I - along with others - believed our fiscal position back in the early-nineties was a disaster in the making. Were we wrong? Our federal debt expanded 134% during the seventies to $779bn. The eighties saw federal borrowings increase another 247% to $2.701 TN. "Fortunately," GDP inflated massively as well, ending the eighties up 457% in 20 years to $5.482 TN.
As a percentage of GDP, federal debt ended the sixties at 33.8% and the seventies at 30.4%. Enormous deficits, however, saw this ratio deteriorate markedly during the eighties, ending 1989 at 49.3%. A few years of record deficits resulted in this ratio jumping to 58.9% by 1993. Miraculously, the economy set course on a protracted boom, and governmental receipts skyrocketed. By 2001, federal debt had dropped to 41.8% of GDP. Many were contemplating the ramifications of Washington paying back all its borrowings.
My thesis holds that the rapid deterioration of our fiscal standing was only interrupted by an extraordinary (and unrepeatable) 15-year boom in private-sector Credit creation. In particular, this historic debt expansion was dominated by a profound change - including a massive expansion - in financial sector risk intermediation. Between 1993 and 2008, GSE assets ballooned from $631bn to $3.4 TN. Over this period, the agency MBS market expanded from about $1.4 TN to end 2009 at $4.96 TN. The asset-backed securities market surpassed $4.5 Trillion in 2007, up from about $400bn to begin 1993. Broker/Dealer assets began 1993 at less than $400bn and grew to about $3.1 TN. After ending 1993 at $3.3 TN, total U.S. financial sector borrowings closed 2008 above $17.0 TN. In the ten years 1998 through 2007, total mortgage debt jumped from $5.13 TN to $14.5 TN, a historic gain of 183%. These were "once-in-a-lifetime" financial and economic developments.
This enormous increase in debt inflated asset prices, inflated incomes, inflated spending, and inflated government receipts and expenditures. In particular, the huge expansion of household and financial sector debt was chiefly responsible for filling government coffers from Washington to Sacramento. Politicians extrapolated this bonanza and spent unwisely. But the 2008 bursting of the mortgage/Wall Street finance Bubble abruptly ended this cycle of Credit inflation. Much of the debt intermediated through the U.S. Credit system was discredited. The housing mania was terminated, resulting in a collapse in demand for mortgage Credit.
In the post-Bubble backdrop, private-sector (household and financial sector) Credit has contracted, and there is little prospect for meaningful expansion for some years to come. Unlike the early nineties, there will be no miraculous new type of finance to fuel booms in the economy, asset prices, and government receipts. Financial innovation and the reckless expansion of Wall Street finance will not bail out Washington. We're basically left with a massive expansion of government debt until the markets decide to impose discipline.
Our recovery has been completely dependent upon government spending and ultra-loose monetary policy. This has entailed an incredible increase in Treasury borrowings. The markets assume our rapidly deteriorating fiscal situation will improve as the economy recovers. On the spending side, the economy is now dependent on massive federal stimulus. I don't expect any self-imposed restraint on government expenditures. And, importantly, it would take renewed expansion of private-sector debt to meaningfully boost the ratio of governmental receipts to expenditures. Washington - or the states - can't spend its way to fiscal recovery. Instead, we're witnessing a fiscal train wreck. Our policymakers, economists, and pundits should read Mr. Trichet carefully and contemplate a course other than inflationism.