Let's Change the Debate

By: Doug Noland | Fri, Aug 20, 2010
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For another volatile week, the S&P500 slipped 0.7% (down 3.9% y-t-d), and the Dow declined 0.9% (down 2.1%). The Banks dropped 2.5% (up 4.9%), and the Broker/Dealers slipped 0.2% (down 10.1%). The Morgan Stanley Cyclicals lost 0.8% (down 1.2%), while the Transports added 0.2% (up 2.8%). The Morgan Stanley Consumer index declined 1.3% (down 1.4%), and the Utilities dipped 0.6% (down 2.3%). The S&P 400 Mid-Caps added 0.3% (up 1.4%), and the small cap Russell 2000 increased 0.2% (down 2.3%). The Nasdaq100 added 0.4% (down 1.9%), and the Morgan Stanley High Tech index rallied 2.2% (down 6.3%). The Semiconductors jumped 1.6% (down 8.9%). The InteractiveWeek Internet index rose 3.5% (up 7.3%). The Biotechs declined 0.6%, reducing 2010 gains to 13.8%. With bullion gaining $12, the HUI gold index gained 3.2% (up 8.9%).

One-month Treasury bill rates ended the week at 14 bps and three-month bills closed at 14 bps. Two-year government yields fell 2.5 bps to 0.485%. Five-year T-note yields were little changed at 1.42%. Ten-year yields declined 6 bps to 2.62%. Long bond yields dropped 20 bps to 3.66%. Benchmark Fannie MBS yields rose 6 bps to 3.49%. The spread between 10-year Treasury yields and benchmark MBS yields widened a notable 12 bps to 87 bps. Agency 10-yr debt spreads widened 3 bps to 24 bps. The implied yield on December 2010 eurodollar futures sank 8 bps to 0.39%. The 10-year dollar swap spread increased 4.25 to 2.0. The 30-year swap spread increased 7.5 to negative 35.5. Corporate bond spreads were little changed. An index of investment grade spreads added less than one basis point to 109 bps. An index of junk bond spreads was unchanged at 573 bps.

Debt issuance slowed during this late-summer week. Investment grade issuers included Bank of America $1.5bn, Baker Hughes $1.5bn, Apache $1.5bn, Moody's $500 million, Rowan Companies $400 million, and Ingram Micro $300 million.

Junk issuers included NRG Energy $1.1bn, Goodyear Tire $1.0bn, Toys R Us $350 million, Choice Hotels $250 million, Mueller Water Products $225 million, Landry's $110 million and Western Alliance Bancorp $75 million.

Convert issuers included Sandisk $1.0bn and Mannkind $100 million.

International dollar debt sales included Royal Bank of Scotland $3.6bn, HSBC $1.3bn, ING Bank $750 million and Manila Cavit Toll Road $160 million.

U.K. 10-year gilt yields dropped 15 bps to 2.97%, and German bund yields fell 12 bps to 2.27%. Greek 10-year bond yields jumped 27 bps to 10.75%, while 10-year Portuguese yields dipped one basis point to 5.20%. The German DAX equities index declined 1.7% (up 0.8% y-t-d). Japanese 10-year "JGB" yields fell 5.5 bps to 0.925%. The Nikkei 225 dipped 0.8% (down 13.0%). Emerging equity markets were mixed. For the week, Brazil's Bovespa equities index added 0.6% (down 2.8%), and Mexico's Bolsa gained 0.6% (up 0.5%). Russia's RTS equities index declined 1.3% (down 1.2%). India's Sensex equities index rose another 1.3% (up 5.4%). China's Shanghai Exchange gained 1.4% (down 19.4%). Brazil's benchmark dollar bond yields dropped 20 bps to 3.85%, and Mexico's benchmark bond yields sank 21 bps to 3.76%.

Freddie Mac 30-year fixed mortgage rates declined 2 bps last week to a record low 4.42% (down 70bps y-o-y). Fifteen-year fixed rates fell 2 bps to 3.90% (down 66bps y-o-y). One-year ARMs were unchanged at 3.53% (down 116bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates unchanged at 5.37% (down 84bps y-o-y).

Federal Reserve Credit declined $6.5bn last week to $2.303 TN. Fed Credit was up $82.6bn y-t-d (5.9% annualized) and $267.8bn, or 13.2%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 8/18) jumped another $11.4bn (9-wk gain of $96bn) to a record $3.176 TN. "Custody holdings" have increased $221bn y-t-d (11.8% annualized), with a one-year rise of $362bn, or 12.9%.

M2 (narrow) "money" supply rose $8.3bn to $8.644 TN (week of 8/9). Narrow "money" has increased $132bn y-t-d, or 2.5% annualized. Over the past year, M2 grew 2.7%. For the week, Currency added $1.4bn, while Demand & Checkable Deposits declined $4.2bn. Savings Deposits jumped $19.1bn, while Small Denominated Deposits fell $3.8bn. Retail Money Fund assets declined $4.2bn.

Total Money Market Fund assets (from Invest Co Inst) increased $4.1bn to $2.826 TN. In the first 33 weeks of the year, money fund assets dropped $485bn, with a one-year decline of $755bn, or 21.1%.

Total Commercial Paper outstanding rose $5.8bn to a 21-wk high $1.111 TN. CP has declined $59bn, or 7.9% annualized, year-to-date, while it was up $33bn from a year ago.

International reserve assets (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.459 TN y-o-y, or 20.6%, to a record $8.547 TN.

Global Credit Market Watch:

August 18 - Bloomberg (Andrew MacAskill and Simon Kennedy): "The Basel Committee on Banking Supervision said proposed bank regulations would have a 'modest' impact on economic growth, a rebuff to warnings from financial institutions that the new rules threaten growth and job creation. The annual growth rate would be reduced by an average of 0.04 percentage points over a four-and-a-half-year period, said the committee..."

Global Government Finance Bubble Watch:

August 20 - Bloomberg (David Wilson): "Nationalizing the U.S. mortgage- finance system would turn taxpayers into servants of the 'housing investment and debt complex,' according to David Stockman, a former head of the Office of Management and Budget. This shift would complete a transformation that started during the 1970s, when federal housing subsidies were expanded, Stockman wrote... 'All principled political opposition to Pimco-style crony capitalism has been extinguished,' wrote Stockman, a senior managing director at Heartland Industrial Partners... 'Indeed, the magnitude of the burden already created is staggering.'"

August 19 - Bloomberg (Prashant Gopal): "U.S. mortgage rates set a record low for the ninth straight week... The average rate for a 30-year fixed mortgage dropped to 4.42%..."

August 16 - Financial Times (Sam Jones): "The hedge fund strategy pioneered - and made notorious - by Long Term Capital Management is returning to prominence amid one of its most successful years yet, aided in large part by the massive issuance of bonds by the UK government and other sovereigns. Fixed-income relative value trading - shunned by investors after the collapse of LTCM in 1998 - has been one of the industry's few outperformers this year, thanks to massive pricing anomalies caused by fiscal stimulus packages and unconventional central bank monetary policies around the world. According to Hedge Fund Research, the average relative value fund has returned 5.33% so far this year, compared with just 1.52% from the average hedge fund. Relative value trading involves identifying 'inefficient' prices in bonds - typically government bonds - and wagering that the prices will correct over time. With mainstream hedge fund strategies such as equity long/short and global macro floundering amid volatile markets, relative value funds have seen their inflows increase. The strategy has taken in $10bn from investors this year - accounting for close to half of the entire industry's inflows."

August 16 - Market News International (Brai Odion-Esene): "Influential bond trader Bill Gross... called on U.S. policymakers to implement a nationwide refinancing scheme that he argued will provide of a boost to the economy of between $50 billion to $60 billion. In prepared remarks during a panel discussion to begin the Obama administration's conference on the future of housing finance, Gross... said he favors the consolidation of all the housing finance agencies into a single public entity fully backed by the government. He said policymakers should quickly re-engineer a refinancing opportunity for all borrowers that are current with their payments and are included in the GSEs securitized mortgages... PIMCO's proposal to introduce refinancing opportunities on a large scale, Gross said -- where 5%, 6% and 7% mortgages are turned into 4% mortgages -- will provide a stimulus of $50 billion to $60 billion in consumption as well as a potential lift of 5% to 10% in terms of housing prices. PIMCO also advocates a 100% public housing finance system, Gross said..."

Currency Watch:

August 16 - Bloomberg (Candice Zachariahs and Ron Harui): "China, whose $2.45 trillion in foreign-exchange reserves are the world's largest, is turning bullish on Europe and Japan at the expense of the U.S. The nation has been buying 'quite a lot' of European bonds, said Yu Yongding, a former adviser to the People's Bank of China... 'Diversification should be a basic principle,' Yu said... adding a 'top-level Chinese central banker' told him to convey to European policy makers China's confidence in the region's economy and currency. 'We didn't sell any European bonds or assets, instead we bought quite a lot.'"

August 17 - Bloomberg (Wes Goodman and Daniel Kruger): "China cut its holdings of Treasury notes and bonds by the most ever, raising speculation a plunge in U.S. yields that sent two-year rates to a record low has made government securities unattractive. The Asian nation's holdings of long-term Treasuries fell by $21.2 billion in June to $839.7 billion... Total Chinese investment in U.S. debt declined 2.8% to $843.7 billion, the least in a year, following a 3.6% slide in May."

August 18 - Bloomberg (Frances Yoon): "China more than doubled South Korean debt holdings this year, spurring the notes' longest rally in more than three years, as policy makers shifted part of the world's largest foreign-exchange reserves out of dollars... China should allocate some reserves to 'financial assets in major Asian economies,' Ding Zhijie, a former adviser to China's sovereign wealth fund, said... China's holdings of Treasuries fell 6% in the first half to $843.7 billion..."

August 16 - Bloomberg (Yasuhiko Seki): "The Japanese yen, the best performer among major currencies this year with a 7.9% gain against the dollar, may surge further as concern grows that U.S. efforts to boost economic growth will fail. 'What we are seeing is not appreciation of the yen but weakness of the dollar, reflecting concerns that the U.S. economy may falter,' Eisuke Sakakibara, formerly Japan's top currency official, said... 'There is a chance the yen will reach an all-time high and stay at that level for the time being.'"

The dollar index added 0.1% to 83.01 (up 6.6% y-t-d). For the week on the upside, Swiss franc increased 1.7%, the Brazilian real 0.9%, the Japanese yen 0.7%, the Singapore dollar 0.5%, the Swedish krona 0.5%, the New Zealand dollar 0.1% and the Australian dollar 0.1%. For the week on the downside, the Canadian dollar declined 0.5%, the British pound 0.4%, the euro 0.3%, the Danish krone 0.3%, the Mexican peso 0.3%, and the Norwegian krone 0.3%.

Commodities Watch:

August 18 - Bloomberg (Rebecca Keenan and Jesse Riseborough): "BHP Billiton Ltd., the world's largest mining company, made a hostile $40 billion takeover offer for Potash Corp. of Saskatchewan Inc., seeking to become the biggest fertilizer producer."

August 20 - Financial Times (Javier Blas and William MacNamara): "The rise of China and India has sparked a renewed surge in aggressive dealmaking in the resources sector, with more than $50bn in proposed takeovers this week alone wagering on continued strong commodities demand... In the first concrete signs of Beijing's interest in the deal, Li Qiang, a spokesman for Sinochem, said the company was paying 'close attention' to the takeover battle, adding that it was 'interested in overseas potash investment opportunities'."

August 20 - Financial Times (Jack Farchy): "Coffee and sugar prices spiked to fresh highs as tight physical markets encouraged speculative interest in the soft commodities. The price of Arabica coffee - the high-quality variety prized by espresso lovers - jumped 3%... [to a] a 12-year high. October raw sugar rose above 20 cents a pound for the first time in five months.

August 16 - Bloomberg (Jennifer A. Johnson and Elizabeth Campbell): "Cotton may climb to the highest price since 1995 as rising demand in emerging markets for everything from shirts to bed sheets forces textile makers to restock inventories that are the tightest in 13 years."

The CRB index declined 0.7% (down 5.8% y-t-d). The Goldman Sachs Commodities Index (GSCI) fell 1.4% (down 3.7% y-t-d). Spot Gold rose 1.0% to $1,228 (up 11.9% y-t-d). Silver slipped 0.6% to $18.055 (up 7.2% y-t-d). October Crude declined $1.73 to $74.04 (down 7% y-t-d). September Gasoline declined 0.7% (down 6% y-t-d), and September Natural Gas sank 4.6% (down 26% y-t-d). December Copper added 1.3% (down 1% y-t-d). December Wheat retreated 3.0% (up 32% y-t-d), while December Corn gained 2.1% (up 5% y-t-d).

China Watch:

August 16 - Bloomberg (Dan Levy): "China surpassed Japan as the world's second-largest economy last quarter, capping the nation's three-decade rise from Communist isolation to emerging superpower... The country of 1.3 billion people will overtake the U.S., where annual GDP is about $14 trillion, as the world's largest economy by 2027, according to Goldman Sachs Group Inc. chief economist Jim O'Neill."

August 16 - Bloomberg: "Agricultural Bank of China Ltd. boosted the size of its initial public offering to $22.1 billion after selling more stock in Shanghai, making it the world's largest first-time share sale."

August 17 - Bloomberg (Sophie Leung): "Hong Kong's jobless rate fell to the lowest level since December 2008, encouraging consumers to spend and aiding the city's recovery. The rate for the three months ended July 31 was 4.3%, compared with 4.6% in the second quarter..."

Japan Watch:

August 19 - Financial Times (Michiyo Nakamoto): "Chitose, a small city of 93,000 on Japan's northernmost island of Hokkaido, seems an unlikely destination for Chinese home buyers. But when Nitori Public, an advertising company, put 17 houses on the market there, they were snapped up by wealthy Chinese willing to pay about Y30m ($353,000) for a second home in Japan. The city, which has an airport that serves Sapporo... is not the first choice among Japanese for a country home, but for Chinese visitors it offers a base in a popular holiday destination. From Hokkaido in the north to Fukuoka in the south, estate agents report rising interest among Chinese for property for their own use and as an investment."

Asia Bubble Watch:

August 18 - Bloomberg (Shamim Adam and Ranjeetha Pakiam): "Malaysia's economy grew near the fastest pace in a decade last quarter... Gross domestic product increased 8.9% in the three months through June from a year earlier, after expanding 10.1% in the first quarter..."

August 18 - Bloomberg (Max Estayo and Joel Guinto): "The Philippines expects the economy to expand 5% this year and grow more than 7% from next year to 2016, Economic Planning Secretary Cayetano Paderanga said..."

Latin America Watch:

August 16 - Bloomberg (Helder Marinho and Telma Marotto): "Banco do Brasil SA, Latin America´s largest lender by assets, said second-quarter profit rose 35% as economic growth encouraged consumers and companies to take out more loans... Outstanding loans in the country expanded almost 20% in June from a year earlier, to a record 1.53 trillion reais. It was the 16th consecutive month of credit expansion."

Unbalanced Global Economy Watch:

August 17 - International Herald Tribune (Jack Ewing): "Higher energy prices drove inflation in the euro area to an annual rate of 1.7% in July, the highest level in 20 months but still within the range considered acceptable by the European Central Bank..."

August 19 - Financial Times (Ralph Atkins and David Oakley): "Germany's economy will grow by 3% this year, according to a sharply upwardly revised Bundesbank forecast... The economic recovery in Europe's largest economy was increasingly generating its own momentum, the country's central bank reported... with positive ripple effects spreading to other eurozone countries."

August 17 - Bloomberg (Johan Carlstrom): "Swedish house prices rose for a 15th consecutive period in the three months through July even after the central bank raised interest rates to stem further gains."

August 16 - Bloomberg (Fiona MacDonald): "Kuwait M1 money supply growth, an indicator of future inflation, accelerated to 17.9% in July from 11.3% in June..."

U.S. Bubble Economy Watch:

August 17 - Bloomberg (Joshua Zumbrun and Scott Lanman): "Demand for loans at the majority of lenders in the U.S. failed to rise last quarter even as banks eased standards for the first time since the credit crisis began, a Federal Reserve survey showed. Banks eased standards and most terms on loans to businesses of all sizes... The Fed described the change as 'a modest unwinding of the widespread tightening that occurred over the past few years.' Credit standards for small firms were loosened for the first time since late 2006."

August 16 - Bloomberg (Erik Matuszewski): "New York Jets quarterback Mark Sanchez said he was anxious to see what the team's new stadium looks like filled with fans. He'll get the chance tonight when the Jets host the rival New York Giants in the preseason opener for both clubs. It's the first National Football League game at the $1.6 billion venue at the Meadowlands in East Rutherford, New Jersey."

Central Bank Watch:

August 20 - Bloomberg (Christian Vits, Jana Randow and David Tweed): "European Central Bank council member Axel Weber said the ECB should help banks through end-of-year liquidity tensions before determining in the first quarter when to withdraw emergency lending measures. 'Most of these discussions about the continuation of the exit I think will be focused on the first quarter,' Weber, who heads Germany's Bundesbank, said... 'It's clear that we need to re-embark on a normalization procedure.'"

August 17 - Bloomberg (Jennifer Ryan): "Bank of England Governor Mervyn King said inflation is likely to exceed the U.K. government's upper 3% limit in coming months as higher sales taxes drive gains in consumer prices. King was today forced to write a third public letter this year after the Office for National Statistics said prices rose 3.1% in July from a year earlier after climbing 3.2% in June. Under U.K. law, King must write to the Treasury every three months when inflation exceeds 3%."

Fiscal Watch:

August 20 - Bond Buyer (Patrick Temple-West): "The Congressional Budget Office... upped the estimated cost of the Build America Bond program by $10 billion to $36 billion over 10 years in its new estimates on the fiscal 2010 budget deficit and economic outlook."

GSE Watch:

August 20 - Bloomberg (Gregory Mott): "U.S. Representative Barney Frank said the Obama administration must ensure the Federal Housing Finance Administration is using its full legal authority to recover money from banks that used fraud and deception to shift losses to Fannie Mae and Freddie Mac. 'Private companies sold Fannie and Freddie loans or securities based on fraudulent documents,' Frank... wrote in a letter to President Barack Obama... 'These transactions created private profits at public expense, and they should be fought with every tool at the companies' and the agency's disposal.'"

Muni Watch:

August 20 - Bloomberg (Dunstan McNichol): "Taxpayers must cover at least a third of a $3 trillion bill for public employee pensions even if lawmakers eliminate cost-of-living increases and raise the retirement age, according to an academic study. 'Even if states uniformly eliminated generous early retirement deals and raised the retirement age to 74, the unfunded liability for promises already made would still be more than $1 trillion,' Joshua D. Rauh, associate professor of finance at Northwestern University's Kellogg School... said..."

California Watch:

August 20 - Los Angeles Times (Alana Semuels): "California employers cut their payrolls by 9,400 jobs in July, adding to worries that the labor market is weakening and the recovery is losing steam. The state's unemployment rate remained constant at 12.3%."

August 19 - Financial Times (Matthew Garrahan): "California will be forced to issue IOUs to public workers and other creditors in lieu of cash in the next two months if a budget deadlock cannot be broken, the state's financial controller has warned. America's most populous state faces a repeat of 2009, when a slumping economy and its failure to agree a budget caused an unprecedented fiscal crunch and the issuing of $2.6bn of IOUs, which damaged California's credit rating and forced it to scrap some social programmes."

August 16 - Bloomberg (Nicole Gelinas): "The struggling city of Bell has ousted its overpriced executives. But its money troubles are far from over, thanks to a huge debt load. By the end of the credit and real estate bubbles, Bell had amassed more than $77 million in direct debt. The city's debt burden today clocks in at nearly three times its annual revenues. Debt in far wealthier New York City, by contrast, is less than 1.5 times its revenues."

August 17 - Bloomberg (Dan Levy): "Southern California home sales dropped the most in two years in July as unemployment and the end of a federal tax credit cut demand, MDA DataQuick said. A total of 18,946 homes sold in Los Angeles, Riverside, San Diego, Ventura, San Bernardino and Orange counties, down 21% from both June and a year earlier..."

August 19 - Bloomberg (Dan Levy): "San Francisco Bay Area home sales dropped to the lowest July total in 15 years as unemployment and the end of a federal tax credit kept buyers from making purchases, according to MDA DataQuick."

New York Watch:

August 20 - Bloomberg (Michael Quint): "New York State, which earlier this month closed a $9.2 billion deficit, expects a gap of $8.2 billion next year because of declining federal aid and the expiration of a temporary increase in income-tax rates."

Speculator Watch:

August 18 - Bloomberg (Katherine Burton): "Hedge-fund icon Stanley Druckenmiller is shutting his firm and ending a 30-year career after amassing one of the best long-term trading records in the industry and generating $1 billion for George Soros by forcing a devaluation of the British pound. Druckenmiller... said he was tired of the stress of managing money for others and frustrated by his failure in the past three years to match returns that had averaged 30% annually since 1986. His Duquesne Capital Management LLC, which oversees $12 billion and has never had a losing year, is down 5% in 2010."

August 19 - Financial Times (Julie Creswell): "They were revered as the brightest minds in finance, the 'quants' who could outwit Wall Street with their Ph.D.'s and superfast computers. But after blundering through the financial panic, losing big in 2008 and lagging badly in 2009, these so-called quantitative investment managers no longer look like geniuses... The combined assets of quantitative funds specializing in United States stocks have plunged to $467 billion, from $1.2 trillion in 2007, a 61% decline, according to eVestment Alliance... One in four quant hedge funds has closed since 2007, according to Lipper Tass. 'If you go back to early 2008, when Bear Stearns blew up, that's when a lot of quant managers got blown out of the water,' said Neil Rue, a managing director with Pension Consulting Alliance... 'For many, that was the beginning of the end,' he added."


Let's Change the Debate:

August 19 - Bloomberg (Laura Litvan): "The U.S. Congressional Budget Office predicted the budget deficit for fiscal year 2011 will be $1.066 trillion, revised up from an estimate of $996 billion in March... CBO Director Doug Elmendorf said the agency's projections haven't changed significantly since its March forecast... 'Unfortunately, this is a case where no news is not good news,' Elmendorf said. 'The country faces serious budget problems and serious economic problems.' ...The CBO said... the deficit for the current fiscal year ending Sept. 30 will be $1.34 trillion. That is 9.1% of GDP, or the second largest shortfall in the past 65 years, exceeded only by last year's 9.9%."

August 19 - MarketNews International (John Shaw): "Congressional Budget Office director Doug Elmendorf said... his agency's new fiscal report may 'significantly underestimate' the nation's short-term deficit outlook because of the requirements of budget estimating. ...Elmendorf emphasized that under budget law the CBO must make its baseline estimates by assuming that current tax and spending laws are unchanged. He added the U.S. fiscal outlook would be 'quite different' if other, arguably more plausible, assumptions were made. ...'This is an extraordinarily high level of debt' when viewed in the context of American history, he said..."

"It's important to be a diplomat for the diplomatic corps, it's not so important for a central bank. I think it's very important for central banks to be clearly focused and also, if necessary, to deliver undiplomatic messages to governments." Bundesbank President Axel Weber, August 20, 2010 (interviewed by Bloomberg)

Push the inflation/deflation debate to the backburner. The critical issue these days is whether global debt markets have succumbed to Bubble Dynamics. Are investors and speculators, once again, participating in a historic bout of (Hyman Minsky) "Ponzi Finance"? Is flawed policymaking fomenting yet another dangerous speculative Bubble and period of deepening economic maladjustment? Are central bankers and markets accommodating history's greatest expansion/inflation of non-productive government debt?

As an analyst who has for some time been warning of mounting risks associated with a Global Government Finance Bubble, it now seems obvious that the situation has taken a decided turn for the worst: Bubble Dynamics have become more entrenched and dangerous, while policymaking has reached the precipice of outright failure.

There reaches a point in the evolution of a Credit Bubble where things really begin to get out of hand; the "terminal phase of excess." If policymakers fail to act forcefully to rein in "terminal" government borrowing excesses, they will be held hostage to escalating risks from an out of control Bubble (think mortgage finance Bubble 2005/'06). There would be no turning back. A consensus view is taking shape that would amount to the worst-case policy scenario from a Credit Bubble analysis perspective.

Some claim (reminiscent of views held back in 2002) that "fat tail" deflation risk is the critical issue. They argue forcefully for more extreme inflationary policymaking - larger deficits and additional Federal Reserve monetization. With inflation now effectively out of the picture, they believe the only policy risk is a lack of resolve for inflating/stimulating sufficiently. There is increasing contempt and ridicule directed at the Fed, Administration and Congress for not stimulating more aggressively.

Some argue that the Federal Reserve has a profound duty to balloon its balance sheet by monetizing Treasury debt. They state that the Fed has a profound duty to sacrifice its independence, as it works in concert with extreme fiscal measures to eliminate deflation risk. This is no more than New Age theorizing and experimental policymaking lacking of any historical basis of support. It is, at the same time, a skillfully sophisticated version of age-old inflationism propaganda and monetary quackery.

Nowhere from this ("inflationists") camp do we see any recognition of the potentially catastrophic Bubble that - after years of migrating from one market to the next - has finally found its home right in the heart of our monetary system. Indeed, the inflationists have deep disdain for Bubble analysis. They write off the mortgage finance Bubble as a housing boom led astray by one-off failures of underwriting standards and supervision. Such analysis ignores the key policy, monetary, and global market dynamics that only a few years ago were allowed to destroy the creditworthiness and market confidence in our system's (non-government guaranteed) mortgage Credit (almost bringing down the global financial system).

I have posited that the 2008 bursting of the mortgage/Wall Street finance Bubble unleashed an even bigger ("mother of all...") Bubble throughout global fixed-income marketplaces. I trace today's Bubble back at least to the Greenspan Fed's 1987 post-crash systemic reliquefication. Resulting late-eighties' excess led to severe early-90's banking system impairment; followed by an another aggressive monetary policy response; the 1992/93 bond market Bubble; the 1994 bond bust and Mexican crisis; expanded monetary largess; the South East Asian Bubbles and collapses; additional policy accommodation; the Russian and LTCM fiascos; more extreme monetary stimulus; the resulting technology Bubble; and historic monetary stimulus and reliquefication leading to the mortgage/Wall Street Bubble. Recent history of monetary disorder fueling serial boom and bust cycles is unequivocal.

From my analytical perspective, we're in the midst of history's greatest and most perilous financial Bubble. And I am beside myself that nobody in a position of influence seems to care. We've witnessed momentous analytical and policy errors over the years - and these blunders are allowed to repeat themselves without thorough analysis and review. All this talk about fighting deflation and helping Main Street misses the point - and only feeds the Bubble. I'm fed up with ideology trumping sound analysis.

Why is there no consensus recognizing that the number one priority must be to protect the soundness of our government debt market - the heart of contemporary "money." For me, talk emanating from bond fund managers about how to help the average guy rings hollow. It is fundamental to our nation's future that we stabilize the government debt Bubble and secure the integrity of our monetary system. The chorus of calls for larger deficits and greater Fed monetization is fueling distortions that risk financial calamity.

The Treasury Department's conference this week on housing finance overhaul epitomizes the dysfunctional backdrop. These days, Fannie, Freddie, Ginnie, the FHA, etc. ensure that mortgage borrowing costs are quite low and mortgage Credit reasonably available. The mortgage market has already essentially been nationalized, and the GSEs are an unmitigated financial black hole. Enough already. Yet policy proposals are presented including a massive refinancing of current mortgages to reset at today's historic low rates. The idea seems impractical. Yet such notions - proving that there are no longer any bounds on policy reasonableness or government intrusion - along with the possibility for a tsunamis of mortgage refis throw additional weight upon the Treasury yield collapse, while spurring general market instability (and big profits for those on the right side of the trade).

The U.S. housing mania was historic - and it's over. Mortgage Credit will not provide a meaningful source of system Credit expansion for some years to come. This post-Bubble reality is misdiagnosed as "deflation." As we've already witnessed, even enormous fiscal and monetary stimulus does little to incite mortgage borrowing. Just as post-tech Bubble reflation bypassed the technology sector in favor of inflating mortgage Credit, the MBS marketplace, and housing prices, today's reflationary forces flow vigorously to government (and related) debt markets.

I found it interesting that hedge fund legend Stanley Druckenmiller announced his retirement this week, ending an incredible 30-year run in hedge fund management. And today's New York Times ran a story highlighting the ongoing difficulties suffered by the "quant" hedge funds. Massive government stimulus may be benefiting bond fund managers, but it's certainly not improving the overall functioning of the financial markets. I would not be surprised if sophisticated market operators such as Mr. Druckenmiller look at the current backdrop and are content to exit the game before the bloody havoc of the next bursting Bubble.

As the great German economist Dr. Kurt Richebacher was fond of saying, "The only cure for a Bubble is not to allow it to inflate." Regrettably, there is little government policymaking can do in the short run to improve the situation. There is, however, a great deal policymakers are doing to make a bad situation worse. The current backdrop - certainly impacted by the Greek debt crisis, related market tumult and a faltering U.S. recovery - has created an elevated risk of further policy mistakes.

A multi-decade Credit Bubble badly distorted our economy's underlying structure. The harsh reality is that this structural maladjustment can only be rectified gradually over a period of many years. There's just no quick fix. Ongoing massive fiscal and monetary stimulus only exacerbates our economy's ills. Moreover, it risks an inevitable crisis of confidence in our debt markets and monetary system.

The economy is muddling through right now. It's frustrating and discouraging but, under the circumstances, this is about the best we could have hoped for. I am increasingly troubled by the direction (and tone) of economic analysis and policy discussion. All the inflationism histrionics, including the notion that the Fed and Congress are committing a dereliction of duties by not stimulating more aggressively, are unhelpful. Describing fiscal policy as increasingly "austere" is ridiculous. But mostly, calls for the (un-independent) Federal Reserve to monetize a massive federal spending plan are as irresponsible as they are dangerous.

An increasing weight of evidence supports the global government finance Bubble thesis. But, of course, there's nothing like the euphoria associated with rapidly inflating asset prices (in this case bonds) to embolden those dismissive of Bubble analysis. All the more reason that it is imperative that we not ignore this Bubble as we did the mortgage/Wall Street finance Bubble. The risks and costs today are infinitely greater.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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