Bubble Thesis Update

By: Doug Noland | Fri, Sep 10, 2010
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For the week, the S&P500 gained 0.4% (down 0.5% y-t-d), and the Dow added 0.1% (up 0.3%). The Banks slipped 0.2% (up 9.0%), while the Broker/Dealers declined 0.2% (down 9.3%). The Morgan Stanley Cyclicals declined 0.8% (up 2.6%), while the Transports added 0.3% (up 7.4%). The Morgan Stanley Consumer index gained 1.0% (up 1.9%), while the Utilities lost 0.6% (up 0.4%). The S&P 400 Mid-Caps dipped 0.4% (up 5.1%), and the small cap Russell 2000 declined 1.1% (up 1.8%). The Nasdaq100 gained 1.2% (up 1.7%), and the Morgan Stanley High Tech index rose 0.4% (down 4.3%). The Semiconductors dropped 3.8% (down 12.0%). The InteractiveWeek Internet index gained 0.4% (up 11.0%). The Biotechs jumped 1.5%, increasing 2010 gains to 21.0%. With bullion little changed, the HUI gold index declined 1.1% (up 12.1%).

One-month Treasury bill rates ended the week at 9 bps and three-month bills closed at 14 bps. Two-year government yields rose 5 bps to 0.54%. Five-year T-note yields jumped 10 bps to 1.53%. Ten-year yields jumped 10 bps to 2.80%. Long bond yields increased 8 bps to 3.86%. Benchmark Fannie MBS yields rose 13 bps to 3.60%. The spread between 10-year Treasury yields and benchmark MBS yields increased 3 bps to 80 bps. Agency 10-yr debt spreads narrowed one to 23 bps. The implied yield on December 2010 eurodollar futures rose 5 bps to 0.445%. The 10-year dollar swap spread increased 0.5 to negative 1.5. The 30-year swap spread increased one to negative 37. Corporate bond spreads were little changed. An index of investment grade spreads narrowed one to 103 bps. An index of junk bond spreads narrowed one to 554 bps.

Debt issuance picked up markedly. Investment grade issuers included Hewlett-Packard $3.0bn, American Express $2.0bn, Dell $1.5bn, Aon $1.5bn, Medco Health Solutions $1.0bn, International CCE $1.0bn, US Bancorp $1.0bn, Burlington Northern $750 million, Nabors Industries $700 million, Allergan $650 million, Goodrich $600 million, Pacific G&E $550 million, Home Depot $500 million, Oncor Electric Delivery $475 million, Health Care REIT $450 million, Duquesne Light $450 million, Unum $400 million, Parker-Hannifin $300 million, City National $300 million, Nevada Power $250 million, and Gulf Power $125 million.

Junk issuers included Linn Energy $1.0bn, Metropcs $1.0bn, Alliant Techsystems $350 million, Scientific Games $250 million, and Powerlong RE $200 million.

I saw no converts issued.

A long list of international dollar debt sales included Bank of Vale Overseas $2.75bn, Societe Generale $2.0bn, Tokyo-Mitsubishi $2.0bn, Lloyds Bank $2.0bn, Canadian Imperial Bank $1.5bn, Ontario $1.25bn, Teck Resources $1.15bn, CIE Financement Foncier $1.0bn, Total Capital $1.0bn, Telemar $1.0bn, JBS Finance $900 million, Banco Credito Peru $800 million, Lithuania $750 million, France Telecom $750 million, Korea Hydro & Nuclear $500 million, Hospira $500 million, Odebrecht Finance $500 million, Caisse Centrale Desjardn $1.0bn, and Grupo Kuo $250 million.

U.K. 10-year gilt yields jumped 12 bps to 3.12%, and German bund yields increased 5 bps to 2.40%. Greek 10-year bond yields surged 42 bps to 11.73%, and 10-year Portuguese yields rose 17 bps to 5.76%. Ireland yields increased 6 bps to 5.81%. The German DAX equities index increased 1.3% (up 4.3% y-t-d). Japanese 10-year "JGB" yields added one basis point to 1.15%. The Nikkei 225 rallied 1.4% (down 12.4%). Emerging equity markets were mostly higher. For the week, Brazil's Bovespa equities index slipped 0.2% (down 2.6%), and Mexico's Bolsa added 0.1% (up 1.6%). Russia's RTS equities index gained 1.2% (up 2.9%). India's Sensex equities index jumped 3.1% (up 7.6%). China's Shanghai Exchange increased 0.3% (down 18.7%). Brazil's benchmark dollar bond yields jumped 14 bps to 4.18%, and Mexico's benchmark bond yields rose 4 bps to 4.16%.

Freddie Mac 30-year fixed mortgage rates increased 3 bps last week to 4.35% (down 72bps y-o-y). Fifteen-year fixed rates were unchanged at bps to 3.83% (down 67bps y-o-y). One-year ARMs were down 4 bps to 3.46% (down 118bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 11 bps to 5.37% (down 81bps y-o-y).

Federal Reserve Credit was little changed at $2.287 TN. Fed Credit was up $66.7bn y-t-d (4.3% annualized) and $217bn, or 10.5%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 9/8) jumped another $9.9bn (13-wk gain of $145bn) to a record $3.221 TN. "Custody holdings" have increased $265bn y-t-d (13.0% annualized), with a one-year rise of $393bn, or 13.9%.

M2 (narrow) "money" supply jumped $30.7bn to $8.690 TN (week of 8/30). Narrow "money" has increased $157bn y-t-d, or 2.7% annualized. Over the past year, M2 grew 3.1%. For the week, Currency added $1.6bn, and Demand & Checkable Deposits surged $31.6bn. Savings Deposits gained $4.8bn, while Small Denominated Deposits fell $5.2bn. Retail Money Fund assets dipped $2.1bn.

Total Money Market Fund assets (from Invest Co Inst) increased $10.6bn to $2.839 TN. In the first 36 weeks of the year, money fund assets dropped $455bn, with a one-year decline of $705bn, or 19.9%.

Total Commercial Paper outstanding declined $5.5bn to $1.059 TN. CP has declined $111bn, or 13.7% annualized, year-to-date, and was down $115bn from a year ago.

International reserve assets (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.375 TN y-o-y, or 19.1%, to a record $8.572 TN.

Global Credit Market Watch:

September 10 - Bloomberg (Sapna Maheshwari and Kate Haywood): "Global high-yield bond sales are poised to exceed 2009's record issuance as the riskiest companies take advantage of plunging borrowing costs and investor demand for greater returns to refinance debt. Ally Financial Inc., the lender previously known as GMAC Inc., and the lending arm of Ford Motor Co. led $206.9 billion of speculative-grade debt sales in 2010 through yesterday, compared with $208.1 billion for all of last year... Junk-rated companies are accelerating issuance amid rating upgrades and average borrowing costs that have plummeted from a high of 21.6% in 2009 to 8.4% as of yesterday..."

September 8 - Bloomberg (Joe Brennan and Louisa Fahy): "Anglo Irish Bank Corp. will be broken in two as Ireland's government seeks 'finality' on the bailout of the nationalized bank and tries to calm investor concern that the cost will continue to mount. Anglo Irish will be split into a so-called good bank, which will retain the lender's deposits, and an asset recovery bank which will run down its loans over time..."

September 10 - Bloomberg (Andrea Catherwood and Joe Brennan): "Anglo Irish Bank Corp. Chief Executive Officer Mike Aynsley said 25 billion euros ($32bn) is a 'pretty good estimate' of the total bailout cost for the bank. 'There will be some adjustments to that,' he said... 'It's not possible to entirely predict the exact numbers. But we feel that we're really coming to the end of the process now and we're not very far away.'"

September 10 - Bloomberg (Sonja Cheung and Kate Haywood): "Banks in Europe boosted bond sales to the most in two months as borrowers took advantage of falling borrowing costs and investor demand to refinance debt. BNP Paribas SA and UniCredit SpA lead issuers raising 18 billion euros ($23 billion) this week..."

September 8 - Bloomberg (Alan Katz and Elisa Martinuzzi): "Four months after the 110 billion- euro ($140bn) bailout for Greece, the nation still hasn't disclosed the full details of secret financial transactions it used to conceal debt. 'We have not seen the real documents,' Walter Radermacher, head of the European Union's statistics agency Eurostat, said... Eurostat first requested the contracts in February. Radermacher vows new toughness when officials from his staff head to Greece this month to come up with a 'solid estimate' of the total value of debt hidden by the opaque contracts. 'This is a new era,' he said."

August 25 - Bloomberg (Patricia Kuo): "BHP Billiton Ltd.'s loan to buy Potash Corp. of Saskatchewan Inc. has pushed lending to commodity firms to $128 billion this year, the most since 2007, as rising prices for raw materials draws European bank demand... In 2007, banks committed a record $220 billion to natural resources deals in Europe, according to data compiled by Bloomberg."

September 8 - Bloomberg (Paul Armstrong): "The global default rate on... junk, debt will fall to 2.7% by the end of this year before dropping to 2% a year from now, according to Moody's... Defaults worldwide declined to 5% in August from 5.5% in the previous month... A year ago, the rate was at 12.3%."

September 8 - Bloomberg (Maria Levitov and Paul Abelsky): "Russia will be 'technically ready' to sell its first ruble-denominated Eurobond in November as it borrows less than planned on the domestic market, Deputy Finance Minister Dmitry Pankin said. Western banks have suggested raising the equivalent of $1 billion to $3 billion in a sale of bonds with a maturity of as much as five years..."

Global Government Finance Bubble Watch:

August 23 - Bloomberg (John Glover and John Detrixhe): "The amount of money flowing into bond funds is poised to exceed the cash that went into stock funds during the Internet bubble, stoking concern fixed-income markets are headed for a fall. Investors poured $480.2 billion into mutual funds that focus on debt in the two years ending June, compared with the $496.9 billion received by equity funds from 1999 to 2000..."

August 23 - Bloomberg (Charles Stein): "Retail investors in the U.S., burned by two market crashes in a decade, have shunned stocks for the longest stretch in more than 23 years, upsetting the balance of power in the $10.5 trillion mutual-fund industry. Bond funds attracted more money than their equity counterparts in 30 straight months through June... Preliminary data show the trend continued in July, matching the streak posted by bonds from 1984 through 1987."

September 8 - Bloomberg (Yalman Onaran, Jana Randow and Karin Matussek): "Global regulators reached a compromise on capital ratios for banks that will introduce higher capital requirements over a five- to 10-year period starting in 2013, a German central bank official said. The Basel Committee on Banking Supervision drafted key points of the so-called Basel III reforms... The proposal will be the basis for the Sept. 12 meeting of the Group of Governors of Central Banks and Heads of Banking Supervision Authorities who will decide on the reform framework."

September 9 - Bloomberg (Scott Hamilton): "Bank of England Governor Mervyn King may have to embark on a new round of bond purchases as Britain's rebound from the worst recession since World War II fades. Manufacturing, services and construction all faltered in August and the housing market weakened... That suggests 200 billion pounds ($309 billion) in bond purchases by the central bank since March 2009 and record-low interest rates may not be enough..."

September 9 - Bloomberg (Josiane Kremer): "Norway, which has amassed the world's second-biggest sovereign wealth fund, says Greece won't default on its debts. The Nordic nation's $450 billion Government Pension Fund Global has stocked up on Greek debt, as well as bonds of Spain, Italy and Portugal. Finance Minister Sigbjoern Johnsen says he backs the strategy... '...The Greek holdings are particularly interesting because the consensus in the market is that they will at some point restructure or default.' Norway says its long-term perspective will protect it from losses. 'One could say we are investing for infinity,' Johnsen said..."

Currency Watch:

The dollar index rallied 1.0% to 82.87 (up 6.4% y-t-d). For the week on the upside, the Australian dollar increased 1.1%, the New Zealand dollar 1.1%, the South Korean won 0.8%, the Brazilian real 0.6%, the Canadian dollar 0.3%, the Singapore dollar 0.3%, the Taiwanese dollar 0.2%, the Japanese yen 0.2%, and the Mexican peso 0.1%. For the week on the downside, the the Danish krone declined 1.5%, the euro 1.5%, the Norwegian krone 1.3%, the British pound 0.6%, the Swiss franc 0.3%, and the Swedish krona 0.1%.

Commodities Watch:

September 10 - Bloomberg (Jeff Wilson): "Corn futures rose to 23-month high on speculation the U.S. crop will be smaller than the government forecast after hot, dry weather reduced yields."

September 9 - Bloomberg (Cecilia Yap and Luzi Ann Javier): "Rice prices are becoming 'worrisome' as global supplies tighten because of crop losses in some of the largest exporters, according to an official in the Philippines, the world's biggest buyer. The global supply-and-demand balance is 'not at the 2008 level yet, but it's pretty worrisome because of the prices,' Lito Banayo, head of the National Food Authority... said..."

The CRB index increased 0.9% (down 2.9% y-t-d). The Goldman Sachs Commodities Index (GSCI) gained 2.1% (up 0.3% y-t-d). Spot Gold was little changed at $1,246 (up 13.5% y-t-d). Silver gave back 0.3% to $19.89 (up 18% y-t-d). October Crude rallied $1.87 to $76.47 (down 4% y-t-d). October Gasoline rose 2.8% (down 4% y-t-d), while October Natural Gas declined 1.6% (down 31% y-t-d). December Copper dropped 2.5% (up 2% y-t-d). December Wheat slipped 0.6% (up 36% y-t-d), while December Corn jumped 3.0% (up 14% y-t-d).

China Watch:

September 8 - Bloomberg (Yoshiaki Nohara): "China bought more Japanese bonds than it sold for a seventh month in July, heading for a record annual increase, as a weakening dollar encouraged it to diversify debt holdings. China purchased a net 583.1 billion yen ($6.97bn) of Japanese debt in July... 'It's part of China's ongoing efforts to diversify its currency holdings, and they are increasing yen-denominated assets,' said Koji Ochiai, chief market economist... at Mizuho Investors Securities... 'Dollar weakness is continuing, which will weigh on China if they do nothing.'"

September 10 - Bloomberg: "China posted a third straight trade surplus of more than $20 billion in August even as imports leaped, highlighting friction with the U.S. over claims that the nation's currency is undervalued. Exports rose 34.4% and inbound shipments climbed a more-than-forecast 35.2%, leaving a $20.03 billion excess..."

September 8 - Bloomberg: "China's attempts to cool the real-estate market may be faltering as sales surge, prompting speculation the government may issue more tightening measures. Housing transactions in cities including Shanghai jumped in August from July... China Vanke Co., the nation's biggest developer, said sales increased 149% from a year earlier."

August 26 - Bloomberg: "Lydia Wang, a 28-year-old marketing manager in Shanghai, gripes that the shoes and clothing she normally buys are at least 50% pricier than in 2009. Wu Sengyun, a 54-year-old retiree in the coastal city of Ningbo, Zhejiang, says prices of fruit and fish are up more than 20% in the past year. Willy Lin has cut back on free drumsticks in the canteen of his Jiangxi clothing factory as meat and vegetables grow dear. 'The workers suffer,' he says. 'Everybody is crying.' Officially, China's consumer price inflation topped out at 3.3% in July..."

September 9 - Bloomberg (Cecilia Yap and Luzi Ann Javier): "China's passenger-car sales to dealerships grew at a faster pace in August as dealers offered discounts to clear rising inventories. Wholesale deliveries of passenger cars rose 18.7% to 1.02 million units in August, compared with 13.6% growth in July..."

September 6 - Bloomberg:: "China's retail sales may outstrip those of the U.S. by reaching 34 trillion yuan ($5 trillion) in 2016, Huang Hai, a former Chinese assistant commerce minister, said... The forecast is based on annual growth so far this century of 14.5% in China and 4.6% in the U.S...."

September 6 - Bloomberg (Katrina Nicholas and Henry Sanderson): "Bonds issued by China developers are rebounding from their worst first half in two years as a record $6.8 billion in offshore debt sales spurs confidence the borrowers have the resources to weather a slowing economy."

September 9 - Bloomberg (Kelvin Wong): "A 26-year-old government-built apartment near one of Hong Kong's busiest shopping areas sold for a record price per square foot, underscoring concerns that home prices in the city are becoming unaffordable. The 420-square-foot (39-square-meter) home in the Sham Shui Po area of the Kowloon district was bought for HK$1.98 million ($255,000)..."

Japan Watch:

September 10 - Bloomberg (Keiko Ujikane): "Japan's economy slowed less than initially estimated in the second quarter as companies boosted capital spending, indicating the nation's recovery was intact before a surge in the yen threatened to stunt export gains. Gross domestic product grew an annualized 1.5%, faster than the 0.4% reported last month..."

India Watch:

September 6 - Bloomberg (Abhishek Shanker): "India's steel ministry raised its forecast for steel consumption on increased demand from carmakers and construction companies in Asia's second-fastest growing major economy. Steel consumption may increase 10% in the year..."

Asia Bubble Watch:

September 8 - Bloomberg (Chan Sue Ling): "Cathay Pacific Airways Ltd., Qantas Airways Ltd. and Emirates Airline are awaiting deliveries of about 400 planes to capitalize on Asia's rising prosperity. Finding pilots is the next job. Boeing Co. expects the region's carriers to be the biggest buyers of twin-aisle planes as travel grows in China and India, home to a combined 1.1 billion middle-class people. Asia-Pacific airlines will buy about 8,000 planes worth $1.2 trillion over the next 20 years, Airbus SAS said."

September 8 - Bloomberg: "Vietnam's bank lending rose 16.3% in the first eight months of 2010 from the end of last year... The Southeast Asian nation has pressed commercial banks to cut interest rates and boost lending in an attempt to meet its target for a 25% increase in credit and 6.5% growth in gross domestic product this year."

Latin America Watch:

September 6 - Bloomberg (Telma Marotto): "Analysts covering Brazil's economy raised their forecast for gross domestic product growth this year to 7.34%, according to a central bank survey."

September 8 - Bloomberg (Thomas Black and Carlos Manuel Rodriguez): "When Cessna Aircraft Co. sought a low-wage country in 2006 where it could manufacture airplane parts, its first instinct was to go to China. After struggling to find a way to ship supplies to the Asian country in less than a month, the... producer of light airplanes discovered a better solution just across the U.S. border: Mexico."

Unbalanced Global Economy Watch:

September 8 - Bloomberg (Peter Laca): "Czech economy grew at the fastest pace in two years in the second quarter... Gross domestic product rose an annual 2.4%, compared 1.1% in the first quarter..."

U.S. Bubble Economy Watch:

September 10 - Bloomberg (Sarah Mulholland): "Monthly losses on commercial property debt bundled into bonds have doubled since April as loan specialists gave up trying to restructure smaller mortgages, Deutsche Bank AG data show. Average losses on loans packaged into U.S. commercial mortgage-backed securities totaled $501 million in August compared with $245 million in April.... In August 2009, the number was $41 million."

Central Bank Watch:

September 8 - Bloomberg (Theophilos Argitis and Alexandre Deslongchamps): "The Bank of Canada raised its benchmark interest rate... for a third time this year, and said it expects households and businesses to spend even as the outlook for the U.S. economy weakens. The bank raised its target rate for overnight loans between commercial banks to 1% from 0.75%..."

September 6 - Bloomberg (Christian Vits): "European Central Bank Governing Council member Ewald Nowotny said policy makers will wait until December before discussing how to withdraw emergency measures to give the economy time to gather strength. 'We certainly won't discuss the first quarter before December of this year' Nowotny told Bloomberg News... 'We're still facing an economic development with a very high uncertainty in many respects. It's certainly too early to take a clear position.'"

September 10 - Bloomberg (Gabi Thesing): "European Central Bank President Jean-Claude Trichet said it will take time to wean banks off its emergency lending measures, which policy makers extended last week into 2011. 'We are accompanying the market as it progressively gets back to normal,' Trichet said... The ECB confirmed Trichet's comments. "It's a process that takes time.'"

Muni Watch:

September 9 - New York Times (Ken Belson): "It's the gift that keeps on taking. The old Giants Stadium, demolished to make way for New Meadowlands Stadium, still carries about $110 million in debt... The financial hole was dug over decades by politicians who passed along the cost of building and fixing the stadium, and it is getting deeper... New Jerseyans are hardly alone in paying for stadiums that no longer exist. Residents of Seattle's King County owe more than $80 million for the Kingdome, which was razed in 2000. The story has been similar in Indianapolis and Philadelphia. In Houston, Kansas City, Mo., Memphis and Pittsburgh, residents are paying for stadiums and arenas that were abandoned by the teams they were built for."

California Watch:

September 8 - Bloomberg (Christopher Palmeri): "California property values fell 1.8% for the current fiscal year, only the second drop since the most-populous U.S. state began collecting the data in 1933. Declines in 48 of the state's 58 counties brought the total value to $4.37 trillion... 'This is historic,' Larry Stone, the assessor for Silicon Valley's Santa Clara County, said... 'This is not your normal downturn.'"

Speculator Watch:

September 8 - Bloomberg (Saijel Kishan): "John Paulson, who became a billionaire by betting against U.S. mortgage markets, lost 11% this year in his... firm's biggest hedge fund... The company's Advantage Plus Fund, which uses investment strategies designed to profit from corporate events such as mergers or bankruptcies, fell 4.3% in August, said the person, who asked not to be named..."

September 4 - Bloomberg (Christine Harper and Saijel Kishan): "Goldman Sachs Group Inc. is disbanding its principal-strategies business, one of the groups that makes bets with the firm's own money, to comply with new U.S. rules aimed at curbing risk, two people with knowledge of the decision said."


Bubble Thesis Update

My thesis coming into the year was that 2010 was a "Bubble year." The unprecedented global fiscal and monetary policy response to the 2008 bursting of the Mortgage/Wall Street finance Bubble had unleashed the Global Government Finance Bubble. The "Bubble year" analysis implies bipolar outcome possibilities: if the Bubble is accommodated by ongoing loose financial conditions, it would demonstrate a propensity to broaden and strengthen. Fragile underpinnings, however, leave this emerging Bubble susceptible to bursting and the rapid reemergence of financial and economic crises.

Throw into the mix that acute systemic fragilities ensure that policymakers will attack any potential crisis quickly and with overwhelming force. Such a backdrop would seem to ensure uncertainty and heightened market volatility, and that's what has transpired thus far in 2010.

I have also posited the thesis that the Greece debt crisis was an important inflection point for the Government Finance Bubble, with similarities to the eruption of subprime debt issues in the spring of 2007. Global markets have certainly awakened to structural debt issues. Even so, outside of the European periphery sovereign yields have tanked.

It was more than a year before the subprime crisis evolved to the point of fomenting systemic crisis. There are reasons an even longer gestation period may be in the offing this time around. In contrast to mortgage-related fragilities, global policymakers will not be caught complacent and unprepared. Indeed, the markets' perception that authorities will act forcefully to support debt markets - and marketplace liquidity more generally - is a key reason why the Government Finance Bubble is potentially so dangerous.

The ECB's forceful response contained the debt crisis in the short-run - and certainly boosted marketplace liquidity. Here at home, post-Greece market and economic weakness forced an abrupt u-turn at the Fed. Planning for the so-called "exit strategy" was put on hold - or perhaps forever abandoned. In a too typical Pavlovian response to the market's clamoring for additional monetization, the Fed announced it would buy Treasurys to ensure its bloated balance sheet did not become less so. Comments from Chairman Bernanke, President Bullard and others assured the markets that the Federal Reserve's commitment to purchase Treasury's was open-ended. Talk of (recommendations for) a massive government-induced refi program threw gas on the fire.

The markets now perceive (are convinced) that global central bankers are irreversibly committed to providing government debt markets a (an inexhaustible) "backstop bid." This is fundamental to a Bubble's "terminal phase" expansion and reminiscent of the fateful mortgage finance "backstop bid" provided by Fannie, Freddie, the FHLB, and the Federal Reserve.

Fixed income markets have enjoyed a historic rally. After touching 4.0% in April, 10-year Treasury yields ended August at 2.47%. Benchmark MBS yields sank from an April high of 4.67% down to a low of 3.29%. After slowing sharply during the Greek crisis period, corporate debt issuance bounced back strongly. Junk bond issuance already equals last year's record for the entire year ($162bn).

After jumping to a seven month high of 695 bps in June, junk bond spreads (IBOX) ended the week at 554 bps. Investment grade spreads (IBOX) have declined back to 103 bps after reaching 132 bps in June. For perspective, junk and investment grade spreads reached respective highs of 1,890 bps and 279 bps at the height of the 2008 Credit crisis. The collapse of market yields has been across the board. The Bond Buyer index of municipal bond yields dropped from an April high of 4.45% to this week's 3.92%.

Global Financial Conditions have loosened markedly over the past month or so. After jumping above 5.5% in May, Brazilian dollar bond yields dropped to a record low 3.63% in August. Mexican bond yields dropped to a low of 3.72%, with emerging debt spreads (EMBI) to Treasurys declining to below 300 bps (from a 2008 high above 901). From a May low of 247, the CRB Commodities index has rallied back to 275. Most global equities markets have significantly reduced 2010 declines or moved back into positive territory.

After trading to 88.71 on June 7th, the dollar index has settled back down to 82.87. Renewed dollar weakness has played an instrumental role in the loosening of Financial Conditions. The Greek crisis caught many on the wrong side of fast-moving markets. Shorting the (structurally unsound) dollar to go long global risk markets had, again, become too crowded. European debt problems, the sinking euro and rallying dollar pounded those participating in the "global reflation trade." De-risking and de-leveraging fueled a squeeze on the dollar bears that further fed an unwind in commodities, equities, and risk asset markets more generally.

While European problems are anything but resolved, the market has become much more focused on dollar vulnerability. Talk of QE2, additional fiscal stimulus in the face of massive deficits, and June's nearly $50bn trade shortfall worked to reenergize the dollar bears. And renewed dollar weakness - and seemingly endless outflows of dollar liquidity - coincided with a big increase in foreign reserves held in custody at the NY Fed (foreign central banks lapping up excess dollar liquidity). These holdings increased a remarkable $145bn in only 13 weeks to a record $3.221 Trillion. It is worth noting that International Reserve Assets (as reported by Bloomberg) are up an incredible $940bn year-to-date to $8.572 Trillion.

I still believe the Greek debt crisis will be viewed as an important infection point with regard to market perceptions of structural debt issues. At the same time, it is also clear that the backdrop has been extraordinarily supportive of Bubble Dynamics.

Of course, skyrocketing bond prices have given rise to fundamental justification. Interminable deflation risk is at the top of the list of why bond returns will indefinitely outperform cash. I am reminded of how technology stocks and home prices were only to go higher. My analytical framework downplays deflation and focuses instead on a debt Bubble fueled by the Federal Reserve, The People's Bank of China, the ECB, BOJ, and the approaching one Trillion y-t-d increase in global central bank reserves. Throw in hedge fund/speculator leveraging and the billions flowing weekly (in search of any yield) into global fixed income and one sees all the necessary financing for a historic Bubble.

Developments and dynamics over the past couple of months have provided important confirmation for the Global Government Bond Bubble thesis. At the same time, there are numerous fault lines. Stress has reemerged in European debt markets, with yields rising notably in Greece, Portugal and Ireland. Here at home, stress continues to build in municipal finance. To what extent - and for how long - Global Government Finance Bubble Dynamics and attendant liquidity/speculative excesses mitigate some of these crisis points is an open question.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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