The Official Start of QE2

By: Doug Noland | Fri, Nov 12, 2010
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For the week, the S&P500 dropped 2.2% (up 7.5% y-t-d), and the Dow fell 2.2% (up 7.3%). The Banks sank 3.3% (up 10.2%), and the Broker/Dealers declined 2.7% (down 1.9%). The Morgan Stanley Cyclicals fell 2.4% (up 14.7%), and the Transports declined 2.4% (up 17.3%). The Morgan Stanley Consumer index declined 2.3% (up 7.5%), and the Utilities fell 2.5% (up 0.6%). The S&P 400 Mid-Caps declined 2.0% (up 16.1%), and the small cap Russell 2000 fell 2.4% (up 15.0%). The Nasdaq100 declined 2.2% (up 14.9%), and the Morgan Stanley High Tech index lost 2.2% (up 8.7%). The Semiconductors dropped 2.4% (up 6.3%). The InteractiveWeek Internet index lost 2.1% (up 29.5%). The Biotechs gave back 1.3%, reducing 2010 gains to 22.8%. Although bullion declined $25 for the week, the hyper-volatile HUI gold index added 0.4% (up 28.4%).

One-month Treasury bill rates ended the week at 10 bps and three-month bills closed at 13 bps. Two-year government yields jumped 13 bps to 0.50%. Five-year T-note yields ended the week 26 bps higher at 1.31%. Ten-year yields jumped 25 bps to 2.79%. Long bond yields jumped 17 bps to a 5-month high 4.28%. Benchmark Fannie MBS yields were 32 bps higher at 3.63%. The spread between 10-year Treasury yields and benchmark MBS yields widened 7 bps to 84 bps. Agency 10-yr debt spreads were 3.5 bps wider to 13.5 bps. The implied yield on December 2011 eurodollar futures jumped 25 bps to 0.815%. The 10-year dollar swap spread increased 0.75 bps to 14.0. The 30-year swap spread was little changed at negative 37. Corporate bond spreads widened. An index of investment grade bond risk jumped 8 bps to 94 bps. An index of junk bond risk jumped 50 to 486 bps.

Investment grade issuers included United Parcel $2.0bn, Time Warner Cable $1.9bn, JPMorgan $1.75bn, PPG Industries $1.0bn, Becton Dickinson $1.0bn, LG & E Energy $875 million, Boston Properties $850 million, Talisman Energy $600 million, Plum Creek Timber $575 million, Louisville G&E $535 million, Autozone $500 million, Ventas Realty $400 million, Public Service Colorado $400 million, Coca-Cola Enterprises $400 million, Entergy Arkansas $350 million, American Honda $350 million, Continental Trust $350 million, Hubbell Inc. $300 million, Cleco Power $250 million, Integrys Energy $250 million, Avalonbay Communities $250 million, Kentucky Utilities $1.5bn, and AMB Property $175 million.

Junk bond funds attracted inflows of $382 million (from Lipper), the tenth straight week of positive flows. Junk issuers included HCA Holdings $1.525bn, Berry Plastics $800 million, Mylan $800 million, West Corp $650 million, Omega Healthcare $575 million, Univision Communications $500 million, Ferrellgas $500 million, Affinion Group $475 million, Health Care REIT $450 million, Calfrac Holdings $450 million, Checkout Holdings $440 million, Polypore International $365 million, Seneca Gaming $325 million, Icahn Enterprises $500 million, Medassets $325 million, Allen Systems $300 million, Mercer Intl $350 million, Roofing Supply $225 million, Beazer Homes $250 million, Mobile Mini $200 million, Frontier Oil $150 million and Star Gas $125 million.

Converts issues included Radian Group $450 million.

The list of international dollar debt sales included IPIC $2.5bn, Odebrecht Drill $1.5bn, Peru $1.0bn, ICICI Bank $1.0bn, Precision Drilling $650 million, Vnesheconombank $1.6bn, Renhe Commercial $600 million, MBPS $320 million, China Oriental $300 million, China Forestry $300 million, Allied World Assurance $300 million, Aerospace Satellite $165 million, Global Crossing $150 million, and International Bank of Reconstruction and Development $100 million.

U.K. 10-year gilt yields rose 24 bps to 3.21%, and German bund yields gained 9 bps to 2.51%. Greek 10-year bond yields declined 5 bps to 11.39%. Ten-year Portuguese yields jumped 23 bps to 6.725%. Ireland yields rose 70 bps to 7.62%. The German DAX equities index slipped 0.3% (up 13.0% y-t-d). Japanese 10-year "JGB" yields jumped 7 bps to 0.99%. The Nikkei 225 gained 1.0% (down 7.8%). Emerging equity markets were under pressure. For the week, Brazil's Bovespa equities index dropped 3.1% (up 2.6%), and Mexico's Bolsa slipped 0.7% (up 12.3%). South Korea's Kospi index declined 1.3% (up 13.7%). India's Sensex equities index fell 4.0% (up 15.4%). After today's steep decline, China's Shanghai Exchange ended the week down 4.6% (down 8.9%). Brazil's benchmark dollar bond yields jumped 32 bps to 3.90%, and Mexico's benchmark bond yields rose 36 bps to 3.82%.

Freddie Mac 30-year fixed mortgage rates dropped 7 bps last week to a record low 4.17% (down 74bps year-over-year). Fifteen-year fixed rates fell 6 bps to 3.57% (down 79bps y-o-y). One-year ARMs were unchanged at 3.26% (down 120bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 5 bps to 5.16% (down 75bps y-o-y).

Federal Reserve Credit expanded $8.4bn to $2.289 TN. Fed Credit was up $69.3bn y-t-d (3.6% annualized) and $173.5bn, or 8.2%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 11/10) surged $20.4bn (22-wk gain of $260bn) to a record $3.336 TN. "Custody holdings" have increased $380.7bn y-t-d (14.9% annualized), with a one-year rise of $419bn, or 14.4%.

M2 (narrow) "money" supply jumped $22.4bn to $8.786 TN. Narrow "money" has increased $253bn y-t-d, or 3.5% annualized. Over the past year, M2 grew 3.2%. For the week, Currency added $1.9bn, and Demand & Checkable Deposits gained $6.1bn. Savings Deposits jumped $22.0bn, while Small Denominated Deposits declined $6.1bn. Retail Money Fund assets slipped $1.6bn.

Total Money Market Fund assets (from Invest Co Inst) increased $2.0bn to $2.802 TN. Year-do-date, money fund assets have dropped $492bn, with a one-year decline of $533bn, or 16.0%.

Total Commercial Paper outstanding declined $11.7bn (8-wk gain of $97.6bn) to $1.134 TN. CP has declined $36.4bn year-to-date, and was down $105bn from a year ago.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.516 TN y-o-y, or 20.2%, to a record $9.033 TN.

Global Credit Market Watch:

November 8 - Bloomberg: "Chinese Vice Finance Minister Zhu Guangyao said the U.S. Federal Reserve's decision to pump $600 billion into the economy might 'shock' emerging markets by flooding them with capital. The first round of quantitative easing, as the Fed policy is termed, in 2009 was justified because the global economy lacked liquidity, Zhu told reporters... With a recovery now under way, new purchases of Treasuries to inject funds into the financial system may be destabilizing, he said. 'Around the world we have $10 trillion of hot money flowing around, more than the $9 trillion in hot money at the beginning of the global financial crisis,' Zhu said. The U.S. 'has not fully taken into consideration the shock of excessive capital flows to the financial stability of emerging markets.'"

November 8 - Bloomberg (Jonathan Stearns): "Luxembourg's Jean-Claude Juncker, who heads the panel of euro-area finance ministers, said he agreed with German Finance Minister Wolfgang Schaeuble's criticism of the Federal Reserve's decision to pump more money into the U.S. economy. 'I am in full agreement with Mr. Schaeuble when it comes to the way he was criticizing the U.S.,' Juncker told reporters... Schaeuble on Nov. 5 described the Fed's move as 'clueless.'"

November 10 - Bloomberg: "President Barack Obama finds himself on the defensive as world leaders gather in Seoul for the Group of 20 summit, with members disparaging U.S. economic policies they say weaken the dollar and stoke hot-money flows. The U.S. Federal Reserve decision last week to pump $600 billion into world's biggest economy has stolen the spotlight away from China's currency. Brazilian Finance Minister Guido Mantega said... that the Fed's move may inflate commodities prices and proposed the world move away from using the dollar as the main reserve currency. Former Chinese central bank governor Dai Xianglong this week faulted the U.S. for adopting policies without regard for the dollar's global role."

November 8 - Bloomberg: "China's middle-income and affluent consumers will probably almost triple in 10 years with the bulk of the increase coming from smaller cities, Boston Consulting Group Inc. said... There will be 270 million more consumers whose annual household incomes exceed 60,000 yuan ($9,000) in the world's most populous country by 2020, said Carol Liao... That would lift the total number of middle-class and affluent Chinese to 415 million from 148 million now, she said."

November 11 - Bloomberg (Veronica Navarro Espinosa and Gabrielle Coppola): "The best year for Brazilian bank bond sales may be over as a probe into accounting irregularities at Banco Panamericano SA increases investor scrutiny and drives up borrowing costs for lenders. Yields on dollar debt... jumped yesterday to the highest level since they were issued this year... Panamericano is being investigated by the central bank after the controlling shareholder, Grupo Silvio Santos, borrowed 2.5 billion reais ($1.5 billion) from the deposit insurance fund to cover potential losses at the bank that it said were caused by accounting 'inconsistencies.' Brazil's banks have sold a record $15.2 billion of debt this year, up from $4.3 billion in all of 2009, to help finance loan growth..."

November 8 - Bloomberg (Patricia Kuo): "Leveraged loans prices climbed to a three-year high as demand for secured high-yield investments overshadowed Europe's deepening sovereign debt crisis. The average bid price for actively-traded European leveraged loans rose 52 basis points to 97.23% of face value last week..."

November 12 - Bloomberg (Emre Peker): "Lenders led by Bank of America Corp. and JPMorgan Chase... are on pace to double U.S. leveraged-loan sales, tapping demand to help companies finance buyouts and dividends... Armstrong World Industries... led borrowers raising $8.1 billion of high-yield loans this week as 2010 issuance rose to $299 billion, 76% more than all of last year..."

November 9 - Bloomberg (Cristina Alesci and Alex Nussbaum): "HCA Inc., the hospital chain acquired four years ago in a $33 billion leveraged buyout, plans to pay a $2 billion dividend to private-equity owners including KKR & Co. and Bain Capital LLC. The dividend will be partly funded with a $1.53 billion high-yield bond issue..."

Global Government Finance Bubble Watch:

November 12 - Bloomberg (Liz Capo McCormick): "The Federal Reserve began a second round of unconventional monetary easing by buying $7.229 billion of Treasuries in attempt to drive down borrowing rates to help reduce unemployment and avert deflation... The acquisitions are part of the Fed's plan to acquire $600 billion of Treasuries through June and reinvest maturing mortgage holdings."

November 8 - Bloomberg (Joao Lima): "China said it's 'available' to support Portugal's efforts to come through the economic crisis that has prompted its borrowing costs to spiral this year. 'We are available to support, through concrete measures, Portuguese efforts to face the impacts caused by the international financial crisis, and deepen and broaden our economic and commercial cooperation,' Chinese President Hu Jintao said..."

Currency Watch:

November 12 - Bloomberg (Theophilos Argitis): "The Group of 20 said emerging markets facing a surge of capital inflows can adopt regulatory steps to cope, offering them cover to limit currency swings and stem asset bubbles as the U.S. adds $600 billion of liquidity. 'In circumstances where countries are facing undue burden of adjustment, policy responses in emerging-market economies with adequate reserves and increasingly overvalued flexible exchange rates may also include carefully designed macro- prudential measures,' leaders of the G-20 nations said in a statement..."

The dollar index rallied 2.0% (up 0.3% y-t-d) to 78.11. For the week on the downside, the Swedish krona declined 3.7%, the Norwegian krone 3.3%, the Australian dollar 3.1%, the New Zealand dollar 2.8%, the South African rand 2.7%, the Brazilian real 2.5%, the euro 2.4%, the Danish krone 2.4%, the Swiss franc 2.0%, the South Korean won 1.8%, the Japanese yen 1.5%, the Canadian dollar 1.2%, the Mexican peso 1.1%, the Singapore dollar 0.9%, the British pound 0.4%, and the Taiwanese dollar 0.3%.

Commodities Watch:

November 12 - Bloomberg (Alaric Nightingale): "Frontline Ltd., the world's biggest supertanker operator, said it's seeing 'huge' demand for crude-oil imports from China, potentially reversing a slump that contributed to mostly unprofitable charter rates since June."

November 8 - Bloomberg (Leslie Patton): "Arabica-coffee prices rose to a 13-year high in New York on speculation that adverse weather will disrupt supplies in Vietnam, the world's second-largest grower."

The CRB index dropped 3.2% (up 7.1% y-t-d). The Goldman Sachs Commodities Index (GSCI) declined 2.1% (up 10.9% y-t-d). Spot Gold declined 1.8% to $1,369 (up 24.7% y-t-d). Silver dropped 2.7% to $26.02 (up 55% y-t-d). December Crude declined $1.98 to $84.87 (up 7% y-t-d). December Gasoline gained 1.8% (up 8% y-t-d), while December Natural Gas fell 3.0% (down 31% y-t-d). December Copper declined 1.7% (up 16% y-t-d). December Wheat sank 8.2% (up 24% y-t-d), and December Corn dropped 9.1% (up 29% y-t-d).

China Bubble Watch:

November 10 - Bloomberg: "China posted a larger-than-forecast $27.1 billion October trade surplus... Exports gained 22.9% from a year earlier and imports rose 25.3%... With the surplus pumping cash into the fastest-growing major economy..."

November 10 - Bloomberg: "China will force banks to hold more foreign exchange and strengthen auditing of overseas fund raising, stepping up efforts to curb hot-money inflows... The State Administration of Foreign Exchange will introduce new rules on currency provisioning and tighten management of banks' foreign-debt quotas, the regulator said... The government will also regulate Chinese special-purpose vehicles overseas and tighten controls on equity investments by foreign companies in China, it said."

November 10 - Bloomberg: "China's property prices rose at the slowest pace in 10 months in October... Home prices in 70 cities climbed 8.6% from a year earlier, the statistics bureau said... That's slower than the 9.1% increase in September... Price gains also slowed to 0.2% from September after increasing 0.5 percent last month."

November 10 - Bloomberg: "China's passenger-car sales in October rose at the fastest pace in six months... Wholesale deliveries of cars, sport-utility vehicles and multipurpose vehicles increased 27% from a year earlier to 1.2 million last month... Passenger-car sales surged 76% to 946,400 vehicles in October 2009 as the government cut the tax rate for small cars..."

November 9 - Bloomberg (Wing-Gar Cheng): "China's challenger to Boeing Co. and Airbus SAS expects to announce the first order for its single-aisle passenger plane next week, breaking into a market that may be worth $1.68 trillion over 20 years... 'This is a big breakthrough for China, which will eventually become a player in the global aircraft market,' said Bai Bingyang, an analyst at Capital Securities Corp in Shanghai. 'Boeing and Airbus's duopoly will be under threat.'"

November 11 - Bloomberg: "Moody's... raised China's debt rating to its fourth highest ranking, citing the nation's financial strength and ability to contain losses from a credit boom. The increase is to Aa3 from A1..."

November 12 - Bloomberg (Sophie Leung): "Hong Kong reported a more-than- estimated 6.8% economic expansion in the third quarter from a year earlier as Chief Executive Donald Tsang warned asset bubbles could threaten the city's recovery."

November 9 - Bloomberg (Debra Mao): "An office property in Hong Kong's Central business district sold for a record HK$25,581 ($3,300) per square foot as vacancies drop in the world's second-most expensive market, according to Knight Frank LLP and Savills Plc."

Japan Watch:

November 9 - Bloomberg (Toru Fujioka and Mayumi Otsuma): "Japan's current-account surplus widened in September as exports increased, indicating that demand from Asia has helped offset the impact of a yen near its highest level against the dollar since 1995. The gap expanded 24% from a year earlier to 1.96 trillion yen ($24bn). Exports climbed 16%, while imports advanced 11%..."

India Watch:

November 11 - Bloomberg (Madelene Pearson): "In his office above a room stacked with jute sacks of turmeric, many streaked yellow by the powder, Deepak Shah is extolling the virtues of the spice. 'It's very good for health, it's used in cooking, in cosmetics and it's medicinal,' said Shah, owner of P. Amratlal & Sons, a trader at Mumbai's wholesale Vashi market. Falling stockpiles and speculation have also pushed up the price of the curry ingredient 64% this year...boosting food costs in a country where 7 out of 10 people live on less than $2 a day."

Asia Bubble Watch:

November 9 - Bloomberg (Barry Porter): "Asian economies may need to turn to capital controls as quantitative easing by the U.S. threatens to spur asset bubbles in the region's stock, currency and property markets, the World Bank said. Any curbs should be 'targeted,' temporary and tailored to address specific problems, Sri Mulyani Indrawati, a World Bank managing director, said...This could include countries tying up funds for as long as a year to help limit hot-money, she said."

November 8 - Bloomberg (Joshua Fellman): "China and Indonesia signed $6.6 billion of agreements for trade and cooperation, in areas including finance, energy, electricity and agriculture, Xinhua News Agency reported."

November 12 - Bloomberg (Scott Reyburn): "A battle between Asian buyers last night pushed a Qianlong-dynasty vase to a price of 51.6 million pounds ($83.2 million), an auction record for Chinese art. The vase had been discovered during a routine house clearance in the suburb of Pinner in London."

Latin America Watch:

November 10 - Bloomberg (Jens Erik Gould and Andres R. Martinez): "The peso's biggest rally on record may prompt Mexico's central bank to cut interest rates next year to boost exports after other Latin American policy makers raised borrowing costs to cool their economies. Governor Agustin Carstens signaled... he would consider cutting rates should the peso keep gaining, according to analysts..."

Unbalanced Global Economy Watch:

November 12 - Bloomberg (Simone Meier and Emma Ross-Thomas): "Europe's economic growth weakened in the third quarter from the fastest pace in four years... Gross domestic product in the 16-nation euro area rose 0.4% from the second quarter, when it increased 1%..."

November 8 - Bloomberg (Klaus Wille): "The Swiss jobless rate fell to the lowest in more than 1 1/2 years in October... The jobless rate dropped to 3.6% from 3.7% in September..."

U.S. Bubble Economy Watch:

November 10 - Bloomberg (William Selway): "The Republican landslide in U.S. House elections may derail efforts to extend the Build America Bond program, a part of President Barack Obama's stimulus that has helped pump $158 billion into local public-works projects. With the federally subsidized bond program set to expire at year-end, supporters are pressing for an extension... Prospects will grow dimmer in January, when Republicans, who have called Obama's $787 billion stimulus too costly, take control of the House and reduce the Democratic majority in the Senate."

November 12 - Bloomberg (Elizabeth Campbell): "Americans will be paying more for their Thanksgiving turkeys this month... U.S. wholesale, frozen turkeys jumped to $1.09 a pound on average yesterday, the highest price ever and up 28% from a year earlier..."

Real Estate Bubble Watch:

November 11 - Bloomberg (Kathleen M. Howley): "Home prices fell in half of U.S. cities in the third quarter... The median price of a single-family home dropped in 76 of 155 metropolitan areas measured, the National Association of Realtors said... The median U.S. price fell 0.2% to $177,900."

Central Bank Watch:

November 8 - Bloomberg (Vivien Lou Chen): "The Federal Reserve's decision to undertake a second round of large-scale Treasury purchases may be prescribing the 'wrong medicine' to the economy's ailments, said Richard Fisher, president of the Fed bank of Dallas... 'I asked that the FOMC consider that we might be prescribing the wrong medicine for the ailment from which our economy is suffering,' Fisher said... 'The remedy for what ails the economy is, in my view, in the hands of the fiscal and regulatory authorities, not the Fed.'"

November 8 - Bloomberg (Niklas Magnusson and Kim McLaughlin): "Sweden's economy needs higher interest rates to prevent the build-up of financial imbalances even as concerns mount about the strength of recovery in the U.S. and Europe, Riksbank Governor Stefan Ingves said. It is 'appropriate to gradually continue to make monetary policy somewhat less expansionary,' Ingves said..."

Fiscal Watch:

November 12 - Bloomberg (Angela Greiling Keane): "The U.S. Postal Service said its loss widened to $8.5 billion in the year ended Sept. 30, exceeding its forecast... Revenue fell 1.5% to $67.1 billion for the year and mail volume dropped 3.5%... The loss in the previous fiscal year was $3.8 billion..."

California Watch:

November 12 - Bloomberg (Michael B. Marois): "California Governor Arnold Schwarzenegger, citing a $25.4 billion budget gap over the next 19 months, declared a fiscal emergency and called lawmakers to a special session next month to begin dealing with the problem... In addition to the gap forecast for the fiscal year through June, the nonpartisan Legislative Analyst's Office yesterday projected a $19 billion gap in the following 12 months. By Jan. 10, Governor-elect Jerry Brown, a Democrat who will be sworn in Jan. 3, must propose a plan to erase the next year's deficit."

November 8 - Bloomberg (Michael B. Marois): "The budget agreement California Governor Arnold Schwarzenegger and lawmakers reached last month will have a 'negative influence' on the credit of school districts more than on other parts of local government, Moody's... said... Schwarzenegger signed the $86.6 billion budget Oct. 8 after lawmakers wrestled over an agreement for 100 days into the fiscal year, the longest the most populous U.S. state has ever gone without a spending plan. It eliminated a $19 billion deficit by cutting spending almost $8 billion, half of that from health and welfare programs administered by local governments. It also delayed paying more than $5 billion in subsidies to schools and community colleges."

November 8 - Bloomberg (Alison Vekshin): "California's finances are less flexible after voters approved a ballot measure last week that barred the state from diverting money destined for transport and local government projects, Moody's... said... 'In fiscal year 2012 and beyond, this action decreases budgeting flexibility by further restricting the use of various funds,' Moody's said."

Speculator Watch:

November 9 - Bloomberg (Tomoko Yamazaki): "Hedge-funds assets exceeded $1.6 trillion, reaching the highest in more than two years, as managers returned 2.3% last month helped by gains in global markets, according to Eurekahedge Pte."

November 9 - Bloomberg (Alexis Xydias): "Quantitative funds, which choose stocks according to mathematical models, may have lost almost half their assets since 2007 after failing to capture swings in markets, according to...Nomura Holdings Inc. Money overseen at a sample of 137 quant funds fell 43% over three years to $44 billion, while the quant share of actively managed equity funds is also estimated to have halved since 2007..."


The Official Start of QE2

There are a couple key facets of my thesis worthy of some extra focus today, the official start of QE2: First, in the post-Greek crisis world - with parallels to the subprime eruption in the spring of 2007 - the markets are increasingly keen to structural debt issues. Second, inflationary pressures have gained significant momentum in China, Asia and the "emerging" economies more generally.

In the world of structural debt problems, the European debt crisis turned more acute this week. Ireland's 10-year yields surged to almost 9% yesterday (from about 5% in early-August), before declining 76 bps today on more conciliatory talk from European officials. Prior to today's bond rally, Portuguese yields were up another 50bps (to 7.0%) this week and Greece yields were another 15 bps higher (to 11.60%). Recalling the 2007-08 experience in U.S. mortgage finance, the initial policy response to the European peripheral debt crisis may have bought some time but has had little effect on underlying structural debt problems.

On the inflation front, Chinese stocks (Shanghai Composite) were hit for 5.2% today on fears of more aggressive monetary tightening by the People's Bank of China. Chinese authorities have warned of the heightened inflation risk related to QE2. The markets are taking this talk seriously.

Earlier this week, gold and cotton surged to new record highs. Silver, sugar and rubber jumped to near 30-year highs. Copper, corn and crude traded to 2-year highs. From the beginning of September, the CRB Commodities Index rallied about 20%. Indicative of increasingly unstable global markets, the CRB index sank 3.7% today after trading to a 2-year high earlier in the week.

Yesterday, China reported a larger-than-expected 4.4% y-o-y jump in consumer prices. Also this week, China reported its October money supply (up 19.3% y-o-y) and bank loan growth ($89bn) surprised on the upside. Reports on China's retail sales (up 18.6% y-o-y) and auto sales (up 27% y-o-y) were strong. And to the chagrin of Chinese authorities, real estate prices remain resilient at elevated levels. These days, China's policymakers face an overheated Bubble Economy, a dilemma compounded by the prospects for surging commodity costs and destabilizing "hot money" inflows. Patience is wearing thin. Prospects are not favorable for monetary "tinkering" to be effective.

For the past couple of months, the world has been enamored with QE2 and prospects for concerted global central bank monetization/liquidity creation. European peripheral debt problems were viewed as ensuring ECB market intervention/support. Deflation had the Bank of Japan poised for aggressive action. In the U.S., structural problems were sure to support multiple QE's and a feeble dollar. A faltering greenback equated to ongoing Asian central bank dollar purchases and the "recycling" of these balances back to the U.S. Treasury market. Ultra-low Treasury yields would then remain a steadfast anchor on market yields for the vast spectrum of global borrowers.

Global markets - stocks, bonds, commodities, and currencies - have been luxuriating in visions of endless liquidity over-abundance - for all. It's been a backdrop where fundamental factors and issues were relegated to the backburner.

This week, it seemed like the focus may have shifted toward fundamentals. Risk is returning to the equation. For starters, the markets' disregard for global inflation risks has begun to wane. And despite all the focus on global liquidity abundance, systemic risks remain quite elevated. Moreover, the world is increasingly keen to structural debt problems. As the week wore on, the liquidity backdrop suddenly looked a lot less certain. Perhaps the future does not guarantee ultra-loose "money" for all - but rather an increasingly discriminating market environment of "the haves" and "have nots".

Global yields were on the rise. German bund yields gained 9 bps to 2.51% and Japan's JGBs rose 7 bps to 0.99%. Notably, UK 10-year yields jumped 24 bps (3.21%), Spain 17 bps (4.53%), and Italy 18 bps (4.15%). Our 30-year Treasury yields rose 17 bps to 4.29%, the high since mid-May. Benchmark U.S. municipal yields jumped 24 bps to 3.70% (from Bloomberg).

If the markets are indeed beginning to reevaluate the global inflation backdrop and the prospects for China/Asian monetary tightening, the marketplace would also be expected to become more discriminating based on respective borrower fundamentals. After all, the potential for rising global yields and a less accommodating liquidity backdrop would more severely impact the most heavily indebted. As such, I take particular interest in this week's jump in yields for the UK, Spain, Italy, the U.S. long bond, and American municipal bonds.

If the market has in fact begun to shift from "endless liquidity for all" to a more fundamentally-driven focus, don't expect such a transition to go smoothly. After all, ultra-loose financial conditions tend to most benefit the weakest borrowers. That has certainly been the case in the U.S. Credit market, with junk bonds, leveraged loans, and municipal debt having enjoyed such stellar performance. In our stock market, many of the most fundamentally-challenged stocks and sectors have posted tremendous gains. An extraordinary liquidity backdrop has nurtured speculative excess - in the process creating acute vulnerability to changing market perceptions.

On a global macro basis, few governments have benefited more from global liquidity excess than the U.S. Treasury. It is worth noting that in the face of today's global risk markets drubbing - Treasury yields rose and the dollar index barely treaded water.

Has quantitative easing - on this, the initial trading day of QE2 - turned counterproductive? Have markets reached an inflection point, with concern shifting away from perceived liquidity benefits to the heightened risks associated with additional Federal Reserve liquidity creation (i.e. inflation, Chinese/Asian tightening, unwieldy global liquidity flows, heightened market instability, worsening structural problems, etc.)? Did global policymaking and the markets' euphoric perception of endless liquidity set the stage for disappointment and liquidity issues? This week felt different; highly speculative global markets are overdue for a bout of "soul searching."

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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