Issues 2011

By: Doug Noland | Fri, Jan 14, 2011
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For the week, the S&P500 advanced 1.7% (up 2.8% y-t-d), and the Dow gained 1.0% (up 1.8%). The S&P 400 Mid-Caps jumped 2.3% to a new all-time record high (up 2.6%), and the small cap Russell 2000 rose 2.5% (up 3.1%). The Banks surged 3.4% (up 4.8%), and the Broker/Dealers jumped 2.6% (up 4.7%). The Morgan Stanley Cyclicals added 0.8% (up 3.3%), and the Transports gained 1.0% (up 2.4%). The Morgan Stanley Consumer index slipped 0.2% (up 0.2%), and the Utilities added 0.4% (up 1.3%). The Nasdaq100 rose 2.1% (up 4.8%), and the Morgan Stanley High Tech index gained 2.9% (up 5.4%). The Semiconductors surged 6.1% (up 9.7%). The InteractiveWeek Internet index increased 1.7% (up 4.9%). The Biotechs gained 1.2% (up 1.9%). Although bullion was down only $8, the HUI gold index dropped 3.0% (down 10.0%).

One-month Treasury bill rates ended the year at 13 bps and three-month bills closed at 15 bps. Two-year government yields were one basis point lower at 0.54%. Five-year T-note yields ended the week down 4 bps to 1.87%. Ten-year yields were little changed at 3.33%. Long bond yields ended the week 4 bps higher to 4.53%. Benchmark Fannie MBS yields were down one basis point to 4.09%. The spread between 10-year Treasury yields and benchmark MBS yields narrowed one to 76 bps. Agency 10-yr debt spreads were little changed at 9.5 bps. The implied yield on December 2011 eurodollar futures fell 7.5 bps to 0.715%. The 10-year dollar swap spread declined somewhat to 7.2 bps. The 30-year swap spread declined one to negative 30 bps. Corporate bond spreads were narrower. An index of investment grade bond risk declined 5 to 83 bps. An index of junk bond risk sank 20 to 412 bps.

The debt selling machine was at full throttle. Investment grade issuers included JPMorgan Chase $3.25bn, SLM Corp $2.0bn, Commonwealth Edison $600 million, O'Reilly Automotive $500 million, Texas Gas Transmission $325 million, Chevron Phillips $300 million, Georgia Power $300 million, Public Service Oklahoma $250 million, and Senior Housing Realty Trust $250 million.

Junk bond funds saw inflows of $323 million (from EPFR). Issuers included Cequel Communications $1.82bn, Commscope $1.5bn, Citicenter Holdings $1.5bn, Petrohawk Energy $1.22bn, NRG Energy $1.2bn, Grifols $1.1bn, Calpine $1.2bn, Univision Communications $815 million, Exide Technologies $675 million, RSC Equipment Rental $650 million, Polymer Group $560 million, Elm Road Generating Station $420 million, Verso Paper $360 million, Laredo Petroleum $350 million, Level 3 Communications $305 million, Valassis Communications $260 million, Elizabeth Arden $250 million, Dycom $190 million, AS Americas $190 million, Cogent Communications $175 million, Nuveen Investment $150 million, and Columbus Mckinnon $150 million.

Convertible debt issuers included Dendreon $540 million.

International dollar debt issuers included Lloyds Bank $4.75bn, HSBC $4.0bn, Nordea Bank $2.75bn, BNP Paribas $2.0bn, Japan Finance Corp $1.5bn, Nomura $1.25bn, Credit Suisse $2.0bn, Credit Agricole $650 million, Commonwealth Bank of Australia $1.0bn, Cencosud $750 million, Banco Santander $500 million, Banco Cruzeiro $1.05bn, Inversiones $500 million, Uncle Acquisition $400 million, Navios Maritime $350 million, BR Malls $230 million, Texhong Textile $200 million and State Bank India $100 million.

U.K. 10-year gilt yields jumped 10 bps this week to 3.61%, and German bund yields rose 16 bps to 3.03%. Ten-year Portuguese yields dropped 27 bps to 6.81%. Spanish yields fell 17 bps to 5.33%, and Irish yields sank 72 bps to 8.33%. Greek 10-year bond yields collapsed 150 bps to 11.11%. The German DAX equities index gained 1.8% (up 2.3% y-t-d). Japanese 10-year "JGB" yields were unchanged at 1.195%. Japan's Nikkei slipped 0.4% (up 2.6%). Emerging markets were mixed. For the week, Brazil's Bovespa equities index gained 1.3% (up 2.4%), while Mexico's Bolsa dropped 1.6% (down 1.4%). South Korea's Kospi index added 1.1% to a record high (up 2.8%). India's equities index sank 4.2% (down 8.0%). China's Shanghai Exchange declined 1.7% (down 0.6%). Brazil's benchmark dollar bond yields declined 2 bps to 4.33%, while Mexico's benchmark bond yields declined 2 bps to 4.34%.

Freddie Mac 30-year fixed mortgage rates declined 6 bps last week to a 5-wk low of 4.71% (down 35bps y-o-y). Fifteen-year fixed rates fell 5 bps to 4.08% (down 37bps y-o-y). One-year ARMs dipped one basis point to 3.23% (down 116bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 6 bps to 5.61% (down 41bps y-o-y).

Federal Reserve Credit jumped $21.6bn to a record $2.432 TN (10-wk gain of $151.7bn). Fed Cred it was up $207bn from a year ago (9.3%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 1/12) rose $6.2bn to $3.350 TN. "Custody holdings" were up $400bn from a year ago, or 13.5%.

M2 (narrow) "money" supply dropped $23.1bn to $8.826 TN. Over the past year, "narrow money" grew 4.0%. For the week, Currency increased $1.3bn. Demand and Checkable Deposits increased $4.1bn, while Savings Deposits dropped $24.8bn. Small Denominated Deposits declined $4.5bn. Retail Money Funds added $1.1bn.

Total Money Market Fund assets (from Invest Co Inst) slipped $2.0bn to $2.796 TN. Over the past year, money fund assets have dropped $509bn, or 15.4%.

Total Commercial Paper outstanding dropped $29.7bn to $936 billion. CP was down $166bn y-o-y, or 15.1%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.60 TN y-o-y, or 21.0%, to a record $9.243 TN.

Global Credit Market Watch:

January 12 - Bloomberg (Tony Czuczka and Patrick Donahue): "Chancellor Angela Merkel indicated that Germany is ready to revise the terms of a 750 billion-euro ($973 billion) rescue fund for indebted states, saying Europe's biggest economy will do whatever is necessary to protect the euro... 'We support whatever is needed to support the euro, also with respect to the bailout package,' Merkel told reporters... 'We're saying what we've always said since the Greek crisis: We will stand by the euro,' Merkel said. 'We will do whatever is necessary -- and everything else will be discussed step by step.'"

January 12 - Bloomberg (Joao Lima): "Portugal's borrowing costs fell and demand rose at a sale of 10-year bonds after European Central Bank debt purchases helped push down yields in the last two days."

January 13 - Bloomberg (Emre Peker and Lisa Abramowicz): "Leveraged-loan prices rose to the highest in more than three years, returning more than junk bonds as investors seek protection from a possible increase in interest rates."

January 11 - Bloomberg (Dara Doyle): "Irish commercial real estate values have fallen by 60% since peaking in the third quarter of 2007, Jones Lang LaSalle Inc. said."

Global Bubble Watch:

January 12 - Financial Times (Gregory Meyer, Javier Blas and Jack Farchy): "The world has moved a step closer to a food price shock after the US government surprised traders by cutting stock forecasts for key crops, sending corn and soyabean prices to their highest level in 30 months. The price jump comes after the UN's Food and Agriculture Organisation warned last week that the world could see repetition of the 2008 food crisis if prices rose further. The trend is becoming a major concern in developing countries. While officials are drawing comfort from stable rice prices, key for feeding Asia, they warn that a sustained period of high prices, especially in grains such as wheat, would hit poorer countries. Food price hikes have already led to riots in Algeria and Mozambique. 'Stocks of corn and soyabean are at incredibly tight levels ... and the markets are surging to incredibly strong prices,' Chad Hart, agricultural economist at Iowa State University, said."

January 13 - Bloomberg (Jana Randow and Jeff Black): "European Central Bank President Jean-Claude Trichet signaled he's prepared to raise interest rates if needed to fight inflation even as leaders struggle to contain the region's sovereign debt crisis. 'We are permanently alert, we are never pre-committed not to move interest rates and our level of interest rates is designed to deliver price stability,' Trichet said..."

January 10 - Bloomberg (Daniel Kruger): "Wall Street banks are cutting their holdings of Treasuries at the fastest pace since 2004 as the world's biggest bond firms bet that the economy will strengthen and demand for higher-yielding assets will increase. The 18 primary dealers that trade with the Federal Reserve reported that holdings of U.S. government debt tumbled to a net $2.34 billion on Dec. 29 from $81.3 billion on Nov. 24..."

January 10 - Bloomberg (Matt Walcoff and Lynn Thomasson): "Following the advice of equity analysts may be perilous for your profits. Companies in the Standard & Poor's 500 Index that analysts loved the most rose 73% on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest 'buy' recommendations gained 165%... Now, banks' favorites include retailers and restaurant chains, the industry that did best in last year's rally and that are more expensive than the S&P 500 compared with their estimated 2011 profits."

Currency Watch:

January 12 - Bloomberg: "China said it would 'welcome' a positive statement from the U.S. on the stability of Chinese- held dollar assets during next week's summit in Washington between President Hu Jintao and President Barack Obama. 'If the U.S. makes a positive statement on this issue we surely will welcome that,' Chinese Vice Foreign Minister Cui Tiankai said... 'China follows very closely the economic health of the United States and vice versa.'"

January 9 - Financial Times (Jonathan Wheatley and Joe Leahy): "Brazil has warned that the world is on course for a full-blown 'trade war' as it stepped up its rhetoric against exchange rate manipulation. Guido Mantega, finance minister, told the Financial Times that Brazil was preparing new measures to prevent further appreciation of its currency... and would raise the issue of exchange-rate manipulation at the World Trade Organisation and other global bodies. He said the US and China were among the worst offenders. 'This is a currency war that is turning into a trade war,' Mr Mantega said... His comments follow interventions in currency markets by Brazil, Chile and Peru last week and recent sharp rises in the Australian dollar, the Swiss franc and other currencies amid an exodus of investment from the sluggish economies of the US and Europe."

The U.S. dollar index dropped 2.5% to 79.07 (up 0.1%). On the upside for the week, the Swedish krona increased 4.2%, the Danish krone 3.7%, the euro 3.7%, the Norwegian krone 2.6%, the British pound 2.1%, the Mexican peso 1.5%, the Taiwanese dollar 1.2%, the New Zealand dollar 0.8%, the Singapore dollar 0.5%, the Swiss franc 0.4%, the Japanese yen 0.3% and the Canadian dollar 0.3%. On the downside, the South African rand declined 1.9%, the Australian dollar 0.7%, and the Brazilian real 0.1%.

Commodities and Food Watch:

January 10 - Bloomberg: "China, the biggest soybean buyer, boosted imports by 29% to a record in 2010 as the domestic crushing industry expanded to supply higher consumption of livestock feed and cooking oil."

January 10 - Bloomberg (Mike Lee and Jim Polson): "U.S. natural-gas companies are getting hit with the highest costs in four years as they shift more production to oil to escape low gas prices. EOG Resources Inc., Chesapeake Energy Corp. and SandRidge Energy Inc. each have announced $1 billion transactions in the past year to ramp up onshore production of higher-profit oil and other petroleum liquids as booming gas production deflated prices."

January 12 - Bloomberg (Ben Sharples): "Coal used by steelmakers may jump to $330 a ton, compared with first-quarter contract levels of $225 and a spot price of $280, amid shortages caused by Australia's floods, Bank of America Merrill Lynch said."

January 11 - Bloomberg (Aya Takada and Supunnabul Suwannakij): "Rubber extended its rally to a record after data showed China's car sales jumped by a third last year, boosting expectations that demand for the commodity used in tires will keep expanding amid tight supply."

The CRB index rallied 2.8% (up 0.1% y-t-d). The Goldman Sachs Commodities Index (GSCI) fell 1.8%. Spot Gold declined 0.6% to $1,362. Silver fell 0.7% to $28.48 (down 7.9%). February Crude gained $3.64 to $91.67 (up 0.3%). February Gasoline jumped 3.3% (up 2.5%), and February Natural Gas gained 1.4% (up 1.8%). March Copper rallied 3.5% (down 0.3%). March Wheat slipped 0.1% (down 2.6%), while March Corn jumped 9.0% (up 3.1%).

China Bubble Watch:

January 14 - Bloomberg: "China told banks to set aside more deposits as reserves for the fourth time in two months, stepping up efforts to rein in liquidity after foreign-exchange reserves rose by a record and lending exceeded targets."

January 12 - Reuters: "Chinese banks continued their lending frenzy in the beginning of the year, doling out 500 billion yuan ($75.6bn) in new loans in the first week of January alone... The overall lending figure would roughly equal the new loans extended during all of December. New lending in December reached 480.7 billion yuan, meaning China overshot the government's target of keeping bank loans to 7.5 trillion yuan in 2010. The surge in lending in the first week of 2011 continues a pattern seen in recent years of Chinese banks rushing out lending at the start of the year, after they built up a backlog of potential loans at the end of the previous year due to credit curbs and as they sought to extend credit ahead of any further official restrictions. New loans extended in the first quarter have accounted for an average of 33% of the full-year total over the past decade... Banks lent 7.95 trillion yuan ($1.2 trillion) in 2010... In the past, China used loan quotas to keep a handle on lending. This year, the central bank has pledged to refine that system with regular calibrations of reserve requirements and capital ratios targeted at individual lenders. Li Daokui, an academic adviser to the People's Bank of China, said the government wants to rein in bank lending, but added that setting a full-year credit quota by itself was insufficient. 'China's economic structure is complicated today, so it is not sufficient to only set a lending target this year to control the economic performance,' Li said."

January 12 - Bloomberg: "The People's Bank of China should focus more on regulating the aggregate volume of financing in the economy, Xia Bin an adviser to the central bank, said... China has excessive growth in M2... Xia said. To maintain a steady and stable monetary policy 'we must use aggregate volume as the figure to be studied,' said Xia who is director of the Research Institute of Finance at the State Council's Development and Research Center and a member of the central bank monetary policy committee. Policy makers in the world's fastest-growing major economy are struggling to control cash flooding the nation from an unprecedented two-year lending spree and surging capital inflows that have boosted foreign-exchange reserves to a record. China's encouragement of fundraising through bond issues and initial public offerings to cut reliance on bank lending is complicating efforts to rein in liquidity and curb inflation. 'China's economic structure is so complex now that only controlling credit isn't sufficient for macro-economic management,' Li Daokui, an academic adviser to the People's Bank of China, told reporters... The government may need to look at managing the total volume of financing in the system this year and not only bank lending, he said."

January 11 - Bloomberg: "China's vehicle sales jumped 32% in 2010 as government stimulus measures and economic growth helped the nation stay the world's largest auto market for a second year. Total auto sales... rose to 18.06 million, while passenger-car deliveries gained 33% to 13.8 million... Sales of cars and light trucks in the U.S. gained 11% to 11.6 million in 2010, according to researcher Autodata Corp."

January 11 - Bloomberg: "China's property market isn't a bubble because household incomes are rising in line with housing prices, according to Andy Rothman, CLSA Asia-Pacific Markets' China macro strategist. Housing prices in so-called second-tier cities, where most urban Chinese live, are about 75% lower than in larger cities such as Beijing and Shanghai, and price increases are slower, Rothman said... 'With leverage this low and with house prices rising in line with income, these are not bubbles,' said Rothman. 'There are obviously individual segments of the market which have problems. But in terms of systematic problems, I don't see it.'"

January 10 - Bloomberg: "China reported a less-than-forecast $13.1 billion trade surplus for December... Exports rose 17.9% to $154.2 billion from a year earlier and imports climbed 25.6% to $141.1 billion..."

Japan Watch:

January 12 - Bloomberg (Toru Fujioka and Kyoko Shimodoi): "Japan may extend purchases of bonds sold by a European financial aid fund in coming months to support the region's recovery from the sovereign debt crisis, two government officials familiar with the matter said. Finance Minister Yoshihiko Noda said yesterday Japan intends to buy more than a fifth of the bonds to be sold later in January to fund the bailout of Ireland."

India Watch:

January 13 - Bloomberg (Madelene Pearson and Jay Shankar): "Record imports of gold by India show the central bank may be losing the battle to tame inflation, spurring investors to sell government bonds. Shipments into Asia's third-biggest economy may have increased to 800 metric tons from 557 tons in 2009 and exceeding the previous all-time high of 769 in 2007, according to Ajay Mitra, managing director for... the World Gold Council... 'Gold is being used as a store of value to protect against never-ending inflation,' Ritesh Jain, the... head of fixed income at Canara Robeco Asset Management...said 'Inflation is the biggest concern in the minds of investors and savers.'"

Asia Bubble Watch:

January 13 - Bloomberg (Eunkyung Seo and William Sim): "South Korea's third interest-rate increase since the global financial crisis and the government's planned price controls may fail to curb inflation unless the won appreciates further... The Bank of Korea raised borrowing costs by a quarter of a percentage point to 2.75% yesterday and the government said it aims to freeze utility prices and reduce food tariffs to damp quickening inflation."

January 11 - Bloomberg (Eunkyung Seo): "South Korea's producer-price inflation rate accelerated to a two-year high, adding to the case for the central bank to raise borrowing costs again. Producer prices increased 5.3% in December from a year earlier..."

January 12 - Bloomberg (Suttinee Yuvejwattana): "Thailand raised its benchmark interest rate for the fourth time in seven months and signaled it will boost borrowing costs further to contain inflation... The Bank of Thailand increased the one-day bond repurchase rate by a quarter of a percentage point to 2.25%... 'Inflationary pressure going forward is still expected to increase as the economy continues to grow and oil and commodity prices are on an uptrend,' Bank of Thailand Assistant Governor Paiboon Kittisrikangwan said..."

Latin America Watch:

January 13 - Bloomberg (Matthew Bristow and Jens Erik Gould): "Central banks in Latin America are 'overburdened' by capital inflows that reached $203 billion last year, restricting their ability to use interest rates to curb inflationary pressure, the World Bank said. The... lender said Brazil and other Latin American economies may need to contain spending to ease pressure for higher interest rates that could exacerbate the flows... Low interest rates in rich countries, along with the strong growth outlook for Latin America, are attracting flows of money that may be 'destabilizing' for exchange rates..."

January 12 - Bloomberg (Matthew Bristow): "Brazil's retail sales rose more than economists expected in November, driven by credit growth and record low unemployment. Sales rose 1.1% in November, their fastest pace in three months, the national statistics agency... Sales rose 9.9% from a year ago..."

January 11 - Bloomberg (Matthew Bristow): "Economists covering the Brazilian economy raised their forecast for 2011 inflation for a fifth straight week... Consumer prices will rise 5.34% this year, up from a week earlier forecast of 5.32%, the survey found."

January 13 - Dow Jones: "Brazilians will pay more for fruits and vegetables in the wake of heavy rains that have caused massive floods and landslides in the southeastern part of the country, according to an economist Thursday. 'The torrential rains are going to hinder--and by quite a bit--the production and transport of natural foods, which is going to translate into higher prices for consumers,' said economist Andre Guilherme Pereira Perfeito at Sao Paulo's Gradual Investimentos fund... The latest natural disaster will compound Brazil's recent troubles with inflation..."

January 10 - Bloomberg (Eliana Raszewski): "Argentina's central bank plans the biggest increase in the money supply since at least 2006 in a bid to keep local interest rates down. Argentina aims to boost the amount of money in the economy, as measured by the M2 gauge, by 28% in December from a year earlier..."

Unbalanced Global Economy Watch:

January 12 - Bloomberg (Rainer Buergin and Brian Parkin): "German Chancellor Angela Merkel's policy of deficit reduction, which pushed last year's government borrowing below target, helps boost growth in Europe's biggest economy, Deputy Finance Minister Steffen Kampeter said. Net borrowing totaled 44 billion euros ($57.3bn) last year, beating an original target of 80.2 billion euros... The government has to 'make an effort' to undershoot a goal of 48.4 billion euros for this year and 'won't stray' from its course... 'The federal government believes that budget consolidation is an engine of growth,' Kampeter said. 'Consolidation has priority and tax reductions are the return on investment.'"

January 12 - Bloomberg (Simone Meier): "European industrial production advanced more than economists forecast in November... Production increased 7.4% in the year."

January 13 - Bloomberg (Janina Pfalzer and Adam Ewing): "Sweden's inflation rate rose in December, exceeding the central bank's target for the first time in two years... Headline inflation accelerated to 2.3% from 1.8% in November... The annual rate was last above the Riksbank's 2% target in November 2008. On the month, prices rose 0.7%."

January 13 - Bloomberg (Michael Heath and Daniel Petrie): "Reserve Bank of Australia Governor Glenn Stevens can glimpse the inflation threat he faces from the nation's floods at the produce shop near his suburban Sydney home in Sylvania Waters. Tomato prices soared 20% in the past week and bananas, grapes and sweet potatoes are up 10% said Maurice Sorace, owner of Sylvania Best Fresh... 'Prices will be higher in the next week' as the deluge drowns more crops and clogs roads, he said. The crisis may force the RBA to accept higher inflation in coming months as the floods spur food and commodity costs and slow growth in a disaster zone the size of Egypt."

January 12 - Bloomberg (Michael Heath): "Australian home-loan approvals unexpectedly rose in November, reaching the highest level of 2010, as the job market posted its biggest gain in 10 months and unemployment declined."

U.S. Bubble Economy Watch:

January 13 - Bloomberg (Shobhana Chandra): "Wholesale costs in the U.S. increased more than projected in December, led by higher prices for commodities such as fuel and food. The producer price index rose 1.1%, the most in 11 months..."

January 12 - Bloomberg (Michelle Fay Cortez): "Cancer care may cost the U.S. two-thirds more in the next decade, potentially topping $200 billion as the population ages and drug prices rise. The tab last year was $125 billion, according to National Cancer Institute researchers..."

Central Bank Watch:

January 10 - Bloomberg (Jana Randow and Simone Meier): "European Central Bank President Jean-Claude Trichet, speaking on behalf of the world's central bankers, said the global economy has recovered better than expected, boosting inflation pressures in emerging markets. 'Inflationary threats present some kind of general feature in the emerging world; it's something you don't see necessarily in advanced economies,' Trichet said... It's clear that it is extremely important that we all keep control of inflation expectations, and that calls for appropriate decisions.'"

Fiscal Watch:

January 11 - Bloomberg (Patrick Cole): "Against a backdrop of exhibits at New York's Museum of American Finance highlighting the U.S.'s financial history, Blackstone Group LP Chairman Emeritus Peter G. Peterson told patrons and supporters of the museum that the country's future could be harmed by its national debt. 'I think the American dream is threatened,' Peterson, 84, said... 'It's very important that we start educating the country about why this is important.' The U.S. has accumulated more than $14 trillion of debt and had a $1.3 trillion budget deficit in the fiscal year..."

Muni Watch:

January 10 - Bloomberg (Terrence Dopp): "New Jersey Governor Chris Christie gives his first State of the State speech tomorrow after saying he may cut Medicaid and employee benefits to eliminate a $10.5 billion budget deficit in the second-wealthiest U.S. state. Christie... said he'll tell lawmakers in his address that New Jersey remains in a financial crisis and they need to maintain fiscal controls as employment and revenue recover slowly from the longest recession since the 1930s."

January 13 - Bloomberg (Brendan A. McGrail): "New Jersey Governor Chris Christie has learned that talking about state insolvency may have a cost. About 20 minutes after Christie, 48, told a town-hall meeting in Paramus today that health-care costs 'will bankrupt' the state, the New Jersey Economic Development Authority cut its tax-exempt school-related bond offering by more than half to $712.3 million."

January 11 - Bloomberg (David Mildenberg): "Texas state revenue will fall 2.9% to $72.2 billion for the 2012-2013 biennium, Comptroller Susan Combs said, leaving legislators convening tomorrow with the prospects of multibillion dollar budget cuts. Lawmakers also face an unexpected $4.3 billion deficit at the end of the current fiscal year Aug. 31 that must be balanced... The state is spending about $86 billion in the current biennium, including more than $6 billion in federal stimulus money that will not continue, she said."

Illinois Watch:

January 12 - Bloomberg (Tim Jones): "Illinois lawmakers passed a 67% income-tax increase, the largest in the state's history, to help close a $13 billion budget deficit. The boost in the tax rate to 5% from 3% was approved by both chambers in the waning hours of the legislative term... The increase, intended to last through 2014, is aimed at fixing Illinois's worst fiscal crisis, including a backlog of more than $6 billion in unpaid bills and almost $4 billion in missed payments to underfunded state pensions. The deficit amounts to about half of planned general-fund spending for this fiscal year..."

January 13 - Bloomberg (Tim Jones and Esmé E. Deprez): "The biggest tax increase in Illinois history, a last-minute bid to resolve the state's worst fiscal crisis, drew applause from investors, gloating from neighbors and scorn from taxpayers and businesses. Within hours of Senate approval yesterday for the 67% income-tax increase aimed at closing a $13 billion budget deficit, an eruption of protests put Governor Pat Quinn on the defensive. 'We had to take decisive action,' the Democratic governor said... The tax boost was needed to protect a state that was 'careening toward bankruptcy and fiscal insolvency,' he said."

Speculator Watch:

January 13 - Bloomberg (Matthew Leising): "Wall Street's largest dealers during the fourth quarter eased credit terms to hedge funds and private-equity firms that borrow against securities while provisions for private derivatives trades were little-changed, according to the Federal Reserve."


Issues 2011

The unfolding historic Bubble backdrop is the overarching Issue for 2011. This is a "Bubble year." Yes, the prognosis has remained the same since I wrote "Issues 2010." There are, however, important distinctions, developments and evolutions from a year ago.

A 12-month period of robust Bubble Dynamics has elevated systemic risks - risks at home and risks to global financial and economic systems. A major worldwide inflation has impacted risk assets generally -if not evenly. One additional year of aggressive policymaking has further distorted market perceptions - in particular how markets perceive liquidity and Credit risks. "Exit strategies" lost their credibility last year, while those acting on faith in the global central banking liquidity "backstop bid" have been rewarded - and emboldened.

To be sure, the dramatic rise in bullish optimism has engendered susceptibility to disappointment - and perhaps even disillusionment. Yet Bubbles do have that perverse way of persevering long enough to ensure that virtually everyone has had the opportunity to climb aboard.

Having survived the Greek crisis and contagion scare, the global government finance Bubble soldiered right through 2010. This allowed - the markets accommodated - another year of our federal and municipal governments adding significantly to their debt loads. It was one more year where the maladjusted U.S. economy ran a Current Account Deficit approaching $500bn. It was a year where the Fed's bloated balance sheet added another $200bn, while global central bank international reserve holdings expanded an unfathomable $1.6 TN.

The past year saw another $500 billion flee the U.S. money fund complex in search of higher yields. Tens of billions flooded into perceived low-risk bond and muni funds, while tens of billions more headed overseas. Meanwhile, money flowed into the hedge fund community, where assets and leverage are said to now approach pre-crisis levels.

Stock market risk has grown steadily over the past year. Capping an extraordinary two-year period, the broader market again dramatically outperformed the S&P500. Especially during 2010's fourth quarter, a highly speculative market turned dangerously speculative. Many of the more suspect stocks continue their period of outperformance. And, despite the overhang of serious economic issues, the broader U.S. stock market now approaches record levels.

The market commences 2011 with many of the market's favored stocks/sectors at wildly bullish levels of valuation and expectations. Overall market sentiment has moved to extreme bullishness. In Bubble Dynamic fashion, equity fund flows have turned strongly positive subsequent to a historic market rally. Equities today are winning by default within a backdrop of near-zero short rates, rising bond yields and municipal bond angst. Throughout the marketplace, prices have become increasingly detached from underlying fundamentals.

Rising global yields is a key Issue 2011. Fixation on deflation risk has given way to the reality that the world faces significant inflation, Credit and, inevitably, liquidity risks. Mounting inflationary pressures were given a major push when the Fed back peddled from an "exit strategy" and moved forward with "QE2". Subsequent to the initial euphoria, markets now appreciate the heightened risks associated with additional quantitative easing. And as global yields move higher - and deficits mount - risk premiums must adjust further in order to discount the possibility of destabilizing market revulsion to any number of profligate borrowers. It is a major Issue 2011 that central bankers at home and abroad may confront tough decisions as to whether to implement additional market liquidity support into a backdrop of rising long-term bond yields and waning market confidence.

In the case of Europe, market "success" in disciplining politicians has initiated the problematic downside of the Credit cycle. The transition to "austerity" and policy restraint is, as it always has been, challenging, painful and destabilizing. Economic and social upheaval is not conducive to market confidence. Yet, at the same time, fiscal prudence and economic adjustment are fundamental to a more stable economic future. It's not pretty, but at least Europe has commenced the process.

In the case of the U.S., the markets' accommodation of fiscal and monetary profligacy creates some short-term benefits along with major intermediate-term risks. Somewhat amazingly, our policymakers still enjoy great flexibility to inflate government/system Credit. This, for now, supports bullish fundamental prospects. The $4.0 TN increase in federal government liabilities over 27 months has inflated incomes, corporate revenues and securities markets, while stabilizing real estate prices. At this dangerous stage of the Credit Bubble, so-called economic "fundamentals" will tend to support bullish optimism and elevated stock prices. Strong corporate earnings and accelerating GDP growth will be viewed as confirmation of the bullish thesis, while they are in reality consequences of the unprecedented expansion of governmental control over the Credit system and economy.

It is a major Issue 2011 that U.S. federal government debt will for the third straight year account for all - or at least the vast majority - of total system Credit creation. I would argue (confidently) that this dynamic is dysfunctional. U.S. government debt is being mispriced, over-issued, and misdirected - ensuring only deeper economic maladjustment and financial vulnerability. Tough decisions and tough economic adjustments are only being postponed.

It is a fundamental issue that total system Credit creation is originating from chiefly non-productive marketable debt of the - not especially efficient or productive - governmental sector. It is an Issue 2011 that our recovery is entirely dependent upon a favorable global macro and market backdrop necessary to ensure the ongoing massive issuance of increasingly Credit-challenged U.S. government debt obligations.

It is the ("moneyness") nature of government obligations that they enjoy special treatment in the marketplace: confidence tends to be sustained during longer periods of over-issuance than for private Credit instruments. And whether it is Greece, Portugal or the United States, fundamentals may very well appear encouraging so long as the marketplace accommodates uninterrupted borrowing excess. But, make no mistake, underlying Minskian "Ponzi Finance" dynamics ensure a problematic day of reckoning when the market inevitably cools to the debt explosion. Importantly, the longer the markets accommodate a government Ponzi debt scheme the greater the inevitable dislocation - the greater the tumult when the financial and economic systems are forced to operate with reduced government debt expansion. The costs associated with a crisis of confidence in government debt - the foundation of contemporary "money" systems - are enormous.

For 2011, the bulls take comfort that, in spite of all the talk and elections and such, Washington has no intention to adjust its borrowing and spending habits. At the same time, it is becoming increasingly challenging for the marketplace to disregard a troubling debt growth trajectory. Two years ago the bulls could argue that U.S. government debt ratios were ok and that massive borrowing was a short-term phenomenon. Neither has credibility today.

The possibility for a surprising jump in Treasury bond yields is a major Issue 2011. On the one hand, Treasury is not interest rate sensitive; the marketplace doesn't have to fear much of an issuance impact from a moderate jump in borrowing costs. On the other hand, this dynamic would imply that yields are poised to surprise on the upside when the markets eventually force borrowing restraint. It doesn't take a wild imagination to envisage a market problem leading to an economic problem, to additional "TARP," more bailouts and a jump in borrowing costs - all combining for a dramatic deterioration in our nation's debt position.

That borrowing restraint is being imposed upon U.S. muni finance is a major Issue 2011. The year has commenced with municipal bond yields adding to Q4's surprising jump. Today, state and local finance is our Credit system's weak link. What began in ("subprime") Greece has made its way to Illinois, California, New York, New Jersey, Florida and elsewhere. Throughout the country, governments will now be forced into the messy proposition of getting their books in order. After ignoring this issue for too long, a global marketplace keen to structural debt issues has commenced the disciplining process.

The dilemma now facing U.S. muni finance has been significantly compounded by policymaking and market dynamics. For two years, loose fiscal and monetary policies allowed governments of all dimensions to paper over structural problems. Washington largess postponed needed austerity measures, while zero rates incited a stampede into seemingly attractive state and local debt instruments. The proliferation of Build America bonds and ETF products, in particular, were critical for enticing atypically large speculative flows into the sector.

Now, with the Bubble having burst, municipal borrowers confront the challenge of large borrowing needs in the face of steady financial flows out of the sector. Moreover, this poor liquidity backdrop could be further compounded by bearish speculative bets against the muni bonds. There is a real downside to the proliferation of seemingly liquid instruments that allow participation in the upside of a sector: they create acute risk of illiquidity and dislocation in the event of an unexpected reversal of that sector's fortunes.

2010 witnessed the "flash crash." This is potentially a huge Issue for 2011. Throughout the markets, there has been a proliferation of instruments - especially exchanged-traded funds - that seemingly offer liquid ways of speculating on a vast range of risk assets and market outcomes. Many players have been drawn to these products because they offer a much more attractive liquidity profile than what is available for the underlying stocks, debt instruments, or commodities. Others have taken a more aggressive stance when playing a particular sector or theme specifically because of the capability of rapidly hedging various risks in the liquid ETF and derivatives marketplaces. And I would expect that many of the more sophisticated players have one eye on the exit - and both eyes on what instruments they might use to protect themselves - when they see the Bubble beginning to burst.

The explosion of trading in these instruments has significantly altered risk perceptions and risk taking. Especially because of today's Bubble backdrop, I believe risk to any number of market liquidity issues has created major systemic vulnerabilities. The concept of "portfolio insurance" has evolved mightily since 1987.

2011 is extraordinary for the degree and variety of risks that confront market participants when compared to the extent speculation and bullishness has become engrained throughout the marketplace. The ongoing evolution of the European debt crisis creates great uncertainty. There are big unknowns when it comes to issues surrounding the mounting inflationary pressures throughout China and "developing" Asia. The year begins with "developing" economy Credit systems in overdrive, fueled by loose Credit, robust inflationary forces and unrelenting "hot money" inflows. Such Monetary Instability foments myriad market, economic and policymaking risks.

In particular, China faces very challenging Bubble dynamics. The Credit and inflation backdrop beckons for "slamming on the brakes" - or at least tapping them. There will be none of that. Following in the footsteps of others, Chinese authorities failed to act with sufficient force to quash Bubble and inflationary forces early enough in the cycle. Bubble risks have grown exponentially, and I would expect policymakers to continue to tread softly. The Chinese juggernaut Credit system and economy have become a force to be reckoned with.

If, as I have to presume at this point, the Chinese Credit Bubble is sustained through 2011, Asian economies will become an even greater glutton of global resources and commodities. Policymakers are grappling these days with how to contain the inflationary effects of massive "hot money" inflows and an increasingly complex Credit backdrop that goes way beyond monitoring bank lending and setting loan quotas. And while focus on consumer and real estate inflation garners the most attention, the Chinese plan to continue stimulating consumption and lower-end housing construction.

Policy endeavors - is poised to walk the highwire - to manage inflation, while boosting incomes for the hundreds of millions of lower-end and rural workers that have lost major headway against the urban and rising middle and upper classes. To say the Chinese face an extremely challenging task in controlling a runaway Credit Bubble and historic economic transformation is an understatement.

Here at home, policymaking has turned simple: run massive deficits, keep rates at zero, and have the Fed monetize debt until the private sector can be trusted to do the heavy lifting. Well, don't hold your breath. So, for Issues 2011, we can assume the Fed stands pat on rates. And while they have little credibility, both Congress and the Fed are talking tough against bailing out troubled states. Whether they can stick to this rhetoric is an Issue 2011. The dollar continues to benefit from the capacity of our policymakers to inflate Credit, a dynamic that will compound our dilemma when the markets turn their sights on disciplining Washington.

I'll posit that each year of massive government marketable debt issuance reduces the likelihood that central bankers will be able to exit their market liquidity backstop operations. History has shown how systems become precariously addicted to inflationary measures and market interventions. The Fed's balance sheet will only move in one direction. And when push comes to shove, they may be forced to buy municipal debt or monetize more Treasurys to help finance bailouts. For now, the most important Issue 2011 is that serious structural deficiencies ensure that the Federal Reserve errs on the side of liquidity creation. This would seem to ensure a year of even greater Monetary Disorder, with the risk of heightened instability throughout global fixed-income, currency, commodities and equities markets.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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