Pondering Greece, Spain and the End of QE2

By: Doug Noland | Fri, May 20, 2011
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For the week, the S&P500 slipped 0.3% (up 6.0% y-t-d), and the Dow declined 0.7% (up 8.1%). The Banks inched up 0.4% (up 4.8%), while the Broker/Dealers were hit for 1.3% (down 5.7%). The Morgan Stanley Cyclicals dropped 1.6% (up 3.4%), while the Transports gained 1.2% (up 6.7%). The Morgan Stanley Consumer index was little changed (up 5.5%), while the Utilities increased 0.6% (up 7.6%). The S&P 400 Mid-Caps declined 0.7% (up 8.8%), and the small cap Russell 2000 fell 0.8% (up 5.8%). The Nasdaq100 declined 1.2% (up 6.0%), and the Morgan Stanley High Tech index slipped 0.9% (up 3.2%). The Semiconductors dropped 1.9% (up 5.0%). The InteractiveWeek Internet index declined 0.5% (up 4.1%). The Biotechs fell 1.4% (up 13.8%). With bullion gaining $17, the HUI gold index rallied 2.7% (down 7.6%).

One-month Treasury bill rates ended the week at 2 bps and three-month bills closed at 4 bps. Two-year government yields declined 2 bps to 0.51%. Five-year T-note yields ended the week down 4 bps to 1.79%. Ten-year yields declined 3 bps to 3.15%. Long bond yields dipped one basis point to 4.30%. Benchmark Fannie MBS yields gained a basis point to 3.99%. The spread between 10-year Treasury yields and benchmark MBS yields widened 4 to 84 bps. Agency 10-yr debt spreads declined one to negative 2 bps. The implied yield on December 2011 eurodollar futures fell 2 bps to 0.40%. The 10-year dollar swap spread increased 1.5 to 9.25 bps. The 30-year swap spread increased one to negative 24 bps. Corporate bond spreads were somewhat wider. An index of investment grade bond risk added about a basis point to 90 bps. An index of junk bond risk jumped 13 bps to a 4-wk high 446 bps.

May 20 - Bloomberg (Tim Catts): "Google... and AAA rated Johnson & Johnson sold corporate bonds as issuance soared to at least $53.7 billion in the busiest week on record."

Investment-grade issuers included Johnson & Johnson $3.5bn, Texas Instruments $3.5bn, Google $3.0bn, International Lease Finance $2.25bn, Blackrock $1.5bn, US Bancorp $1.0bn, Burlington Northern $750 million, Caterpillar $750 million, Liberty Mutual $600 million, Energizer $600 million, CSX $900 million, Alabama Power $500 million, Walt Disney $500 million, Aetna $500 million, Cintas $500 million, Duke Energy $500 million, E-Trade $435 million, McDonalds $400 million, Norfolk Southern $400 million, Kellogg $400 million, Ryder System $350 million, South Carolina E&G $350 million, Great Plains Energy $350 million, DTE Energy $300 million, UDR $300 million, B-Corp $240 million and Public Service New Hampshire $120 million.

Junk bond funds saw inflows of $373 million (from Lipper). Junk issuers included Chrysler $3.2bn, EH Holdings $2.0bn, Alpha Natural Resources $1.5bn, Connacher Oil & Gas $900 million, Concho Resources $600 million, Petrohawk Energy $600 million, Kindred $550 million, Host Hotels & Resorts $500 million, Amkor Technologies $400 million, Cricket Communications $400 million, Centene $250 million, Xerium Technologies $240 million, First Wind Capital $200 million and Eldorado Resorts $180 million.

Convert issuers included Iconix Brand Group $275 million.

International dollar bond issuers included HSBC $3.0bn, Rabobank $1.5bn, Banco de Brasil $1.5bn, Eksportfinans $1.25bn, Total Capital Canada $1.0bn, QBE Capital $1.0bn, ICIC Bank $1.0bn, Rio Tinto $2.5bn, Pertamina $1.0bn, Comision Fed de Electric $1.0bn, Pertamina $500 million, China Shanshui Cement $400 million, and Automotores Gildemeister $300 million.

U.K. 10-year gilt yields dipped 2 bps this week to 3.34% (down 17bps y-t-d), and German bund yields declined 2 bps to 3.055% (up 10bps). Ten-year Portuguese yields rose 17 bps to 9.16% (up 258bps). Irish yields added 3 bps to 10.32% (up 126bps), and Greek 10-year bond yields surged 111 bps to 16.37% (up 391bps). Two-year Greek yields jumped 58 bps this week to 24.72%. Spain's 10-year yields bps to 5.2% (down 1bps). The German DAX equities index fell 1.8% (up 5.1% y-t-d). Japanese 10-year "JGB" yields bps to 1.% (%). Japan's Nikkei slipped 0.4% (down 6.1%). Emerging equity market weakness continued, while emerging debt remained resilient. For the week, Brazil's Bovespa equities index declined 1.0% (down 9.7%), while Mexico's Bolsa rallied 0.7% (down 8.4%). South Korea's Kospi index slipped 0.5% (up 3.0%). India's equities index dropped 1.1% (down 10.6%). China's Shanghai Exchange dipped 0.4% (up 1.8%). Brazil's benchmark dollar bond yields fell 8 bps to 4.22%, and Mexico's benchmark bond yields declined 7 bps to 4.03%.

Freddie Mac 30-year fixed mortgage rates dipped 2 bps to a 23-wk low 4.61% (down 23bps y-o-y). Fifteen-year fixed rates declined 2 bps to 3.80% (down 44bps y-o-y). One-year ARMs were up 4 bps to 3.15% (down 85bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 4 bps to 5.12% (down 47bps y-o-y).

Federal Reserve Credit surged $26.4bn to a record $2.739 TN (28-wk gain of $459bn). Fed Credit was up $332bn y-t-d and $400bn from a year ago, or 17.1%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 5/18) dropped $18.2bn to $3.443 TN. "Custody holdings" were up $92bn y-t-d and $386bn from a year ago, or 12.6%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.437 TN y-o-y, or 17.1%, to a record $9.816 TN. Over two years, reserves were $3.116 TN higher, or 47% growth.

M2 (narrow) "money" supply declined $8.6bn to $8.984 TN. "Narrow money" has expanded at a 4.6% pace y-t-d and 5.1% over the past year. For the week, Currency increased $2.5bn. Demand and Checkable Deposits dropped $24.8bn, while Savings Deposits jumped $18.0bn. Small Denominated Deposits declined $4.1bn. Retail Money Funds were little changed.

Total Money Fund assets fell $12.4bn last week to $2.738 TN. Money Fund assets were down $72bn y-t-d, with a decline of $106bn over the past year, or 3.7%.

Total Commercial Paper outstanding jumped $24.3bn to $1.183 Trillion, the high since December 2009. CP was up $214bn y-t-d, or 48% annualized, with a one-year rise of $107bn.

Global Credit Market Watch:

May 20 - Bloomberg (Maria Petrakis): "Greece's credit rating was cut three levels by Fitch Ratings, which said that even a voluntary extension of its bond maturities being studied by European Union policy makers would be considered a default. Fitch cut its rating to B+, four levels below investment grade, from BB+ and said that the country could face a further reduction in its creditworthiness... 'The rating downgrade reflects the scale of the challenge facing Greece in implementing a radical fiscal and structural reform program necessary to secure solvency of the state and the foundations for sustained economic recovery,' Fitch said..."

May 17 - Victor Mallet (James Politi): "The rapid growth of 'hidden' public debt in Spain is likely to be revealed by incoming regional and local administrations to be elected on Sunday, damaging Spain's credibility in the bond markets... 'It is clear that in some or even many regional governments the official accounts do not reflect the truth,' says the research by Freemarket Corporate Intelligence... 'It also seems clear that the new administrations, if there is a change of the party in power, are not going to take on the inherited debt without clarifying the details,' the report says... Latest data from the Bank of Spain, calculated in accordance with European Union guidelines, show that the country's 17 autonomous regions have nearly doubled their public debt to more than €115bn ($160bn) since 2008, while municipal and provincial debt has risen to €35bn. Central government debt stands at €488bn. But the Freemarket report recalls that public companies owned by local and regional governments are also heavily indebted, and that the figures of many of these groups do not have to be included in EU calculations. 'In fact there are about 5,200 regional and local entities with indebtedness that is not included in the official accounts, amounting to some €26.4bn,' it says. Another popular method of hiding public debt during the fiscal and financial crisis of the past three years has been to leave bills unpaid."

May 19 - Bloomberg (Abigail Moses): "Greece is unlikely to restructure its debt in the short term because it would be difficult to do so without triggering payouts of credit-default swaps, according to Citigroup Inc. 'It is certainly possible to envisage forms of restructuring which fail to trigger CDS, but we are doubtful that they will be employed in practice,' said Michael Hampden-Turner, a strategist at Citigroup... 'We suspect that European and ECB policy makers will duck the hard decisions.' Political leaders and European Central Bank officials are likely to 'muddle through' with another 'state-funded bailout, perhaps this time collateralized by future asset sales,' he said. New steps are needed after last year's 110 billion-euro ($156 billion) rescue failed to restore Greece's financial health. European officials are trying to avoid tripping swaps, with French Finance Minister Christine Lagarde saying this week that 'anything that would constitute a credit event, is for me off the table.' Speculation is increasing that a restructuring of Greek bonds may be possible without meeting the International Swaps & Derivatives Association's definitions of such an event."

May 18 - Bloomberg (Sonia Sirletti): "European Central Bank Executive Board member Lorenzo Bini Smaghi rejected any debt restructuring for nations such as Greece as it would 'jeopardize all of Europe.' A debt restructuring, whether 'hard or soft,' would require a recapitalization of banks, which would be hard to carry out in a country that has defaulted, Bini Smaghi said... 'The state of public finances in Greece, Ireland and Portugal represents the biggest challenge of the coming years... Time has been lost talking about how to come up with a way to reduce the debt, but if we accept this we'll jeopardize all of Europe. A solution for reducing debt but not paying for it will not work.'"

May 19 - Bloomberg (Sarah McDonald): "Australian companies plan to boost bank borrowing from a 14-month high to fund expansion and acquisitions as a mining investment boom drives economic growth. Firms will increase loans from Australian lenders by 60% to A$259 billion ($276bn) in the six months to October..."

May 18 - Bloomberg (Sapna Maheshwari): "Johnson & Johnson... and McDonald's Corp. leapt at the lowest borrowing costs since November in the busiest start to a week in two months for U.S. bond sales. Issuance of $27.9 billion is the most since the two-day period ended March 22."

May 18 - Bloomberg: "China, the biggest foreign owner of U.S. Treasuries, trimmed its holdings for a fifth straight month in March as American lawmakers grappled with a government debt set to reach its legal limit. The Asian nation owns $1.145 trillion of the debt, down $9 billion... The holdings reached a record $1.175 trillion in October last year. China's concern that U.S. government securities may become more risky because of the nation's deficits and debt burden prompted its call this month for President Barack Obama's administration to lay 'a solid fiscal foundation' for long- term growth. Former Chinese central bank adviser Yu Yongding said last month that China should stop buying Treasuries because of the risk that the U.S. may eventually default."

Global Bubble Watch:

May 19 - Reuters (Alina Selyukh and Clare Baldwin): "LinkedIn Corp's shares more than doubled in their public trading debut on Thursday, evoking memories of the investor love affair with Internet stocks during the dot-com boom of the late 1990s."

May 18 - Bloomberg (Simon Kennedy and Rich Miller): "Investment spending in emerging markets is outpacing expenditures in developed economies for the first time, as a surge in infrastructure supports global growth and profits at companies from Siemens AG to Caterpillar Inc. The 'biggest investment boom of recent decades' will help boost expansion worldwide about 4% this year and next, compared with a long-run average of just below 3%, according to Michael Saunders, Citigroup Inc.'s chief European economist. International Monetary Fund data show investment will top 24% of global gross domestic product in 2012, the most in more than two decades, and then rise above 25%, the highest since records began 30 years ago."

May 19 - Financial Times (Telis Demos): "US investors are piling into exchange-traded stock funds, even as they become more bearish and pull back from actively managed funds. Investors pumped a net $14.2bn into equity ETFs by the middle of the second quarter, nearly double the pace of investment in the first quarter, when net inflows for the entire period were $12.9bn, according to data from brokerage ConvergEx Group."

Currency Watch:

May 17 - Financial Times (James Politi): "The World Bank expects the US dollar to lose its solitary dominance in the global economy by 2025, as the euro and the renminbi establish themselves on an equal footing in a new 'multi-currency' monetary system. The shift will be driven by the increasing power and strength of emerging market economies, with six countries - Brazil, China, India, Indonesia, Russia and South Korea accounting for more than half of global growth in 14 years. According to the World Bank report... emerging economies will grow at a rate of 4.7% between now and 2025, a much faster pace than advanced economies which are expected to grow by 2.3%... 'The balance of global growth and investment will shift to developing or emerging economies,' said Mansoor Dailami, the lead author of the report. The implications are wide-ranging. For instance, Mr Dailami said this power shift would lead to big boosts in investment flows to the countries driving global growth, with a significant increase in cross-border mergers and acquisitions activity, and a changing corporate landscape in which 'you're not going to see the dominance of established multinationals'. In addition, a different international monetary system will gradually evolve, wiping out the US dollar's position as the world's main reserve currency."

The U.S. dollar index slipped 0.4% to 75.435 (down 4.5% y-t-d). For the week on the upside, the Swiss franc increased 1.7%, the South African rand 1.5%, the Swedish krona 1.3%, the New Zealand dollar 0.8%, the Australian dollar 0.8%, the Mexican peso 0.7%, the Singapore dollar 0.6%, the South Korean won 0.4%, the Norwegian Krone 0.4%, the euro 0.3%, the Danish krone 0.3% and the British pound 0.2%. On the downside, the Japanese yen declined 1.1%, the Canadian dollar 0.6%, and the Taiwanese dollar 0.4%.

Commodities and Food Watch:

May 18 - Bloomberg (Lars Paulsson): "The driest spring in France in half a century is threatening to send electricity prices to the highest since November 2008 as water levels drop and Germany keeps nuclear plants shut. Power for next month in Germany... may jump as much as 16% to 67 euros ($96) a megawatt-hour, according to... Summit Energy... Falling water levels, combined with the worst nuclear disaster in 25 years, are driving up Europe's power prices. Drought may cut France's atomic output and disrupt hydroelectric supplies from Switzerland to Scandinavia. Germany halted its oldest reactors for three months after the March 11 earthquake and tsunami devastated Japan's Fukushima Dai-Ichi power plant."

May 19 - Financial Times (Jack Farchy): "China overtook India to become the largest market for gold bars and coins in the first quarter of this year, as rising inflation inspired a surge in bullion investment. Chinese investors bought 93.5 tonnes of gold between ¬January and March in the form of coins, bars and medallions, a 55% increase from the previous quarter and more than double the level of a year earlier, according to... the World Gold Council..."

May 19 - Bloomberg: "Gold jewelry demand in China, the world's second-largest consumer of the precious metal, jumped to a record in the first quarter, the World Gold Council said. Demand for gold jewelry gained 21% in the first three months from a year ago to 142.9 metric tons..."

May 18 - Bloomberg (Elizabeth Campbell): "U.S. dairies are generating record production as farmers seek to benefit from a rally in milk prices that is boosting costs for shoppers at Wal-Mart... and eroding profit for Starbucks Corp... Milk futures are up 24% this year..."

The CRB index rallied 0.9% (up 2.6% y-t-d). The Goldman Sachs Commodities Index gained 0.7% (up 9.0%). Spot Gold rallied 1.2% to $1,512 (up 6.4%). Silver was little changed at $35.05 (up 13%). July Crude slipped 2 cents to $100.10 (up 10%). June Gasoline dropped 4.1% (down 3%), while May Natural Gas added 0.4% (down 5%). July Copper was up 3% (down 8%). May Wheat jumped 10.8% (up 2%), and May Corn surged 11.4% (up 21%).

China Bubble Watch:

May 18 - Bloomberg: "China's home prices rose in 67 of 70 cities monitored by the government in April from last year, led by smaller cities that are defying efforts to control property prices nationwide. Housing prices increased at a faster pace in smaller cities and slowed in major ones... New home prices in Urumqi, capital of far western Xinjiang province, posted the biggest gain, up 9.3% last month from a year earlier, while prices in northern Mu Danjiang climbed 8.7%. In the capital Beijing, prices rose 2.8% in April... while those in Shanghai slowed to a 1.3% gain."

May 18 - Bloomberg (Kelvin Wong): "Hong Kong's Causeway Bay, home to the world's third-most expensive shopping strip, is set for its biggest facelift in almost two decades with a new mall that may drive up rents in the area. Hysan Development Co., the area's biggest commercial landlord, next year will complete a complex the size of 12 American football fields in the district's biggest addition since 1994, when Wharf Holdings Ltd.'s Times Square put the area on the luxury retail map. About 45% of Hysan Place's retail space is already filled with tenants that may include Apple Inc."

May 19 - Bloomberg (Sophie Leung): "Hong Kong's unemployment rate rose for the first time in 11 months... The jobless rate for the three months through April climbed to 3.5% from a 31-month low of 3.4%..."

Japan Watch:

May 19 - Bloomberg (Keiko Ujikane): "Japan's economy shrank more than estimated in the first quarter after the March 11 earthquake and tsunami disrupted production... sending the nation to its third recession in a decade. Gross domestic product contracted an annualized 3.7% in the three months through March, following a revised 3% drop in the previous quarter..."

Asia Bubble Watch:

May 19 - Bloomberg (Chinmei Sung and Andrea Wong): "Taiwan's economy grew... 6.55% in the three months through March from a year earlier, compared with a revised 7.13% in the fourth quarter..."

May 18 - Bloomberg (Shamim Adam and Gan Yen Kuan): "Malaysia's growth eased last quarter... Gross domestic product increased 4.6% in the three months through March from a year earlier..."

May 19 - Bloomberg (Shamim Adam and Kristine Aquino): "Singapore raised its growth forecast for 2011 after the island's economy expanded the most in Southeast Asia last quarter... Gross domestic product will increase 5% to 7% this year, from an earlier forecast of 4% to 6%... The economy expanded 22.5% in the three months through March from the previous quarter..."

Latin America Watch:

May 19 - Bloomberg (Jose Enrique Arrioja): "Mexico's gross domestic product expanded less than... forecast in the first quarter... GDP... grew 4.6%..."

May 18 - Bloomberg (Randy Woods): "Chile's economy expanded at the fastest pace in 15 years in the first quarter... The economy grew 9.8% from the first three months of last year..."

Unbalanced Global Economy Watch:

May 17 - Bloomberg (Hui-yong Yu and Christopher Donville): "Vancouver's Royal Pacific Realty had such a surge of business during the first two weeks of February that agents and assistants worked day and night shifts to find homes for Chinese buyers visiting during the Lunar New Year. 'It was unprecedented,' said Royal Pacific Chief Executive Officer David Choi. 'I called them sleepwalkers.' Sales of detached homes, townhouses and condominiums in metropolitan Vancouver jumped 70% in February from January, to 3,097 units from 1,819, and were up 25% from a year earlier... In March, sales climbed 32% from February, to just shy of a record for the month of 4,371 transactions set in 2004. Sales increased by 80% from two years ago."

May 18 - Bloomberg (Luzi Ann Javier): "Global food prices are set to extend gains as production struggles to keep pace with demand, said Rabobank Groep and Armajaro Trading Ltd., potentially pushing up costs for Tyson Foods Inc. and Kellogg Co. 'My view is the only way would be up' in the longer term, Jasper van Schaik, regional head Europe Agri Commodities at Rabobank, said... 'We can't create any more land,' said Richard Ryan, chief executive... of Armajaro Trading..."

May 18 - Bloomberg (Scott Reyburn): "A pink diamond the size of a SIM card sold last night in Switzerland for 9.6 million francs ($10.9 million) as collectors continued to battle for rare gems."

May 17 - Bloomberg (Jennifer Ryan): "U.K. inflation accelerated more than economists forecast in April to the fastest since October 2008, forcing Bank of England Governor Mervyn King to explain publicly why officials haven't raised interest rates yet. Consumer prices rose 4.5% in April after a 4% increase in March..."

May 18 - Bloomberg (Scott Hamilton): "U.K. unemployment claims rose in April at the fastest pace since January 2010, underlining the fragility of the economic recovery as government spending cuts and accelerating inflation sap consumer confidence."

May 19 - Bloomberg (Joe Brennan and Colm Heatley): "The share of Irish private home loans in arrears or restructured rose to 11% in the three months through March... At the end of last year, the figure was 79,173 or 10% of all loans."

U.S. Bubble Economy Watch:

May 20 - Bloomberg: "Former U.S. Treasury Secretary Lawrence Summers said there's a rising concern that technology stocks are in a bubble as investors shake off their apprehension from the 2007-2009 American mortgage and credit collapse. 'Who could have imagined that the concern with respect to any American financial asset, just two years after the crisis, would be a bubble?' Summers... said... 'Yet that concern is increasingly raised with respect to American technology, with respect to certain other American assets. That is a reflection of the resumption of confidence.'"

Central Bank Watch:

May 18 - Bloomberg (Marcus Bensasson and Sonia Sirletti): "European Central Bank officials ruled out a Greek debt restructuring, clashing with political leaders over a solution to the sovereign financial crisis. 'A Greek debt restructuring is not the appropriate way forward -- it would create a catastrophe' because it would damage the banking system, ECB Executive Board member Juergen Stark said... Fellow board member Lorenzo Bini Smaghi said in Milan that 'a solution for reducing debt but not paying for it will not work.' European Union finance ministers for the first time this week floated the idea of extending Greece's debt-repayment schedule as the nation struggles to meet the terms of last year's 110 billion-euro ($156bn) rescue. EU officials say that Greece won't be able to return to markets and sell 27 billion euros of bonds next year as scheduled under the bailout, leaving them searching for alternatives to avoid a default."

May 20 - Bloomberg (Christian Vits): "European Central Bank Governing Council member Christian Noyer said the analysis of money and credit trends remains important for the conduct of the bank's policy. 'A key lesson of the crisis is that inflation forecasts at let's say the two-year horizon is not a sufficient statistic for monetary policy,' Noyer said... 'A thorough and broad-based analysis of underlying trends in monetary and credit aggregates may help in identifying longer-term risks to price stability.'"

Muni Watch:

May 17 - Bloomberg (David Mildenberg): "Texas joined California and New Jersey in reporting higher revenue estimates, reflecting a strengthening U.S. economy while falling short of the level needed to avert spending cuts on education and health care. Texas may collect $1.2 billion more in general revenue than forecast for the two years beginning in September, mainly because of rising sales-tax receipts... The state may face a deficit of as much as $15 billion for the next budget cycle... In January, Combs forecast a 2.9% drop in revenue for the coming biennium compared with the current period. Under the latest estimates, the figure will rise almost 5% from the previous biennium to about $78 billion, said R.J. DeSilva, a Combs spokesman."

California Watch:

May 17 - Bloomberg (Michael B. Marois and James Nash): "California Governor Jerry Brown's revised budget with $6.6 billion more revenue may not avert a cash crisis looming in July that may force the most-populous U.S. state to pay bills with IOUs for the first time since 2009. Brown... proposed asking lawmakers to keep $9.1 billion of taxes and fees from expiring, then having a referendum to validate the extension in November or later, when a statewide ballot can be arranged. The state won't be able to borrow cash from Wall Street in July or August with that validation vote pending unless Brown and lawmakers agree on spending cuts that would be activated if voters turn down the tax plan, Treasurer Bill Lockyer said."

May 16 - Bloomberg (Dan Levy): "San Francisco Bay area home sales fell 3.1% in April from a year earlier to the lowest level in three years as buyers waited for prices to drop amid distressed deals, DataQuick... said."


Pondering Greece, Spain and the End of QE2

Greek debt worries; issues in the European Credit default swap (CDS) marketplace; and a U.S. economic "soft patch." Yes, the backdrop does recall the year ago period. Contemplating the similarities - and some key differences - seems a worthwhile exercise.

The Greek debt crisis erupted in late-April 2010. I have in the past noted parallels between last year's market revulsion to Greece's debt and U.S. subprime tumult back in the spring of 2007. Both were cases of the marginal borrower in respective fragile Bubbles ("Mortgage/Wall Street Finance" in the case of subprime, and "Global Government Finance" with respect to Greece) losing market access to cheap finance. Initially, both developments provoked aggressive policy responses. I have argued that the Fed's move to slash rates in '07/early-'08 incited deleterious global market speculation and financial excess - that played a commanding role in worsening the severity of the 2008 crisis. It seems rather obvious that QE2 and other global stimulus measures were been behind a powerful bout of global market speculative excess again this past year.

This week provided additional confirmation that the U.S. economy has downshifted. Despite exceptionally low mortgage rates, housing data continue to be dreadful. Reports from the New York and Philadelphia regions hint at less momentum for the booming manufacturing sector. And earnings and anecdotal reports point to mounting price pressures and a weakening of consumer spending enthusiasm.

With some justification, the recent "soft patch" elicits little concern. After dropping from Q1 2010's 3.7% rate to Q2's 1.7%, last year's recovery then reaccelerated. Q3 GDP increased to 2.6% and then rose to 3.1% in Q4. Q1 2011 growth downshifted abruptly to 1.8%, although economists and pundits point to temporary factors including inclement weather and Japan-related supply disruptions. There clearly have been some unusual issues - and, with general financial conditions remaining loose, I would tend to side against "the economy's falling off a cliff" prognosis. At the same time, the economic recovery - and especially recent performance - has been notably unimpressive (I'm being kind here) considering the unprecedented nature of fiscal and monetary stimulus. The bulls would certainly dispute this, but I discern ongoing confirmation of the secular bear thesis.

Importantly, last year's "soft patch" was resolved through another round of intensive monetary and fiscal stimulus (double-digit to GDP deficits and $600bn of QE!). Alarmingly, current weakness has unfolded in the midst of this extraordinary stimulus - and there is at this point every indication that quantitative easing will have run its course by the conclusion of next month. I would argue that stock market weakness rocked confidence and precipitated last year's economic slowdown. This year's lagging growth is in spite of strong markets (the S&P500 is about 30% above last year's lows).

An important factor supporting current complacency has to be the perception that QE3 (and indefinitely-pegged zero rates) is available to thwart any onset of financial or economic fragility. Yet, a crucial facet of bearish analysis is that quantitative easing has confronted the law of diminishing marginal returns. Yes, QE2 had enormous inflationary effects on the markets. Yet the economic impact was muted and mixed. In particular, Washington policymaking negatively affected the markets' view of dollar soundness, which translated into a rapid escalation of energy and commodities prices. And the big jump in gas and food costs has hurt confidence and the willingness to spend. I would further argue that the prospect of American savers continuing to earn virtually nothing on their savings is an additional factor stifling many households. QE is anything but costless.

But avoiding getting bogged down in economic tealeaves is imperative when more critical analysis lays waiting in the financial sphere. From my analytical perspective, the extreme monetary measures from 2008 reflated global risk markets to unsustainable levels. Historically, there were myriad problems with governments printing money to mitigate the pain of faltering Bubbles. For one, it provided only a fleeting fix that would require additional destabilizing inflation later. In our contemporary era, I would note that a fundamental dilemma associated with injecting marketplace liquidity: once such a program is commenced, there will be no less-than-painful exit. We've witnessed monetary policy distort markets, incite intense speculative excess, elevate prices to unsustainable levels, and foment unappreciated vulnerabilities. No one should count on an easy exit.

Conventional thinking has it that the end of QE3 will prove a non-event for the markets. Since market participants are fully aware of the impending end to the Fed's Treasury purchase program, this circumstance has been, as they say, "fully discounted in the marketplace." Ok, but this avoids the heart of the issue.

Fed liquidity operations have been instrumental in bolstering speculation and financial flows out to the risk markets more generally. The end to QE2 doesn't necessary mark the end to this cycle of speculative excess or to the nature of more recent flows of finance. The hedge funds, proprietary trading desks, and others in the "leveraged speculating community" don't seem about to reverse course just because the Fed has wound down this round of Treasury purchases. Moreover, if the leveraged speculators continue to build positions and expand leverage, in the process bolstering marketplace liquidity and sustaining Bubbles, then the absence of additional quantitative easing might not be much of an issue at all.

On the other hand, the absence of QE2 becomes a very big deal for the markets in the event of significant market de-risking and de-leveraging. Conventional thinking has it that QE2 was in response to U.S. economic shortcomings. I'm skeptical, believing instead that faltering marketplace liquidity likely played a decisive role. When Greek debt fears last year instigated dislocation throughout the CDS market, the speculators immediately found themselves positioned on the wrong side of a multifaceted "risk on" trade - one coming unglued from all directions.

Talk of additional quantitative easing last year stopped a potentially problematic unwind of speculative leverage - and the implementation of QE2 then incited a new huge bout of speculative excess. More important than the $600bn of new liquidity was the assurance that the Fed was going to be there when the markets found themselves in a bind. This course of policymaking and the market response papered over problems, while creating additional fragilities and vulnerabilities. Fundamentally, perceptions of endless liquidity and "too big to fail" fueled excessive speculative leveraging - setting the backdrop for inevitable abrupt market reversals, de-leveraging, and market liquidity problems.

Most of the QE2 debate has thus far centered on the Treasury market. Treasury bond prices have rallied sharply over the past month, emboldening those analysts predicting the end of QE2 would prove a non-event. Yet, when it comes to de-risking and de-leveraging, analysis gravitates away from Treasurys and instead to the recent swoon in commodities markets. Indeed, a drop in Treasury yields, as it did in 2008, can actually exacerbate problems in "carry trades" and other leveraged speculations (catching those that shorted Treasuries to finance leveraged positions in higher-yielding instruments).

Thus far, the global "risk on" trade has persevered through some rather abrupt declines in commodities prices; weak performance by "emerging" equities; a recent bid to the dollar; and a worsening crisis in the European periphery debt markets. As yet, there's little indication of more general market liquidity "contagion" issues. In particular, corporate risk premiums remain meager and "developing" debt markets retain their "bulletproof" status. I'll add, however, that the Fed's $20bn+ weekly market liquidity injections would be expected to provide an ameliorating effect systemically from the impacts of limited de-risking and de-leveraging operations. To be sure, QE2 should at least mute market fears of contagion effects.

Greece's 10-year bond yields jumped 57 bps points today to 16.37% (2-year yields up 55bps to 24.72%). Portuguese yields surged 25 bps today to 9.16%, and Ireland saw yields jumped 9 bps to 10.32%. Despite last year's nearly $160 Eurozone bailout, Greece's situation remains untenable. Greece is in no position to service its debt load or to meet deficit reduction goals. There is no tolerable resolution to this crisis, and a painful debt restructuring appears unavoidable. But how and when?

The Greek debt crisis debate may have reached a critical juncture this week. Behind the scenes, reports have the ECB turning more vocal against restructuring. Fears are mounting for what a technical default would mean for the expansive CDS marketplace. Under the terms of these contracts, a debt restructuring (or even "re-profiling") would likely trigger "default," forcing those that wrote/sold this swap (Credit insurance) protection to assume this liability. Today, Fitch Ratings slashed Greece's Credit rating three notches, while stating that even a voluntary extension of Greek debt maturities would be considered a technical default. As was suggested this week from comments from ECB officials and market analysts, this circumstance pits the interests of the ECB and the European banks against the hedge fund and proprietary-trading ("London and New York") community.

Ramifications for the Greek debt crisis travel far and wide. The CDS marketplace must prepare for what not too long ago was considered a very remote possibility - a sovereign debt default. The marketplace is increasingly coming to grips with the degree of financial and economic dislocation - and the arduous recovery process - unleashed when markets turn against a profligate sovereign borrower. There is also the issue of how a Greek default might impact the debt and CDS markets for Portugal, Ireland and beyond. It may be a case of the CDS tail wagging the sovereign debt market dog.

It is worth noting that Spain's two-year yields jumped 29 bps this week to 3.62%, the high since early January. When it comes to the "bull vs. bear" view of the European debt crisis, Spain is the battleground. Most agree that Portugal, Ireland and Greece are basket-cases - but they're relatively small economies in the grand scheme of the Eurozone. Spain is a significant player - but their debt problems are nowhere as acute as the PIG's. The success of Spain's austerity measures have been encouraging, although there are increasing indications that some of the improvement in federal deficits has been offset by continued borrowing excesses at the local and regional government level.

Earlier in the week, the Financial Times (Victor Mallet) went with the headline "'Hidden debt raises Spain bond fears," calling into question the credibility of borrowing data reported by regional and local government units. The article included this zinger: "Latest data from the Bank of Spain, calculated in accordance with European Union guidelines, show that the country's 17 autonomous regions have nearly doubled their public debt to more than €115bn ($160bn) since 2008..." And then in today's Wall Street Journal (Jonathan House and Sara Schaefer Munoz) comes further detail, as "Spain Vote Threatens to Uncover Debt." Sunday is election day for 13 of the 17 regions and 8,000 municipalities. There is concern that losses by the ruling Socialist party could lead to the revelation of hidden debts. Since a changing of the political guard in Catalonia five months ago, it has been revealed that the region's true deficit is double that previously reported. Stay tuned...

From my analytical perspective, Spain is in line to suffer the consequence of an interminable global sovereign debt crisis. It's the timing that is most in question, and I would expect a Greek default and/or bout of global risk aversion to push the timeline forward. Spain's borrowing costs have risen significantly over the past year (10-yr 5.5% vs. 4.0%, 2-yr 3.6% vs. 2.0%). Not only does the issue of runaway regional and local government borrowings increase risk, it raises the question of the true success of federal austerity measures. With Greece in the hot seat and Portugal and Ireland sitting close by, Spain is these days especially susceptible to contagion effects. Little wonder the ECB is fretting about the CDS market.

And the backdrop really turns uncertain when one ponders a repeat of last year's scenario where Greek debt problems turn systemic through a dislocation in the CDS market. And if, once again, such a development leads to euro weakness, the resulting boost to the dollar could further catch players on the wrong side of various "carry trades" and other bets gone astray. As I noted above, the end of QE2 doesn't have to mean liquidity issues for the marketplace. Then again, the end of quantitative easing becomes a major market liquidity event if the marketplace is in the midst of a serious bout of speculative de-risking and de-leveraging. Much to contemplate and analyze over the coming days and weeks.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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