The King of Non-Productive Debt

By: Doug Noland | Fri, Jun 10, 2011
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For the week, the S&P500 declined 2.2% (up 1.1% y-t-d), and the Dow fell 1.6% (up 3.2%). Broad market weakness continued. The S&P 400 Mid-Caps sank 3.0% (up 2.7%), and the small cap Russell 2000 dropped 3.5% (down 0.5%). The Banks declined 2.0% (down 10.5%), while the Broker/Dealers sank 2.8% (down 12.2%). The Morgan Stanley Cyclicals fell 2.2% (down 2.7%), and the Transports sank 3.1% (down 0.9 %). The Morgan Stanley Consumer index slipped 0.9% (down 0.3%), and the Utilities dipped 0.5 % (up 3.8%). The Nasdaq100 fell 3.1% (up 0.2%), and the Morgan Stanley High Tech index sank 3.3% (down 3.8%). The Semiconductors dropped 3.8% (down 2.2%). The InteractiveWeek Internet index fell 3.8% (down 3.1%). The Biotechs dropped 3.8% (up 8.9%). While bullion declined only $10, the HUI gold index was hit for 5.4% (down 11.3%).

One-month Treasury bill rates ended the week at one basis point and three-month bills closed at 4 bps. Two-year government yields fell 2.5 bps to 0.40%. Five-year T-note yields ended the week down 3 bps to 1.56%. Ten-year yields dipped 2 bps to 2.97%. Long bond yields fell 4 bps to 4.19%. Benchmark Fannie MBS yields were little changed at 3.89%. The spread between 10-year Treasury yields and benchmark MBS yields increased 2 to 92 bps. Agency 10-yr debt spreads declined one to negative 5 bps. The implied yield on December 2011 eurodollar futures was little changed at 0.40%. The 10-year dollar swap spread was little changed at 11 bps. The 30-year swap spread was about changed at negative 25 bps. Corporate bond spreads widened. An index of investment grade bond risk increased 4 bps to a six-month high 99 bps. An index of junk bond risk surged 33 bps to 507 bps, the high since late-November.

Investment-grade issuers included Citigroup $1.88bn, Met Life $1.15bn, Fiserv $1.0bn, Spectra Energy $500 million, Valmont Industries $450 million, Texas Gas Transmission $440 million, Nextera Energy $400 million, Nisource $400 million, Atmos Energy $400 million, and Florida Power & Light $250 million.

Junk bond funds saw outflows of $671 million (from Lipper). Junk issuers included CenturyLink $2.4bn, Arch Coal $2.0bn, Clear Channel $1.75bn, Freescale Semiconductor $750 million, Basic Energy Services $475 million, Audatex $450 million, Wireco Worldgroup $425 million, Symbion $350 million, and Teleflex $250 million.

Convertible debt issuers included Brookdale Senior Living $275 million, Integra Lifesciences $200 million, and Molycorp $200 million.

International dollar bond issuers included Poland $2.0bn, Ukraine $1.25bn, KFW $1.25bn, Iceland $1.0bn, Austria $1.0bn, Neder Waterschapsbank $1.0bn, Kommunalbanken $1.0bn, New Brunswick $750 million, Kia Motors $500 million, Quadra Mining $500 million and Latvia $500 million.

German bund yields fell 10 bps to 2.96% (unchanged), and U.K. 10-year gilt yields declined 6 bps this week to 3.22% (down 29bps y-t-d). Greek two-year yields surged 299 bps this week to 25.12% (up 1,288bps). Greek 10-year note yields jumped 79 bps to 16.52% (up 357bps). Spain's 10-year yields rose 24 bps to 5.46% (up 2bps). Ten-year Portuguese yields surged 56 bps to 10.15% (up 357bps). Irish yields increased 42 bps to 11.00% (up 195bps). The German DAX equities index slipped 0.6% (up 2.3% y-t-d). Japanese 10-year "JGB" yields were unchanged at 1.135% (up one basis point). Japan's Nikkei added 0.2% (down 7.0%). Emerging markets were mostly lower. For the week, Brazil's Bovespa equities dropped 2.6% (down 9.5%), while Mexico's Bolsa dipped 0.5% (down 9.3%). South Korea's Kospi index sank 3.3% (down 0.2%). India's equities index declined 0.6% (down 10.9%). China's Shanghai Exchange declined 0.9% (down 3.7%). Brazil's benchmark dollar bond yields dropped 8 bps to 4.10%, while Mexico's benchmark bond yields were little changed at 3.99%.

Freddie Mac 30-year fixed mortgage rates dropped 6 bps to 4.49% (down 23bps y-o-y). Fifteen-year fixed rates declined 6 bps to 3.68% (down 49bps y-o-y). One-year ARMs sank 18 bps to 2.95% (down 96bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 3 bps to 5.01% (down 57bps y-o-y).

Federal Reserve Credit jumped $13.5bn to a record $2.784 TN (31-wk gain of $504bn). Fed Credit was up $377bn y-t-d and $471bn from a year ago, or 20.3%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 6/8) rose $10.7bn to $3.443 TN. "Custody holdings" were up $92.8bn y-t-d and $367bn from a year ago, or 11.9%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.533 TN y-o-y, or 18.4%, to a record $9.860 TN. Over two years, reserves were $3.062 TN higher, for 45% growth.

M2 (narrow) "money" supply rose $12.6bn to a record $9.018 TN. "Narrow money" has expanded at a 4.9% pace y-t-d and 4.7% over the past year. For the week, Currency increased $1.2bn. Demand and Checkable Deposits jumped $20.5bn, while Savings Deposits dipped $4.4bn. Small Denominated Deposits fell $3.5bn. Retail Money Funds declined $1.3bn.

Total Money Fund assets jumped $15.9bn last week to $2.742 TN. Money Fund assets were down $68bn y-t-d, with a decline of $98bn over the past year, or 3.5%.

Total Commercial Paper outstanding jumped another $23.9bn to $1.221 Trillion (high since Nov. '09). CP was up $252bn y-t-d, or 49% annualized, with a one-year rise of $156bn.

Global Credit Market Watch:

June 10 - Financial Times (Gerrit Wiesmann): "The German government on Friday signalled it would not back down in its stand off with the European Central Bank over the involvement of owners of Greek sovereign bonds in a new round of aid for the debt-ridden country. Wolfgang Schäuble, German finance minister, told the country's parliament he was sticking by his demand that the package observe 'a fair distribution of risks between tax payers and private creditors'. That followed Thursday's warning by ECB president Jean Claude Trichet that forcing the involvement of Greece's private creditors would be akin to a default, an "enormous mistake" that would rattle a recovering financial system. Mr Trichet was reacting to a letter from the German finance minister to eurozone peers and the ECB in which he demanded that 'substantial' numbers of private creditors agree to extending the maturity on Greek paper by seven years."

June 10 - Financial Times (Ralph Atkins, Peter Spiegel in Brussels and Quentin Peel): "Jean-Claude Trichet, European Central Bank president, has escalated his dispute with Berlin over a fresh international bail-out for Greece, after making clear he sees no scope for forcing a contribution from holders of Greek government bonds. Eurozone governments had to avoid Greece being deemed in default or a 'credit event', Mr Trichet warned... Any private sector involvement had to be voluntary and without any element of coercion. His comments were a riposte to Wolfgang Schäuble, Germany's finance minister, who has demanded a 'quantified and substantial contribution' by bondholders as a condition of German support for a new aid programme... 'It is a showdown between Mr Schäuble and Mr Trichet,' said Jörg Kramer, chief economist at Commerzbank..."

June 10 - Bloomberg (Matthew Brockett and Gabi Thesing): "Germany dug in on demands that investors pay some of the cost of a second Greek rescue after Jean-Claude Trichet rejected direct involvement by the European Central Bank. 'Participation of private creditors in cases of insolvency is indispensable," German Finance Minister Wolfgang Schaeuble told lawmakers... ignoring warnings from credit- rating firms that his proposal to extend Greek debt maturities by seven years would be deemed a default."

June 8 - Bloomberg (Paul Dobson): "European Union plans to include private investors in a second Greek bailout are a threat to the creditworthiness of Ireland and Portugal, and risk driving up both nations' borrowing costs. Ratings companies warn that they may consider any duress or worsening terms for bondholders in a debt deal as a default, and that they would cut Greece's credit rank accordingly. Moody's... said... that given how a Greek restructuring may be a model for other rescues, 'multi-notch downgrades' for Ireland and Portugal may be a result."

June 6 - Bloomberg (Maria Petrakis and James Hertling): "George Papandreou is the last man standing among the euro-area leaders who needed a handout after Jose Socrates's defeat in Portuguese elections... For Papandreou and the investors and taxpayers who will share the cost of a beefed-up bailout for Greece, questions are increasing about whether he will complete a term that runs until 2013 and enact the budget reductions and asset sales that his benefactors demand."

June 10 - Bloomberg (Dara Doyle): "As the International Monetary Fund urges Europe to help Ireland out of its crisis, politicians in France and Germany are doing the opposite. The government in Dublin said this week ministers in Paris are blocking a cut in the interest rate that Ireland pays for its package of rescue loans."

June 10 - Bloomberg (Tim Catts): "Company debt offerings in the U.S. of $14.4 billion fell short of the 2011 average for the second consecutive week... issuance fell 53.1% below this year's weekly mean of $30.7 billion... Sales are slumping after surging to a record $55 billion during the week ended May 20 as companies took advantage of borrowing costs near all-time lows... Issuance this year of $673.5 billion, including $157.9 billion last month, compares with $458.2 billion during the similar period of 2009."

June 10 - Bloomberg (Esteban Duarte and Ben Martin): "Political wrangling over the future of Greece is infecting Europe's corporate bond market, pushing relative yields to a 2 1/2-month high and forcing borrowers to pull deals."

June 6 - Bloomberg (Daniel Kruger): "The risk of owning U.S. government debt is as great as any time since the 1950s with yields at the year's lows and Treasury Secretary Timothy F. Geithner locking in borrowing costs by selling longer-term securities. Yields on Treasuries would only need to rise 0.3 percentage point over one year on average from 1.67% to produce a loss, based on the benchmark Barclays Treasury index, a study by... First Pacific Advisors shows. The last time bonds were close to this level was in March 2009, when a 0.43 percentage point rise in yields would have left holders of comparable maturity five-year Treasuries with losses."

June 6 - Bloomberg (Boris Groendahl): "German lenders were the biggest foreign owners of Greek government bonds with $22.7 billion in holdings last year, making them a likely negotiation partner in burden-sharing deals for the country... French banks, which led the group of Greek creditors with overall claims amounting to $56.7 billion, trailed their German peers on sovereign debt with $15 billion..."

Global Bubble Watch:

June 9 - Bloomberg (James G. Neuger): "European governments and the International Monetary Fund would lend as much as an extra 45 billion euros ($65bn) to Greece under an expanded plan to avoid the euro area's first sovereign default, two people with direct knowledge of the talks said. European estimates put Greece's 2012-14 financing gap at as much as 170 billion euros..."

June 7 - Bloomberg (Sandrine Rastello): "The International Monetary Fund's 26 billion-euro ($38.1bn) loan to Portugal 'entails important risks,' the agency's staff said... The measures attached to the loan 'may fail to alleviate sovereign debt concerns, with an adverse impact on government financing prospects,' IMF staff wrote... 'In particular, refinancing risks from the closure or contraction of the Treasury bills market represent a near-term refinancing risk for the government.' Other threats cited by the IMF staff include the needed support from Portugal's population and from the political class, lower-than-expected growth and deepening problems in other European countries."

Currency Watch:

The U.S. dollar index rallied 1.4% to 74.83 (down 5.3% y-t-d). For the week on the upside, the New Zealand dollar increased 0.7%. On the downside, the Swedish krona declined 3.1%, the Norwegian krone 2.8%, the Mexican peso 2.0%, the Danish krone 2.0%, the Euro 2.0%, the Australian dollar 1.7%, the South African rand 1.4%, the Brazilian real 1.3%, the British pound 1.2%, the Swiss franc 1.1%, the Singapore dollar 0.7%, the Taiwanese dollar 0.4%, the South Korean won 0.2%, and the Canadian dollar 0.2%.

Commodities and Food Watch:

June 6 - Bloomberg (Luzi Ann Javier, Madelene Pearson and Whitney McFerron): "The worst droughts in decades are wilting wheat fields from China to the U.S. to the U.K., overwhelming Russia's return to grain markets and driving prices to the highest levels since 2008. Parts of China, the biggest grower, had the least rain in a century, some European regions are the driest in 50 years and almost half the winter-wheat crop in the U.S., the largest exporter, is rated poor or worse. Inventory is dropping 8.8%, the most in five years, Rabobank International says... Wheat as much as doubled in the past year as crops failed, spurring Ukraine and Russia to curb shipments and increasing the U.S. share of global sales by the most since 2004."

June 6 - Bloomberg (Rudy Ruitenberg): "Global wheat production will lag behind demand, helping to keep food prices high and volatile at least through next year, the United Nations' Food and Agriculture Organization said. Wheat output will rise 3.2% to 673.6 million metric tons in the season starting in July, trailing demand of 677 million tons... Food prices stayed near record levels in May on higher meat and dairy costs. Food imports will rise 21% to a record $1.29 trillion this year, the FAO said separately."

The CRB index slipped 0.2% (up 4.6% y-t-d). The Goldman Sachs Commodities Index added 0.3% (up 11.1%). Spot Gold dipped 0.7% to $1,532 (up 7.8%). Silver added 0.4% to $36.32 (up 17%). July Crude declined 93 cents to $99.29 (up 9%). July Gasoline added 0.8% (up 23%), and July Natural Gas gained 1.1% (up 8%). July Copper dropped 1.9% (down 8%). July Wheat fell 1.9% (down 4%), while July Corn jumped 4.4% (up 25%).

China Bubble Watch:

June 10 - Bloomberg: "China reported a less-than-estimated $13.1 billion trade surplus in May, as surging imports signaled the nation's demand may support global growth while adding pressure for higher interest rates. Inbound shipments climbed 28% from a year earlier and exports rose 19%..."

June 9 - Bloomberg: "China's Ministry of Railways, the nation's biggest issuer of corporate debt, is paying a record yield premium to sell bonds as construction of the world's biggest high-speed network strains its finances. The difference between yields on its 10-year notes and similar-maturity Treasuries doubled in the last five months to 141 bps, the most in ChinaBond data going back to September 2008."

June 8 - Bloomberg (Richard Frost): "Hong Kong secondary home prices will rise a further 14% by the end of the year, Credit Suisse Group AG said, driven by a widening in negative real interest rates, a weaker dollar and buying by mainland Chinese."

June 9 - Bloomberg (Kelvin Wong): "Hong Kong's government sold a site in one of the city's most exclusive areas below surveyors' estimates... Cheung Kong (Holdings) Ltd., the developer controlled by billionaire Li Ka-shing, paid HK$11.65 billion ($1.5 billion), 10% lower than the HK$13 billion median estimate of five surveyors and analysts polled by Bloomberg..."

June 7 - Bloomberg (Fion Li): "Hong Kong residents will receive a HK$6,000 government payout in late November or early December, Sing Tao reported..."

Japan Watch:

June 8 - Bloomberg (Shigeki Nozawa): "Japan faces the rising risk of surging bond yields in the decade from 2015, according to SMBC Nikko Securities Inc. The nation has maintained a current-account surplus in the past 30 years, with household savings financing the world's largest government debt and helping driving down bond yields, said Hidenori Suezawa, chief strategist at SMBC Nikko Securities..."

India Watch:

June 9 - Bloomberg (Tushar Dhara): "India's food inflation accelerated to an eight-week high, adding pressure on the central bank to raise interest rates next week. An index measuring wholesale prices of agricultural products rose 9.01%... from a year earlier..."

Unbalanced Global Economy Watch:

June 10 - Bloomberg (Greg Quinn): "Canada's jobless rate unexpectedly declined in May to the lowest since January 2009 as the economy added workers for the seventh time in eight months. The unemployment rate fell to 7.4% last month from April's 7.6%..."

June 8 - Bloomberg (Marcus Bensasson): "Greece's unemployment rate exceeded 16% in March, extending a record high as the nation's economy remained mired in the third year of a recession."

U.S. Bubble Economy Watch:

June 8 - Bloomberg (Catarina Saraiva and Tom Keene): "The U.S. should stop kicking 'the can down the road' and implement fiscal austerity measures so the economy can fully recover from the financial crisis, according to Pacific Investment Management Co.'s Neel Kashkari. The government should abandon stimulative measures and focus on economic adjustments in order to allow for long-term growth... 'There's no question that austerity has short-term consequences, but we can't just continue to kick the can down the road here... We can't continue to try to use short-term stimulus measures to delay the necessary economic adjustment. At the end of the day, our economy needs to adjust. We need to get our fiscal house in order and it's not pain-free.'"

June 9 - Bloomberg (Alan Bjerga): "A middle-income family may spend $226,920 to raise a child born in 2010 to the age of 18, the U.S. Department of Agriculture said... The estimate is up 2.1% from 2009... Expenses for child care, education, transportation and health services represented the biggest increases in child-rearing costs, the USDA said..."

Central Bank Watch:

June 9 - Bloomberg (Jana Randow and Christian Vits): "The European Central Bank signaled a July rate increase while damping investor expectations for further moves by reiterating a forecast that inflation will fall below its 2% limit next year."

Speculator Watch:

June 7 - Bloomberg (Alexander Ragir): "They arrive every week, in ones and twos and groups of 10, some of them coming straight from Sao Paulo's Guarulhos International Airport. These investors head for the dark-wood halls of Credit Suisse Hedging-Griffo as supplicants, asking to put their millions of dollars into one of the world's top-performing hedge funds... One American offered to sign a contract that wouldn't allow him to ask for his cash back for three years, says Luiz Paulo Parreiras, strategist for the firm. 'Pension funds, endowments, sovereign-equity money -- we've turned all of them down,' he says. The money managers are concerned that if Hedging-Griffo's $8 billion hedge fund becomes too large, its trades may move Brazilian markets, Parreiras says..."

June 6 - Bloomberg (Kelly Bit): "John Paulson, the money manager who earned about $5 billion in 2010, lost 6% in his main fund last month as stocks and commodities slumped... The decline left Paulson's Advantage Plus Fund... down 7.6% since the start of the year..."


The King of Non-Productive Debt

There is important confirmation of the "bear" thesis to discuss. But, as usual, let's first set the backdrop:

The world is in the midst of history's greatest Credit Bubble. A dysfunctional global financial system essentially operates without mechanisms to restrain the quantity and quality of debt issuance. In response to severe banking system impairment and fiscal problems in the early-nineties, the Greenspan Fed helped nurture a Credit system shift to nontraditional marketable debt. The bank loan was largely replaced by mortgage-backed securities (MBS), asset-backed securities (ABS), GSE debt instruments, derivatives and a multitude of sophisticated "Wall Street" Credit instruments. The Credit expansion grew exponentially, while becoming increasingly detached from production and economic wealth-creation (the boom, in fact, exacerbated deindustrialization).

The Fed implemented momentous changes in monetary management to bolster the new "marketable debt" Credit system structure, including "pegging" short-term interest rates; serial interventions to assure "liquid and continuous markets;" and adopting an "asymmetrical" policy framework that disregarded asset inflation/Bubbles, while guaranteeing the marketplace an aggressive policy response to any risk of market illiquidity or financial/economic instability. Massive expansion of marketable debt coupled with a highly-accommodative policy backdrop incited incredible growth in speculation and leveraging. Over time, trends in U.S. Credit, policy and speculative excess took root around the world.

Global markets suffered a devastating crisis of confidence in 2008. The failure of Lehman Brothers, in particular, set off a panic throughout global markets for private-sector debt, especially Credit intermediated through sophisticated Wall Street structures. Unprecedented government intervention reversed the downward spiral in Credit and economies. Especially in the U.S., Trillions of private debt instruments were put under the umbrella of government backing. Meanwhile, Trillions more were acquired by the Fed, ECB and global central bankers in the greatest market intervention and debt monetization in history. Policy making - fiscal and monetary, at home and abroad - unleashed the "Global Government Finance Bubble".

Currency market distortions have been instrumental in sowing financial fragility. Chiefly because of the dollar's special "reserve currency" status, U.S. Credit system excesses have been accommodated for way too long. Global central banks have been willing to accumulate Trillions of our I.O.U.s, providing a critical liquidity backstop for the marketplace. Highly liquid and orderly currency markets have been instrumental in ensuring a liquid Credit market, which has provided our fiscal and monetary policymakers extraordinary flexibility to inflate our Credit, our asset markets and our economy. Meanwhile, massive U.S. Current Account Deficits and other financial flows have inundated the world, creating liquidity excess and unfettered domestic Credit expansion throughout the world. Global imbalances, having mounted for decades, went "parabolic" over the past three years.

I would argue strongly that the euro currency regime owes much of its great success to the structurally weak U.S. dollar. For all the flaws and potential pitfalls of a common European currency, the euro has from day one looked awfully appealing standing side-by-side with the dollar. And the buoyant euro created powerful market distortions that promoted Credit excess throughout the region, especially in Europe's periphery (Greece and the so-called "PIIGS" would never have enjoyed the capacity to push borrowing to such extremes had they been issuing debt denominated in their own currencies). The weak dollar and strong euro - along with the perception that the Eurozone and ECB would never tolerate a default by one of its sovereigns - were instrumental in promoting profligate borrowing, lending, spending and speculating.

I have recently turned more focused on differentiating between "productive" and "non-productive" debt. This is an important analytical distinction - although, by nature, a challenging gray area for Macro Credit Analysis. At the time of its creation, there might actually be little difference from a systemic perspective whether a new financial claim is created in the process of financing real investment or an asset purchase or, instead, to fund a government stimulus program. In each case, new purchasing power is released into the system. The key is that the new Credit stimulates economic "output" through increased spending, incomes and/or asset inflation. Especially during the halcyon Credit boom days, the markets will pay scant attention to the assets underpinning the new debt instruments (particularly when policymakers are actively intervening and distorting markets!).

However, don't be fooled and don't become too complacent. At some inevitable - if not predictable - point the markets will care tremendously whether a Credit system is sound or not. Regrettably, the current era's (unrestrained global finance, structurally-unsound dollar, "activist" policymaking, rampant global speculation, etc.) unique capacity for sustaining non-productive debt booms poses major problems. In short, the booms last too long and activist policymaking ensures they end up afflicting the heart of Credit systems. These protracted Bubbles are resolved through problematic crises of confidence and debt revulsion.

First of all, booms create a fragile mountain of debt not supported by underlying wealth-creating capacity. Second, Credit Bubbles inflate various price levels throughout the economy, creating systemic dependencies requiring ongoing debt and speculative excess. And, third, the boom in non-productive debt will tend to foster consumption and malinvestment at the expense of sound investment in productive capacity. When the boom eventually falters, market revulsion to unsound debt, the economy's addiction to uninterrupted Credit expansion, and the lack of capacity for real wealth creation within the ("Bubble") real economy ensure a very severe crisis and prolonged adjustment period. These dynamics become critically important when a government (finally) loses its capacity to perpetuate the Bubble (i.e. Greece, Portugal, Ireland, etc.)

As a crisis unfolds, the markets eventually must come to grips with a very harsh reality: There will be denial and it will take some time to really sink in - but the markets will come to recognize that too little of the existing debt is backed by real wealth. Non-productive Credit booms are, after all, essentially "Ponzi Finance" schemes. Worse yet, only huge additional injections of debt/purchasing power will hold economic collapse at bay. Fundamentally, non-productive Credit booms foment deleterious effects upon the economic structure - that compound over time. As we have witnessed with Greece and Ireland, "bailout" costs can quickly skyrocket to meaningful percentages of GDP - and keep growing.

And once stunned by the downside of "Ponzi Finance," markets will be keen to mitigate risk exposure to the next episode. This is the essence of "contagion effects." Especially in interlocking global markets dominated by leveraged speculation and trend-following trading strategies, de-risking and de-leveraging in one market tend to quickly translate to risk aversion and faltering liquidity throughout the marketplace. Markets perceived as liquidity abundant can almost overnight be transform to liquidity-challenged. This dynamic went to devastating extremes during the 2008 crisis - only to begin mount a resurgence with last year's Greek debt crisis and contagion.

It has been my thesis that last year's aggressive market interventions - QE2, the European fiscal and monetary "bailouts," and massive global central bank monetization - incited a highly speculative Bubble environment vulnerable to negative liquidity surprises. And now we're down to the final few weeks of QE2. The European bailout strategy is unwinding, with little possibility of near-term stabilization. Meanwhile, the US economy has downshifted in spite of massive fiscal and monetary stimulus. Risk and uncertainty abound; de-risking and de-leveraging are making a return.

Bloomberg went with the headline, "Fed's Maiden Lane Sales Trigger Bank Stampede to Dump Risk." At The Wall Street Journal, it was "As 'Junk' Bonds Fall, Some Blame the Fed." Both articles noted the deterioration in pricing for a broadening list of Credit market instruments, including junk bonds, subprime mortgage securities, and various Credit derivatives. And while the Fed's liquidation of some old AIG portfolio positions is surely a drag on some prices, I believe the rapidly deteriorating liquidity backdrop is more indicative of global de-risking dynamics. This is providing important confirmation of the bear thesis.

There are fascinating dynamics at work throughout our Credit market. Arguably, the U.S. is the King of Non-Productive Debt. In the wake of a historic expansion of non-productive household debt comes a Bubble in Treasury (and related) government Credit. The assets underpinning too much of the U.S. debt mountain are suspect, although this hasn't mattered recently. And in true Bubble fashion, the marketplace has increasingly gravitated to Treasury debt as the "Greek" crisis escalates and contagion effects gather momentum. The corporate debt market has enjoyed extreme bullish sentiment - along with waves of investment and speculative inflows. While the corporate balance sheet appears sound, I would counter that corporate earnings and cash flows have been artificially inflated by unsustainable federal deficits. In particular, the bubbling junk bond market would appear vulnerable to the deteriorating liquidity backdrop.

Elsewhere, there is the murky world of subprime derivatives and such. This bastion of speculative excess certainly enjoyed the fruits of policy-induced reflation. But not only has housing performed dismally, there is now the market issue of de-risking and liquidity uncertainties. Today from the WSJ: "Since April, prices of many subprime mortgage securities have declined between 15% and 20%... The decline in subprime mortgage bonds accelerated in the last two weeks..." From Bloomberg this morning: "Declines in credit-default swaps indexes used to protect against losses on subprime housing debt and commercial mortgages accelerated this month, reaching almost 20% in the past five weeks.." Also from Bloomberg: "Default swaps on the six largest U.S. banks have gained an average of 19.4 bps to 137.2 bps since May 31..."

In conclusion, support seemed abundant this week for the thesis which holds that the U.S. Credit system and economy are much more vulnerable to contagion effects than is commonly appreciated. Treasury and dollar rallies appear constructive for system liquidity. In reality, it is likely that both markets are heavily impacted by speculative trading (speculators, in various forms, have used Treasury and dollar short positions to finance higher-returning holdings). Strength in the Treasury market and the dollar are indicative of - and place additional pressure on - the unwind of leveraged trades. And it is when the speculator community is on its heels and backing away from risk that market liquidity becomes a market issue.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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