Compare and Contrast: 2011 versus 2008

By: Doug Noland | Sat, Aug 13, 2011
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For the week, the S&P500 declined 1.7% (down 6.3% y-t-d), and the Dow fell 1.5% (down 2.7%). The S&P 400 Mid-Caps dipped 0.2% (down 7.1%), and the small cap Russell 2000 fell 2.4% (down 11.0%). The Banks sank 8.9% (down 27.8%), and the Broker/Dealers dropped 6.0% (down 26.2%). The Morgan Stanley Cyclicals lost 2.3% (down 15.5%), and the Transports declined 1.5% (down 9.5%). The Morgan Stanley Consumer index declined 1.7% (down 8.4%), and the Utilities gave back 1.2% (up 0.4%). The Nasdaq100 dipped 0.6% (down 1.6%), and the Morgan Stanley High Tech index declined 0.9% (down 12.5%). The Semiconductors rallied 1.5% (down 13.6%). The InteractiveWeek Internet index gained 0.4% (down 8.4%). The Biotechs declined 1.0% (down 13.0%). With bullion surging $83 in a record-setting week, the HUI gold index rallied 7.0% (down 1.6%).

One and two-month Treasury bill rates ended the week at one basis point. Two-year government yields declined 9 bps to 0.19%. Five-year T-note yields ended the week down 29 bps to 0.96%. Ten-year yields sank 31 bps to 2.25%. Long bond yields fell 12 bps to 3.72%. Benchmark Fannie MBS yields declined 35 bps to 3.29%. The spread between 10-year Treasury yields and benchmark MBS yields narrowed 4 to 104 bps. Agency 10-yr debt spreads were little changed at one basis point. The implied yield on December 2012 eurodollar futures sank 22 bps to 0.445%. The 10-year dollar swap spread was little changed at 16 bps. The 30-year swap spread declined 12 bps to negative 39 bps. Corporate bond spreads widened significantly. An index of investment grade bond risk increased 12 bps to 115 bps. An index of junk bond risk jumped 70 bps to 652 bps.

Investment-grade issuers included Thermo Fisher $2.1bn, Procter & Gamble $2.0bn, Berkshire Hathaway $2.0bn, Enterprise Products $1.25bn, Wellpoint $1.1bn, Baker Hughes $750 million, Dominion Resources $450 million, Transcontinental Gas Pipeline $375 million, University of Southern California $300 million, and Public Service Electric & Gas $250 million.

Junk bond funds saw outflows surge to $3.42bn (from Lipper). Junk debt issuers included Cownrock $150 million

I saw no convertible debt issued.

International dollar bond issuers included Mexico $2.0bn and Network Rail Infrastructure $1.0bn.

German bund yields dipped one basis point to 2.33% (down 63bps y-t-d), and U.K. 10-year gilt yields dropped 16 bps this week to 2.53% (down 98bps). Greek two-year yields ended the week down 46 bps to 32.06% (up 1,982bps). Greek 10-year note yields rose 34 bps to 15.20% (up 274bps). ECB purchases helped Italian 10-yr yields drop 108 bps to 5.00% (up 18bps) and Spain's 10-year yields sink 106 bps to 4.97% (down 47bps). Ten-year Portuguese yields fell 56 bps to 10.11% (up 353bps). Irish yields fell 19 bps to 9.62% (up 56bps). The German DAX equities index sank 3.8% (down 13.3% y-t-d). Japanese 10-year "JGB" yields rose 4 bps to 1.04% (down 8bps). Japan's Nikkei sank 3.6% (down 12.4%). Emerging markets fell under further pressure. For the week, Brazil's Bovespa equities index rallied 1.0% (down 22.8%), while Mexico's Bolsa declined 1.0% (down 13.5%). South Korea's Kospi index sank 7.7% (down 12.6%). India's equities index fell 2.7% (down 17.9%). China's Shanghai Exchange declined 1.3% (down 7.7%). Brazil's benchmark dollar bond yields rose 8 bps to 3.70%, and Mexico's benchmark bond yields jumped 12 bps to 3.65%.

Freddie Mac 30-year fixed mortgage rates fell 7 bps to 4.32% (down 12bps y-o-y). Fifteen-year fixed rates declined 4 bps to 3.50% (down 42bps y-o-y). One-year ARMs sank 13 bps to 2.89% (down 64bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 3 bps to 4.95% (down 47bps y-o-y).

Federal Reserve Credit rose $5.2bn to $2.855 TN. Fed Credit was up $447bn y-t-d and $546bn from a year ago, or 23.6%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 8/10) increased $6.8bn to a record $3.470 TN. "Custody holdings" were up $120bn y-t-d and $306bn from a year ago, or 9.7%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.584 TN y-o-y, or 18.5% to a record $10.126 TN. Over two years, reserves were $3.007 TN higher, for 42% growth.

M2 (narrow) "money" supply surged $159bn to a record $9.475 TN. "Narrow money" has expanded at a 12.2% pace y-t-d and 9.6% over the past year. For the week, Currency increased $1.4bn. Demand and Checkable Deposits jumped $99.5bn, and Savings Deposits rose $61.1bn. Small Denominated Deposits declined $3.6bn. Retail Money Funds added $1.1bn.

Total Money Fund assets jumped $52.8bn last week to $2.621 TN. Money Fund assets were down $189bn y-t-d, with a decline of $205bn over the past year, or 7.2%.

Total Commercial Paper outstanding declined $6.4bn to $1.169 Trillion. CP was up $198bn y-t-d, or 28% annualized, with a one-year rise of $64bn.


Global Credit Market Watch:

August 11 - Bloomberg (Will Robinson, Shannon D. Harrington and Mary Childs): "The cost to protect against a default by U.S. banks soared a second day and a benchmark gauge of corporate credit risk reached a 14-month high amid fear that Europe's debt crisis will infect the global financial system and sink the economy back into recession. Credit-default swaps on Bank of America... surged to the highest since April 2009... A swaps index that gauges the perceived risk of owning junk bonds, which falls as sentiment deteriorates, plunged to the lowest in almost two years."

August 11 - Bloomberg (Tim Catts and Mary Childs): "Speculative-grade bonds worldwide are inflicting the biggest losses on investors since November 2008 amid the credit-market seizure on mounting evidence that the global economy is in danger of tumbling into recession... Investors withdrew an unprecedented $2.1 billion from junk mutual funds on Aug. 9, research firm EPFR Global said."

August 11 - Bloomberg (Ben Martin and Hannah Benjamin): "Junk corporate bonds in Europe are losing money this year, erasing their returns in the first half as the region's deepening debt crisis forced investors to flee all but the safest assets."

August 11 - Bloomberg (Michael Shanahan): "The cost of protecting European corporate bonds from default surged to the highest since April 2009..."

August 9 - Bloomberg (Jack Jordan and Maria Levitov): "Surging borrowing costs threaten to disrupt Russia's sale of 10-year bonds for the second time in a month amid the rout in global equities. Plunging bond prices lifted yields on ruble-denominated debt due in 2021 by 30 bsp..."

August 9 - Bloomberg (Gabrielle Coppola and Boris Korby): "Banco Cruzeiro do Sul SA and Banco Industrial e Comercial SA are posting the biggest losses among Brazilian bonds, part of a rout in midsize bank debt, on concern the global sell-off will cause credit markets to seize up."

August 8 - Bloomberg (Lorenzo Totaro): "Italian bank borrowing from the European Central Bank nearly doubled last month as yields on the country's bonds surged amid the region's debt crisis. Italian banks' borrowing from the ECB rose 39.2 billion euros ($55.9 billion) to 80.49 billion euros from June..."

August 11 - Bloomberg (Boris Korby): "Investors are demanding the biggest premium to own Brazilian corporate dollar bonds instead of government securities in more than two years, signaling a drought in overseas debt sales may deepen."


Global Bubble Watch:

August 12 - Bloomberg: "China's central bank said that the U.S. faces 'debt sustainability' risks in the medium- and long-term, the latest expression of concern from the nation that is America's biggest creditor. 'Developed countries' debt problems are worrisome' and may restrain a longer-term global recovery, the People's Bank of China said in a quarterly monetary policy report... In addition, the euro zone's debt woes may spread to 'key nations,' it said."

August 11 - Bloomberg (Jana Randow, Jeannine Aversa and Scott Lanman): "Central bankers are racing to shield their economies from fiscal tightening and lopsided currency swings that threaten a new global recession. In the 72 hours after a Group of Seven conference call on Aug. 7, the Federal Reserve pledged to keep interest rates near zero through at least mid-2013, the European Central Bank intervened in bond markets and the Bank of England indicated it's ready to add more stimulus if needed. Japan signaled renewed concern about the yen and Switzerland yesterday stepped up its fight to curb an 'overvalued' franc. 'Central bankers have so far been the tower of strength,' said Stefan Schneider, chief international economist at Deutsche Bank... 'Lawmakers have done everything to destroy belief in their ability to solve the problems they're facing.'"

August 10 - Bloomberg (Susanne Walker and Betty Liu): "The Federal Reserve faces a 'hard discussion' in response to a slowing U.S. economy before the Kansas City Fed's conference in Jackson Hole, Wyoming, according to Mohamed El-Erian... 'People have gone from asking is the Fed going to do something to will the Fed be effective in doing something,' El- Erian said..."

August 11 - Bloomberg (Arnaldo Galvao): "South American finance officials are considering creating a $10 billion to $20 billion emergency fund to assist nations that experience capital flight should the global economic crisis deepen, two government officials involved in the talks said."

August 9 - Bloomberg (Seonjin Cha): "South Korea's regulator will ban short sales of stocks for three months after the nation's benchmark equity index had its biggest six-day drop in three years amid concerns that European and U.S. debt problems will lead to a global recession."

August 11 - Bloomberg (Michael Patterson and Benjamin Harvey): "Turkey moved to curb short sales and threatened 'severe penalties' for stock manipulation, joining nations from Greece to South Korea in trying to stem bearish bets after the worst tumble in global shares since 2008."


Currency Watch:

August 11 - Bloomberg (Klaus Wille and Paul Verschuur): "The franc weakened after Swiss Central Bank Vice President Thomas Jordan said a temporary franc peg is within the range of options that policy makers could use to stem the currency's record-breaking rally. 'Any temporary measures to influence the exchange rate are permissible under our mandate as long as these are consistent with long-term price stability,' Jordan said..."

The U.S. dollar index was little changed this week at 74.61 (down 5.6% y-t-d). For the week on the upside, the Japanese yen increased 2.2% and the Singapore dollar 0.4%. On the downside, the South African rand declined 3.6%, the Mexican peso 2.6%, the Brazilian real 2.2%, the Swiss franc 1.4%, the South Korean won 1.1%, the Norwegian krone 0.9%, the Australian dollar 0.8%, the British pound 0.7%, the Canadian dollar 0.5%, the Swedish krona 0.5%, the Danish krone 0.3%, the Danish krone 0.3%, the Euro 0.2% and the Taiwanese dollar 0.2%.


Commodities and Food Watch:

August 9 - Bloomberg (Justin Doom and Debarati Roy): "The worst Texas drought in more than a century has left cotton-crop conditions that rival the Dust Bowl of the early 1930s, forcing farmers to abandon more fields than ever before. Most growers will at least break even this year from insurance claims, with the reimbursement rate on policies higher than the price of New York cotton futures, according to a Bloomberg News survey... 'The number and severity of claims in the Texas Panhandle, High Plains, rolling plains and backlands will be substantially higher than recent years,' said Ted Etheredge, president of Lubbock, Texas-based Armtech Insurance, the fifth-largest U.S. writer of federally sponsored crop-insurance policies. 'The drought is severe, so non-irrigated acreage in most areas had emergence issues, and now irrigated crops are suffering.'"

August 9 - Bloomberg (Lucia Kassai): "Brazil's coffee crops were 'severely' damaged by frost in June and August in some areas, Cooperativa Regional de Cafeicultores em Guaxupe Ltda, Brazil's largest coffee cooperative, said. About 4,400 hectares (10,872 acres) of crops had freezing temperatures, of which 70% had 'light to moderate' damage and 30% were 'severely' damaged..."

The CRB index was little changed this week (down 1.9% y-t-d). The Goldman Sachs Commodities Index slipped 0.4% (up 1.8%). Spot Gold surged 5.0% to $1,747 (up 23%). Silver rose 2.4% to $39.12 (up 27%). September Crude declined $1.45 to $85.43 (down 7%). September Gasoline added 0.6% (up 15%), and September Natural Gas gained 3.1% (down 8%). December Copper fell 2.9% (down 9%). September Wheat rallied 3.5% (down 12%), and September Corn added 1.3%(up 12%).


China Bubble Watch:

August 9 - Bloomberg: "China's inflation accelerated to the fastest pace in three years in July, limiting the scope for monetary easing to support growth as plunging stock markets signal the global recovery is weakening. Consumer prices climbed 6.5% from a year earlier as food costs surged..."

August 12 - Bloomberg: "China's new lending sank to the least this year in July and money supply expanded at a slower pace, adding to signs the fastest-growing major economy is cooling as the global recovery falters. Lending of 492.6 billion yuan ($77 billion) was less than the 550 billion yuan median estimate... M2... rose 14.7% after a 15.9% gain in June."

August 12 - Bloomberg: "Chinese regulators have told banks to tighten lending for real estate on concern credit risks will increase as the impact of government curbs deepens in the next three to five months, a person familiar with the matter said."

August 12 - Bloomberg: "Wenzhou-based Topsun Group makes diesel generators and runs hotels in China. Chairman Wang Chonghuan is a typical entrepreneur -- hard-working, hands-on, ready to pounce on any opportunity, accustomed to bouncing back from difficulties. Yet he doesn't sound very optimistic when he talks about the credit situation that China's small business sector faces today. 'I have been doing business for 30 years, and I have never seen such high interest rates,' says Wang. 'Borrowing any money almost amounts to committing suicide.'"


India Watch:

August 11 - Bloomberg (Tushar Dhara): "India's food inflation accelerated to a three-month high and exports grew at the fastest pace in at least 16 years, maintaining pressure on the central bank to raise interest rates amid the risk of a global downturn. An index measuring wholesale prices of farm products rose 9.9%... from a year earlier..."

Latin America Watch:

August 9 - Bloomberg (Francisco Marcelino): "Banco do Brasil SA, Latin America's largest bank by assets, cut its forecast for loan growth after Brazil's government took measures to curb credit expansion. The lender posted a 22% increase in second-quarter profit. The... lender's loan portfolio is likely to expand 15% to 18% this year, down from an earlier forecast of 17% to 20%... Banco do Brasil said its domestic loan portfolio climbed 17% to 358.6 billion reais ($220.5bn) in the second quarter."


Unbalanced Global Economy Watch:

August 9 - Bloomberg (Theophilos Argitis): "Canadian housing starts climbed in July at the fastest pace in 15 months, adding to evidence the country's real estate market remains buoyant amid low borrowing costs."

August 12 - Bloomberg (Maria Petrakis): "Greece's economy continued to contract in the second quarter, offering a cautionary tale for policy makers struggling to solve Europe's debt crisis. Gross domestic product fell 6.9% from a year earlier, after declining 8.1% on an annual basis in the first quarter..."

August 11 - Bloomberg (Scott Rose and Alena Chechel): "Russia's economy slowed for a second quarter and missed economist estimates as industrial growth eased and inflation eroded consumer buying power... Gross domestic product expanded 3.4%..."


U.S. Bubble Economy Watch:

August 12 - Bloomberg (Angela Greiling Keane): "The U.S. Postal Service, which predicts a loss this year of as much as $9 billion, may seek to break union contracts so it can slash 220,000 jobs by 2015 and withdraw from federal health-benefit and retirement programs, according to draft proposals."


Central Banking Watch:

August 10 - Bloomberg (Craig Torres and Joshua Zumbrun): "Federal Reserve Chairman Ben S. Bernanke's plan to hold interest rates near zero through at least mid-2013 provoked the most opposition among voting policy makers in 18 years as central bank consensus frayed. The Fed chief achieved unanimous support on the Federal Open Market Committee in 2008 when he lowered interest rates to near zero, and in 2009 when he launched $1.73 trillion in bond purchases. Last year, his plan to buy another $600 billion in assets drew one dissent. Yesterday, three policy makers dissented from the decision to apply a specific date to the Fed's low rate pledge for the first time."

August 11 - Bloomberg (Vivien Lou Chen): "Federal Reserve Bank of Minneapolis President Narayana Kocherlakota identified limits to Fed policy in a speech last year that suggested he might be willing to break ranks with his colleagues. On Aug. 9, he made his move. The 47-year-old economist said in a September speech that 2.5 percentage points or more of the U.S. jobless rate is due to mismatches between workers and businesses, including location, which the Fed lacks the tools to fix. 'Central bankers alone cannot solve the world's economic problems, Kocherlakota said."

August 9 - Bloomberg (Jeff Black and Jana Randow): "When Jean-Claude Trichet retires on Oct. 31, the euro area may lose more than just a European Central Bank president. Trichet has emerged as Europe's key policy maker during the sovereign debt crisis, holding the 12-year-old monetary union together as heads of state squabble over their response. While ECB officials have sometimes split over the direction, under Trichet the central bank shown itself more willing and able to act than the bloc's 17 finance ministers and government leaders. 'Trichet has become the de facto president of Europe,' said Marco Valli, chief European economist at UniCredit Global Research... 'He is the only one who's delivered the leadership necessary during this crisis.'"

August 8 - Bloomberg (Rich Miller): "Central bankers from the U.S. to China may have to decide which is their worst nightmare: the Great Inflation of the 1970s or Great Depression of the 1930s. As stock markets slump worldwide and the global economy sputters, monetary-policy makers are struggling to come up with new strategies to spur growth. The catch is that they risk adding to price pressures if they pump more money into the financial system as inflation climbs. It's what 'are you most scared of' -- the risk of spiraling prices or a plunging economy, said Vincent Reinhart, who was the Federal Reserve's chief monetary-policy strategist from 2001 until 2007 and is now a resident scholar at the American Enterprise Institute in Washington."

August 12 - Bloomberg (Vivien Lou Chen): "Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said he sees no need for further monetary accommodation, releasing a statement to explain his dissenting vote at the Fed's Aug. 9 meeting. 'I do not believe that providing more accommodation -- easing monetary policy -- is the appropriate response to these changes in the economy,' he said today, referring to falling unemployment since November and rising inflation as measured by the Fed's preferred price gauge."


Fiscal Watch:

August 11 - Bloomberg (Heidi Przybyla and Kristin Jensen): "The lineup of Democrats and Republicans named to a new congressional panel charged with finding $1.5 trillion in budget savings is raising doubts about the prospects for a bipartisan compromise to address the national debt before next year's elections. U.S. House Speaker John Boehner and Senate Republican leader Mitch McConnell yesterday announced their appointments to the 12-member committee created in the Aug. 2 law that raised the nation's debt limit and averted a default."


Real Estate Watch:

August 11 - New York Times (Kirk Semple): "Chinese banks have poured more than $1 billion into real estate loans in New York City in the past year. Investors from China are snapping up luxury apartments and planning to spend hundreds of millions of dollars on commercial and residential projects like Atlantic Yards in Brooklyn. Chinese companies have signed major leases at the Empire State Building and at 1 World Trade Center, which is the centerpiece of the rebuilding at ground zero... The Chinese investments are occurring with little fanfare, in part because Chinese executives tend to shun publicity. But back home, their government is urging them to invest overseas to diversify China's foreign-exchange holdings, develop business partnerships and improve the country's leverage in international affairs."


Muni Watch:

August 9 - Bloomberg (Sarah Frier, Michelle Kaske and William Selway): "More than 11,000 municipal bonds tied to the federal government lost their AAA ratings from Standard & Poor's, including housing securities and debt backed by leases, after the company downgraded the U.S. S&P assigned AA+ scores to about 11,500 securities in the $2.9 trillion municipal bond market..."

August 9 - Associated Press (Chris Tomlinson): "New data shows state governments have lost $527 billion in revenue since 2007, forcing lawmakers to slash state spending nationwide. According to data released Tuesday, state lawmakers expect slow to moderate economic growth in the next few years and expect to make fewer cuts. But that was before the recent political turmoil over the debt ceiling, a precipitous drop in the stock market and the downgrading of government bonds."

August 11 - Bloomberg (Carol Wolf): "The U.S. Environmental Protection Agency is forcing local governments to spend $100 billion to improve their sewage systems... The EPA is enforcing clean-water regulations in 772 municipalities that it says release too much raw sewage into lakes and rivers during rainstorms and snow melts... The mandates add to the fiscal strains of governments already burdened by falling tax revenue."

August 12 - Bloomberg (Mark Niquette): "The Illinois fiscal 2012 budget doesn't address the state's 'sizeable backlog of unpaid bills and an unsustainable ascent' in spending for pension benefits, Moody's... said... The increase in state corporate and individual income tax- rates that took effect in January will contain growth in total liabilities of almost $120 billion..."


California Watch:

August 9 - Bloomberg (James Nash): "California, the most populous U.S. state, collected $538.8 million, or 10.3%, less revenue in July than projected as higher taxes adopted in 2009 expired. Sales taxes were 12.5%, or $139.4 million, below forecasts, while corporate taxes were down 19.3%, or $69.5 million. Personal-income taxes were 2.9%, or $89 million, higher than projected in May... The July numbers widen the gap between actual receipts and additional revenue on which Governor Jerry Brown and Democrats based their new budget, Chiang said. That $86 billion spending plan signed into law June 30 cut spending by $12 billion and counted on $4 billion in higher-than-forecast tax revenue from a recovering economy."

August 9 - Associated Press (Adam Weintraub): "Building tracks for the first section of California's proposed high-speed rail line will cost $2.9 billion to $6.8 billion more than originally estimated, raising questions about the affordability of the nation's most ambitious rail project at a time when its planning and finances are under fire. A 2009 business plan developed for the California High-Speed Authority... estimated costs at about $7.1 billion..."


Speculation Watch:

August 12 - Bloomberg (Nina Mehta): "The stock market's fastest electronic firms boosted trading threefold during the rout that erased $2.2 trillion from U.S. equity values, stepping up strategies that profit from volatility, according to one of their biggest brokers. The increase from Aug. 1 to Aug. 10 over their 2011 average surpassed the 80% rise in U.S. equity volume, showing that high-frequency traders made up more of the market during the plunge, Gary Wedbush, executive vice president and head of capital markets at Wedbush Securities, said... 'We're seeing a tremendous amount of high-frequency trading,' said Wedbush, whose company is one of the biggest execution and clearing brokers catering to high-speed firms."

August 11 - Bloomberg (Katherine Burton, Saijel Kishan and Kelly Bit): "John Paulson, the billionaire who is betting on an economic recovery by the end of 2012, lost 11% in the first week of August in his largest hedge fund... The decline leaves the Advantage Plus Fund, which tries to profit from corporate events such as takeovers and bankruptcies, down 31% since the start of the year..."

August 9 - Bloomberg (Christine Harper): "Goldman Sachs... the U.S. bank that makes more than half its revenue from trading, lost money in that business on 15 days during the second quarter, the most daily losses since the fourth quarter of 2008."

August 11 - Bloomberg (Katherine Burton, Saijel Kishan and Zachary R. Mider): "Ken Griffin is in talks to sell his investment bank and is shutting the equity-research group of his securities unit, ending a three-year effort to build a business he said would rival Goldman Sachs..."


Compare & Contrast: 2011 vs. 2008:

I thought a paragraph from today's Financial Times ("This is Not a 2008 Redux," Jennifer Hughes) succinctly captured the consensus view:

"At the bottom of all of this is a lurking fear that this is 2008 all over again. But it is not. Since then banks have written down swathes of dud loans and assets, they have built up capital and most immediately important, they have access to central bank liquidity should the market freeze up. Granted, major banks back on life support would, and should, send markets reeling, but the central bank option means investors would not face the cliff-edge event that was Lehman's collapse."

With astonishing market volatility, faltering marketplace liquidity, collapsing global bank stocks and the imposition of limited bans on short-selling, the unfolding global financial crisis this week definitely recalled the 2008 experience. As the FT noted, there are important differences. There are, as well, some critical similarities. I thought it was worth delving into a little "Compare and Contrast" - from my analytical perspective.

First of all, the nucleus of the current crisis is in Europe instead of the U.S. financial system. I have for awhile now posited the thesis that policy responses to the 2008 meltdown unleashed a perilous "global government finance Bubble." The first crack in the latest Bubble developed in the eurozone (Greece), as opposed to the 2008 crisis that emerged at the fringe of U.S. mortgage finance (subprime). Our banks and Wall Street firms were the focal point of 2008 market fears, while it is today the European banking system. It is certainly easier these days for U.S. pundits, analysts and investors to remain complacent - and content to believe that market selling has been way overdone.

Global policy responses to the 2008 turmoil emboldened the view that policymakers retain powerful tools to manage financial crises. A key facet of my bearish thesis is that the bursting of the "government finance Bubble" will find policymaking increasingly ineffective and, in the end, incapacitated. A Bubble fueled by massive fiscal and monetary stimulus nurtures inevitable vulnerability to the waning capacity of these measures to sustain inflated markets and maladjusted economic structures. As we've witnessed in the European periphery (and, to a lesser extent, here at home), massive government stimulus reaches a point of diminishing returns. And when a crisis of confidence unfolds in government debt - as has been the case in Greece, Ireland, Portugal, Spain and Italy - newfound policymaking constraints quickly become a focal point of market worries.

Yet, a well-entrenched view holds that governments can simply create liquidity and boost bank capital, ensuring no repeat of the "cliff-edge event that was Lehman's collapse." Policymakers have supposedly learned from past mistakes. Especially this week, with market attention turning to French and European banks, market debate centers around the capacity for the ECB and European governments to support their fragile banking system.

I'll again borrow the phrase "a banking system is only as good as its sovereign." In major contrast to 2008, the issue today is not the vulnerability of heavily leveraged banking systems to a crisis of confidence in private (mainly mortgage) debt and sophisticated "Wall Street" structures. Crisis 2011 is foremost a sovereign debt issue - and this changes things profoundly. Since '08, governments have issued Trillions of new debt and, at the same time, have assumed enormous amounts of private-sector risk. Increasingly, governments are losing their capacity to underpin financial systems and economies through additional debt issuance. To keep the latest Bubble from imploding, markets are demanding that those sovereigns that retain the capacity to take on huge additional burdens do so in order to more generally backstop faltering debt structures.

The cost of protecting against a sovereign default by France (in the Credit default swap/CDS market) traded above 180 bps this week, compared to a high of about 65 bps back during 2008 market tumult. Importantly, a crisis that began last year at Europe's periphery has now afflicted its core. On the one hand, markets expect France and Germany to backstop the faltering eurozone debt structure (sovereign and banking system). On the other, the marketplace is recognizing that the enormity of such an undertaking risks pushing French debt over the proverbial cliff. In contrast to '08, the pressing issue today is not susceptible firms such as Bear Stearns or Lehman - but (G7) nations such as Italy and France. Already weighed down by holdings of impaired periphery debt, the French banking system is clearly vulnerable to any waning market appetite for French sovereign Credit.

Italian CDS traded above 400 last week, double the 2008 high. Throughout the CDS marketplace, prices (especially the past week) have surged to levels significantly above those from the heart of the 2008 crisis. In the past seven sessions, CDS prices have jumped 36 bps (to 151) in Brazil and 33 bps (to 152 ) in Mexico. In general, the CDS market appears impaired. This week in particular, "emerging" currencies and debt markets turned tumultuous - and worryingly 2008-like, only compounding banking and market worries. Importantly, mechanisms that transmitted instability around the globe back in 2008 are very much intact in 2011.

We've all listened to the argument "there's less leverage in the system now than in 2008." Well, I'll assume that much of the egregious speculative excess in high-yielding U.S. mortgage Credit was wrung out of the system (not so confident the same can be said for "AAA" mortgage exposure). Clearly, the U.S. banking system has been much more cautious in their exposures to mortgage and private-sector debt, although there have been ample excesses in corporate "leveraged finance". I'll also assume that Wall Street balance sheets are less vulnerable now than in 2008. But when it comes to the global leveraged speculating community, I'm not so convinced that they are any less exposed to tumultuous markets than they were in 2008. And with counter-party risk again an issue, I increasingly fear for the stability of the nebulous entity referred to as "the global derivatives marketplace".

When the leveraged speculators (hedge funds, proprietary trading desks, etc.) were caught poorly positioned during a faltering U.S. mortgage finance Bubble back in 2008, their problems swiftly became the global financial system's problem. As they were throughout the 2008 crisis, the leveraged players remain the predominant transmission mechanism from one market to virtually all markets. As losses mount, speculators are forced to reduce risk and leverage throughout the global risk markets. In our highly interlinked global marketplace, liquidity issues and market dislocation in a key market rather quickly evolve into de-risking, de-leveraging and liquidity issues throughout.

Post-2008, a rejuvenated hedge fund community grew to record size (surpassing $2 TN). From my vantage point, their market influence seems as great as ever - at least it appeared so this week. And I'll venture a guess that leveraged "carry trade" speculations are greater in scope today than was the case in '08. An important aspect of "global government finance Bubble" analysis is that the sophisticated players were emboldened - and highly incentivized - by post-'08 government reflationary policymaking. In particular, financial and economic vulnerability ensured extremely low interest rates (and currency devaluation) in the "developed" world, while strong (domestic and global) inflationary biases virtually guaranteed higher returns and strengthening currencies for the "developing" economies/markets. While this trend - along with attendant speculation - was prominent leading up to the 2008 crisis, I fear speculative excesses might have been on an even grander scale over the past two years.

The scope of global "carry trades" (i.e. take the proceeds from shorting/selling a low-yielding currency to speculate in instruments from higher-returning currencies) is a big unknown. How much shorting of dollar instruments (i.e. Treasurys and such) has funded leveraged speculations in the "developing" markets is a question I ponder on a daily basis. We do know that the enormous global "macro" funds have become much bigger and richer since 2008. And, from what I can discern, their returns have seemed to be at least somewhat negatively correlated to the dollar.

Currency markets turned unstable this week. Meanwhile, global risk markets - certainly including the emerging currency, equity and debt markets - became highly correlated. Market action seemed to confirm the view of heightened market vulnerability to the unwind of leveraged "carry trades." Or, at least, the market became increasingly nervous about the ramifications from weakness in the higher-yielding currencies (quite reminiscent of 2008).

From a high of 1.60 (to the $) in July 2008, the euro sank to 1.25 during the worst of the crisis that October. On a fundamental basis, the euro would appear much more vulnerable today than it was during 2008. And while I would assume that there has been less speculative long buying buoying the euro of late, there has likely been significant hedging activity to protect against a major euro breakdown. This type of hedging activity would tend to increase volatility - which has been the case recently. And it would also increase the risk of an accelerating euro decline - and general currency market instability - in the event the euro begins to break through important levels. This is a big market worry.

From my perspective, the post-2008 landscape has been one of myriad Bubbles enveloping the globe. I believe China is in the midst of a historic Credit Bubble. Looking at rampant Credit and speculative excesses throughout the "developing" markets, I see ample confirmation of the Bubble thesis there as well. In hindsight, it should be indisputable that the massive issuance of debt (at artificially low borrowing costs) throughout the European periphery was a major Bubble. And I am very comfortable with the view that Washington policymaking - and resulting dollar devaluation - were fundamental to the global inflationary Bubble backdrop. From my perspective, the Treasury market has evolved into a most precarious Bubble of mispriced finance, over-issuance and severe market distortions of great consequence.

Analysis is a lot simpler in hindsight. From my analytical perspective, the sequence of how these global Bubbles might falter wasn't obvious. Who would go first? China, Europe, "developing," Treasurys, etc. The sequence would make a big difference on how things would be expected to unfold. Now, with the bursting of the sovereign debt Bubble in Europe, kindred Bubbles are impacted and in heightened jeopardy. Markets are under pressure, finance has tightened meaningfully, and faltering confidence is a major issue in Europe, the U.S. and beyond.

A strong case can be made that the global economy will prove less resilient than 2008. Credit excess over the past few years throughout the "developing" economies is a source of concern. China, Brazil, India, Russia, Mexico and others were at robust phases of their respective Credit cycles when the global crisis hit in 2008. Their markets, Credit systems and economies bounced back quickly - and proved the growth locomotive for global recovery. I fear recent excesses have created unappreciated vulnerabilities.

For now, Europe will likely remain the focal point. The continent's debt structure is a major issue. Huge deficits have been financed by their banking sector. As confidence in sovereign debt falters, banking system stability crumbles. Here at home, we today enjoy a different dynamic. Most of our federal debt has been purchased by the People's Bank of China, The Federal Reserve, The Bank of Japan and "developing" central banks around the world. In the short term, our debt structure is proving much more stable than Europe's. Our banks look better by comparison - and our Treasury market appears bulletproof. The ECB has been forced into its version of "QE3", while our divided Fed may not be as quick with additional quantitative easing as markets had expected. And perhaps, at least for now, we won't have the world's preeminent policy-induced currency devaluation - as the speculative trading world had confidently assumed. Or, stated differently, shorting dollars to fund inflating "undollar" risk markets around the globe might not be the sure bet many were presuming.

But let's not digress... What we do know is that acute market instability has again reared its ugly head. Policymakers are reacting, of course. To this point, policy measures have succeeded in thwarting a breakdown. I am skeptical that policymaking will so easily stabilize the markets. The Fed's move to pre-commit to "pegged" zero rates for a couple more years may somewhat benefit the leveraged speculating community - while throwing a volatile mixture on the Treasury Bubble. But who believes this is fair to savers or the right medicine for our economy? And Europe will be walking a tightrope, as they struggle to support the faltering periphery without imperiling the system's core. And as contagion effects continue to mount, it will come down to the markets' view of the German taxpayer's willingness to backstop the continent.

Sovereign debt crisis means all the easy solutions have been expended - and all the proven and conventional ones as well. When former Federal Reserve Vice Chairman Alan Blinder was asked to comment on National Public Radio about the Fed's new rate policy, he chuckled and said "they're desperate." I'll assume it was nervous laughter. I will also presume that the marketplace will be increasingly unnerved that desperate policy measures risk destabilizing already highly unstable global markets (5% daily swings in equities; abrupt 4 point moves in bonds; 5% in currencies...). Are there any "safe havens"? There were in '08. And all this equates to myriad market and economic uncertainties, including the risk of ongoing de-risking and de-leveraging. Best I can tell, the strongest bull argument going is that governments will support the markets. Well, the markets are in a world of hurt when that faith evaporates. This wasn't much of an issue in 2008.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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