Recalling 'King Dollar' Distortions

By: Doug Noland | Sat, Sep 24, 2011
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For the week, the S&P500 sank 6.5% (down 9.6% y-t-d), and the Dow fell 6.4% (down 7.0%). The Banks dropped 9.5% (down 33%), while the Broker/Dealers fell 8.8% (down 32.9%). The Morgan Stanley Cyclicals were clobbered for 11.1% (down 26.1%), and the Transports sank 9.6% (down 17.4%). The Morgan Stanley Consumer index declined 5.1% (down 9.4%), and the Utilities dipped 1.4% (up 6.5%). The S&P 400 Mid-Caps fell 8.3% (down 12.4%), and the small cap Russell 2000 were hit for 8.7% (down 16.8%). The Nasdaq100 declined 4.3% (down 0.5%), and the Morgan Stanley High Tech index dropped 5.8% (down 14.6%). The Semiconductors lost 5.8% (down 12.6%). The InteractiveWeek Internet index dropped 6.4% (down 11.7%). The Biotechs declined 4.1% (down 11.9%). With bullion hit for $155, the HUI gold index sank 11.7% (down 6.4%).

One month Treasury bill rates ended the week at negative one basis point and 3-month bills closed at zero. Two-year government yields were up 5 bps to 0.21%. Five-year T-note yields ended the week down 5 bps to 0.86%. Ten-year yields declined 22 bps to 1.83%. Long bond yields sank 41 bps to 2.90%. Benchmark Fannie MBS yields sank 37 bps to 2.91%. The spread between 10-year Treasury yields and benchmark MBS yields narrowed 15 to 108 bps. Agency 10-yr debt spreads widened 9 to 11 bps. The implied yield on December 2012 eurodollar futures rose 2 bps to 0.52%. The 10-year dollar swap spread was little changed at 18 bps. The 30-year swap spread increased 5 to negative 24 bps. Corporate bond spreads widened. An index of investment grade bond risk rose 15 bps to 141 bps. An index of junk bond risk surged 65 bps to 720 bps.

Debt issuance slowed sharply. I saw no Investment-grade issuance this week.

Junk bond funds saw inflows of $517 million (from Lipper). Junk issuance included Bill Barrett Corp $400 million, Iron Mountain $400 million, and AE Corp $250 million.

I saw no convertible debt issued.

International dollar bond issuers included Serbia $1.0bn and Kommunalbanken $800 million.

Greek two-year yields ended the week up 1,393 bps to 65.66% (up 5,342bps y-t-d). Greek 10-year yields jumped 240 bps to 22.58% (up 1,012bps). German bund yields fell 12 bps to 1.745% (down 122bps), and U.K. 10-year gilt yields dropped 12 bps this week to 2.36% (down 115bps). Italian 10-yr yields rose 12 bps to 5.62% (up 80bps), while Spain's 10-year yields declined 9 bps to 5.19% (down 25bps). Ten-year Portuguese yields surged 57 bps to 11.47% (up 489bps). Irish yields were up 19 bps to 8.59% (down 47bps). The German DAX equities index sank 6.8% (down 24.8% y-t-d). Japanese 10-year "JGB" yields declined 2 bps to 0.98% (down 14bps). Japan's Nikkei fell 3.6% (down 16.3%). Emerging markets were mostly lower. For the week, Brazil's Bovespa equities index sank 7.0% (down 23.2%), and Mexico's Bolsa dropped 7.4% (down 15.5%). South Korea's Kospi index fell 7.8% (down 17.2%). India's equities index declined 4.6% (down 21.2%). China's Shanghai Exchange dipped 2.0% (down 13.4%). Brazil's benchmark dollar bond yields jumped 34 bps to 4.06%, and Mexico's benchmark bond yields rose 13 bps to 3.57%.

Freddie Mac 30-year fixed mortgage rates were unchanged at 4.09% (down 28bps y-o-y). Fifteen-year fixed rates declined one basis point to 3.29% (down 53bps y-o-y). One-year ARMs added a basis point to 2.82% (down 62bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 4 bps to 4.76% (down 57bps y-o-y).

Federal Reserve Credit declined $4.3bn to $2.840 TN. Fed Credit was up $432bn y-t-d and $554bn from a year ago, or 24.2%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 9/21) fell $7.1bn to $3.468 TN. "Custody holdings" were up $118bn y-t-d and $255bn from a year ago, or 7.9%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.645 TN y-o-y, or 19.2% to $10.224 TN. Over two years, reserves were $3.013 TN higher, for 42% growth.

M2 (narrow) "money" supply declined $7.5bn to $9.584TN. "Narrow money" has expanded at a 11.9% pace y-t-d and 10.3% over the past year. For the week, Currency increased $2.4bn. Demand and Checkable Deposits dropped $32bn, while Savings Deposits jumped $31bn. Small Denominated Deposits fell $3.8bn. Retail Money Funds declined $4.9bn.

Total Money Fund assets fell $11.8bn last week to $2.621 TN. Money Fund assets were down $189bn y-t-d, with a decline of $182bn over the past year, or 6.5%.

Total Commercial Paper outstanding declined $13.4bn (10-wk decline of $207bn) to $1.030 Trillion. CP was up $58bn y-t-d, or 6.8% annualized, with a one-year fall of $34bn.

Global Credit Market Watch:

September 20 - Dow Jones: "Sovereign debt woes rocking world financial markets are a global phenomenon and not just a European one, even though tensions are the most acute in the euro area now, European Central Bank President Jean-Claude Trichet said Friday. 'What we are seeing now is the illustration of a global phenomenon, the global crisis of sovereign risk," Trichet told a conference in Washington on the sidelines of the annual meetings of the International Monetary Fund. 'Forgetting that the euro zone is at the epicenter would be a mistake, but forgetting that this is a global phenomenon would also be a mistake.'"

September 20 - Bloomberg (Jeffrey Donovan): "Italy's credit rating was cut by Standard & Poor's, the country's first downgrade in five years, as Greece's worsening fiscal crisis fans concern that contagion will engulf countries such as Spain and Italy. S&P lowered its rating last night to A from A+, saying weak economic growth, a 'fragile' government and rising borrowing costs would make it difficult to reduce Europe's second-biggest debt. The yield on Italy's 10-year bond rose 8 basis points to 5.662%, 385 bps more than similar German debt. The cost of insuring Italy against default rose to a record."

September 19 - Bloomberg (Emma Ross-Thomas): "Spanish debt is more expensive to insure than Baa2-rated Bulgaria, signaling the euro region's fourth-biggest economy may not warrant its Aa2 credit status. Moody's... rates Spain two levels below AAA as does Standard & Poor's at AA. Fitch has Spain at AA+, one from the top, even after the European Central Bank stepped in to buy its bonds to bring yields down from euro-era records. While Spain is ranked the same as Slovenia by Moody's and S&P, costs to insure its debt against default are twice as much. 'The rating agencies have got their head in the sand,' Harvinder Sian, a strategist at Royal Bank of Scotland... 'Any country where you need the central bank in there supporting the bond market, and a AA rating, suggests something is very badly wrong with the ratings process.'"

September 20 - Bloomberg (Tony Czuczka): "A 'wrong philosophy' of economic growth at all costs has spurred countries to take on debt and must end if policy makers want to leave the crisis behind, German Chancellor Angela Merkel said. 'If we understand the crisis properly, we have an historic chance to anchor a new culture of sustainable financial policy in Europe,' Merkel said... That's why Germany wrote debt reduction into its constitution and why 'we are talking about budget consolidation' as a crisis solution. 'I'm convinced that what we are seeing is partly the result of a wrong philosophy over decades -- growth first, regardless of the cost... We can't go on like that. This has to end.'"

September 21 - Bloomberg (Sandrine Rastello): "The European debt crisis has generated as much as 300 billion euros ($410bn) in credit risk for European banks, the International Monetary Fund said, calling for capital injections to reassure investors and support lending."

September 22 - Bloomberg (Brendan Greeley): "Germany, like never before, is questioning whether it still wants to be the savior of Europe. Maybe that's a good thing. 'Germans, we don't look to see what's in our own national interest,' Frank Schaeffler, a member of the Bundestag, Germany's lower house of Parliament, said... 'We're drunk with Europe.' In two sentences, he highlights the bedrock assumptions of postwar German politics: Greater European integration is always and necessarily a good thing and Germany has no interests of its own. 'As a good German, one has to be a good European,' Schaeffler said."

September 21 - Bloomberg (Boris Cerni): "Slovenian President Danilo Turk urged leaders to settle squabbles that toppled the government of the first former communist euro-region member to avoid a delay in approving the European Union's rescue fund amid a sovereign- debt crisis. Lawmakers ousted Prime Minister Borut Pahor's government yesterday in a confidence motion... The fall of the minority Cabinet may force a postponement of a vote to back the legislation enhancing the European Financial Stability Facility..."

September 23 - Bloomberg (Sapna Maheshwari): "The Federal Reserve's 'Operation Twist' is failing to ignite the corporate bond market as its second round of quantitative easing did in November, showing the central bank may be running out of tools to revive the economy. Relative yields widened to a two-year high, a benchmark index of credit-default swaps rose and new sales ground to a halt after the Fed said it will buy $400 billion of long-term debt to cut borrowing costs and avert a recession."

September 23 - Bloomberg (Andre Soliani and Ye Xie): "Brazilian policy makers took steps to prop up the real for the first time since 2009 and scaled back a local debt auction after the currency's tumble helped drive yields up by the most in 16 months. Yields on the government's debt due in 2021 soared 59 bps in the past five days, the biggest jump since the period ended May 6, 2010, to 12.26%..."

September 20 - Bloomberg (Sarah McDonald): "Bond sales by foreign borrowers in Australia are set for the slowest month in more than a year after global market turmoil helped push the discount for swapping the proceeds into U.S. dollars to the least since 2009."

September 22 - Bloomberg (John Glover and Ben Martin): "It's been 2 1/2 months since a bank managed to sell a conventional bond in Europe's public markets, the longest period without a deal ever and another example of the sovereign crisis choking off funding."

September 21 - Bloomberg (Shannon D. Harrington and Sapna Maheshwari): "Investors are extracting the biggest concessions in more than a year to buy new corporate bonds in the U.S. raising the cost of financing for companies as a slowing economy and Europe's debt crisis curb demand for all but the safest assets."

September 23 - Bloomberg (Richard Bravo): "Blackstone Group LP is offering the highest interest seen on a loan this year if lenders agree to swap debt in Travelport Ltd. for longer-dated obligations, or else it may put the parent of the second-largest travel- reservation system provider into bankruptcy."

September 22 - Bloomberg (Frederic Tomesco and Colin McClelland): "Corporate-debt sales in Canada are at the slowest quarterly pace in two years as rising relative borrowing costs deter companies and risk aversion climbs on concern that the global economy is losing steam."

Global Bubble Watch:

September 19 - Bloomberg (Daniel Kruger and John Detrixhe): "Wall Street's biggest bond traders are stockpiling Treasuries at the fastest pace since 2007 on speculation the Federal Reserve will announce a plan this week to buy longer-term debt to spur the faltering economy. The 20 primary dealers held $15.1 billion of Treasury securities due in more than one year as of Sept. 7, up from a $75 billion bet against the debt on May 6..."

September 21 - Bloomberg (Jennifer Ryan): "Bank of England officials said they may need to buy more bonds to bolster a faltering recovery after holding off adding stimulus this month in a decision that was 'finely balanced.' Most policy makers said it was 'increasingly probable that further asset purchases to loosen monetary conditions would become warranted at some point,' the minutes of the Monetary Policy Committee's Sept. 8 decision said. 'For some members, a continuation of the conditions seen over the past month would probably be sufficient to justify an expansion of the asset purchase program at a subsequent meeting.'"

September 21 - Bloomberg (Jennifer Ryan): "Britain had its biggest budget deficit for any August since modern records began in 1993 as government spending jumped and income-tax receipts declined. The shortfall of 15.9 billion pounds ($25bn), which excludes government support for banks, compares with 14 billion pounds a year earlier... Revenue rose 5.9% and spending increased 7.2%."

September 21 - Bloomberg (Nichola Saminather): "A quarter of Australian homeowners are experiencing mortgage stress and rental vacancies remain 'tight,' driven by higher interest rates, rising costs and a shortage of rental properties in some cities. The number of homeowners facing mortgage stress has jumped from 21% in March..."

September 22 - Bloomberg (Sarah McDonald): "Investors have more than tripled the amount of insurance on Australian government debt through credit-default swaps, amid a drop in property prices and concern China will slow purchases of iron ore and coal."

September 20 - New York Times (Paul Krugman): "Inflation hawks, including Paul Volcker in today's NYT, often invoke the supposed lessons of history, to the effect that inflation is always harmful and always gets out of control. But that's a selective reading of history, and it skips the most relevant examples. Early on in this crisis, I began wondering why the US didn't relapse into the Great Depression after World War II. And there's a good case that this had something to do with it: The big rise in prices during and after WWII arguably did a lot to eliminate the debt overhang, making it possible for the economy to enter a sustained, non-inflationary boom. And this is the relevant history we should be looking at: this isn't your father's slump, it's your grandfather's slump. Volcker, I'm sorry to say, is worrying about refighting the 1970s when we're actually refighting the 1930s. And fighting the wrong war is a good way to lose the one we're in."

Currency Watch:

September 23 - Bloomberg (Yumi Teso): "Asian currencies had their biggest weekly drop since 1998 as concern the global economy is headed for a recession dimmed the outlook for exports and prompted investors to favor safer bets than emerging-market assets."

The U.S. dollar index jumped 2.5% this week to 78.501 (down 0.7% y-t-d). For the week on the upside, the Japanese yen increased 0.3%. On the downside, the South African rand declined 7.7%, the New Zealand dollar 6.3%, the Australian dollar 5.6%, the Brazilian real 5.5%, the Canadian dollar 4.9%, the South Korean won 4.7%, the Norwegian krone 4.7%, the Swedish krona 4.6%, the Singapore dollar 4.4%, the Mexican peso 3.8%, the Swiss franc 3.3%, the Taiwanese dollar 2.7%, the euro 2.1%, and the Danish krone 2.1%.

Commodities and Food Watch:

September 21 - Bloomberg (Chanyaporn Chanjaroen, Nicholas Larkin and Debarati Roy): "Deep in the 7.4-acre Singapore FreePort next to Changi International Airport's runways is the bullion vault of Swiss Precious Metals, behind seven-metric-ton steel doors built to survive a plane crash or earthquake. The rooms are almost full after demand rose fivefold in the year since the Geneva-based company opened the facility. The firm plans an extension, and relocated Chief Executive Officer Jean-Francois Pages to Singapore last month to cope with the surge of investors willing to pay as much as 1% of the value of their holdings each year to keep them secure. 'The European debt crisis and its impact on the solvency of European financial players are driving European customers to find refuge in tangible values like physical gold and other precious metals,' Pages said. Demand 'is totally compatible with the current financial and political global turmoil.'"

September 20 - Bloomberg (Elizabeth Campbell): "Texas cattle ranchers, the biggest suppliers in the world's top beef-producing nation, will cull the most breeding cows ever this year as drought increases feed costs, driving livestock prices to a record. Cattle futures that gained 16% in the past year in Chicago may reach an all-time high of $1.36 a pound in as few as seven months, said Rich Nelson, the director of research at... Allendale Inc.... Feed costs have surged, with corn heading for the highest annual average price ever. The 11 months through August were the driest since at least 1895 in Texas, and the state's farm losses may top $5.2 billion. Ranchers may sell or slaughter 500,000 beef cows they would normally keep for breeding because it's too expensive to feed them, Texas A&M University estimated. Tighter supply in the $51.5 billion U.S. cattle industry is boosting global meat costs already rising faster than any other food group."

Pretty much a bloodbath. The CRB index sank 8.4% this week (down 9.3% y-t-d). The Goldman Sachs Commodities Index fell 8.2% (down 5.2%). Spot Gold dropped 8.6% to $1,656 (up 17%). Silver collapsed 26.3% to $30.101 (down 3%). November Crude cents sank $8.33 to $79.85 (down 13%). October Gasoline fell 8.2% (up 4%), and October Natural Gas declined 2.8% (down 16%). December Copper was hit for 16.6% (down 26%). December Wheat fell 6.9% (down 19%), and December Corn dropped 7.7% (up 2%).

China Bubble Watch:

September 21 - Bloomberg: "Turmoil in global financial markets may be spurring a surge in flows of speculative capital into China as investors bet on the nation's growth and prospects for gains in the yuan. Financial institutions' yuan positions, accumulated from purchases of foreign exchange by the central bank, had a net gain of 376.94 billion yuan ($59bn) in August, 72% more than in July and the biggest increase in five months, central bank data showed today. Economists watch the numbers for signs of inflows of so-called hot money."

September 21 - Bloomberg: "The International Monetary Fund cut its China growth estimates for this year... Gross domestic product will grow 9.5% this year... The 2012 forecast was lowered to 9% from 9.5%."

September 21 - Bloomberg: "Companies in China face record interest rates on short-term debt as curbs on lending force them to rely on commercial paper to pay back loans. The average yield on top-rated, one-year corporate notes has risen 101 bps since June 30 to 5.9%, and is poised for the biggest quarterly increase in Chinabond data going back to 2007."

Japan Watch:

September 22 - Bloomberg (Toru Fujioka and Lily Nonomiya): "Japan's exports increased less than expected as shipments of electronic parts fell... Overseas shipments increased 2.8% in August from the same month a year earlier..."

India Watch:

September 21 - Bloomberg (Theophilos Argitis and Andrew Mayeda): "Indian companies may turn to Hong Kong's yuan bond market to raise funds at 40% the cost of top-rated companies at home after the South Asian nation eased borrowing rules. The government agreed for the first time last week to allow Indian companies raise as much as $1 billion of debt in the Chinese currency, bolstering the yuan's challenge to the dollar as a funding currency."

Asia Watch:

September 21 - Bloomberg (Eunkyung Seo): "South Korea's unemployment rate fell to a three-year low... The jobless rate was at 3.1% in August, the lowest since July 2008..."

Latin America Watch:

September 22 - Bloomberg (Jonathan J. Levin): "Mexican drug cartel violence is preventing initial share sales as businesses seek to avoid the public eye, said Omar Taboada, head of Mexico investment strategy at Citigroup Inc.'s Acciones y Valores brokerage. The Mexican stock exchange would have twice as many initial public offerings, or IPOs, per year if security weren't a concern for business owners, Taboada said... 'There are many small- and medium-sized companies that could be ready to go to the market,' said Taboada... 'When a company enters the market, it becomes a public company, and you have to name your shareholders, release numbers, earnings. People prefer to keep a low profile.'"

Unbalanced Global Economy Watch:

September 21 - Bloomberg (Greg Quinn): "Canada's inflation rate accelerated more than economists forecast in August, with gains led by gasoline, insurance premiums and food. The consumer price index increased 3.1% in August from a year earlier..."

September 22 - Bloomberg (Theophilos Argitis and Andrew Mayeda): "Canadian Prime Minister Stephen Harper, an economist who has pursued free-trade agreements from Costa Rica to India, is prepared to stem capital flows if they jeopardize domestic control of key industries or fuel speculative currency gains. Harper said he will 'proceed with caution' when it comes to foreign takeovers of important companies... policy makers also won't tolerate a speculative jump in the country's dollar that could hurt the economy, Harper said..."

September 20 - Bloomberg (Keith Jenkins and Emma Charlton): "Borrowing costs may rise even further for Europe's most indebted nations as slower growth at home combines with a weakening global economy to subvert deficit-reduction plans... 'The market is afraid of a lack of growth that will make debt rebalancing quite a challenging task,' said Koen Van De Maele, global head of fixed income at... Dexia Asset Management, which oversees the equivalent of about 83 billion euros ($113bn). 'As an investor, if you know that the growth will be lower then it's definitely a concern in terms of the debt sustainability. You have to balance the risk and the return.'"

U.S. Bubble Economy Watch:

September 20 - Bloomberg (Timothy R. Homan): "The International Monetary Fund lowered its forecast for U.S. growth this year and in 2012, citing unresolved debt-reduction concerns and waning confidence among consumers and businesses. The world's largest economy will expand 1.5% this year, down from the 2.5% projected in June... Unemployment will average 9% or higher through next year, the IMF said."

Central Bank Watch:

September 21 - Bloomberg (Michael Heath): "Republican lawmakers urged Federal Reserve Chairman Ben S. Bernanke to refrain from additional monetary easing to avoid 'further harm' to the U.S. economy, saying Americans have reason to be 'skeptical' of his plans. 'Although the goal of quantitative easing was, in part, to stabilize the price level against deflationary fears, the Federal Reserve's actions have likely led to more fluctuations and uncertainty in our already weak economy,' according to a letter to Bernanke signed by Senate Minority Leader Mitch McConnell, House Speaker John Boehner, Senator Jon Kyl and House Majority Leader Eric Cantor."

Fiscal Watch:

September 19 - Bloomberg (William Selway): "In statehouses across the U.S., a budget-cutting congressional supercommittee and the sputtering economy threaten a fledgling recovery from the worst fiscal crisis in more than 70 years. Stalled job growth, eroding consumer confidence and a stock market that has lost more than $2 trillion since April may cut into tax collections... At the same time, Washington policy makers are moving to slash federal spending, a potential threat to dozens of programs -- from Medicaid and school-lunch subsidies to defense contracts and law-enforcement grants -- that nourish state budgets and local economies. 'We need money,' California Governor Jerry Brown...told reporters... 'The state is facing a national economy that may go into another recession, a great retraction, and the people in Washington are cutting back even more.'"

Muni Watch:

September 23 - Bloomberg (Darrell Preston): "Congress's deficit-cutting supercommittee may cap or end a tax exemption that helps set state and local debt prices, raising borrowing costs and disrupting the $2.9 trillion municipal-bond market. Bankers, bondholders and issuers are preparing for an attack on the tax break investors get for interest earned on some municipal securities, already targeted by President Barack Obama in his jobs and deficit-reduction proposals. The exemption, which has never been cut, lowers the cost of loans for schools, highways, hospitals and other public works."


Recalling "King Dollar" Distortions

"Since lecturing Japanese officials in the late 1990s and early 2000s about how they should deal with their nation's economic malaise, Mr. Bernanke has made clear his mindset about post-bubble economics: Keep experimenting as long as the economy is stumbling and inflation is muted... In a 2000 paper, Mr. Bernanke cited President Franklin Roosevelt and 'his willingness to be aggressive and to experiment -- in short to do whatever it took to get the country moving again' even though some of those policies failed.'" Wall Street Journal (John Hilsenrath), September 23, 2011

"Inflation hawks, including Paul Volcker... often invoke the supposed lessons of history, to the effect that inflation is always harmful and always gets out of control. But that's a selective reading of history, and it skips the most relevant examples... And this is the relevant history we should be looking at: this isn't your father's slump, it's your grandfather's slump. Volcker, I'm sorry to say, is worrying about refighting the 1970s when we're actually refighting the 1930s." New York Times (Paul Krugman), September 19, 2011

Before we get though all of this, I expect Dr. Bernanke and U.S. Federal Reserve doctrine to be fully discredited. I fear Dr. Krugman has lost him mind.

I'm not one for ideologies. I'm for low taxes, but enact big tax cuts late in a historic Credit Bubble and you're asking for trouble. I'm sympathetic to a measured dose of "Keynesian" fiscal stimulus to help grease the gummed-up wheels of a post-Bubble "depressionary" financial mechanism. Importantly, however, meander down an inflationist (referred to these days as "Keynesian") policymaking path to sustain a Bubble landscape and you will eventually find you've destroyed the entire Credit system. As Dr. Krugman notes, policy success (or, I'll add, catastrophic failure) depends very much on fighting the right war. Regrettably, Bernanke, Krugman and others have mobilized to fight the post-'29 crash Great Depression. The dilemma is that the global system has remained more in a Bubble than a thirties-like environment.

The consensus in the economic community (and among market pundits) is that 2008 was the "hundred year flood" - "the worst financial crisis since the Great Depression." Many view 2008 as our generation's versions of the 1929 crash. Policymakers, at home and abroad, have mounted an incredible mobilization to fight the Great War against so-called post-Bubble deflation risk. More than any policymaker of our era, the focal point of Dr. Bernanke's distinguished academic career has been fashioning the "how to" for marshaling post-Bubble recovery. As Mr. Hilsenrath noted, Dr. Bernanke has a clear post-Bubble "mindset."

I clearly recall the fear of depression that immediately followed the 1987 stock market crash. Promising abundant marketplace liquidity, chairman Greenspan eased monetary policy, in the process helping to fuel late-80's ("decade of greed") excesses (the S&Ls, junk bonds, leveraged M&A finance, coastal real estate Bubbles, etc.). The Greenspan Fed dramatically eased monetary conditions in the early 90's in response to an impaired banking system and renewed fears of economic depression. The global system nearly buckled during the 1998 crisis, and the Fed was again at war against so-called deflationary conditions. When the Tech and corporate debt Bubbles burst in 2001/2002, Fed governor Bernanke was already waging his war against deflation risk with talk of the Fed's "electronic printing press" and "helicopter money." When the latest and greatest Bubbles in mortgage/Wall Street finance burst in 2008, what had been a more gradualist evolution of experimental policymaking quickly turned into an all-out nuclear campaign against some threatening scourge of deflation and depression.

The 1929 crash marked the bursting of a historic Credit Bubble. Soon after, confidence in the entire global financial apparatus collapsed. The dynamics of 2008 were no replay of 1929. Sure, market revulsion saw a problematic dislocation negatively impact "private-label" Wall Street mortgage securitizations, along with a painful decline in inflated global equities and risk markets. The maladjusted U.S. economy has suffered, but collapse it has not. In no way was it a post-'29 wholesale crisis of confidence in global financial assets. Especially in China, Asia and the emerging markets, powerful Credit booms were virtually impervious to the U.S. mortgage bust.

Even here at home, the vast majority of domestic financial claims were largely immune to the crisis (the vast majority of system debt, including Treasury, agency securities actually held or increased in value!). And with faith in government finance as strong as ever, policymakers retained extraordinary capacity to mobilize fiscal and monetary stimulus. The "core" of the U.S. monetary system was not yet in jeopardy.

It has been fundamental to my thesis that the global fiscal and monetary response to the 2008 crisis would significantly increase the likelihood of a 1929-style global crisis in confidence in financial institutions and financial contracts and assets more generally. At home and abroad, the massive issuance of government debt and the ballooning of central bank balance sheets set a course that would place the core of the U.S. and global Credit systems at perilous risk. A confluence of unprecedented issuance of non-productive marketable debt and unprecedented global speculative excess had created the backdrop for a very problematic crisis of confidence. Highly leveraged players - albeit international banks or the hedge funds - were incentivized to re-risk and re-leverage. The derivatives Bubble, that should have deflated, instead inflated bigger-than-ever.

It has been, as well, my view that at this dangerous stage of global Credit Bubble excess, policymaking would prove much less effective - and, actually, much more destabilizing. The "core" of U.S., European and global monetary systems were being put at great risk.

Having attempted to set the backdrop, let's touch on some recent developments. I was this week reminded of the late-nineties "King dollar" era. It is certainly not that I see the fundamentally vulnerable dollar again reining supreme. Instead, once again we're witnessing U.S. policies proving destabilizing to global markets. The Greenspan Fed was at the heart of problematic dynamics throughout the "developing" markets during the tumultuous nineties. Back then, "activist" U.S. monetary policy essentially provided a competitive advantage to American financial assets (especially debt securities). In an unstable world, why accept myriad risks associated with the susceptible developing markets (i.e. liquidity, Credit, currency...) when chairman Greenspan essentially ensured, especially in the event of a crisis, that he would orchestrate rate cuts, liquidity abundance and higher prices for Trillions of U.S. Treasurys, agency debt and MBS. Federal Reserve market manipulation acted as a powerful global financial flow magnate for speculative - as well as "safe haven" - flows during the nineties (in the process fueling powerful U.S. Credit and economic Bubble Dynamics).

With "operation twist," the Bernanke Fed this week has moved decidedly in the direction of "pegging" the entire Treasury yield curve - along with the prices of Trillions of U.S. debt securities. In a world of escalating instability, this provides U.S. debt securities a (short-term) competitive advantage over debt securities in, say, Europe, "developing" Asia, Brazil and Mexico. In a different market environment this wouldn't be such a big deal.

For going on three years now, the global leveraged speculating community has been positioning for ongoing dollar devaluation. The Washington policy playbook ensured massive Treasury issuance, zero rates, and unprecedented central bank monetization. Chairman Bernanke essentially signaled to the hedge funds to short the dollar and take the proceeds and acquire any higher-returning asset anywhere in the world. A strong case can be made that never in history has policymaking so incentivized global leveraged speculation. The leveraged players anticipated riding QE1 to QE15, not a policy course that would abruptly stop at QE2 and do a twist - especially not in the midst of a global crisis and de-risking environment.

Anyway, post-2008 reflation stoked a massive flow of "hot money" that inundated the "developing" world, where domestic Credit systems were already firing on all cylinders. It was a historic boom - as well as a fundamental facet of my "global government finance Bubble" thesis. And the more these currencies, markets and economies inflated, the greater the self-reinforcing flow of finance from U.S. and international investors into global funds and "developing" bonds and equities. Those with longer memories may recall the analogies of emerging markets to "roach motels" or "Hotel California."

In a week when ECB President Trichet and Pimco's El-Erian both referred to a global sovereign debt crisis, the scope of market tumult broadened meaningfully. Importantly, de-risking/de-leveraging dynamics intensified, and "developing" bond markets started to come unglued. Emerging debt spreads widened dramatically. In the (dislocating) Credit default swap market (CDS), the cost to protect against default in Brazil surged 53 bps to 211, in Mexico 58 bps to 216, Argentina 185 bps to 1,052, South Korea 40 bps to 187, Poland 74 bps to 312, Hungary 79 bps to 531 and Russia 93 bps to 310. Commodities were also crushed, with silver down 26.3%, copper 16.6%, coffee 12.4%, crude oil 9.4%, sugar 9.7%, cotton 8.3%, and gasoline 8.2%. In "developing" currencies, the South African rand dropped 7.7%, the Chilean peso 7.2%, the Brazilian real 5.5%, the Mexican peso 3.8%, the Russian ruble 4.8%, the South Korean won 4.7%, the Singapore dollar 4.4%, the Indian rupee 4.4%, and the Polish zloty 3.9%. Basically, it was a slaughter.

The focus remains the unfolding Greek and European debt crisis. But there were further indications this week that the global leveraged players now face a heightened state of duress. You were absolutely hammered this week if you were short Treasurys (or U.S. dollar securities) against long positions in global risk assets. And there seems to be evidence of forced liquidations everywhere, as a 2008-like scenario comes into clearer view. The bursting of the Bubbles in global leveraged speculation and the associated reversal of finance away from the "developing" world portends tightened financial conditions and growth headwinds for the post-2008 crisis global growth "locomotive." This more than justifies the pounding that global cyclical stocks suffered this week.

I've been really worrying about the European banks; about global derivatives; about the unwind of leveraged trades throughout global markets. This week's policy and market developments only added to my anxiety, while confirming my view that risks are greater today than in 2008. And it's quite a contrast between the escalating global financial crisis and the rather sanguine consensus view for the U.S. economy and markets. And I'll be the first to admit that, with the Fed and global central banks still willingly accommodating Washington profligacy, the Government Finance Bubble-driven U.S. economy does appear, for now, relatively isolated from global crisis dynamics. If I only had a dollar for every time I've heard "selling is overdone."

Much to the U.S. stock market's relief, our policymakers retain the capacity to continue stimulating. The Treasury will keep issuing, and the Fed will keep experimenting. And wouldn't it be ironic if this dynamic now works to bolster (the reversal of) flows into dollar assets, only intensifying the problematic squeeze on a vulnerable global leveraged speculating community. It is not easy to envisage a scenario that would, at this point, reverse global risk aversion and de-leveraging. But, then again, most participants seem more fixated on areas of market technical support that could signal the rush of sideline cash into U.S. equities. Not the mood one would expect at an important market bottom.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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