Ring-Fencing

By: Doug Noland | Fri, Oct 14, 2011
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For the week, the S&P500 jumped 6.0% (down 2.6% y-t-d), and the Dow rose 4.9% (up 0.6%). The S&P 400 Mid-Caps jumped 7.1% (down 5.7%), and the small cap Russell 2000 surged 8.6% (down 9.1%). The Banks rallied 6.9% (down 27.2%), and the Broker/Dealers surged 7.2% (down 29%). The Morgan Stanley Cyclicals surged 8.5% (down 16.9%), and the Transports jumped 7.6% (down 8.1%). The Morgan Stanley Consumer index increased 3.7% (down 4.3%), and the Utilities added 1.6% (up 7.8%). The Nasdaq100 rose 7.7% (up 6.9%), and the Morgan Stanley High Tech index rallied 7.5% (down 4.9%). The Semiconductors jumped 6.8% (down 7.5%). The InteractiveWeek Internet index surged 8.0% (down 3.9%). The Biotechs gained 2.6% (down 11.7%). With bullion up $43, the HUI gold index rose 5.8% (down 3%).

One and three-month Treasury bill rates ended the week at one basis point. Two-year government yields were down 2 bps to 0.265%. Five-year T-note yields ended the week up 3 bps to 1.11%. Ten-year yields jumped 17 bps to 2.25%. Long bond yields rose 21 bps to 3.23%. Benchmark Fannie MBS yields rose 15 bps to 3.33%. The spread between 10-year Treasury yields and benchmark MBS yields narrowed 2 to 108 bps. Agency 10-yr debt spreads narrowed 6 to negative 5 bps. The implied yield on December 2012 eurodollar futures declined 3.5 bps to 0.685%. The 10-year dollar swap spread declined one to 19 bps. The 30-year swap spread increased one to negative 23 bps. Corporate bond spreads narrowed. An index of investment grade bond risk dropped 9 bps to 130 bps. An index of junk bond risk sank 85 bps to 721 bps.

Investment-grade issuance this week included GE Capital $3.0bn, Time Warner $1.0bn, Smucker $750 million, Kohl's $650 million, and Mississippi Power million $300 million.

Junk bond funds saw outflows increase to $635 million (from Lipper). Junk issuance included Laredo Petroleum $550 million and Beagle Acquisition $375 million.

Convertible debt issuers included United Therapeutics $250 million.

International dollar bond issuers included Inter-American Development Bank $2.25bn, Toronto Dominion Bank $1.5bn, National Bank of Canada $1.4bn, Petroleos Mexicanos $1.25bn, Neder Waterschapsbank $1.0bn, and ING Bank $925 million.

Greek two-year yields ended the week up only 667 bps to 70.19% (up 5,795bps y-t-d). Greek 10-year yields jumped 46 bps to 23.0% (up 1,054bps). German bund yields rose 20 bps to 2.20% (down 76bps), and U.K. 10-year gilt yields gained 14 bps this week to 2.61% (down 91bps). Italian 10-yr yields jumped 27 bps to 5.78% (up 97bps), and Spain's 10-year yields rose 26 bps to 5.23% (down 21bps). Ten-year Portuguese yields rose 38 bps to 11.32% (up 474bps). Irish yields jumped 49 bps to 8.04% (down 101bps). The German DAX equities index jumped 5.1% (down 13.7% y-t-d). Japanese 10-year "JGB" yields increased 3 bps to 1.01% (down 11bps). Japan's Nikkei rallied 1.6% (down 7.9%). Emerging markets were up big. For the week, Brazil's Bovespa equities index surged 6.9% (down 20.6%), and Mexico's Bolsa jumped 5.6% (down 9.6%). South Korea's Kospi index rose 4.3% (down 10.5%). India's equities index jumped 5.2% (down 16.7%). China's Shanghai Exchange gained 3.1% (down 13.4%). Brazil's benchmark dollar bond yields dropped 24 bps to 3.64%, and Mexico's benchmark bond yields fell 22 bps to 3.51%.

Freddie Mac 30-year fixed mortgage rates jumped 18 bps to 4.12% (down 7bps y-o-y). Fifteen-year fixed rates rose 11 bps to 3.37% (down 25bps y-o-y). One-year ARMs increased 5 bps to 2.90% (down 53bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates up 5 bps to 4.87% (down 36bps y-o-y).

Federal Reserve Credit increased $4.2bn to $2.840 TN. Fed Credit was up $432bn y-t-d and $547bn from a year ago, or 24%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 10/12) sank $21.0bn to $3.404 TN (4-wk decline of $71.5bn). "Custody holdings" were up $53.3bn y-t-d and $136.6bn from a year ago, or 4.2%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.295 TN y-o-y, or 15.4% to $10.227 TN. Over two years, reserves were $2.827 TN higher, for 38% growth.

M2 (narrow) "money" supply rose $14.3bn to $9.618 TN. "Narrow money" has expanded at a 11.5% pace y-t-d and 10.2% over the past year. For the week, Currency declined $0.7bn. Demand and Checkable Deposits jumped $49.1bn, while Savings Deposits dropped $31.6bn. Small Denominated Deposits declined $3.0bn. Retail Money Funds added $2.5bn.

Total Money Fund assets dipped $2.8bn last week to $2.636 TN. Money Fund assets were down $174bn y-t-d and $162bn over the past year, or 5.8%.

Total Commercial Paper outstanding dropped another $19.1bn (13-wk decline of $270bn) to $966 billion. CP was down $5.2bn y-t-d, with a one-year decline of $161bn.

Global Credit Market Watch:

October 11 - Bloomberg (Jana Randow and James G. Neuger): "European Central Bank President Jean-Claude Trichet warned of threats to the financial system as the conflict among political leaders intensified over how to extricate Europe from the debt crisis. 'The crisis has reached a systemic dimension,' Trichet told European lawmakers... 'Sovereign stress has moved from smaller economies to some of the larger countries. The crisis is systemic and must be tackled decisively.'"

October 13 - Financial Times (Richard Milne and Rachel Sanderson): "Italy's benchmark borrowing costs on Thursday reached their highest premium over those of Spain in the euro era, in a worrying sign of how investors are more worried about Rome than Madrid. The spread between Italian and Spanish 10-year bond yields reached 65 bps, higher than the previous high in late 2008... 'The political cloud in Italy is so dense that it is very hard to make a call so the market struggles to put a value on their bonds,' said a senior eurozone banker."

October 12 - Bloomberg (Lorenzo Totaro): "Bank of Italy Governor Mario Draghi said the country must quickly implement austerity measures and boost economic growth to avert an 'ungovernable' debt spiral. 'Action must be taken quickly,' Draghi said... 'If protracted, the high borrowing costs seen in the last three months could largely offset' the effects of the austerity moves approved last month, 'with a further negative impact on the cost of debt, in a spiral that may end up being ungovernable.' Draghi, who on Nov. 1 takes over from Jean-Claude Trichet as president of the European Central Bank, also said that Italy must take steps to boost economic expansion."

October 14 - Bloomberg (Emma Ross-Thomas): "Spain's credit rating was cut for the third time in three years by Standard & Poor's as slowing growth and rising defaults threaten banks and undermine efforts to contain Europe's sovereign-debt crisis... 'Despite signs of resilience in economic performance during 2011, we see heightened risks to Spain's growth prospects,' S&P said. 'The financial profile of the Spanish banking system will, in our opinion, weaken further, with the stock of problematic assets rising further.'"

October 12 - Bloomberg (Emma Ross-Thomas): "Spaniards will probably hand opposition head Mariano Rajoy a record mandate in elections next month. Unwilling to risk his lead in polls, the People's Party leader hasn't told voters what he'd do with it. Five weeks before the Nov. 20 election that polls suggest he'll win, Rajoy hasn't said how he'll cut spending or change labor rules. He's pledged tax breaks for small businesses, said he 'wouldn't like' to cut pensions and vowed a 'true' bank restructuring, without saying what that means. Voters don't know who would be his finance minister. That hasn't stopped Spaniards from telling pollsters they'll hand the PP its largest-ever majority as the country struggles with Europe's highest jobless rate amid a three-year economic slump."

October 13 - Dow Jones (William Horobin and Gabriele Parussini): "France said Thursday that allowing the euro-zone rescue fund to provide insurance on bonds issued by countries that cannot tap markets is one of the options being considered to increase the vehicle's firepower, as the bloc seeks to reassure investors that it can deal with the fallout from the deepening sovereign debt crisis. France favors turning the euro zone's bailout fund into a bank that can easily leverage its resources, but recognizes there is strong opposition to the idea, a senior French official said Thursday."

October 12 - Bloomberg (Fabio Benedetti-Valentini): "France's government plans to guarantee as much as 10 billion euros ($13.8bn) of existing structured municipal loans that Caisse des Depots et Consignations is taking over from Dexia SA. The first 500 million euros in potential losses on these loans will still be shouldered by Dexia, the Belgian-French lender that is being broken up, according to a statement issued today by President Nicolas Sarkozy's office. Dexia will also assume 30% of any additional losses, the statement said."

October 13 - Bloomberg (Johan Carlstrom): "Risks to Europe's bank industry are 'rapidly' mounting as the fallout of Greece's debt crisis engulfs the whole region, said Martin Andersson, director- general of Sweden's Financial Supervisory Authority. 'We don't see any positive signs,' Andersson said... 'Things are getting worse and, of course, then you're more concerned about liquidity and solvency.'"

October 14 - Bloomberg (Liam Vaughan, Kevin Crowley and Elisa Martinuzzi): "Shareholders in European banks are resisting calls to pump more capital into the industry, pressure that may leave taxpayers as the investors of last resort. European Union leaders are working on a plan that may force banks to raise 100 billion euros ($137bn) to more than 300 billion euros in additional capital... That money would come either from existing investors or state funding that may come with strings attached."

October 14 - Bloomberg (Radi Khasawneh): "The eight largest U.S. money-market funds reduced their lending to French banks by 44% last month as the European sovereign debt crisis worsened. Holdings in BNP Paribas SA, Societe Generale SA, Natixis SA and Credit Agricole SA dropped to $23.2 billion at the end of September from $41.5 billion the previous month... The biggest falls were for Natixis, at 74%, and Credit Agricole, at 64%..."

October 13 - Bloomberg (Ott Ummelas): "A majority of Estonians oppose their country's involvement in the euro area's temporary bailout fund, which has channeled aid to Ireland and Portugal, a poll showed. Fifty-eight percent of respondents in the poll... said Estonia shouldn't guarantee loans made by the European Financial Stability Facility, while 28% favored participation and 14% were undecided."

Global Bubble Watch:

October 13 - Bloomberg: "China announced a package of measures to help small companies, including tax breaks and easier access to bank loans, after the collapse of manufacturers in Wenzhou city highlighted growing risks to the economy. The government will provide financial support and preferential tax policies for small companies, the State Council said... The government will be more tolerant of bad loan ratios for small-company loans, the Cabinet said. Small companies play an 'irreplaceable' role in job creation, technical innovation and social stability, and the funding difficulties and tax burdens facing some of them 'deserve high attention,' according to the statement. The support comes after Wen visited Wenzhou in Zhejiang province during a public holiday this month, urging greater support for small- and medium-sized companies. Media 'hype' surrounding reports of Wenzhou factory owners fleeing after failing to pay debts unnerved investors concerned about Chinese banks' asset quality and a slowdown in the property market, UBS AG said in an Oct. 11 report. The city is known for a 'vibrant private sector,' non-bank lending, and speculative investment in property, the brokerage said."

October 13 - Bloomberg (Shamim Adam): "An escalation in Europe's debt crisis may trigger a selloff in Asian assets, force foreign banks to cut lending to the region and disrupt its currency markets, the International Monetary Fund said. Asia's growth has slowed since the second quarter of 2011, the fund said..., cutting its forecast for this year's expansion to 6.3% from an April estimate of 6.8%. Inflationary pressures across the region are still 'elevated' and financial conditions remain accommodative in most of Asia, the IMF said... 'Since 2009, investors from advanced economies have built up substantial positions in Asian markets. A sudden liquidation of these positions could trigger a loss of confidence, and contagion could spread from bond and equity markets to currency and other markets.'"

October 13 - Bloomberg: "China plans to implement new rules from Jan. 1 to ensure banks have adequate short-term funding to cope with any potential shocks, the banking regulator said. Lenders must ensure by the end of 2013 that easily sold 'premium' assets can fully cover net cash outflows for 30 days in times of crisis, according to a draft regulation... China is seeking to prevent the nation's banks from encountering the capital constraints faced by U.S. and European rivals during the global financial crisis. The regulator has been tightening oversight of banks and raising the reserve ratio to prevent the $3.8 trillion of credit extended since September 2008 from souring."

October 13 - Bloomberg (Belinda Cao and Michael Patterson): "Loan losses at Chinese banks may climb to levels equivalent to 60% of their equity capital as real-estate companies and local governments fail to repay debts, according to Credit Suisse... Nonperforming loans will probably increase to 8% to 12% of total debt in the 'next few years,' causing losses amounting to 40% to 60% of Chinese banks' equity, Hong Kong-based analysts led by Sanjay Jain at Credit Suisse wrote... Jain cut 2012 and 2013 profit estimates by as much as 25% and maintained an 'underweight' rating on the industry."

October 13 - Bloomberg (Jack Jordan and Denis Maternovsky): "Russia's biggest injection of money into banks in more than two years is helping ease investor concern over cash shortages and sending bond yields tumbling from all-time highs. The central bank provided 397 billion rubles ($12.8bn) via overnight repurchase auctions yesterday, the most since February 2009..."

Currency Watch:

The U.S. dollar index dropped 2.7% this week to 76.61 (down 3.1% y-t-d). For the week on the upside, the Australian dollar increased 5.9%, the Norwegian krone 4.8%, the New Zealand dollar 4.6%, the Swiss franc 4.0%, the euro 3.8%, the Danish krone 3.8%, the Canadian dollar 2.9%, the Singapore dollar 2.5%, the Brazilian real 2.2%, the South African rand 2.2%, the South Korean won 1.9%, the British pound 1.7%, the Mexican peso 1.6% and the Taiwanese dollar 0.7%. On the downside, the Japanese yen declined 0.6%.

Commodities and Food Watch:

October 14 - Bloomberg (Blair Euteneuer): "Cattle futures rallied to a record for the second time this month on signs that rising demand for U.S. beef will erode supplies that are shrinking as ranchers reduce the size of their herds. Beef output will drop 4.9% next year after high feed costs led ranchers to slaughter more breeding cows... The cattle herd totaled 100 million head on July 1, the lowest for that date since at least 1973."

The CRB index rallied 4.5% this week (down 4.7% y-t-d). The Goldman Sachs Commodities Index jumped 5.2% (up 1%). Spot Gold gained 2.6% to $1,681 (up 18%). Silver jumped 3.8% to $32.17 (up 4%). November Crude surged $3.82 to $86.80 (down 5%). November Gasoline rose 6.7% (up 15%), and November Natural Gas jumped 6.4% (down 16%). December Copper rallied 4.1% (down 23%). December Wheat increased 2.5% (down 22%), and December Corn jumped 6.7% (up 2%).

China Bubble Watch:

October 14 - Bloomberg: "China's bank lending last month was the least since 2009 as inflation stayed above the government's target, highlighting the risk that efforts to tame prices will trigger a slowdown. New loans were 470 billion yuan ($73.7bn)... Consumer prices rose 6.1%... M2... rose 13% from a year earlier, the least in almost a decade, and data for foreign-exchange reserves pointed to capital outflows."

October 14 - Bloomberg (Katrina Nicholas): "Bank lending to China's developers is the least in almost two years, increasing the risk of default for the world's most-indebted real estate companies, which have been shut out of the international bond market since May."

October 13 - Bloomberg: "China's exports rose the least in seven months and the customs bureau warned of 'severe' challenges as the global economic outlook dims, giving Premier Wen Jiabao's government less incentive to let the yuan rise. Exports rose a less-than-forecast 17.1% in September from a year earlier... The trade surplus was $14.51 billion, the smallest since May. Growth in shipments to Europe, China's biggest export market, slumped to 9.8%, from 22%..."

India Watch:

October 14 - Bloomberg (Unni Krishnan): "India's inflation exceeded 9% for a 10th straight month in September, maintaining pressure on the central bank to extend its record interest-rate increases. The benchmark wholesale-price index rose 9.72% from a year earlier..."

October 13 - Bloomberg (Tushar Dhara): "India's food inflation rate exceeded 9% for a third straight week, sustaining pressure on the central bank to maintain its tight monetary policy stance."

October 12 - Bloomberg (Kartik Goyal): "India's industrial production rose less than expected following record interest-rate increases by the central bank and as the global recovery weakens. Output at factories, utilities and mines increased 4.1% in August from a year earlier..."

Asia Watch:

October 13 - Bloomberg (Eunkyung Seo and Deirdre Bolton): "Bank of Korea Governor Kim Choong Soo said inflation is likely to exceed the central bank's 4% target limit this year and board members haven't discussed following other nations in cutting interest rates. 'For year of calendar 2011, probably inflation as measured by CPI may turn out to be slightly over 4%,' Kim said... 'We should meet the medium-term target next year' of 2-4%."

October 12 - Bloomberg (Eunkyung Seo): "South Korea's unemployment rate held near a three-year low last month... The jobless rate was at 3.2% in September..."

October 13 - Bloomberg (Gan Yen Kuan): "Malaysian growth may miss government forecasts this year as a weakening global economy hurts exports, the Malaysian Institute of Economic Research said. The... institute today cut its 2011 estimate for gross domestic product expansion to 4.6% from 5.2%."

October 11 - Bloomberg (Novrida Manurung and Widya Utami): "Indonesia's central bank unexpectedly cut its benchmark interest rate for the first time in more than two years to spur growth as the global recovery weakens and inflation slows."

Latin America Watch:

October 13 - Bloomberg (Karen Eeuwens): "Brazil's Finance Ministry will cut its forecast for 2011 economic growth to 3.8% from 4% currently, Valor Economico reported..."

October 14 - Bloomberg (Boris Korby and Drew Benson): "Brazilian corporate bond sales are falling below last year's pace for the first time after Europe's debt crisis fueled a surge in overseas borrowing costs that's keeping companies from the market. International debt offerings from Brazilian companies have totaled $32.3 billion this year, compared with an all-time high of $32.7 billion during the same period in 2010... Issuance in the U.S. corporate debt market has totaled $930 billion in 2011, compared with $900 billion a year ago."

October 12 - Bloomberg (Camila Russo and Ye Xie): "Argentina's benchmark deposit rate is rising the most in almost three years as banks seek to attract funds and dissuade investors and companies from dumping pesos and sending money out of the country. The rate banks pay...soared 1.63 percentage points, or 163 bps, to 15.625% last week... Deposit rates have risen for five straight weeks as banks seek funding to keep up with an annual lending growth of 35%."

Unbalanced Global Economy Watch:

October 12 - Bloomberg (Svenja O'Donnell): "The U.K. unemployment rate rose to the highest in 15 years in the three months through August... The jobless rate increased to 8.1% from 7.9% in the three months through July..."

October 14 - Bloomberg (Simone Meier): "European inflation accelerated to the fastest in almost three years in September on soaring energy costs... The euro-area inflation rate jumped to 3% last month from 2.5% in August..."

October 13 - Bloomberg (Christian Vits): "Inflation in Germany... accelerated more than initially estimated to the fastest in three years in September, led by energy costs. The inflation rate... rose to 2.9% from 2.5% in August..."

Central Bank Watch:

October 11 - Bloomberg (Jeff Black): "The European Central Bank says the firepower of Europe's bailout fund should be magnified by using government guarantees rather than the central bank's money market operations. The ECB says governments should use the 440-billion-euro ($603bn) European Financial Stability Facility to insure a portion of new bonds issued by debt-strapped nations. That would leverage the amount available to protect member states from the region's debt crisis. EFSF resources 'should be dedicated to enhance sovereign debt new issuance of securities, thus multiplying their effect,' ECB Vice President Vitor Constancio said..."

October 13 - Bloomberg (Andrew Atkinson): "Bank of England Deputy Governor Charles Bean became the third policy maker to signal the central bank might add to its emergency stimulus plan if needed even as its second wave of bond purchases has only just begun. 'If we need to undertake further purchases then we will do so,' Bean told the Guardian newspaper..."

October 11 - Bloomberg (Chiara Vasarri and Andrew Davis): "Prime Minister Silvio Berlusconi's delay in appointing a new Bank of Italy governor highlights the political paralysis that's hampered his response to the debt crisis and helped prompt three rating cuts in as many weeks. Less than a month before Mario Draghi leaves to head the European Central Bank, Berlusconi remains at odds with Finance Minister Giulio Tremonti over the Bank of Italy governor's successor. With the premier facing four criminal trials and his economic-growth plan delayed by Cabinet wrangling, the Northern League party that ensures his parliamentary majority said last week that the government is unlikely to see out the end of its term in 2013... 'Italy's political situation remains extremely fragile,' said Vladimir Pillonca, an economist at Societe Generale... 'There's a material risk that internal rifts, divisions and other vicissitudes will continue to distract the government and undermine the quality and progress of its economic policymaking. The timing is unfortunate, given the climate of acute uncertainty.'"

Muni Watch:

October 14 - Bloomberg (David Mildenberg): "New York, California and Florida are among states reporting revenue collections trailing forecasts in the fiscal first quarter, prompting preparations for a fresh round of budget reductions. California's receipts fell more than 3% short of estimates for the three months through September, raising concern that school aid may be cut. In fiscal 2013, New York state may face a $2.4 billion deficit because of smaller Wall Street bonuses and job cuts, Comptroller Thomas DiNapoli said... States are projecting combined budget gaps of $31.9 billion in fiscal 2013, according to the National Conference of State Legislatures in Denver..."

October 12 - Bloomberg (Romy Varghese, Michael Bathon and Linda Sandler): "Harrisburg, Pennsylvania, facing a state takeover of its finances, filed for bankruptcy protection after failing to pay the debt on a trash-to-energy incinerator. The council made its 4-3 decision against the advice of a city attorney who said the panel did not follow proper procedure. It was the ninth bankruptcy filing this year by a municipal-bond issuer..."

California Watch:

October 12 - Bloomberg (James Nash and Michael B. Marois): "Public schools in California, which already spend less per student than those in 28 states, are bracing for a $1.7 billion cut that may wipe out high-school sports and student busing, and trim the academic calendar by seven days next year. Automatic cuts built into this year's budget, intended to protect bondholders if revenue falls short of projections, are drawing new attention after California fell $705 million behind estimates in the first quarter. A shortfall of $1 billion will slash hundreds of millions of dollars from universities and care of the elderly and disabled. A deficit of $2 billion will trigger reductions to public schools, creating 'a fiscal emergency' that could leave some districts insolvent, a group of superintendents told Governor Jerry Brown in a Sept. 15 letter."

October 14 - Bloomberg (Michael B. Marois): "California, facing mandatory spending cuts with revenue below forecast, may have to pay almost 15% more to borrow $2 billion this month than it did in September as municipal yields climb to a 10-week high. Top-rated 10-year tax-exempt yields exceeded 2.57% yesterday, the highest since Aug. 3. They've jumped from 2 percent on Sept. 26... California, the most-indebted U.S. state, issued $2.4 billion of general-obligation bonds last month..."

October 13 - PRNewswire: "HomeownersInsurance.com reported that average premiums on new homeowners policies sold in California were around $770 in May 2011. This was a 6.5% increase from May 2010 when the company reported average premiums in the Golden State were approximately $729."

Speculation Watch:

October 10 - Bloomberg (Christine Harper): "Wall Street's fixed-income desks could suffer a 25% decline in revenue under a Volcker rule proposal that may outlaw so-called flow trading, according to brokerage analyst Brad Hintz. The draft proposal, written by regulators including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corp., forbids market-makers who trade debt securities for customers from amassing positions 'in expectation of future price appreciation,' Hintz, of Sanford C. Bernstein & Co., wrote... 'Thus flow trading may be prohibited.' Such a move would cut fixed-income revenue by 25% and reduce profit margins by 18%, Hintz estimated."


Ring-Fencing

From October 4th (a mere week ago Tuesday) lows, the S&P500 rallied 12.3%. The S&P400 Mid-Cap index jumped 14.5%, and the Morgan Stanley Cyclical Index surged 17.1%. The Nasdaq 100 jumped 13.9% from October 4 lows. The CRB Commodities index jumped 7.8%, with crude oil up 13.7%. The Australian dollar jumped 9.2% and the Brazilian real rose 7.2%. Italian CDS fell 50bps. China CDS dropped 63%. "Risk off" and bearish bets were pulverized.

Last week's CBB highlighted how the global financial system seemed to have reached a critical juncture back on October 4. Since that point, risk markets have rallied strongly, with participants generally assuming that global policymakers are finally demonstrating the required keen sense of urgency. They haven't done a whole lot, but they're working on it.

European ministers are hard at work fashioning a more comprehensive policy response, perhaps including a mechanism to significantly leverage the recently enlarged European Financial Stabilization Facility (EFSF). The markets were also comforted by last week's moves from the European Central Bank (ECB) and the Bank of England to expand their quantitative easing programs, as well as comments from chairman Bernanke suggesting he stands ready to do more. In China, government officials have moved to loosen policies for the smaller banks and loosen lending generally to small business. There are, as well, high expectations for this weekend's G20 meeting and rising expectations for "developing" countries to assist in the global policy response, perhaps through increasing the firepower of the International Monetary Fund (IMF). Policymakers are energized.

Move over "risk off," and let "risk on" again take over. It is important to appreciate that as bad as things were looking 10 days ago, it had yet to move decisively toward a worst-case scenario. Indeed, the markets have been content to continue accommodating the U.S.'s extreme fiscal and monetary policies, with massive federal borrowing and spending for now lowering the odds of the "falling off a cliff" scenario for the frail U.S. economy. And while there are some important fissures in view, the historic Chinese Credit Bubble is not in an implosion phase. So, in my nomenclature, global Credit is not without some rather robust "inflationary biases" - at least when the markets are cooperating.

Of late, and for good reason, markets have been increasingly petrified by the prospect of a spiraling out of control European debt crisis on the brink of puncturing myriad vulnerable global Bubbles. However, with the entire global financial system succumbing to Credit crisis contagion, the near-universal policymaker response signaled to the markets that, at least for now, the uncontrolled contagion scenario was being taken off the table. Risk markets reversed course, inciting a stampede of buying to reverse hedges and bearish short positions - unleashing powerful short-squeeze dynamics. Rather quickly, illiquid markets turned liquefied - and animal spirits again incited intense buying rather than the selling that has been overwhelming markets the past month or so.

When the markets succumb to de-risking and de-leveraging dynamics, the marketplace rather quickly dismisses inflation risk. The $100 plunge to below $40 crude during the '08 crisis is, for now, forever etched upon the markets' mindset. But crude closed today near $87, and it is not beyond the realm of possibilities that inflationary pressures prove more resilient this time around. This morning's report on September U.S. Import Prices showed an undeflationary 13.4% y-o-y increase. This follows September's 6.5% y-o-y increase in U.S. Producer Prices and 3.8% y-o-y increase in the U.S. Consumer Price Index (reports this week, including from Safeway and Campbell Soup, confirm that food price inflation has become well-entrenched). Euro zone inflation is running at 3.0% y-o-y, the high since October '08. And it is worth noting today's report on Chinese inflation. At 6.1% y-o-y, consumer price inflation remains stubbornly above the government's 4.0% goal, led by a problematic 13.4% y-o-y increase in food prices. India's rate of inflation remains above 9%, also stoked by surging food costs.

I raise the inflation issue this week because it just might prove relevant one of these days. After having afflicted even sovereign debt on a global scale, stemming the unfolding global Credit crisis will require a scope of policy response even beyond that of 2008. And let's assume that attentive policymakers bring out the big guns early - desperate these days to ensure "policy" gets ahead of the crisis. In China, in particular, there is potential for an easing of policy to bolster already robust food and consumer price inflation. And if my "developing" Credit systems and economies thesis is correct, the general global inflation backdrop might depend significantly on whether these Bubbles are at the brink of bursting or whether the global policy backdrop provides these Bubbles an extended lease on life.

Chinese policymaking has turned complex (one might say "dangerous"). There is a real determination to rein in real estate excesses, while there is no indication of any retreat from the objective of raising consumption and purchasing power for an underclass that has enjoyed limited benefits from the nation's protracted boom. It's been my view that Chinese authorities, when confronted with heightened risk of a bursting Bubble, would err on the side of loose policies. Especially with respect to the Chinese economy, the highly unstable global Credit and market backdrop can be expected to engender a manic/depressive view of growth prospects (with resulting wild commodity price vacillations).

Global bond prices certainly have not factored in inflation risk. Indeed, the global bond market has positioned for ongoing "risk off." After having reversed course and repositioned away from "risk on," many players now face difficult decisions. And an important part of my thesis remains that aggressive policymaking and highly speculative global markets make for a volatile and de-stabilizing mix. If the global risk market rally moves much beyond a reversal of bearish bets, U.S. and global bonds could be vulnerable. It would only be fitting that, after a historic squeeze and melt-up in prices, bonds would now run abruptly in the opposite direction.

It is worth noting that France's 10-yr bond yields jumped 58 bps in eight sessions to 3.12% (high since August 9th). The spread between French and German yields widened a notable 17 bps this week to 93 bps, up from about 40 bps at the end of June and to the highest level in years. Belgium yields were up 77 bps in nine sessions. Meanwhile, and despite ongoing ECB support, Italian yields rose 27 bps this week to 5.78%, the high since early August. And it's more than inflation and "risk on" that increasingly spooks European bond investors.

An outline of the latest European crisis response seems to be coming into clearer view. A plan appears to be taking shape that would extend an additional lifeline to Greece, while moving quickly to bolster European bank capital. Mechanisms are also being discussed in an attempt to "ring-fence" Spain and Italy bond markets, including "leveraging" the EFSF. According to news reports, European ministers are even considering using part of the EFSF's lending capacity as reserves for insuring future European bond issues. Apparently, desperate times call for desperate measures. Having witnessed how quickly their systems came under stress, even the "developing" nations are offering to come to Europe's aid.

And (with hyper-volatile markets closed for the weekend) let's try to look somewhat beyond the immediate and attempt to stay focused on key fundamentals. The Europeans appear determined to keep Greece in the euro zone. This will require a big "haircut" on Greek debt, which means big losses for the European banks (and the ECB). A significant boost to bank capital will be required - and apparently many banks are already warning that they will shed assets and de-leverage rather than raise additional capital at today's depressed equity prices. German officials today stated their view that the EFSF should be used to recapitalize banks only as a last resort. It will be up to individual countries to backstop their banking systems, which will likely only add to fiscal stress throughout Europe. Spain had their Credit rating downgraded again yesterday, and the markets are increasingly fearful that banking issues could push sovereigns such as France and Belgium closer to downgrades.

And there's the festering issue of Italy. Sigh. The Italians have a huge debt load (120%+ of GDP) and a major refunding effort ahead of them. Italian yields jumped above 5.80% this week for the first time since early August (when the ECB restarted its bond support operations). In the case of Italian bonds, market fears quickly become self-reinforcing. When yields jump on the market contemplating prospective refunding problems, surging funding costs quickly transform Italy's fiscal position from dismal to unmanageable. ECB buying has somewhat stabilized the situation, although the markets appreciate that further expanding the ECB's bloated balance sheet with Italian sovereign debt provides only a temporary (and problematic) stopgap.

So throughout Europe, great energy is being expended to try to come up with some comprehensive plan to allay the markets' fear of Italian funding problems. Everyone understands that Italy is too big to bail. So, the problem in Italy, and Spain and elsewhere, must be "ring-fenced." If policymakers can only craft a strategy to reduce Italy's (and others') sovereign risk premium, then the hope is that lower yields coupled with additional austerity measures will work towards a return to a semblance of debt sustainability.

And this notion of establishing a "ring-fence" is the impetus for turning the EFSF into a European bond insurance operation. Regular readers are familiar with my view of Credit insurance; how it distorts markets, supports over-issuance and virtually ensures systemic fragility. But who cares about my views. The Europeans see hope (and political expediency) in a mechanisms to "leverage" the EFSF through the guarantee of sovereign debt - possibly creating up to $2 Trillion of firepower. Italy, for example, would be able to issue bonds partially backed by the EFSF - that is backed by the all the euro countries (almost as good as a common Eurobond!). And my guess is that those contemplating such a program are hoping that it would never really see the light of day - that just the availability of such a backing mechanism would suffice to allay market fears, reduce market risk premiums (bond yields) and nurture debt sustainability.

And, again pondering beyond the immediate-term, what is the likelihood that such a structure would gain credibility in the marketplace? Count me skeptical. It's my view that markets have really moved up the Credit Bubble Dynamic learning curve. Having witnessed happenings at Fannie Mae, Freddie Mac, MBIA, Dexia and others, I expect little more than fleeting enthusiasm for a European sovereign insurance scheme. I'm not convinced the marketplace will have sufficient confidence in the long-term viability of such a structure for it to meaningfully reduce long-term Italian, Spanish and other borrowing costs. In the meantime, as is highlighted by the recent ratcheting up of French yields, "periphery" European Credit problems are rather methodically ring-fencing the "core." To what extent will the market question the creditworthiness of the EFSF? And to what degree will EFSF risk-taking impact the markets' view of "core" sovereign creditworthiness?

It's also worth contemplating the probability that further "austerity" measures will prove successful. On the one hand, I see no possibility for European stabilization without additional austerity. Again using the example of Italy: with the backdrop having changed so profoundly, the markets will simply no longer inexpensively finance large Italian deficits. The issue then becomes how Italy's economy (and society) will respond to more painful government cost-cutting. Credit Bubble and Bubble Economy analysis has me quite pessimistic in this regard. Throughout most of the "developed" world, I expect badly maladjusted economic structures to ensure that market-induced "austerity" programs become destabilizing (economically, politically and socially) and protracted affairs. Austerity is absolutely essential - but it will prove incredibly arduous and market unfriendly. Fixated on finance, policy essentially disregards structural economic issues.

"Germany Backing Italian Debt Seen as Key to Europe Bank Crisis," read a Bloomberg headline from earlier today. The markets have increasingly doubted the capacity for the Italians to make good on their debt. I don't expect the German taxpayer to make good on Italian debt either, although the markets still hope that some level of "backing" can postpone the day of reckoning. And perhaps a plan to recapitalize the European banking system and a bigger and more creative EFSF will buy some more time.

From my perspective, the analysis seems to boil down to a few key questions: Did the incredible global policy response to the 2008 crisis only buy a couple years respite from crisis conditions? Did this "respite" come at the high price of severe impairment to sovereign debt markets - impairment now largely impervious to previous policy measures (more government debt, guarantees and central bank monetization)? Have de-risking and de-leveraging dynamics at this point gained unstoppable momentum, especially with respect to the European banking system and the global leveraged speculating community? Are policymakers misdiagnosing the problem, in the process unwittingly funneling the crisis from "peripheries" to system "cores"? And if another round of extraordinary reflationary policy measures actually takes hold (which at this point seems a big "if"), might "core" bond markets now find themselves in harm's way?

"Risk On" or "Risk Off"? Place your bets. And if you don't like the game, go protest at the door of your nearest friendly central banker.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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