For the week, the S&P500 rose 2.3% (up 11.9% y-t-d), and the Dow gained 2.2% (up 6.8%). With AIG up 107%, MBIA 41%, Ambac 39% and Citigroup 21% - all this week! - some may question the quality of the rally. The S&P Homebuilding index jumped 13.4% (up 43.0%) this week, and the Morgan Stanley Retail Index rose 7.5% (up 62.9%). The Banks surged 12.4% (up 2.6%), and the Broker/Dealers jumped 2.9% (up 44.6%). The Morgan Stanley Cyclicals ran another 5.7% (up 51.9%), and the Transports jumped 4.7% (up 6.0%). The broader market remained strong, with the S&P 400 Mid-Caps jumping 4.3% (up 21.7%) and the small cap Russell 2000 advancing 2.8% (up 14.6%). The Morgan Stanley Consumer index increased 2.2% (up 8.5%), and the Utilities added 0.2% (down 1.5%). The Nasdaq100 added 1.0% (up 33.7%), and the Morgan Stanley High Tech index gained 1.2% (up 46.3%). The Semiconductors slipped 1.1% (up 40.7%), while the InteractiveWeek Internet index gained 1.2% (up 52.2%). The Biotechs declined 1.1% (up 33.2%). Although Bullion was down about a buck, the HUI gold index increased 1.6% (up 21.1%).
One-month Treasury bill rates ended the week at 14 bps, and three-month bills closed at 17 bps. Two-year government yields jumped 20 bps to 1.20%. Five-year T-note yields surged 31 bps to 2.79%. Ten-year yields jumped 37 bps to 3.86%. Long bond yields were 31 bps higher at 4.61%. Benchmark Fannie MBS yields surged 42 bps to 4.80%. The spread between 10-year Treasuries and benchmark MBS widened 5 to 94. Agency 10-yr debt spreads narrowed slightly to 6 bps. The implied yield on December eurodollar futures rose 8.5 bps to 0.795%. The 2-year dollar swap spread increased 10.75 to 46.0 bps; the 10-year dollar swap spread increased 8.25 to 32.75 bps; and the 30-year swap spread increased 9.5 to negative 3.75 bps. Corporate bond spreads were mostly tighter. An index of investment grade bond spreads widened one basis point to 166, while an index of junk spreads collapsed 53 to 757 bps (low since September).
Investment grade issuers included Dow Chemical $2.75bn, Citigroup $2.5bn, GE Capital $2.0bn, Firstenergy Solutions $1.5bn, Simon Properties $1.1bn, International Paper $1.0bn, Niagara Mohawk $750 million, Nationwide Mutual $700 million, Magellan Midstream $550 million, and Coca-Cola Enterprises $250 million.
Junk bond fund inflows were strong again at $583 million (from AMG). The list of junk issuers included Smithfield Foods $850 million, Iron Mountain $550 million, Duke Realty $500 million, Hospitality Properties $300 million, Mack-Cali Realty $250 million, Affinia Group $225 million, Global Aviation $175 million and Inverness Medical $150 million.
Convert issuance included Rayonier $170 million.
International dollar debt issuers included Petronas $4.5bn, BP Capital $2.0bn, Majapahit Holding $750 million, Macquarie Group $500 million, CCL Finance $350 million, Westpac Banking $250 million, and Alestra $200 million.
U.K. 10-year gilt yields were little changed at 3.79%, while German bund yields surged 21 bps to 3.51%. The German DAX equities index gained 2.4% (up 13.5%). Japanese 10-year "JGB" yields increased 2.5 bps to 1.43%. The Nikkei 225 added 0.5% (up 17.5%). Emerging equities were mixed, while emerging bond markets were notably resilient. Brazil’s benchmark dollar bond yields sank 20 bps to 5.55%. Brazil’s Bovespa equities index rallied 2.9% (up 50.0% y-t-d). The Mexican Bolsa jumped 4.2% (up 25.9% y-t-d). Mexico’s 10-year $ yields fell 15 bps to 5.67%. Russia’s RTS equities index rallied 6.2% (up 70.9%). India’s Sensex equities index declined 3.3% (up 57.1%). China’s Shanghai Exchange fell 4.4%, lowering 2009 gains to 79.1%.
Freddie Mac 30-year fixed mortgage rates declined 3 bps to 5.22% (down 130bps y-o-y). Fifteen-year fixed rates dropped 6 bps to 4.63% (down 147bps y-o-y). One-year ARMs dipped 2 bps to 4.78% (down 44bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 2 bps to 6.38% (down 109bps y-o-y).
Federal Reserve Credit declined $32.1bn last week to $1.978 TN. Fed Credit has declined $269bn y-t-d, although it expanded $1.089 TN over the past 52 weeks (122%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 8/5) jumped another $17.0bn to a record $2.810 TN. "Custody holdings" have been expanding at a 19.6% rate y-t-d, and were up $414bn over the past year, or 17.3%.
M2 (narrow) "money" supply jumped $24.6bn to a record $8.366 TN (week of 7/27). Narrow "money" has expanded at a 3.6% rate y-t-d and 8.5% over the past year. For the week, Currency gained $2.1bn, and Demand & Checkable Deposits added $0.8bn. Savings Deposits jumped $36.4bn, while Small Denominated Deposits fell $8.1bn. Retail Money Funds declined $6.5bn.
Total Money Market Fund assets (from Invest Co Inst) dropped $27.5bn to $3.606 TN (low since the week of 11/5). Money fund assets have declined $224bn y-t-d, or 9.8% annualized. Money funds expanded $46bn, or 1.3%, over the past year.
Total Commercial Paper outstanding increased $10.7bn to $1.076 TN. CP has declined $605bn y-t-d (60% annualized) and $649bn over the past year (38%). Asset-backed CP declined $3.0bn to $435bn, with a 52-wk drop of $295bn (40%).
International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $97bn y-o-y to a record $7.089 TN. Reserves have increased $324bn year-to-date.
Global Credit Market Watch:
August 3 – Bloomberg (Anna Rascouet): “A gauge of financial-market stress dropped to the lowest level in more than two years… The TED spread, the difference between what banks and the Treasury pay to borrow for three months, narrowed to 29.6 bps… The measure has declined 434 bps since peaking in October last year…”
August 4 – Bloomberg (Caroline Hyde): “Corporate bond sales surged to an all-time high of $1.1 trillion in Europe, beating the previous record set for the whole of 2007… Investors have been lured by the best returns since at least 1998…”
August 6 – Bloomberg (Zijing Wu and Michael Patterson): “The biggest five-month rally in emerging-market debt since 1996 has cut the ranks of ‘distressed’ borrowers in developing nations by more than half. …The yield on bonds sold by Argentina, Georgia, Pakistan and Ukraine dropped to less than 1,000 basis points over U.S. Treasuries in the past three weeks… That leaves only Belize, Ecuador and Venezuela among the 37 developing nations tracked by JPMorgan with yield spreads above 1,000 bps…”
August 7 – Bloomberg (Christine Richard): “Ambac Financial Group Inc., the second-largest bond insurer, posted a net loss for the second quarter of $2.4 billion after increasing its projections for claims on bonds backed by home-equity loans.”
August 5 – Bloomberg (Alan Purkiss): “The global financial crisis has blown a hole in the ‘efficient markets’ theory on which modern economics and modern finance have been based, said Richard Thaler, a professor of economics and behavioral science at the University of Chicago. Writing in the Financial Times, he said the theory assumes that everyone in the economy behaves rationally, which is like leaving friction out of account when doing physics. It consists of two assertions: that asset prices are right, in the sense that they fully reflect available information and thus provide accurate signals for allocation resources; and that market prices are impossible to predict, Thaler said.”
Government Finance Bubble Watch:
August 6 – Bloomberg (Jennifer Ryan): “The Bank of England increased its bond purchase program by 50 billion pounds ($84bn), saying the U.K.’s economic recession is deeper than policy makers expected. The nine-member Monetary Policy Committee, led by Governor Mervyn King, kept the key interest rate at 0.5% and said it will increase its purchase program to 175 billion pounds.”
August 6 – Bloomberg (Matthew Brown and Frances Robinson): “Otmar Issing, former chief economist of the European Central Bank, said inflation will pick up as soon as the financial crisis has passed unless governments and central banks remove economic stimulus measures promptly. ‘Politicians and industry might scream’ when the measures are withdrawn, ‘but this should not be an argument for central banks and fiscal policies,’ Issing said… The exit ‘has to happen at a time when unemployment is still high or even still rising, because of the lagged effect of the crisis on labor markets. As we have seen the strongest expansionary policies, fiscal as well as monetary, in the history of the world, I think it is rather straightforward that as soon as the crisis is behind us, inflationary pressures will emerge unless policies change course in a timely manner,’ Issing said.”
August 4 – Bloomberg (Jody Shenn): “The U.S. government is likely to decide within 18 months that Fannie Mae and Freddie Mac need to be wound down and replaced with a similar entity that would support U.S. housing, Moody’s… said. The government-chartered mortgage-finance companies, which were seized by regulators in September 2008 and since have used $85.7 billion of their capital lifelines, face mounting losses that will mean ‘it could take a decade or longer’ before they are able to emerge from U.S. control as ‘viable standalone entities…’ The increasing losses that will be caused in part by government efforts to use… Fannie Mae and Freddie Mac… as tools to stem the housing slump… ‘This is not bad news for Fannie Mae and Freddie Mac bondholders as the U.S. government has become entwined with these companies and the creation of a new entity to support housing finance likely means the orderly conclusion of Fannie Mae and Freddie Mac,’ Brian L. Harris, Craig A. Emrick and Robert Young, Moody’s analysts, wrote…”
August 6 – Dow Jones: “The government’s ‘Cash for Clunkers’ program sent the auto industry’s annualized U.S. sales in the past two weeks to double what has been seen in the first half of 2009, said… Edmunds.com. It estimated the recent rate annually at 19.6 million. That compares with the under 10-million rate the industry had in the first half of this year.”
August 5 – Wall Street Journal (Liz Rappaport and Meena Thiruvengadam): “The Treasury… said it will borrow less in the third quarter than it had previously expected, in part because banks repaid billions of dollars of government aid under the Troubled Asset Relief Program. The Treasury said it plans to borrow an estimated $406 billion in the quarter, $109 billion less than it had estimated.”
August 4 - Wall Street Journal (Ruth Simon): “A report card…by the Treasury Department showed wide variations in how quickly mortgage companies are helping financially troubled borrowers under the Obama administration’s foreclosure-prevention plan. So far, more than 400,000 borrowers have been offered help. More than 235,000 borrowers, or roughly 9% of those eligible for the program and at least 60 days past due, have begun trial mortgage modifications, the first step to getting a loan reworked.”
August 4 – Bloomberg (Paul Abelsky): “Russia’s ‘unsustainable’ budget deficit in the next three years is a ‘major threat to economic stability’ and won’t spur economic growth, Troika Dialog said. ‘Such fiscal policy leads straight down the path to deadlock,’ Moscow-based economists Evgeny Gavrilenkov and Anton Stroutchenevski…said… The government last week approved a plan to run a deficit of 7.5% of gross domestic product next year… This year’s shortfall, the country’s first in a decade, may reach as much as 9.3%...”
Currency Watch:
August 7 – Bloomberg (Laura Cochrane): “Investor demand for emerging-market bonds is driving the cost of insuring against debt defaults below industrialized governments for the first time. Credit-default swap prices from Turkey to Indonesia are falling as bonds rise… As the U.S. and U.K. borrow record amounts to fund bank bailouts and stimulus, Brazil, Russia, India and China have $3 trillion in reserves, up 19% from January 2008 and now 43% of the worldwide total…”
The dollar index rallied 0.8% this week to 78.97. For the week on the upside, the Brazilian real increased 2.5%, the Mexican peso 1.9%, the New Zealand dollar 1.7%, the Swedish krona 0.3%, and the South Korean won 0.3%. On the downside, the Japanese yen declined 2.9%, the South African rand 2.8%, the Swiss franc 1.3%, the Euro 0.6%, and the Canadian dollar 0.5%.
Commodities Watch:
August 7 – Bloomberg (Jana Randow and Nicholas Larkin): “European central banks agreed to a third five-year cap on gold sales and said planned disposals by the International Monetary Fund could be done within the accord. The European Central Bank and 18 other banks agreed to sell no more than a combined 400 metric tons of the metal a year through September 2014. That’s less than the annual cap of 500 tons in the current agreement…”
August 6 – Bloomberg (Claire Leow): “U.S. proposals to place curbs on commodities trading will drive business overseas, particularly to Asia, said Jim Rogers, chairman of Rogers Holdings. ‘It is remarkable because America is shooting itself in the foot again… It’s going to drive the business away and the rest of the world is going to welcome it with open arms.’”
August 5 – Bloomberg (Rebecca Keenan): “BHP Billiton Ltd., the world’s largest mining company, said China’s iron ore imports are increasing as steel production ‘rapidly’ recovers because of the government’s stimulus package… Iron ore cash prices have jumped 38% this year as China’s 4 trillion-yuan ($586 billion) stimulus plan spurs mills to secure supplies to meet demand for automobiles and buildings.”
August 6 – Bloomberg (Yi Tian): “Sugar jumped to a 28-year high in New York as low monsoon rainfall in India threatens to limit cane yields and excess precipitation delayed harvesting in Brazil, prolonging a global production deficit.”
Gold ended the week little changed at $955 (up 8.2% y-t-d). Silver jumped 4.6% to $14.59 (up 29.1% y-t-d). September Crude rose $1.13 to $70.58 (up 58% y-t-d). September Gasoline slipped 0.8% (up 88% y-t-d), while September Natural Gas gained 0.8% (down 34% y-t-d). September Copper jumped 5.3% (up 96% y-t-d). September Wheat fell 6.3% (down 20% y-t-d), and September Corn dropped 5.2% (down 21% y-t-d). The CRB index jumped 2.7% (up 15.2% y-t-d). The Goldman Sachs Commodities Index (GSCI) rose 2.3% (up 34% y-t-d).
China Bubble Watch:
August 5 – Bloomberg: “Shanghai will take steps to cool the city’s real-estate market as housing prices in China’s financial capital are ‘too high,’ Mayor Han Zheng said. The city government will increase the supply of land for property development and speed up construction of affordable housing… Han, 55, said… Record bank lending in China drove average prices for new homes 6.3 percent higher in June in 36 large and medium-sized Chinese cities… ‘The government should do something to effectively control the speed of growth of the real estate market… The housing price in Shanghai is already too high. We must prevent excessive inflation of home prices in this market.’”
August 3 – Bloomberg: “China’s manufacturing expanded for a fourth month in July as stimulus spending stoked domestic demand… The CLSA China Purchasing Managers’ Index rose to a one- year high of 52.8…”
August 4 – Bloomberg (Kelvin Wong): “HSBC Holdings Plc, the foreign bank with the biggest network in China, has seen ‘significant’ pressure on loan margins in the nation as interest rates fall and domestic rivals boost lending… The lending spree by domestic banks has added to pressure on loan margins, HSBC’s Asia-Pacific Chief Executive Officer Sandy Flockhart said…”
Japan Reflation Watch:
August 7 – Bloomberg (Chris Cooper): “Japan Airlines Corp., Asia’s largest airline by sales, posted the biggest quarterly loss in at least six years… Japan Air had a loss of 99 billion yen ($1 billion) in the three months ended June 30…”
Asia Bubble Watch:
August 7 – Bloomberg (Aloysius Unditu): “Indonesia’s central bank, which has cut interest rates nine times since December, said managing inflation will be a ‘challenge’ for policy makers next year.”
Latin America Watch:
August 4 – Dow Jones: “Brazil's foreign currency reserves reached a new record in July… Brazil’s foreign reserves totaled $211.87 billion at the end of July, up from $208.4 billion at the end of June.”
August 4 – Bloomberg (Steven Bodzin and Daniel Cancel): “Venezuelan President Hugo Chavez said he may nationalize two coffee companies after taking temporary control of their processing plants yesterday and vowed to keep seizing monopolies as he works to construct a socialist economy. ‘We’ve intervened in these big companies,” Chavez said… ‘Now we are conducting a study to expropriate them. They will become property of the nation.’”
Unbalanced Global Economy Watch:
August 5 – Bloomberg (Svenja O’Donnell): “U.K. service industries from law firms to insurers expanded the most since 2008 in July, adding to evidence the economy may be shaking off the recession.”
August 7 – Bloomberg (Jana Randow): “German exports increased the most in almost three years in June… Sales abroad… surged 7% from May…”
August 6 – Bloomberg (Christian Vits): “German factory orders posted their biggest increase in two years in June, the latest sign that Europe’s largest economy is emerging from recession. Orders, adjusted for seasonal swings and inflation, jumped 4.5% from May…”
August 6 – Bloomberg (Jacob Greber): “Australian employers unexpectedly added workers in July… The number of people employed rose 32,200…”
August 4 – Bloomberg (Jacob Greber): “Australian house prices rose in the three months through June for the first time in five quarters … An index measuring the weighted average of prices for established houses in the eight capital cities climbed 4.2% from the first quarter…”
Bursting Bubble Economy Watch:
August 7 – Bloomberg (Andy Fixmer): “The biggest U.S. television networks are posting declines of 15% or more in advertising commitments for the prime-time season starting next month, based on results at CBS and NBC.”
August 4 - Wall Street Journal (Lynn Cowan): “Last year’s meltdown in financial markets isn’t the primary force behind corporate cuts in retirement plans. While pensions certainly were affected by the rout in stock prices, many corporate executives had been eager to put an end to traditional retirement plans prior to 2008… About 31% of Fortune 1,000 companies have frozen their pensions now, up from 27% at the same point in 2008…”
Central Banker Watch:
August 5 – Wall Street Journal (George Melloan): “Federal Reserve Chairman Ben Bernanke assured readers of this page… that he has the tools to prevent the huge reserves he's pumped into the banks from generating an inflation that would abort an economic recovery. But does the Fed have the guts to use those tools? Will it risk censure from Congress and the Obama administration if it tightens money at the crucial juncture when inflationary omens accompany a reviving economy? Mr. Bernanke signaled the probable choice by writing that ‘economic conditions are not likely to warrant tighter monetary policy for an extended period.’ The Fed’s past record of judging when and how to use its tools for regulating the money supply is not impressive, particularly in times of economic distress… The Fed’s difficulties in getting money policy right stretch back to its creation in 1913.”
August 5 – Bloomberg: “China’s central bank reaffirmed today the ‘moderately loose’ monetary policy… Policy makers will fine-tune the approach as needed, the People’s Bank of China said… New lending tripled to more than $1 trillion in the first half of 2009 from a year earlier… The Shanghai Composite Index has climbed 88% this year.”
August 5 – Bloomberg (Aloysius Unditu): “Indonesia’s central bank lowered interest rates for a ninth month… Bank Indonesia reduced its reference rate by a quarter- point to 6.50%...”
August 7 – Bloomberg (Alex Nicholson and Paul Abelsky): “Russia’s central bank said it reduced its main interest rates by a ‘cautious’ quarter of a percentage point… The bank has cut the rates five times since April 24.”
August 6 – Bloomberg (Radoslav Tomek): “The Czech central bank cut its key interest rate a quarter-point to a record low…. Policy makers trimmed the two-week repurchase rate to 1.25% from 1.5% at their meeting…”
Real Estate Bust Watch:
August 5 – Bloomberg (Alan Bjerga): “Farmland prices, which advanced for 21 years, couldn’t escape the worst plunge in real estate since the Great Depression. The value of all land and buildings on farms averaged $2,100 an acre at the start of 2009, down 3.2% from a year earlier, the first decline since 1987…”
GSE Watch:
August 7 – Bloomberg (Jana Randow): “Fannie Mae, the mortgage-finance company taken over by the government, asked the U.S. Treasury for a $10.7 billion capital investment as an eighth straight quarterly loss drove its net worth below zero once again. A second-quarter net loss of $14.8 billion… pushed the company to request money for the third time from a $200 billion government lifeline… Today’s results bring the company’s cumulative losses over the last two years to $101.6 billion and will bring its total draw on the Treasury to $44.9 billion since April."
August 3 – Bloomberg (Dawn Kopecki): “Fannie Mae and Freddie Mac’s ‘serious’ delinquencies rose 6.8% in May as the government retooled its anti-foreclosure programs… The serious delinquency rate rose to 4.14% from 3.87% the previous month.”
California Watch:
August 3 – Associated Press: “When California college students return to campus this fall, they’ll find crowded classrooms, less access to faculty and counselors, fewer campus services and more difficulty getting classes they need to graduate — all while paying higher fees. The state’s financial crisis is battering its world-renowned system of higher education, reducing college opportunities for residents and threatening California’s economic recovery."
August 4 – Bloomberg (Michael B. Marois): “California must reduce its prison population by 44,000 inmates over the next two years to ease overcrowding, a panel of three federal judges… ruled… There are about 167,000 adult inmates in California prisons.”
Speculator Watch:
August 5 – Bloomberg (Michael McDonald): “Massachusetts will cut investments in hedge funds after its public pension plan lost a record 24% on all assets in the fiscal year ended June 30.”
Crude Liquidity Watch:
August 3 – Bloomberg (Zainab Fattah): “Dubai house prices halved from a year ago, almost reaching 2007 levels… Home prices in the desert sheikhdom dropped 48% from a year ago, sliding 9% during the second quarter to an average of 949 dirhams ($258) per square-foot (0.09 square meters).”
The Stock Market and Monetary Disorder:
I’ll restate my thesis as concisely as I can (not my strong suit): The deeply maladjusted U.S. “Bubble” economy requires $2.5 Trillion or so of net new Credit creation to stem systemic (Credit and economic Bubbles) implosion. Only “government” (Treasury, agency debt, and GSE MBS) debt can, today, fill the gigantic void created with the bursting of the Wall Street/mortgage finance Bubble. The private sector Credit system is severely impaired, and there is as well the reality that the market largely lost trust (loss of “moneyness”) in Wall Street obligations (private-label MBS, CDOs, ABS, auction-rate securities, etc.). The $2.0 Trillion of U.S. “government” Credit creation coupled with the Trillion-plus expansion of Federal Reserve Credit over the past year has stabilized U.S. financial and economic systems.
The synchronized global expansion of government deficits, state obligations, and central bank Credit amounts to an historic government finance Bubble. Markets have thus far embraced the surge of debt issuance. This U.S. and global reflation will have decidedly different characteristics when contrasted to previous Fed and Wall Street-induced reflations.
First off all, the most robust inflationary biases are today domiciled in China, Asia and the emerging markets generally. The debased dollar has provided China and the “developing” world Credit systems unprecedented capacity to inflate (expand Credit/financial claims without fear of spurring a run on their currencies). Asian and emerging markets are outperforming, exacerbating speculative inflows. Things that the “developing” world need (energy/commodities) and want (gold, silver, sugar, etc.) should demonstrate increasingly strong inflationary pressures. Their overflow of dollars provides them, for now, the power to buy whatever they desire.
Here at home, the post-Wall Street Bubble financial landscape ensures the old days of the Fed slashing rates and almost instantaneously stoking mortgage Credit, home price inflation and consumption have run their course. Accordingly, the unfolding reflation will be of a different variety than those of the past – and, importantly, largely bypass U.S. housing. This sets the stage for a lackluster recovery in consumption and economic revival generally. Household sector headwinds will likely be exacerbated by higher-than-expected inflation (especially in energy and globally-traded commodities), higher taxes and rising interest rates.
There is a confluence of factors that expose the market to an upside surprised in yields. The bond market has been overly sanguine, emboldened by the prospect of the Bernanke Fed maintaining ultra-loose monetary policy indefinitely. Bond bulls have been further comforted by the deep structural issues overhanging both the U.S. financial system and economy. However, massive government Credit creation has, for now, put systemic issues on hold. Especially in Asia, unfettered Credit expansion creates the backdrop for a surprisingly speedy economic upsurge. The weak dollar plays a major reflationary role globally, while also raising the prospect for inflationary pressures here at home. Massive issuance, global economic resurgence, heightened inflation and a weak currency are offering increasingly tough competition to the bullish “forever loose policy” view.
Meanwhile, fixed income must gaze at the feverish equities market with disbelief – and rising trepidation. The bond market discerns incessant economic impairment, a historic debt overhang, 9.4% unemployment, and begrudging recovery. An intoxicated stock market ganders something altogether different, with the Morgan Stanley Retail Index up 61% y-t-d, the Morgan Stanley High Tech Index up 47%, the Morgan Stanley Cyclical Index up 52%, and the Broker/Dealers up 45%. The bond market has been content to laugh off the silly equities game. The chuckles may have ended today.
My secular bearish thesis rests upon a major assumption: The U.S. economy is sustained by $2.5 Trillion (or so) of new Credit. Only this amount will stem a downward spiral of asset prices, Credit, incomes, corporate cash flows and government finances. On the other hand, if forthcoming, the $2.5 Trillion of additional – chiefly government-directed and non-productive - Credit will foment problematic Monetary Disorder. In simplest terms, another bout of Credit inflation leads further down the path of unhinged market prices, destabilizing speculation, and unwieldy flows of finance.
The stock market has become illustrative of what we might experience in the way of Monetary Disorder. Speculation has returned with a vengeance, galloping blindly ahead of fledgling little greenish shoots. Those of the bullish persuasion contend that the marketplace is, as it should, simply discounting a rosy future. I would counter that problematic market dynamics have taken over, with prices increasingly disconnected from reality. In short, the market is in the midst of one major short squeeze.
There are myriad risks associated with the government’s unprecedented market interventions. Likely not well appreciated, policymaker actions have forced the destabilizing unwind of huge positions created to hedge against systemic risk (as well as to profit from bearish bets). This reversal of various bear positions has created enormous buying power, especially in the securities of companies (and sectors) most exposed to the Credit downturn. The reversal of bets in the Credit default swap (and bond) market has certainly played a role. Surging junk bond and stock prices have fed one another, as the highly leveraged and vulnerable companies provide phenomenal market returns. The markets are today throwing "money" at the weak and leveraged.
The resulting outperformance of fundamentally weak companies spurred short covering more generally, creating a dynamic whereby heavily shorted stocks became about the best performing sector in the equities market. This dynamic put significant pressure on so-called market neutral strategies that have proliferated over the past few years. The strategy of attempting to own the good companies and short bad ones is faltering, likely causing a flow out of these strategies - and a self-reinforcing unwind of positions. The “bad” stock soar and the “good” ones languish.
There’s nothing like a short squeeze panic to get the markets’ speculative juices flowing. Many will say all’s just fine and dandy – let the fun and games continue! My retort is that the stock market is indicative of the current dysfunctional financial backdrop. At the end of the day, the financial system must be capable of effectively allocating finance and real resources throughout the economy. I would argue that this is not possible for a system that congenitally misprices risk and distorts financial asset prices. Today’s stock market will inherently finance mainly speculative Bubbles and fragility. And the core systemic problem, the maladjusted "Bubble economy," well, the financial backdrop only worsens the situation.
I have great confidence that government finance Bubble dynamics ensure ongoing distortions in the markets’ pricing of risk and, as well, a continued misallocation of resources (financial and real). And it is increasingly clear that the stock market is embroiled in this problematic dynamic. But that is a dilemma for another day, as surging stocks fan optimism and risk embracement – not to mention forcing many into the stock market with both nostrils plugged. And speculative equities and Credit markets will spur increased economic output in the short-run.
Everything has been extraordinary; the boom, the bust, policymaker interventions, and now the bear market rally. I wish I could see some mechanism in the works that will help kick our system’s addiction to easy Credit and commence the inevitable process of economic adjustment and restructuring. Instead, I see confirmation everywhere that policy and market dynamics are working in concert to sustain the existing financial and economic structure. I have huge doubts it will work and no doubt about the risks of failure.