For the week, the S&P500 gained 1.3% (up 6.3% y-t-d), and the Dow rose 1.3% (up 8.0%). Strength was broad-based. The S&P 400 Mid-Caps rose 1.3% (up 9.7 %), and the small cap Russell 2000 gained 1.3% (up 7.9%). The Morgan Stanley Cyclicals jumped 2.6% (up 6.2%), and the Transports added 0.1% (up 3.6%). The Morgan Stanley Consumer index gained 0.3% (up 2.7%), and the Utilities increased 0.4% (up 2.2%). The Banks fell 1.3% (down 3.3%), while the Broker/Dealers added 1.1% (down 0.1%). The Nasdaq100 advanced 2.9% (up 7.2%), and the Morgan Stanley High Tech index jumped 2.6 % (up 4.5%). The Semiconductors rose 2.7% (up 7.6%). The InteractiveWeek Internet index gained 2.4% (up 5.6%). The Biotechs added 0.7% (up 10.8%). With bullion jumping $20 to a record high $1,507, the HUI gold index gained 2.0% (up 3.9%).
One-month Treasury bill rates ended the week at 3 bps and three-month bills closed at 5 bps. Two-year government yields declined 3 bps to 0.66%. Five-year T-note yields ended the week 4 bps higher at 2.11%. Ten-year yields declined 2 bps to 3.39%. Long bond yields were little changed on the week at 4.49%. Benchmark Fannie MBS yields were one basis point lower to 4.21%. The spread between 10-year Treasury yields and benchmark MBS yields widened one to 82 bps. Agency 10-yr debt spreads increased one basis point to negative 2 bps. The implied yield on December 2011 eurodollar futures declined 2.5 bps to 0.475%. The 10-year dollar swap spread declined one to 7.75 bps. The 30-year swap spread was little changed at negative 22.5 bps. Corporate bond spreads narrowed modestly. An index of investment grade bond risk declined one to 93 bps. An index of junk bond risk fell 4 bps to 440 bps.
Investment grade debt issuers included Goldman Sachs $2.0bn and Ohio National $250 million.
Junk bond funds saw outflows of $186 million (from Lipper). Issuers included Sesi $500 million, MPT Partners $450 million, CDW $450 million, Community Choice Financial $395 million, and General Shopping $250 million.
I saw no convertible debt issued.
International dollar debt issuers included Abbey National $2.5 TN, China National Petroleum $1.85bn, PPL $1.06bn, Alpha Bank $1.0bn, Evraz $850 million, Orix $800 million, Manitoba $750 million, Calcipar $450 million, Finance Infrastructure $690 million, Consolidated Minerals $405 million, EMP Distribuidora Norte $300 million, Dematic $300 million, Turks & Caicos Islands $170 million, and Geo Maquinaria $160 million.
U.K. 10-year gilt yields dipped 3 bps this week to 3.525% (up 2bps y-t-d), and German bund yields dropped 12 bps to 3.26% (up 30bps). The rout in European periphery bonds gathered momentum this week. Ten-year Portuguese yields jumped 49 bps to 9.36% (up 278bps). Irish yields surged 73 bps to 10.24% (up 1.19bps), and Greek 10-year bond yields jumped 101 bps to 14.72% (up 226bps). Spain's yields gained 5 bps to 5.46% (up 2bps). The German DAX equities index rose 1.6% (up 5.5% y-t-d). Japanese 10-year "JGB" yields dropped 7 bps to 1.21% (up 9bps). Japan's Nikkei rallied 0.9% (down 5.3%). Emerging markets were mixed. For the week, Brazil's Bovespa equities index added 0.6% (down 3.2%), while Mexico's Bolsa declined 0.5% (down 4.5%). South Korea's Kospi index jumped 2.7% (up 7.2%). India’s equities index gained 1.1% (down 4.4%). China’s Shanghai Exchange declined 1.3% (up 7.2%). Brazil’s benchmark dollar bond yields were little changed at 4.57%, while Mexico's benchmark bond yields declined about 2 bps to 4.46%.
Freddie Mac 30-year fixed mortgage rates sank 11 bps to 4.80% (down 27bps y-o-y). Fifteen-year fixed rates dropped 11 bps to 4.02% (down 37bps y-o-y). One-year ARMs were down 9 bps to 3.16% (down 106bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down one basis point to 5.42% (down 41bps y-o-y).
Federal Reserve Credit jumped $16.0bn to a record $2.659 TN (24-wk gain of $379bn). Fed Credit was up $252bn y-t-d and $341bn from a year ago, or 14.7%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 4/20) increased $743 million to a record $3.419 TN. "Custody holdings" were up $362bn from a year ago, or 11.9%.
Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $1.731 TN y-o-y, or 21.8%, to a record $9.655 TN. Over two years, reserves were $2.991 TN higher, or 45% growth.
M2 (narrow) "money" supply increased $5.7bn to a record $8.928 TN. "Narrow money" has expanded at a 3.7% pace y-t-d and 5.2% over the past year. For the week, Currency increased $3.8bn. Demand and Checkable Deposits dropped $23.7bn, while Savings Deposits jumped $33.8bn. Small Denominated Deposits declined $2.2bn. Retail Money Funds fell $6.0bn.
Total Money Fund assets dropped $36.2bn last week to $2.710 TN. Money Fund assets were down $100bn y-t-d, with a decline of $168bn over the past year, or 5.8%.
Total Commercial Paper outstanding declined $800 million to $1.098 Trillion. CP was up $129bn y-t-d, or 36% annualized, and $23bn from a year ago (2.1%).
Global Credit Market Watch:
April 19 – Bloomberg (Keith Jenkins and Emma Charlton): “Greek note yields reached euro-era records amid growing speculation the country will need to restructure its debt as financing costs mount… Greece sold 1.625 billion euros ($2.3bn) of 13-week bills at a higher interest rate amid lower demand than the previous auction of similar debt. Greek two-year note yields breached 20% for the first time yesterday.”
April 21 – Bloomberg (Kati Pohjanpalo): “The rise of the nationalist True Finns party in Helsinki may increase pressure on Portugal to deepen budget cuts in order to win aid from the European Union. The True Finns’ third-place finish in April 17 elections has thrust the party to the center of European bailout politics, giving it a chance to obstruct the rescues of indebted nations. The Social Democrats, who also campaigned against external aid, may join a government with the True Finns that will be led by Finance Minister Jyrki Katainen’s National Coalition. Finnish politics are ‘a cause for concern for the market,’ said Martin Blum, co-head of asset management at Ithuba Capital AG… ‘This is a clear warning signal to other governments in the euro area that doling out cash for bailouts is politically extremely risky.’”
Global Bubble Watch:
April 19 – Financial Times (Sam Jones and Dan McCrum): “Assets under management in the global hedge fund industry have soared to an all-time peak, surpassing the pre-crisis high thanks to the strongest investor inflows in years. The world’s hedge funds at present manage $2,002bn of client funds, according to Hedge Fund Research… That comfortably exceeds the $1,930bn peak of June 2008, just months before the collapse of Lehman Brothers triggered big losses and huge investor redemptions in the industry’s worst-ever crisis. At its nadir, the hedge fund industry’s assets were just $1,330bn in the first quarter of 2009.”
April 20 – Bloomberg (Jeff Kearns): “The benchmark index for U.S. stock options slumped to its lowest intraday level since June 2007 as shares rallied on better-than-estimated quarterly reports from companies including Intel Corp. and Yahoo! Inc.”
Municipal Debt Watch:
April 20 – Bloomberg (Brendan A. McGrail and Matt Robinson): “Congressional cuts to U.S. spending, following a negative outlook on federal debt by Standard & Poor’s, may adversely affect state credit ratings, according to Janney Montgomery Scott LLC. The ratings company put the U.S. government on notice that it risks losing its AAA investment grade unless politicians agree on a plan by 2013 to reduce budget deficits and the national debt. S&P said this week there’s a 1-in-3 chance the ranking may be lowered within two years and that its ‘baseline assumption’ is that Congress and President Barack Obama will agree on a plan to contain deficits before then. There’s a ‘clear connection’ between the federal government’s credit and states, so the ‘trajectory of states’ ratings is more likely to be negative than positive’ as Congress cuts spending, said Guy LeBas, chief fixed-income strategist at… Janney… ‘The problem with the degree of government cutbacks being discussed is that they’re so large that in one way federal government cutbacks are going to affect every sector of the muni market,’ LeBas said. ‘It’s now a matter of how much.’ Investors have pulled about $31.6 billion from U.S. municipal-bond mutual funds since Nov. 10, 22 straight weeks of net withdrawals…”
April 20 – Wall Street Journal (Michael Corkery and Jeannette Neumann): “For many cities and states, the love affair with debt has cooled, as governments cut back on spending and as borrowing comes under political attack. In Marquette, a small city on Michigan's Upper Peninsula, officials last month voted to nearly halve the amount of debt the city plans to issue in fiscal 2012 from the year ending June 30. ‘You get to a saturation point where too much debt is too much debt,’ said Marquette City Commissioner David Saint-Onge. The wariness to take on more debt extends to the municipal-bond market's largest borrowers, such as California, which this year plans to issue a little more than half of the approximately $10 billion in long-term bonds it sold in 2010. ‘It has a lot less to do with the market, and more to do with trying to get back on firm fiscal ground,’ said Tom Dresslar, spokesman for the California Treasurer's Office. The change in attitude raises the prospect that the drought in municipal-bond issuance—the first quarter was the slowest quarter in 11 years—isn’t a temporary blip but a longer-lasting shift in municipal borrowing habits.”
April 18 – Bloomberg (Michael Quint and Henry Goldman): “New York state tax collections for the fiscal year ended two weeks ago were $926.3 million less than what was projected in the 2010-11 budget enacted in August, according to… Comptroller Thomas DiNapoli. Revenue totaled $133.3 billion for the last fiscal year, 5.2% higher than in 2009-10. Spending increased 6.3% to $134.8 billion…”
April 20 – Bloomberg (Mario Bessa Lima): “The U.S. government is devaluating the dollar ‘deliberately’, Fernando Pimentel, Brazil’s Trade Minister, told journalists…”
In a particularly volatile week for the currencies, the U.S. dollar index fell another 0.9% to 74.136 (down 6.2% y-t-d). On the upside for the week, the Australian dollar increased 1.6%, the Japanese yen 1.5%, the South African ran 1.4%, the Swedish krona 1.2%, the British pound 1.2%, the South Korean won 0.8%, the Danish krone 0.8%, the Euro 0.8%, the Swiss franc 0.7%, the Singapore dollar 0.7%, the Brazilian real 0.6%, the Canadian dollar 0.5%, the Mexican peso 0.5%, the Taiwanese dollar 0.4%, and the New Zealand dollar 0.3%. On the downside, the dollar gained 0.2% against the Argentine peso.
Commodities and Food Watch:
April 19 – Bloomberg: “Across the road from Zhao Yuanyi’s wheat field in China’s Shandong province, Chonche Group is expanding a rail-car factory on what used to be 227 hectares of farms. Nearby, Geely Automobile Holdings Ltd. makes sedans on an 87 hectare site that four years ago was covered by crops. The factories sprawling from Jinan city, 350 kilometers (220 miles) south of Beijing, put Zhao on the front line of a clash between a policy of food self-sufficiency and industrial growth that made China the world’s second-biggest economy. Industrialization is winning, signaling prices for crops like wheat and corn will rise as China is increasingly unable to feed itself and vies for supplies on global markets.”
April 18 – Bloomberg (Whitney McFerron): “Wheat production in Texas, the fifth-largest U.S. grower, may plunge 61% because of a prolonged drought, said Mark Welch, a grain-marketing economist at Texas A&M University… ‘The whole state is dry,’ said Welch… ‘Even if it rains pretty soon, our wheat is far enough along that it’s just about too late for it.’”
April 18 – Bloomberg (Ranjeetha Pakiam, Luzi Ann Javier and Jeff Wilson): “At a time when consumers are focused on food costs that are within about 3% of a record, stockpiles of edible oils needed to make everything from noodles to fish sticks are dropping to a three-decade low. The combined stocks of nine oils will plunge 25% to 9.39 million metric tons this year, or about 23 days of demand, the fewest since 1974…”
The CRB index gained 1.3% (up 10.4% y-t-d). The Goldman Sachs Commodities Index rose 1.3% (up 19.0%). Spot Gold increased 1.4% to a record $1,507 (up 6.1%). Silver continued its historic run, jumping 8.2% to $46.08 (up 49%). June Crude rose $2.07 to $112.29 (up 23%). May Gasoline added 0.6% (up 35%), and May Natural Gas jumped 4.9% (flat). July Copper rallied 3.3% (down 0.5%). May Wheat surged 7.4% (up 1%), while May Corn dipped 0.6% (up 17%).
China Bubble Watch:
April 19 – Bloomberg: “China increased banks’ reserve requirements to lock up cash and cool inflation, and central bank Governor Zhou Xiaochuan said monetary tightening will continue for ‘some time.’ Reserve ratios will rise a half point from April 21, the People’s Bank of China said… pushing the requirement to a record 20.5% for the biggest lenders. The move came less than two weeks after an interest-rate increase.”
April 19 – Bloomberg: “Foreign direct investment surged 33% in March from a year earlier as rising inflation and interest rates failed to damp overseas confidence in the world’s fastest-growing major economy.”
April 21 – Bloomberg: “China Mobile Ltd. became the world’s first phone company to exceed 600 million subscribers… China Mobile added 16.8 million subscribers in the first quarter… With mobile devices now accounting for 75% of China’s 1.2 billion phone users, the… carrier is getting most of its new additions from customers in the countryside…”
April 20 – Bloomberg: “The number of Chinese individuals with more than 10 million yuan ($1.5 million) in investable assets may grow to about 590,000 this year, almost double from 2008, according to a Bain & Co. study.”
April 22 – Bloomberg (Toru Fujioka): “Japanese Prime Minister Naoto Kan proposed a 4-trillion yen ($49 billion) extra budget that is likely to be the first of several packages to rebuild areas devastated by last month’s record earthquake and tsunami. The government plans to fund the budget without increasing the 44.3 trillion yen in new bond issuances set for the year ending March 2012…”
April 21 – Bloomberg (Unni Krishnan): “India is targeting annual growth of 9% to 9.5% during the five years ending 2017, Prime Minister Manmohan Singh said…”
April 19 – Bloomberg (Tushar Dhara): “India’s merchandise exports rose to a record in March as engineering and jewelry makers tapped markets such as Latin America… Merchandise shipments in March surged 43.9% to $29 billion from a year earlier…”
Asia Bubble Watch:
April 20 – Bloomberg (Eunkyung Seo): “Bank of Korea Governor Kim Choong Soo said consumer price gains in South Korea will remain above 4% this month.”
April 20 – Bloomberg (Gan Yen Kuan): “Malaysian housing prices are expected to rise as much as 20% this year because of accelerating inflation and rising demand for high-end homes, Deputy Finance Minister Donald Lim said. Property prices are still at a ‘manageable’ level now and there is ‘no property bubble,’ Lim told reporters…”
April 20 – Bloomberg (Suttinee Yuvejwattana): “Thailand raised interest rates for the sixth time in less than a year as Asian nations step up efforts to damp inflation stoked by surging commodity prices, and the central bank signaled that it would do more. The Bank of Thailand increased the benchmark one-day bond repurchase rate by a quarter of a percentage point to 2.75%...”
Latin America Watch:
April 20 – Bloomberg (Iuri Dantas): “Brazil’s inflation rate accelerated to its fastest since November 2008, driven by food, beverages and fuel prices. Consumer prices… rose 6.44% in the year through mid-April…”
April 20 – Bloomberg (Eduardo Thomson): “Chilean companies are preparing a record number of initial public offerings as the country’s economy grows at the fastest pace in more than a decade and its benchmark equity index outperforms Latin American peers. Companies may raise as much as $9.6 billion through next year from IPOs and subsequent offerings, said Santiago Lecaros, a money manager at IM Trust SA…”
Unbalanced Global Economy Watch:
April 19 – Bloomberg (Greg Quinn): “Canada’s inflation rate accelerated in March to the fastest in 2 1/2 years, exceeding all economist forecasts, with widespread increases led by energy costs. Consumer prices rose 3.3% from a year earlier after a 2.2% gain in February…”
April 20 – Bloomberg (Alaa Shahine): “The Egyptian economy shrank 7% in the third quarter of the fiscal year that ends on June 30, after a revolt that toppled former President Hosni Mubarak, Finance Minister Samir Radwan said. Exports fell 40%...”
U.S. Bubble Economy Watch:
April 19 – Bloomberg (Simone Baribeau): “Teri Essex retired a year earlier than planned when she was offered $56,000 to leave her elementary-school teaching job in Elk Grove, California. Instead of accepting a salary cut, larger classes and less money for supplies from spending reductions made last year by California lawmakers closing a $19 billion budget deficit, Essex… took the money over nine years to retire in 2010 after 21 years of teaching. ‘The financial buyout was a no-brainer,’ said Essex… California, Florida and Texas are seeing more retirements as rising benefit costs, pay cuts and looming furloughs prompt workers to leave. Inducements to quit early also boosted departures in New York as U.S. states tackled budget gaps totaling more than $540 billion since fiscal 2009…”
April 19 – Bloomberg (Christopher Payne): “A 2 percentage-point increase in the U.S. government’s borrowing costs would push debt above the nation’s gross domestic product by 2020… A Bloomberg Government Study published March 7, ‘Cutting the Deficit: Painful Choices,’ forecast that U.S. government debt as a percent of GDP will rise to 84.9% in 2020. That forecast assumes that interest rates will average 3.54% from 2011 to 2020. The figure is an average of the Congressional Budget Office’s effective interest rate projections… If the government’s borrowing costs averaged 4.54% over the next decade, debt would rise to 92.5% of GDP in 2020… An increase of an additional percentage point to 5.54% would cause debt to balloon to 100.6% of GDP, and borrowing costs of 6.54% would push debt to 109.5% of GDP in 2020…”
Real Estate Watch:
April 21 – Bloomberg (Kathleen M. Howley): “U.S. home prices fell 5.7% in February from a year earlier as distressed properties weighed down values, according to the Federal Housing Finance Agency. The decline was led by a 12% slump in the region that includes Colorado and Nevada, followed by an 8.7% retreat in the area that includes California and Oregon, the agency said today from Washington. Nationally, prices slid 1.6% from January…”
April 20 – Bloomberg (Brian Louis): “U.S. commercial property prices declined for the third straight month in February as distressed sales dragged down values and transactions were the lowest in a year, according to Moody’s… The Moody’s/REAL Commercial Property Price Index fell 3.3% from January and 4.9% from a year earlier. It’s up 0.8% from an eight-year low in August…”
Central Banking Watch:
April 20 – Bloomberg (Johan Carlstrom): “Sweden’s central bank raised its benchmark repo rate for a sixth time since July, and kept a forecast for coming increases unchanged, as it seeks to cap inflation in the European Union’s fastest-growing economy. The… rate was raised a quarter of a percentage point to 1.75%...”
April 20 – Bloomberg (Andre Soliani and Matthew Bristow): “Brazil’s central bank slowed the pace of rate increases on a less-than-unanimous vote, saying they need to implement policy adjustments ‘for a sufficiently long period’ to bring inflation to target next year. Policy makers… voted 5-2 to raise the Selic rate by a quarter point to 12% from 11.75%...”
S&P Commences the Process:
The good news from Standard and Poor’s was that the company reaffirmed the United States’ “AAA” sovereign debt rating. The bad news was that its outlook was revised to “negative.”
From Standard and Poor’s: “We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation does not begin by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer 'AAA' sovereigns.”
U.S. bond prices actually moved up on the news (in the face of Monday’s weak stock market), and yields ended lower for the week. It’s true that the markets were not caught unaware of our nation’s fiscal woes. And similar to other potentially negative fundamental developments, markets participants are these days content to play the here and now - and leave structural issues for some later date.
From my perspective, S&P’s summary point for why the U.S. retains its top rating provided the most contestable aspect of their report: “The economy of the U.S. is flexible and highly diversified, the country's effective monetary policies have supported output growth while containing inflationary pressures, and a consistent global preference for the U.S. dollar over all other currencies gives the country unique external liquidity.”
Clearly, our “flexible and highly diversified” economy was unsuccessful in thwarting a crisis of confidence for much of our private sector debt – a debacle that nearly led to the collapse of our Credit system, stock market and economy back in 2008. And having witnessed our monetary policy propagate a 20-year cycle of booms and busts, I’ll stick to the view that the Federal Reserve is more of a liability than an asset when it comes to prospective debt quality. Loose monetary policy from the Fed accommodated the greatest expansion in mortgage debt in history – and now zero rates and monetization are well on their way to supporting a historic boom in government debt. And, of course, a decade of dollar weakness raises the question as to the true underlying “global preference” for our currency.
There’s going to be one hell of fight in Washington over the details of deficit reduction. With too many eyes on 2012 elections, it’s sure to be a challenging environment – to say the least – to muster bi-partisan compromise. Prospects for any serious near-term spending cuts are slim to none – and the markets are more than fine with this. The marketplace believes it has at least a couple additional years before the debt situation turns problematic (hence, market-impactful). In the meantime, participants are confident that the odds of big – and destabilizing - spending cuts prior to 2013 are slim. This is all in the market.
During the heart of mortgage finance Bubble (2001 through 2007), Total Mortgage Debt expanded about $7.8 TN, or 115%. Mortgage excesses evolved to dominate the workings of the Credit system, becoming the majority of total system Non-Financial Debt growth. This source of finance provided crucial inflationary fuel for home prices, equity extraction, household Net Worth, incomes, corporate earnings/cash flows, government receipts/expenditures, imports and global financial flows. Over time, these flows – and resulting inflationary effects – became deeply embedded in asset prices, incomes, and system-wide expenditures. During each passing year of mortgage excess, myriad distortions more deeply affected the underlying economic structure. And every year the increasingly maladjusted “Bubble Economy” ensured both a more intense addiction to excess - and a more problematic process of weaning away from mortgage Credit. These dynamics, to this day unappreciated by analysts and policymakers, are so crucial for understanding what got us to where we are and for appreciating that we’re repeating a similar process with federal Credit.
Policymakers, the rating agencies and, apparently, the marketplace never recognized how (“Ponzi finance”) Bubble dynamics were distorting price structures throughout the economy. The Credit system doubled mortgage debt and the markets pretended the quality actually improved (the price of mortgage debt increased!). Amazing as it is to contemplate, it seems that virtually no one appreciated the degree of distortions and underlying fragility. In hindsight, it should now be clear that the mortgage finance boom inflated home prices to unsustainable levels. As important, this atypical expansion of finance inflated incomes and government tax receipts, while distorting the pattern of spending and investment (good old fashioned “Austrian” analysis).
I would argue that today’s atypical expansion in federal finance is having crucial, yet less obvious, impacts on incomes, asset prices and expenditures. Ebullient markets are confident in the slow but ongoing healing process thesis (slow is good, ensuring protracted ultra-easy monetary policy). In reality, fragilities quietly and methodically continue to mount. The system is in desperate need of balance and restraint - but is receiving the opposite.
From S&P’s report: “In our baseline macroeconomic scenario of near 3% annual real growth, we expect the general government deficit to decline gradually but remain slightly higher than 6% of GDP in 2013. As a result, net general government debt would reach 84% of GDP by 2013.”
It is worth highlighting that some forecasts for Q1 growth have dropped to as low as 1.5%, a dismal showing considering unrelenting extreme fiscal and monetary stimulus (and resulting stock market gains). Not surprisingly, the boom in federal finance is having a more muted economic impact when compared to that from previous mortgage excess. The mortgage Bubble inflated the perceived Net Worth of most homeowners, while inciting huge booms in construction and consumption. Today’s boom has certainly been instrumental in stabilizing incomes (at an inflated level), although asset price gains are benefiting a narrower cross-section of the general population. Meanwhile, a large portion of the populace is today suffering from meager (negative real) returns on their savings – while losing out to rising inflation.
I’m confident that S&P’s baseline case is too optimistic. “Austerity” at the state and local level – and perhaps even a little from Washington – are poised to restrain an unbalanced recovery. While no one wants to admit as much, U.S. and global economies are increasingly susceptible to highly speculative and unstable global risk markets. And with U.S. private-sector Credit growth remaining almost non-existent, I believe S&P’s and others’ estimates for the growth in federal receipts will prove overly optimistic ("output" financed by federal government borrowing and spending will not resolve fiscal troubles). The odds of a recession over the next few years are not low. And I would argue strongly that the longer the government finance bubble runs the more difficult the adjustment when this vital source of finance is scaled back. At the end of the day, massive expansions of a particular strain of Credit – albeit mortgage, household, corporate, or government – are destabilizing and difficult to normalize from.
And I refuse to take seriously recent intentions to begin addressing this problem until I hear leadership - from the Halls of Congress, from the Oval Office and from both parties – commit to sticking with spending restraint even in the face of recessionary conditions (weak economy and/or markets). This is where the rubber will meet the road. We’re now two years into both an economic recovery and one heck of a market boom, so politicians will talk tough and extrapolate a favorable backdrop. Yet, it wasn’t many months ago that both parties were too willing to go with another round of borrowing and spending stimulus. I fear both parties will have a very difficult time parting ways with the notion of government as economic/market backstop. I’m not sure the public is really ready to part ways.
Greece’s two-year borrowing costs surpassed 23% yesterday. They were around 2% in November 2009, back when markets were more tolerant of sovereign borrowing transgressions. And, yes, I know we’re not Greece. And I’m not suggesting that Treasury borrowing costs are heading to 20%. But just as mortgage risk – as well as sovereign risk for Greece, Portugal, Ireland, and Spain – was mispriced throughout the Bubble period, I expect that there will be re-pricing of Treasury (and related) risk in the future. An over-liquefied marketplace today under-prices Credit, inflation and liquidity risk, in the process accommodating incredible double-digit to GDP deficits. My base-line case has Treasury borrowing costs at some point unsettling Standard & Poor’s, the Congressional Budget Office and the markets.
I’ll argue that today’s debt to GDP ratios are understating the severity of the debt problem in many ways: measures of debt do not include the enormous contingent liabilities; debt service costs have been pushed down by the Federal Reserve and global monetary policies; and GDP is being inflated by government spending excess and a lot of other “output” that won’t support the capacity of our economy to repay its obligations. But like so many aspects of this Bubble, there is gray area enabling the optimists to take the other side of the argument.
The late-nineties technology/Internet Bubble was spectacular, and many (including Mr. Paul Volcker) worried that it was of sufficient scale to bring the system down. Yet, from a Credit standpoint, it really wasn’t systemic. The Bubble fueled huge distortions in the tech sector, boosted home prices in a select group of cities and flooded California with tax receipts (which they quickly spent). The mortgage finance Bubble was the first systemic Bubble – impacting incomes, asset prices, corporate cash flows and government finances throughout the economy. The Creditworthiness of federal debt proved the key – really, the momentous – advantage the system used to survive the bursting of the mortgage/Wall Street Bubble.
The government finance Bubble is the second – and concluding – systemic Bubble. It's bigger in dimensions than the mortgage Bubble and is having more problematic systemic effects on incomes and the financial markets. In particular, acute vulnerabilities resulting from the previous Bubble period now ensure that, in particular, the municipal debt and mortgage markets remain susceptible to any retrenchment in federal spending (or rise in market yields). And, importantly, there is no potential Creditworthy debt issuer of last resort waiting in the wings to bail out the system when market confidence in U.S. government debt falters. Ironically, the bigger the Bubbles get the less conspicuous they appear to most.
S&P puts the odds of a U.S. debt downgrade in the next two years at 33%. Secretary Geithner says it’s zero. I’ll put the probability of a downgrade in the next few years at close to 100%. Until proven otherwise, I’m going to presume that policymakers will at some point come to the recognition that the economy and markets are vulnerable. They will choose to hold off on the difficult decisions - that is, until the markets force their hands.