For the week, the S&P500 sank 3.9% (up 2.75% y-t-d), and the Dow dropped 4.2% (up 4.9%). The Banks lost 3.8% (down 11.9%), and the Broker/Dealers declined 3.4% (down 13.2%). The Morgan Stanley Cyclicals were hit for 5.6% (down 3.0%), and the Transports sank 4.5% (up 1.5%). The Morgan Stanley Consumer index fell 3.7% (down 1.8%), and the Utilities dropped 2.0% (up 5.2%). The S&P 400 Mid-Caps were slammed for 4.9% (up 4.0%), and the small cap Russell 2000 was down 5.3% (up 1.7%). The Nasdaq100 declined 2.7% (up 6.5%), and the Morgan Stanley High Tech index dropped 4.2% (down 4.4%). The Semiconductors sank 5.3% (down 6.0%). The InteractiveWeek Internet index dropped 4.0% (down 0.8%). The Biotechs sank 7.1% (up 4.3%). Although bullion jumped $26 to yet another record high, the HUI gold index was hit for 6.0% (down 5.2%).
One-month Treasury bill rates ended the week at 17 bps and three-month bills closed at 9 bps. Two-year government yields declined 3 bps to 0.36%. Five-year T-note yields ended the week down 15 bps to 1.36%. Ten-year yields fell 16 bps to 2.80%. Long bond yields dropped 14 bps to 4.12%. Benchmark Fannie MBS yields declined 12 bps to 3.81%. The spread between 10-year Treasury yields and benchmark MBS yields increased 4 to 101 bps. Agency 10-yr debt spreads were little changed at negative 9 bps. The implied yield on December 2012 eurodollar futures dropped 10.5 bps to 0.725%. The 10-year dollar swap spread increased 3 to 10.75 bps. The 30-year swap spread increased 2 bps to negative 31.25 bps. Corporate bond spreads widened. An index of investment grade bond risk increased 3 bps to 96 bps. An index of junk bond risk jumped 32 bps to 495 bps.
Investment-grade issuers included JPMorgan $3.9bn, Caterpillar $750 million, and Goldman Sachs $500 million.
Junk bond funds saw inflows of $304 million (from Lipper). Junk issuers included HCA $5.0bn, Reynolds Group $2.5bn, Amerigas $450 million, Academy LTD $450 million, Antero Resources $400 million, and Precision Drilling $400 million.
Convertible debt issuers included BGC Partners $135 million.
International dollar bond issuers included Bank of Nova Scotia $2.0bn, and China Resources Land $1.0bn.
German bund yields sank 29 bps to 2.54% (down 42bps y-t-d), and U.K. 10-year gilt yields fell 25 bps this week to 2.86% (down 65bps). Greek two-year yields ended the week up 533 bps to 31.62% (up 1,938bps). Greek 10-year note yields rose 29 bps to 14.48% (up 202bps). Italian 10-yr yields jumped 47 bps to 5.86% (up 104bps), and Spain's 10-year yields rose 32 bps to 6.06% (up 62bps). Ten-year Portuguese yields added 6 bps to 10.55% (up 397bps). Irish yields dropped 101 bps to 10.62% (up 157bps). The German DAX equities index declined 2.3% (up 3.5% y-t-d). Japanese 10-year "JGB" yields declined 2 bps to 1.08% (down 4bps). Japan's Nikkei slumped 3.0% (down 3.9%). Emerging markets were mostly lower. For the week, Brazil's Bovespa equities index fell 2.4% (down 15.1%), while Mexico's Bolsa added 0.7% (down 6.6%). South Korea's Kospi index declined 1.8% (up 4.0%). India’s equities index dropped 2.8% (down 11.3%). China’s Shanghai Exchange fell 2.5% (down 3.8%). Brazil’s benchmark dollar bond yields dropped 21 bps to 3.74%, and Mexico's benchmark bond yields fell 17 bps to 3.71%.
Freddie Mac 30-year fixed mortgage rates increased 3 bps to 4.55% (up one basis point y-o-y). Fifteen-year fixed rates were unchanged at 3.66% (down 34bps y-o-y). One-year ARMs declined 2 bps to 2.95% (down 69bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up one basis point to 5.0% (down 42bps y-o-y).
Federal Reserve Credit dipped $2.0bn to $2.853 TN. Fed Credit was up $445bn y-t-d and $541bn from a year ago, or 23.4%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 7/27) dipped $836 million to $3.453 TN. "Custody holdings" were up $102.8bn y-t-d and $307.4bn from a year ago, or 9.8%.
Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $1.617 TN y-o-y, or 19.2% to a record $10.063 TN. Over two years, reserves were $3.038 TN higher, for 43% growth.
M2 (narrow) "money" supply jumped another $34bn to a record $9.293 TN. "Narrow money" has expanded at a 9.3% pace y-t-d and 7.9% over the past year. For the week, Currency increased $1.6bn. Demand and Checkable Deposits dipped $1.2bn, while Savings Deposits surged $41.3bn. Small Denominated Deposits declined $3.7bn. Retail Money Funds dropped $4.0bn.
Total Money Fund assets dropped $37.5bn last week to $2.634 TN. Money Fund assets were down $176bn y-t-d, with a decline of $166bn over the past year, or 5.9%.
Total Commercial Paper outstanding declined $2.8bn to $1.205 Trillion. CP was up $236bn y-t-d, or 35% annualized, with a one-year rise of $104bn.
Global Credit Market Watch:
July 26 – Financial Times (Peter Spiegel): “Did the eurozone’s presidents and prime ministers understand the Greek rescue package they signed up to on Thursday after an eight-hour emergency summit in Brussels? That was the question buzzing around the European Council’s headquarters for hours after leaders returned to their hotel suites, since senior aides from the key capitals spent much of the night giving conflicting accounts of what, exactly, the surfeit of numbers meant. It would be easy to chalk up the confusion to yet another example of the European Union’s inability to communicate to financial markets. Except that days after the deal was struck, confusion still reigns.”
July 27 – Wall Street Journal (Tom Lauricella, Katy Burne and David Enrich): “Banks and investors relying on credit-default swaps to protect themselves against a European government reneging on its debt payments suddenly are finding that the insurance isn't such a sure thing after all. European leaders went to great lengths to ensure their planned Greek restructuring doesn't constitute a default that would trigger CDS payouts, even though holders of Greek bonds are likely to lose money on their investments. That would mean that, at least for now, the credit-default swap contracts, or CDS, won't pay out, rendering the protection essentially worthless. Under the worst-case scenario, European and U.K. banks using CDS to hedge against defaults by other debt-strapped euro-zone countries aren't as protected as they or their investors think. That is especially the case for debt issued by Portugal and Ireland, where some analysts say the Greek plan could be used as a template for any default by those countries. A default by Greece without triggering CDS payouts ‘is weakening the banks and increasing the losses’… said Silvio Peruzzo, an economist at Royal Bank of Scotland…”
July 27 – Bloomberg (Rainer Buergin and Brian Parkin): “The German government rejects a ‘blank check’ for the European Financial Stability Facility to buy bonds of troubled euro members in the secondary market, Finance Minister Wolfgang Schaeuble said. ‘In the future such purchases must only take place under very tight conditions, when the ECB establishes that there are extraordinary circumstances in financial markets and dangers to financial stability,’ Schaeuble said…. The comments echo remarks by Chancellor Angela Merkel, who said one day after the summit that she’s opposed to allowing the region’s 440 billion euro ($637 billion) fund ‘unconditioned’ bond-buying in the secondary market…”
July 27 – Bloomberg (Lucy Meakin and Paul Dobson): “Italian and Spanish government bonds declined, increasing the yield relative to benchmark German bunds, on speculation Europe’s aid package may not be sufficient to prevent contagion… ‘If you look into the details of the EU summit decision, it doesn’t take you long to get to where the weak points are,’ said Marius Daheim, a senior fixed-income strategist at Bayerische Landesbank… ‘You still have two countries that are too big to save and are not effectively protected from negative market sentiment. The U.S. debt crisis is also a factor that supports German bunds.’”
July 27 – Bloomberg (Lorenzo Totaro): “Italian business confidence fell more than economists predicted in July amid signs the recovery in the euro region’s third-biggest economy is losing pace. The manufacturing-sentiment index dropped to 98.5 from a 100.5 in June, a fourth consecutive monthly decline…”
July 27 – Bloomberg (Emma Ross-Thomas and Sharon Smyth): “Castilla-La Mancha, which has Spain’s biggest regional deficit, aims to slash the shortfall fivefold this year without raising taxes as it stays shut out of debt markets, President Maria Dolores de Cospedal said. Cospedal said in an interview today she will seek to shrink a deficit that reached 6.5% of regional gross domestic product last year to meet a goal of 1.3% in 2011.”
July 25 – Bloomberg (Marcus Bensasson and Shamim Adam): “Greece’s credit rating was cut three steps by Moody’s… which said the European Union’s rescue for the debt-laden nation will cause substantial losses for investors and amount to a default.”
July 27 – Bloomberg (Sarah Mulholland): “Deutsche Bank AG and UBS AG cut a $2.2 billion sale of commercial-mortgage backed securities by more than 36% as investors pull back amid a rush of offerings from Wall Street banks. The lenders, unable to close all the planned loans to be bundled into the transaction after yields on the debt rose, reduced the deal to $1.4 billion…”
July 27 – Bloomberg (Ye Xie and Ney Hayashi): “Brazil’s Treasury is exacerbating a slump in the country’s bond market by selling the most fixed-rate debt in three months as inflation soars to a six-year high. The government sold 2.8 billion reais ($1.8 billion) of the notes… in July, up 5.4% from the previous month… The yield on the government’s bonds due in 2017 rose 35 basis points in the past month and reached 12.81% on July 25…”
Global Bubble Watch:
July 27 – Bloomberg (John Detrixhe and Tom Keene): “The U.S. faces ‘massive consequences’ if a failure by lawmakers to lift a ceiling on the nation’s debt leads to a default and loss of its top rating, Pacific Investment Management Co.’s Mohamed El-Erian said. While a credit-rating downgrade likely wouldn’t cause credit markets to freeze as they did after Lehman Brothers Holdings Inc.’s collapse in 2008, the world’s largest economy would experience ‘headwinds’ to growth and employment, already in a crisis, El-Erian… said… ‘If the U.S. defaults, there would be massive consequences… People are concerned, but they sort of think it’s a very, very low probability, and we would agree.’”
July 25 – Bloomberg (Peter Millard): “Petroleo Brasileiro SA, Brazil’s state-controlled oil producer, said it will boost debt and sell assets after approving a $224.7 billion investment plan. Petrobras… will raise as much as $91 billion in debt and sell up to $13.6 billion of assets as part of the spending program for 2011 through 2015…”
July 27 – Bloomberg (Kelly and Laura Keeley): “Private-equity firms are working to convince lawmakers they’re different from Wall Street banks and hedge funds as they seek to avoid additional regulation proposed in response to the 2008 financial-industry bailouts… Private-equity managers and their lobbyists have sought to show that buyout funds are designed as long-term investments whose failure wouldn’t ripple through financial markets.”
Currency Watch:
July 25 – Bloomberg (Mark Gilbert and Paul Dobson): “Brazil, China, Mexico and other so-called emerging economies would make better European Monetary Union members than the nations currently sharing the euro, based on the economic criteria countries are supposed to meet. Only nations whose budget deficits are 3 percent or less of gross domestic product and can achieve a debt-to-GDP ratio of 60% or better are meant to qualify for the common currency. After revisions to historical data, Greece has never complied, and last year even Germany failed to make the cut. South Korea and Indonesia are among nations that do satisfy requirements.”
The U.S. dollar index slipped 0.6% this week to 73.745 (down 6.7% y-t-d). For the week on the upside, the Swiss franc increased 4.3%, the Japanese yen 2.3%, the New Zealand dollar 1.7%, the Australian dollar 1.3%, the South African rand 1.2%, the Swedish krona 0.9%, the British pound 0.8%, the Norwegian krone 0.7%, the Singapore dollar 0.4%, the Danish krone 0.3%, the euro 0.3%, and the Brazilian real 0.2%. On the downside, the Taiwanese dollar declined 0.2%, the South Korean won 0.2%, the Canadian dollar 0.8%, and the Mexican peso 0.8%.
Commodities and Food Watch:
July 25 – Bloomberg (Margot Habiby): “The biggest bet in the oil market has become a 20% increase to $120 by the end of the year as global growth drives demand for raw materials. The number of contracts held by traders in options to buy West Texas Intermediate crude at $120 a barrel in December totaled 45,502 lots on the New York Mercantile Exchange as of July 21, 4,226 lots more than the next-highest wager, which is for $125. Open interest in the two contracts jumped 29% in the past four weeks…”
The CRB index declined 1.7% this week (up 2.5% y-t-d). The Goldman Sachs Commodities Index dropped 2.2% (up 8.6%). Spot Gold gained 1.7% to a record $1,628 (up 14.6%). Silver slipped 0.6% to $39.88 (up 29%). September Crude sank $4.0 to $95.87 (up 5%). September Gasoline declined 1% (up 25%), while September Natural Gas jumped 5.3% (down 1%). September Copper rallied 1.7% (up 1%). September Wheat dropped 2.9% (down 15%), and September Corn fell 3.6% (up 6%).
China Bubble Watch:
July 27 – Bloomberg: “Chinese industrial companies’ profits grew at a faster pace even after the government raised interest rates and tightened credit to counter inflation. Net income climbed 28.7% in the first six months to 2.41 trillion yuan ($374 billion) from a year earlier… The International Monetary Fund forecasts that China’s gross domestic product will rise 9.6% this year, also bolstered by a government plan to build millions of low-cost homes. ‘This is surprising and adds to signs that any slowdown in the economy will be only moderate,’ said Lu Zhengwei, an economist at Industrial Bank… ‘The government’s social housing program may be part of the explanation.’”
July 25 – Bloomberg (Andrea Wong): “Bonds of China’s Ministry of Railways, the nation’s biggest issuer of corporate debt, are heading for their longest losing streak since 2008 as it struggles to sell notes amid a record cash crunch… Demand for its bonds is being sapped as the central bank drains cash from the financial system to damp the fastest inflation in three years. The railway builder has been forced to slow construction of its high-speed network, three weeks after opening the 1,318-kilometer (819-mile) Beijing to Shanghai line…”
India Watch:
July 27 – Bloomberg (Kartik Goyal): “Reserve Bank of India Deputy Governor Subir Gokarn signaled that a move by the government to boost spending on health care and food risks adding to inflation pressures without steps to pay for it, forcing the central bank to respond with higher interest rates. ‘If it comes in a way in which government commitments increase without their ability to finance them, then it is a problem,’ Gokarn said… ‘Inflation pressures mount and in which case the response of the central bank is to use the only instrument that it effectively has, which is the interest rate.’”
July 27 – Bloomberg (Kartik Goyal): “The Reserve Bank of India signaled it’s prepared to accept a slower expansion to pull down an inflation rate that risks causing a crash in the pace of growth in Asia’s third-largest economy if left unchecked. The RBI yesterday surprised all 22 economists surveyed by Bloomberg News with a half-point boost in the repurchase rate to 8%. The bank said in a statement that stronger action was needed in the absence of government steps to damp demand or efforts to address the nation’s supply bottlenecks.”
Asia Bubble Watch:
July 27 – Bloomberg (Lilian Karunungan and David Yong): “Asian currencies rose to a 14-year high on speculation policy makers will lift interest rates to keep inflation under control, increasing the yield advantage of regional assets. Malaysia’s ringgit led gains after Bank Negara Malaysia Governor Zeti Akhtar Aziz said July 25 that taming inflation is ‘critical’… South Korea’s won climbed to its strongest level in almost three years after the government said yesterday it will make an ‘all-out’ effort to limit consumer-price increases to 4% this year.”
July 27 – Bloomberg (Eunkyung Seo and Rose Kim): “South Korea’s economy expanded at a slower pace in the second quarter as a stronger won and Europe’s fiscal crisis weighed on exports. Gross domestic product rose 0.8% from the previous quarter, when it advanced 1.3%, the Bank of Korea said… The economy grew 3.4% from a year earlier, slower than estimates of a 3.5% expansion.”
July 25 – Bloomberg (Chinmei Sung): “Taiwan’s industrial production rose in June at the slowest pace since the 2009 recession… Output advanced 3.61% from a year earlier, after climbing a revised 7.56% in May…”
July 25 – Bloomberg (Shamim Adam and Sarina Yoo): “Singapore’s inflation accelerated to the fastest pace since January as food and housing costs increased… The consumer price index rose 5.2% last month from a year earlier…”
July 25 – Bloomberg (Gan Yen Kuan and Shamim Adam): “Malaysia’s central bank said addressing accelerating inflation is ‘critical’ as rising prices would undermine growth prospects. Price gains in Malaysia are largely due to ‘very high’ energy and commodity costs, Bank Negara Malaysia Governor Zeti Akhtar Aziz told reporters…”
July 27 – Bloomberg (Suttinee Yuvejwattana): “The Bank of Thailand said inflation risks exceed threats to economic expansion and signaled planned spending by the nation’s incoming leader, Yingluck Shinawatra, may add to price pressures. The monetary policy committee ‘judged that the risks to inflation outweighed the risk to growth especially in light of continued fiscal stimulus, which may add to inflationary pressure’… Yingluck’s pledge to increase the minimum wage, cut taxes and provide free computers propelled her to a clear victory in Thailand’s July 3 general election.”
Latin America:
July 27 – Bloomberg (Matthew Bristow): “Credit in Brazil’s economy last month continued to expand at its fastest pace of 2011, failing to respond to efforts by the government to slow its growth. Total outstanding credit rose 1.6% in June to 1.834 trillion reais ($1.17 trillion)… Total credit rose 20% from a year ago, led by a 50% increase in mortgage credit. ‘The fact that labor markets are still so strong may explain continued credit demand,’ said Gustavo Rangel, chief Brazil economist for ING Financial Markets… ‘Wages and employment are growing fast, and as a result the ability to get into debt is also expanding.’”
July 25 – Bloomberg (Matthew Bristow): “Economists covering Brazil raised their 2012 inflation forecast to the highest ever… Consumer prices will rise 5.28% next year, according to the median forecast in a July 22 central bank survey of economists…”
July 27 – Bloomberg (Jose Enrique Arrioja): “Mexico’s economy grew about 4.55% in May from a year earlier, the national statistics agency said…”
Unbalanced Global Economy Watch:
July 27 – Bloomberg (Jana Randow and Jeff Black): “Inflation in five German states accelerated in July as food and energy prices rose. The inflation rate increased to 2.3% from 2.1% in Bavaria and to 2.7% from 2.5% in North Rhine-Westphalia… The rates in Saxony, Hesse and Brandenburg also climbed.”
July 25 – Bloomberg (Charles Penty): “Spain is slowing transfers to regional governments that are in deficit, El Pais reported. Agreed transfers have dropped 35% in the year through May to 370 million euros ($532 million) as the finance ministry puts the brake on projects such as rural development and libraries, the newspaper said, citing government accounts.”
July 25 – Bloomberg: “Iceland’s annual inflation quickened to 5% in July from 4.2% reported in June, the Reykjavik-based statistics office said in a statement on its website today. Consumer prices rose 0.1% from a month earlier, it said.”
July 27 – Bloomberg (Selcuk Gokoluk): “Turkey’s economy is probably heading for a ‘hard landing,’ and it’s difficult to anticipate what the country’s future credit rating or outlook may be, Standard & Poor’s said. S&P is watching measures against Turkish ‘overheating,’ which could include a higher ex-interest budget surplus and a fall in debt ratios, analyst Frank Gill said… ‘If the debt flows stop coming into the economy and if the economy comes to a hard landing and slows down really rapidly, which we think is likely, that could really hit public finances,’ Gill said.”
July 25 – Bloomberg (Rudy Ruitenberg): “Famine in the Horn of Africa that has killed tens of thousands of people risks leaving a generation of physically and mentally stunted children, the United Nations’ World Food Programme said. ‘We face the prospect of a generation of children whose brains and bodies will be damaged if we cannot reach them with lifesaving nutritional support,’ Josette Sheeran, the WFP’s executive director, said… The east African region has suffered from two poor rainy seasons that have caused one of the worst droughts since 1950-51…”
U.S. Bubble Economy Watch:
July 25 – Bloomberg (Sarah Mulholland): “A cut in the U.S. government’s AAA grade could force investors to sell asset-backed securities tied to student loans, causing spreads to widen ‘significantly,’ according to Citigroup Inc. ‘A ratings downgrade would be a significant blow’ to the $250 billion government-guaranteed sector, Citigroup analysts led by Mary Kane said… ‘The likelihood of forced selling is elevated.’”
July 25 – Bloomberg (Alan Bjerga): “Food prices in the U.S. may be rising faster than the government forecast as companies including Coca-Cola Co., Safeway Inc. and Chipotle Mexican Grill Inc. pass higher commodity costs on to consumers. Rallies in meat, grain and dairy products since February may mean the increase in food costs will surpass the 3% to 4% that the U.S. Department of Agriculture predicted last month, said Christopher Hurt, an agricultural economist at Purdue University…”
Speculation Watch:
July 26 – Financial Times (Peter Garnham): “Foreign exchange trading volumes in London have risen sharply to record levels… The surge in activity in London came as turnover in New York and on electronic broking platforms remained relatively stable, suggesting that London banks were strengthening their hold on the world’s largest financial market. Average daily turnover in traditional forex products in London… rose to $2,000bn in April 2011… That was up 25% from the $1,600bn daily volume reported in April 2010 and was driven by a 43% surge in daily spot forex volumes, which climbed from $642bn in April 2010 to $919bn.”
More on Moneyness:
“To UNDERSTAND THE GREAT DEPRESSION is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also – to the extent that is not always fully appreciated – the experience of the 1930s continues to influence macroeconomists’ beliefs, policy recommendations, and research agendas. And, practicalities aside, finding an explanation for the worldwide collapse of the 1930s remains a fascinating intellectual challenge.” Ben S. Bernanke, Journal of Money, Credit and Banking, February 1995
Most economists agree that the Great Depression was associated with a breakdown in the international monetary system. But that’s about where any semblance of consensus ends. Some will argue that monetary factors were “passive” – mostly the inevitable consequence of economic breakdown. Others hold the view that monetary forces were the primary cause of the economic collapse. Contemporaneous economic analysis placed significant responsibility on momentous Credit and speculative excesses from the Roaring Twenties and the inevitable bursting of a historic financial Bubble. As time passed and the analytical (and ideological) focus shifted, many, including the leading economic policymakers of our era, saw the Depression as primarily the consequence of inept U.S. monetary policy in the late-twenties and early-thirties. I view this misdirected analysis as a most dangerous case of “historical revisionism.”
The causes of crises and depressions are incredibly important and pertinent issues – and they are, as well, exceedingly complex. There will be no resolution in what is essentially a one-sided debate. Chairman Bernanke, considered the eminent economic analyst of the Great Depression, has been a long-time “disciple” of the Milton Friedman view that repeated Federal Reserve errors – beginning with ill-timed tightening moves to ward off stock market speculation in 1928 and culminating with a failure to adequately ease policy and ensure sufficient money supply growth after the crash and as bank failures weighed on the system – were the prevailing cause of the Depression.
Then Fed governor Bernanke concluded his November 2, 2002 speech commemorating Milton Friedman’s 90th birthday with the following: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we (the Federal Reserve) did it. We're very sorry. But thanks to you, we won't do it again.”
For more than twenty years now (commencing with aggressive monetary ease to recapitalize the banking system back in 1990), the prevailing objective of Federal Reserve policy has been to ensure that deflationary forces were not allowed to take root. And while these deflation “panics” occurred only on those few occasions when market confidence in the U.S. Credit system waned, Fed alarm and associated policy responses were sufficient to convince the markets that the Fed held a singular top priority. This “asymmetrical” policy bias has been instrumental in distorting the markets’ view of financial excess. The Greenspan/Bernanke Federal Reserve communicated clearly to the markets that the Fed would not intervene to thwart asset Bubbles, but would instead focus on having aggressive “mopping up” measures ready in the event that faltering asset markets risked impacting the real economy. In short, accommodatiive Fed policy incentivized speculation throughout Bubble periods – and the bigger the Bubbles inflated the more speculative profit potential available to financial operators seeking to profit from the government’s “mop up” reflationary measures. And, as we’re witnessing both at home and abroad, the greater the scope of the bust the more confident the markets become that policymaking will factor potential market responses very importantly into all decisions.
We now have an almost three year “mopping up” experience to contemplate. I’ve referred to this period as the “global government finance Bubble.” Sovereigns have issued Trillions upon Trillions of debt, while global central bank balance sheets have inflated somewhere in the neighborhood of $5 Trillion (largely with holdings of government debt). Moreover, governments around the world have both explicitly and implicitly guaranteed Trillions more of private-sector debt and various obligations. The notion of "too big to fail" has evolved from a focus on major financial institutions to the system overall.
Here at home, the mortgage finance market has essentially been nationalized, with combined GSE and FHA obligations continuing to swell. FDIC insurance obligations grow by the week. Washington is assuming additional current and prospective healthcare expenses, and so on. In Europe, debt failure at the “periphery” has added greatly to obligations now weighing on the “core.” It is worth noting that Moody’s this morning addressed the additional cost of European debt bailouts as an important factor behind the deterioration in France’s Credit standing.
On the causes of the Great Depression, I side strongly with the “contemporaneous” view that economic cataclysm emanated primarily from a collapse of what evolved over years into an exceedingly fragile Credit structure. This fragility was primarily the consequence of more than a decade of Credit excess, policy accommodation, reckless speculation, and an economic structure that over time had become dangerously distorted and imbalanced. Similar critical issues haunt the global system today.
Major fissures are developing in the global government finance Bubble. And, to be sure, so-called “mopping up” strategies have become pressing factors in an evolving crisis of confidence in sovereign debt. In Europe, the markets are better appreciating the enormous – and unending – costs associated with bailouts of badly maligned “periphery” Credit systems and economies. And, importantly, markets are seriously questioning the perception that eurozone politicians and central bankers retain the capacity to thwart any crisis that risks the stability of its euro currency. The market distortion that allowed sovereigns from Greece to Italy to borrow at rates inconsistent with their underlying Credit standing has come to a rather abrupt end. Moreover, the market’s reassessment – the repricing of sovereign debt to incorporate more reasonable risk premiums – is illuminating the severe structural debt and economic problems afflicting the region.
Here at home, the politics of dealing with massive deficit spending is illuminating the vulnerability of the market’s unflinching faith in our debt. Similar to Europe, our nation’s debt problem has been festering for many years. But unlike European policymakers, our policymakers have yet to confront debt market confidence issues. In this respect, there is some truth to the notion that this is a self-imposed crisis. On the other hand, Washington is doing its best to test both market perceptions and general complacency, an exercise I last week noted was “playing with fire.”
Debt crises tend to follow a common path: the problem mounts over an extended period, with distorted markets doing an increasingly poor job of adjusting constructively to significantly heightened risk late in the cycle. However, at some critical juncture the pressure becomes too much to bear. Markets will likely react abruptly and, often, in dramatic fashion (think subprime, Greece or, more recently, Italy).
Today’s dismal Q2 GDP data and the Q1 downward revisions provide added confirmation that ongoing massive fiscal and monetary stimulus has had diminished economic impact. I certainly see ample confirmation that economic issues are fundamentally structural, from my viewpoint ensuring that aggressive stimulus (and concomitant distortions) exerts only fleeting boosts. Indeed, there is a strong argument that unprecedented “mopping up” has aggravated structural issues and only delayed economic reform.
The Wall Street Journal’s Greg Ip penned an insightful article back in December 2005, “Lessons of the ‘30s”. “Even as a child, Mr. Bernanke…was intrigued by the Depression.” Mr. Ip conveys a story (recounted in a Bernanke textbook) where Bernanke’s grandmother explains to young Benjamin why “many neighborhood children had to go to school in tattered shoes or barefoot.” When he inquired as to why parents didn’t buy new shoes, grandmother replied that they had lost their jobs when the (shoe) factory shut down. When Ben asked why the factory had closes, she responded “because nobody had the money to buy shoes.”
The “revisionist” view is that the Fed was negligent in the 30’s for not ensuring there was sufficient money in the system. The Fed should have created additional “money” both to recapitalize the banking system and to ensure that there was an ample supply of money available in the economy for consumers to buy shoes and things and for companies to invest. OK. It sounds reasonable enough.
Yet the problem was not so much a lack of money supply as it was a lack of confidence in the entire monetary system. And this gets right to the heart of my issue with “revisionist” analysis and current policymaking doctrine. From my perspective, it seems rather obvious that the root cause of the Great Depression was the collapse of trust in system Credit along with faith in the broader financial apparatus. And I have argued for going on three years now that the utmost (post-mortgage/Wall Street finance Bubble) policy priority should be to safeguard the creditworthiness of the core of our monetary system – government debt obligations in particular. Above everything else, there must be bounds placed on stimulus measures (debt expansion and market intervention/manipulation) to protect the credit standing of our “money” system. Policymakers have gone in an opposite direction, sparing no (current and future “public”) expense pursuing the top priority of supporting asset markets and stimulating economic recoveries.
Importantly, the dangerous flaw in this approach is becoming increasingly apparent. First, tepid economic recoveries in Europe and the U.S. are demonstrating acute vulnerabilities – this despite unprecedented fiscal and monetary stimulus. Second, “core” debt markets are showing the strains associated with a combination of persistent massive deficits and the assumption of more and more typically “non-core” obligations. And whether is it U.S. deficit spending or European bailouts, the further policymakers proceed down the current path the less flexibility they will have to change course.
We are, indeed, witnessing the proverbial “throwing good ‘money’ after bad.” Over the years I have harped on the importance of the notion of “moneyness of Credit.” The past decade notwithstanding, “Moneyness” is a precious commodity. If the market demonstrates great trust in a particular type of financial claim (say, perceptions of liquidity and a store of nominal value), this amounts to “moneyness.” Why is this so important? Because there will be basically insatiable market demand for additional issuance of these claims so long as the market perceives money-like qualities. Throughout history, this special attribute has repeatedly led to over-issuance and attendant consequences. This certainly played a fundamental role in the massive Bubble in (mostly “AAA”) mortgage-related securities.
“Moneyness” continues to play a profound role in the unfolding global government finance Bubble. Markets have accommodated unprecedented issuance of sovereign debt, both on the assumption that this worldwide Credit boom would fuel economic recovery and that global central banks would ensure ongoing ample liquidity and low official interest rates (essentially placing a very elevated floor on sovereign debt prices). The market assumption that massive U.S. stimulus - while good for GDP, corporate profits and stock prices - would pressure the dollar lower has been integral to the global reflationary boom.
The perception of ongoing dollar devaluation has been a critical factor for global sovereign “moneyness” (helping explain why negative U.S./dollar fundamentals have been generally viewed bullishly with respect to global risk markets). A weak greenback ensures the ongoing recycling of dollar liquidity by (primarily Chinese and Asian central banks) global central banks back to the Treasury market. Ongoing dollar devaluation would also continue to entice huge speculative flows to “undollar” assets, including the emerging markets and commodities – fashioning an unusual degree of “moneyness” for securities issued by countries with unimpressive histories of monetary management. And the worse things look for the dollar, the more the world’s new financial powers (accumulators of massive international reserves) would have vested interests in supporting the euro as a competitive store of value to dollars.
So, the markets’ hardened perceptions of “moneyness” owe a great deal to the notions 1) that the Fed will buy as many Treasurys as it deems necessary to sustain abundant market liquidity and support economic recovery; 2) that “developing” economy Credit systems will continue enjoying unprecedented flexibility and capacity; 3) that Asian central banks have too much invested to back away from dollar and Treasury market support; and 4) that China and others will bolster an increasingly fragile euro as a critical counterbalance to the dollar. In sum, markets have viewed global central bankers as sharing a unified interest in sustaining the sovereign Credit boom.
I really worry when I see divergences between headstrong market perceptions of “moneyness” and a marked deterioration in the trend of underlying creditworthiness. Such “gulfs” are the trappings of market dislocations and crises of confidence. I believe this is especially the case currently. Emboldened by past successes, market perceptions have been driven by unrealistic assumptions of the efficacy of government policy measures.
Italian bond yields surged 47 bps this week, as market enthusiasm for Greek bailout II dissipated with an alarmingly short half-life. Meanwhile, negotiations to avoid an August 2nd debt ceiling debacle became only a greater national embarrassment – and the Treasury market enjoyed another rally!
Perceptions of “moneyness” played a major role in nations attaining the capacity to accumulate unmanageable debt loads. And it was not long after market perceptions began to normalize that periphery European sovereigns faced untenable situations. As I’ve written recently, debt loads (from Greece to Italy) were manageable only so long as markets disregarded (mounting) underlying Credit risk. Today, the markets are content to perceive perpetual “moneyness” in Treasury debt. And this guarantees that an insidious impairment to underlying creditworthiness runs unabated. Yes, the Fed has thus far succeeded in ensuring that the system remains flush with “money.” Meanwhile, a dysfunctional market pricing mechanisms ensures that these debt obligations continue to be over-issued in ridiculous quantities. It will be an interesting weekend in Washington.