I have liberally excerpted from Janet Yellen’s July 2 speech to the International Monetary Fund: “Monetary Policy and Financial Stability.” I expect this paper to be critiqued for years (perhaps generations) to come. History will not be kind. For now, exuberant markets see Yellen’s comments as confirmation that she’s determined to keep the punchbowl flowing. It is worth noting that Yellen’s dovish doctrine was presented with U.S. stock prices at record highs; corporate debt spreads at lows since 2007, record-pace corporate debt issuance, record-pace CLO issuance, the most robust IPO market since 2000 and the strongest M&A activity since 2007. Take it away Dr. Yellen,
"In my remarks, I will argue that monetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macro-prudential approach to supervision and regulation needs to play the primary role. Such an approach should focus on "through the cycle" standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities. These efforts should be complemented by the use of countercyclical macro-prudential tools, a few of which I will describe. But experience with such tools remains limited, and we have much to learn to use these measures effectively.
I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macro-prudential measures to address these and other financial stability concerns. Accordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability. Because of this possibility, and because transparency enhances the effectiveness of monetary policy, it is crucial that policymakers communicate their views clearly on the risks to financial stability and how such risks influence the appropriate monetary policy stance. I will conclude by briefly laying out how financial stability concerns affect my current assessment of the appropriate stance of monetary policy…
When considering the connections between financial stability, price stability, and full employment, the discussion often focuses on the potential for conflicts among these objectives. Such situations are important, since it is only when conflicts arise that policymakers need to weigh the tradeoffs among multiple objectives. But it is important to note that, in many ways, the pursuit of financial stability is complementary to the goals of price stability and full employment. A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment…
Despite these complementarities, monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant…
Although it was not recognized at the time, risks to financial stability within the United States escalated to a dangerous level in the mid-2000s. During that period, policymakers--myself included--were aware that homes seemed overvalued by a number of sensible metrics and that home prices might decline, although there was disagreement about how likely such a decline was and how large it might be. What was not appreciated was how serious the fallout from such a decline would be for the financial sector and the macroeconomy. Policymakers failed to anticipate that the reversal of the house price bubble would trigger the most significant financial crisis in the United States since the Great Depression because that reversal interacted with critical vulnerabilities in the financial system and in government regulation…
It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s. At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities I have just described. A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some SIFIs and markets to escape comprehensive supervision; a tighter monetary policy would not have shifted supervisory attention to a macro-prudential perspective; and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector…
A review of the empirical evidence suggests that the level of interest rates does influence house prices, leverage, and maturity transformation, but it is also clear that a tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment. In particular, a range of studies conclude that tighter monetary policy during the mid-2000s might have contributed to a slower rate of house price appreciation. But the magnitude of this effect would likely have been modest relative to the substantial momentum in these prices over the period; hence, a very significant tightening, with large increases in unemployment, would have been necessary to halt the housing bubble. Such a slowing in the housing market might have constrained the rise in household leverage, as mortgage debt growth would have been slower. But the job losses and higher interest payments associated with higher interest rates would have directly weakened households' ability to repay previous debts, suggesting that a sizable tightening may have mitigated vulnerabilities in household balance sheets only modestly…
Furthermore, vulnerabilities from excessive leverage and reliance on short-term funding in the financial sector grew rapidly through the middle of 2007, well after monetary policy had already tightened significantly relative to the accommodative policy stance of 2003 and early 2004. In my assessment, macro-prudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities…
If monetary policy is not to play a central role in addressing financial stability issues, this task must rely on macro-prudential policies… If macro-prudential tools are to play the primary role in the pursuit of financial stability, questions remain on which macro-prudential tools are likely to be most effective, what the limits of such tools may be, and when, because of such limits, it may be appropriate to adjust monetary policy to 'get in the cracks' that persist in the macro-prudential framework…
At this point, it should be clear that I think efforts to build resilience in the financial system are critical to minimizing the chance of financial instability and the potential damage from it. This focus on resilience differs from much of the public discussion, which often concerns whether some particular asset class is experiencing a 'bubble' and whether policymakers should attempt to pop the bubble. Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical…
First, it is critical for regulators to complete their efforts at implementing a macro-prudential approach to enhance resilience within the financial system, which will minimize the likelihood that monetary policy will need to focus on financial stability issues rather than on price stability and full employment…
Second, policymakers must carefully monitor evolving risks to the financial system and be realistic about the ability of macro-prudential tools to influence these developments…
In recent years, accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector…
Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macro-prudential approach…
Conclusion: In closing, the policy approach to promoting financial stability has changed dramatically in the wake of the global financial crisis. We have made considerable progress in implementing a macro-prudential approach in the United States, and these changes have also had a significant effect on our monetary policy discussions. An important contributor to the progress made in the United States has been the lessons we learned from the experience gained by central banks and regulatory authorities all around the world…”
When considering the connections between financial stability, price stability, and full employment, the discussion often focuses on the potential for conflicts among these objectives. Such situations are important, since it is only when conflicts arise that policymakers need to weigh the tradeoffs among multiple objectives. But it is important to note that, in many ways, the pursuit of financial stability is complementary to the goals of price stability and full employment. A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment…
Despite these complementarities, monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant…
Although it was not recognized at the time, risks to financial stability within the United States escalated to a dangerous level in the mid-2000s. During that period, policymakers--myself included--were aware that homes seemed overvalued by a number of sensible metrics and that home prices might decline, although there was disagreement about how likely such a decline was and how large it might be. What was not appreciated was how serious the fallout from such a decline would be for the financial sector and the macroeconomy. Policymakers failed to anticipate that the reversal of the house price bubble would trigger the most significant financial crisis in the United States since the Great Depression because that reversal interacted with critical vulnerabilities in the financial system and in government regulation…
It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s. At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities I have just described. A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some SIFIs and markets to escape comprehensive supervision; a tighter monetary policy would not have shifted supervisory attention to a macro-prudential perspective; and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector…
A review of the empirical evidence suggests that the level of interest rates does influence house prices, leverage, and maturity transformation, but it is also clear that a tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment. In particular, a range of studies conclude that tighter monetary policy during the mid-2000s might have contributed to a slower rate of house price appreciation. But the magnitude of this effect would likely have been modest relative to the substantial momentum in these prices over the period; hence, a very significant tightening, with large increases in unemployment, would have been necessary to halt the housing bubble. Such a slowing in the housing market might have constrained the rise in household leverage, as mortgage debt growth would have been slower. But the job losses and higher interest payments associated with higher interest rates would have directly weakened households' ability to repay previous debts, suggesting that a sizable tightening may have mitigated vulnerabilities in household balance sheets only modestly…
Furthermore, vulnerabilities from excessive leverage and reliance on short-term funding in the financial sector grew rapidly through the middle of 2007, well after monetary policy had already tightened significantly relative to the accommodative policy stance of 2003 and early 2004. In my assessment, macro-prudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities…
If monetary policy is not to play a central role in addressing financial stability issues, this task must rely on macro-prudential policies… If macro-prudential tools are to play the primary role in the pursuit of financial stability, questions remain on which macro-prudential tools are likely to be most effective, what the limits of such tools may be, and when, because of such limits, it may be appropriate to adjust monetary policy to 'get in the cracks' that persist in the macro-prudential framework…
At this point, it should be clear that I think efforts to build resilience in the financial system are critical to minimizing the chance of financial instability and the potential damage from it. This focus on resilience differs from much of the public discussion, which often concerns whether some particular asset class is experiencing a 'bubble' and whether policymakers should attempt to pop the bubble. Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical…
First, it is critical for regulators to complete their efforts at implementing a macro-prudential approach to enhance resilience within the financial system, which will minimize the likelihood that monetary policy will need to focus on financial stability issues rather than on price stability and full employment…
Second, policymakers must carefully monitor evolving risks to the financial system and be realistic about the ability of macro-prudential tools to influence these developments…
In recent years, accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector…
Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macro-prudential approach…
Conclusion: In closing, the policy approach to promoting financial stability has changed dramatically in the wake of the global financial crisis. We have made considerable progress in implementing a macro-prudential approach in the United States, and these changes have also had a significant effect on our monetary policy discussions. An important contributor to the progress made in the United States has been the lessons we learned from the experience gained by central banks and regulatory authorities all around the world…”
It was tempting to write “The Fed never learns.” But I fear the truth is that they are not even attempting to learn from previous mistakes. I always believed the Greenspan era was one of progressively intrusive activism and attendant obfuscation. The Fed was looking for excuses to spur market and economic booms. I saw Dr. Bernanke as the over-confident academic with a terribly flawed analytical framework and economic doctrine. He was the sophisticated inflationist brought in to provide the Fed the framework for post-tech Bubble reflation (in the name of fighting the “scourge of deflation”). Bernanke was in over his head, and his real world monetary experiment got completely away from him. The crisis pushed him deep into obfuscation. In chair Yellen I see the trusted grandmotherly approach to rank obfuscation. I simply don’t buy it.
In Yellen’s paper, she focuses on the “housing Bubble” period. Even in hindsight, the Fed apparently sees no problem with its monetary policy throughout this period. “…Tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment.”
Objective analysis would question a fundamental premise from that fateful (mortgage finance) Bubble period: the Bernanke Doctrine – that monetary policy should ignore Bubbles and instead be prepared for aggressive post-Bubble “mopping up” measures, as necessary. Clearly, ignoring Bubbles was an unmitigated disaster – although this should have already been readily apparent after the nineties' experience.
Dr. Bernanke crafted sophisticated analysis in support of his doctrine that the Fed should be out of the Bubble popping business. He was never held accountable. Today, similar doctrine holds that so-called “macro-prudential” regulation basically ensures that monetary policy will not be employed to ward off Bubble excess.
The 1994 “bond” market bust should have provided ample evidence that the Fed better think twice before again aggressively manipulating interest rates, stoking market excess and nurturing mis-priced finance. Instead, the '94 spike in market yields taught the Fed that they should move with extreme caution and go to great pains to forewarn the marketplace before any effort to “tighten” monetary policy. This “lesson” greatly contributed to the mortgage finance Bubble episode. Clearly, the Fed waited much too long to tighten policy – and having fallen “behind the curve” our central bank was then unwilling to raise rates to the point where it impinged Credit growth and market excess.
Had the Fed moved when mortgage Credit first began to expand rapidly, I have no doubt that monetary policy could have reined in lending and speculating excess. But there was a major problem: The Fed had specifically targeted rapid mortgage lending as central to their efforts to reflate system Credit and stimulate the real economy. Indeed, policy activism (inflationism) made it impractical to rein in (or even “lean against”) mortgage and speculative excesses until it was too late – until “Terminal Phase” excess and attendant systemic fragilities ensured timid (ineffective) policy measures.
Monetary policy doesn’t have to be a “blunt tool.” It only becomes a blunt instrument when excesses have been allowed to engender significant financial distortions and economic imbalances.
“Moneyness of Credit” was integral to my analysis back during the mortgage finance Bubble period. Essentially, the Fed, the GSEs, securitizations and derivatives all worked in concert to turn endless amounts of risky loans into perceived “money-like” financial instruments. By the end of the Bubble period, Trillions of dollars of finance had been created – and were subject to mis-pricing in the marketplace. A day of reckoning was unavoidable. Yet so long as enormous amounts of new mortgage Credit were forthcoming, home prices continued rising, households kept spending and Wall Street was still dancing – things looked relatively sound and sustainable. The precariousness associated with a historic mis-pricing of finance remained unrecognized.
Throughout this post-mortgage finance Bubble reflation, all the grave mistakes from the post-tech Bubble reflation have been committed on a much grander scale. In contrast to post-tech Bubble reflation that targeted mortgage Credit, a desperate Federal Reserve (and global central bank cohorts) this time around used the inflation of securities (prices and issuance) more generally – stocks, Treasuries, MBS and corporate Credit. Once again, the precariousness remains unrecognized. These days, it’s a virtual miracle. But historic asset inflation and Bubbles will not work in reverse.
After five years, the proliferation of all varieties of instruments, products and strategies have combined with Fed policies and market assurances to create the perception of “moneyness” for all types of risk assets. Endless cheap liquidity, inexpensive risk insurance and profound faith in central bank market backstops have evolved into an all-powerful market phenomenon – I would argue history’s greatest mis-pricing of finance. And epic misperceptions and securities mis-pricing remain completely outside the purview of the Fed’s so-called “macroprudential” tools. Dr. Yellen, you just condoned “Terminal Phase” excesses – including one heck of a speculative melt-up/equities market dislocation.
For the Week:
The S&P500 gained 1.2% (up 7.4% y-t-d), and the Dow rose 1.3% (up 3.0%). The Utilities sank 3.3% (up 10.7%). The Banks rallied 1.5% (up 4.5%), and the Broker/Dealers jumped 2.1% (up 1.2%). The Morgan Stanley Cyclicals were up 1.9% (up 9.7%), and the Transports gained 1.5% (up 12.1%). The S&P 400 Midcaps added 1.2% (up 7.6%), and the small cap Russell 2000 jumped 1.6% (up 3.8%). The Nasdaq100 gained 2.0% (up 9.2%), and the Morgan Stanley High Tech index jumped 2.0% (up 8.1%). The Semiconductors surged 3.4% (up 21.6%). The Biotechs jumped 3.3% (up 22.5%). With bullion gaining $4, the HUI gold index was 1.3% higher (up 21.3%).
One- and three-month Treasury bill rates ended the week at one basis point. Two-year government yields gained five bps to a ten-month high 0.51% (up 13bps y-t-d). Five-year T-note yields jumped 10 bps to 1.74% (up 10bps). Ten-year Treasury yields rose 10 bps to 2.64% (down 39bps). Long bond yields jumped 10 bps to 3.47% (down 50bps). Benchmark Fannie MBS yields surged 14 bps to 3.32% (down 29bps). The spread between benchmark MBS and 10-year Treasury yields widened four to 68 bps. The implied yield on December 2015 eurodollar futures jumped 11 bps to 1.065%. The two-year dollar swap spread increased one to 14 bps, while the 10-year swap spread was little changed at 10 bps. Corporate bond spreads narrowed. An index of investment grade bond risk declined two to 55 bps. An index of junk bond risk fell six to 293 bps. An index of emerging market (EM) debt risk dropped six to 260 bps.
Debt issuance slowed for the holiday-shortened week. Investment-grade issuers included Oracle $10bn, Goldman Sachs $4.0bn, Anadarko Petroleum $1.25bn and ERAC USA Finance $1.25bn.
Junk issuers included RJS Power Holdings $1.25bn, Jaguar Holding $1.13bn, AmSurg $1.1bn, Altegrity $850 million, New Cotai $550 million and Hub Holdings $350 million.
Convertible debt issuers this week included Starwood Waypoint Residential Trust $200 million.
International dollar debt issuers included Portugal $4.5bn, International Finance Corp $3.0bn, Puma International Financing $1.0bn, Jamaica $800 million, Odebrecht Oil & Finance $550 million, Korea National Oil $550 million, Colbun $500 million, InRetail Shopping Malls $350 million, Ithaca Energy $300 million, VCK Lease $162 million and Barclays $100 million.
Ten-year Portuguese yields increased two bps to 3.58% (down 255bps y-t-d). Italian 10-yr yields were unchanged at 2.83% (down 129bps). Spain's 10-year yields gained four bps to 2.68% (down 147bps). German bund yields were about unchanged at 1.27% (down 66bps). French yields declined one basis point to 1.70% (down 86bps). The French to German 10-year bond spread narrowed one to 43 bps. Greek 10-year yields added a basis point to 5.93% (down 249bps). U.K. 10-year gilt yields jumped 12 bps to 2.76% (down 26bps).
Japan's Nikkei equities index jumped 2.3% (down 5.2% y-t-d). Japanese 10-year "JGB" yields were up a basis point to 0.57% (down 17bps). The German DAX equities index rallied 2.0% (up 4.8%). Spain's IBEX 35 equities index increased 0.5% (up 11.0%). Italy's FTSE MIB index gained 1.1% (up 13.7%). Emerging equities were mostly higher. Brazil's Bovespa index advanced 1.7% (up 5.0%). Mexico's Bolsa surged 2.4% (up 1.9%). South Korea's Kospi index rose 1.1% (down 0.1%). India’s Sensex equities index surged 3.4% to a record high (up 22.6%). China’s Shanghai Exchange gained 1.1% (down 2.7%). Turkey's Borsa Istanbul National 100 index fell 1.2% (up 14.4%). Russia's MICEX equities index increased 0.8% (down 1.0%).
Freddie Mac 30-year fixed mortgage rates slipped two bps to 4.12% (down 17bps y-o-y). Fifteen-year fixed rates were unchanged at 3.22% (down 17bps). One-year ARM rates added two bps to 2.40% (down 28bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates up five bps to 4.58% (down 10bps).
Federal Reserve Credit last week declined $1.6bn to $4.331 TN. During the past year, Fed Credit inflated $886bn, or 25.7%. Fed Credit inflated $1.520 TN, or 54%, over the past 86 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt declined $11.2bn to $3.304 TN. "Custody holdings" were down $50bn year-to-date, with a one-year increase of $18.6bn.
M2 (narrow) "money" supply increased $43.5bn to a record $11.360 TN. "Narrow money" expanded $787bn, or 7.4%, over the past year. For the week, Currency increased $1.3bn. Total Checkable Deposits fell $5.4bn, while Savings Deposits surged $50.6bn. Small Time Deposits were little changed. Retail Money Funds dipped $2.6bn.
Money market fund assets gained $13.1bn to $2.569 TN. Money Fund assets were down $149bn y-t-d and dropped $30bn from a year ago, or 1.1%.
Total Commercial Paper was little changed at $1.054 TN. CP was up $8.2bn year-to-date and $18bn over the past year, or 1.8%.
Currency Watch:
The U.S. dollar index rallied 0.3% to 80.27 (up 0.3% y-t-d). For the week on the upside, the British pound increased 0.7%, the South Korean won 0.5%, the Singapore dollar 0.3%, the Canadian dollar 0.3% and the Taiwanese dollar 0.1%. For the week on the downside, the Swedish krona declined 1.6%, the South African rand 1.6%, the Norwegian krone 1.0%, the Brazilian real 0.9%, the Australian dollar 0.7%, the Japanese yen 0.4%, the Danish krone 0.4%, the euro 0.4%, the Swiss franc 0.4% and the Mexican peso 0.1%.
Commodities Watch:
The CRB index fell 1.3% this week (up 9.5% y-t-d). The Goldman Sachs Commodities Index dropped 1.5% (up 3.3%). Spot Gold added 0.3% to $1,321 (up 9.5%). September Silver was unchanged at $21.14 (up 9%). August Crude fell $1.68 to $104.06 (up 5.7%). August Gasoline dropped 1.8% (up 8%), and August Natural Gas slipped 0.1% (up 4%). July Copper gained 3.5% (down 3%). July Wheat was hit for 2.9% (down 6%). July Corn sank 5.9% (down 1%).
U.S. Fixed Income Bubble Watch:
July 1 – Wall Street Journal (Mike Cherney): “Megadeals… helped push the number of debt sales by highly rated companies in the U.S. to record levels in the first half of the year. These companies sold about $642 billion of debt, according to… Dealogic, which has records going back to 1995. That is more than the $560 billion sold in the first half of last year and outstrips the previous record set in 2009, when $612 billion of bonds was sold…”
July 2 – Dow Jones (Michael Aneiro): “As investors scour the landscape for income, the first half of the year saw record amounts of new corporate bond issuance as well as record issuance of collateralized loan obligations. CLOs are securitized vehicles that invest in bank loans made to junk-rated companies, first pooling the loans and then dividing them into tranches to be sold to investors at varying levels of income and risk. The second quarter produced $35.6 billion of CLO issuance, according to Thomson Reuters LPC, beating the previous record set in the second quarter of 2007, at the height of the last credit cycle. The $58 billion of CLO issuance in the first half of this year puts 2014 on pace to top $100 billion and break the previous single-year issuance record, also set in 2007, per LPC. The pickup in CLO issuance this year has helped support demand for leveraged loans even as individual investors have soured on loans over the past two months.”
July 2 – Wall Street Journal (Matt Wirz): “Moody's… downgraded Puerto Rico's bond rating to B2 from Ba2, which the ratings firm said affects $14.4 billion of outstanding general obligation bonds. The move is a response to Puerto Rico Gov. Alejandro Garcia Padilla's proposal last week of new legislation that would allow the island to overhaul debts of some of its public entities such as its power, water and transportation authorities, said Moody's… Moody's ratings change calls into question contentions by the island's government that other government borrowers wouldn't be negatively affected by restructuring of public-corporation debts… The new legislation, passed last week, doesn't include provisions to restructure general-obligation and tax-backed bonds.”
July 1 – Bloomberg (Michelle Kaske): “The credit rating of Puerto Rico was cut three levels further into junk by Moody’s… as a law allowing some government entities to restructure debt outside bankruptcy failed to contain the U.S. commonwealth’s fiscal crisis. The general-obligation rating went to B2 from Ba2, with the potential for further cuts, according to its release. The change affects $14.4 billion of debt… The Moody’s decision shows that little is certain about what has grown to become a $73 billion obligation for the commonwealth and its agencies. The tax-free debt is held in 66% of U.S. muni mutual funds as the yield created by risk made it a mainstay of U.S. municipal finance.”
July 1 – Bloomberg (Michelle Kaske): “Investor confidence in Puerto Rico’s ability to repay debt is sinking as the cost to protect commonwealth bonds against default has more than doubled since June 12 to the highest ever… The market reflects the uncertainty. It costs about $1.5 million annually, the most ever, to protect $10 million of commonwealth debt for 10 years through credit-default swaps, according to data provider CMA… The crisis reflects a broader malaise in the island commonwealth, whose tax-free debt is held in 66% of U.S. muni mutual funds. Puerto Rico’s economy has struggled to grow since 2006 and its unemployment rate of 13.8% is more than double the U.S. average. About 45% of its residents are in poverty… The commonwealth for years has borrowed to keep its government functioning, and investors hungry for the rewards of risky debt kept lending.”
June 30 – Wall Street Journal (Matt Wirz): “Corporate-bond markets performed well in 2014's first half alongside an unexpected rally in U.S. Treasury debt. Now, many bond-fund managers worry their early gains are too good to last… Average junk-bond yields hit an all-time low of 4.8% in June, while the difference, or spread, between the yield of investment-grade corporate bonds and Treasury bonds dropped below one percentage point for the first time since 2007, according to… Barclays Capital. While low yields are provoking anxiety among some debt buyers, corporations are taking advantage of low borrowing costs to sell a bumper crop of bonds, especially in high-risk categories. Global sales of bonds rated below investment grade hit a first-half high of $286 billion in 2014, fueled by a 39% rise in high-yield bond sales by European companies, according to Dealogic.”
Federal Reserve Watch:
July 2 – Reuters (Michael Flaherty and Howard Schneider): “Monetary policy faces ‘significant limitations’ as a tool to counter financial stability risks, Federal Reserve Chair Janet Yellen said…, adding that heading off the U.S. housing bubble with higher interest rates would have caused major economic damage. Weighing in on a global debate, Yellen reiterated her view that regulation - not rate policy - needs to play the lead role in combating excessive financial risk-taking. The potential cost ... is likely to be too great to give financial stability risks a central role in monetary policy discussions,’ Yellen said at an event sponsored by the International Monetary Fund.”
July 2 – Bloomberg (Craig Torres and Christine Idzelis): “Federal Reserve Chair Janet Yellen said there is no need to change current monetary policy to address financial stability concerns although she sees ‘pockets of increased risk-taking’ in the financial system. In a comprehensive salvo into the worldwide debate among central bankers over whether interest rates are a first-order tool to curb financial excess, Yellen came down against that idea and in favor of regulatory mechanisms. ‘Monetary policy faces significant limitations as a tool to promote financial stability,’ Yellen said… ‘Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach.’ Yellen said the ‘primary role’ should fall to a macroprudential approach, a combination of multiagency oversight, attention to bank capital and liquidity, and regulatory pressure to create buffers against failure.”
U.S. Bubble Watch:
June 29 – Bloomberg (Anchalee Worrachate): “The Federal Reserve has taken some of the sting out of selloffs in Treasuries through its accumulation of government bonds, according to the Bank for International Settlements. Last year’s rout in the securities between May and July generated total losses of $425 billion, equal to about 2.5% of U.S. gross domestic product, the BIS estimated… With the Fed’s holdings softening the blow, private investors incurred only about $280 billion of the costs, or 1.7% of GDP. ‘The valuation losses for public holders of U.S. Treasury securities in 2013 were relatively contained,’ the… BIS said in its annual report.”
June 27 – Fox Business (Katie Roof): “The first half of the year is off to the best start since 2000 for U.S. IPOs, according to Dealogic. There have been 154 IPOs raising $36 billion in the first six months of the year, compared to 235 IPOs and $67 billion in the first half of 2000. Leading the pack with the most IPOs is the healthcare sector, which has seen 55 IPOs raising $4.1 billion, largely stemming from a biotechnology boom. Technology has seen the most volume, with $10 billion raised from 33 offerings… Venture-backed IPOs have had a strong turnout with 63 IPOs, compared to 30 in the first half of last year. The last time venture-backed IPOs had a stronger start was in 2000, with 166 deals priced in the first 6 months. In terms of volume, this has been the best year ever for financial sponsors. Fifty-five private equity-backed IPOs have raised $24 billion so far this year.”
Central Banker Watch:
July 3 – Bloomberg (Johan Carlstrom): “Sweden’s central bank cut its main interest rate by a more-than-estimated half a percentage point and predicted no increases until the end of next year to shield the largest Nordic economy from deflation. The repurchase rate was reduced to 0.25% and the deposit rate to minus 0.5%... The reduction will send ‘a clear signal that monetary policy will ensure that inflation approaches the inflation target within the reasonably near future,’ the bank said.”
June 30 – Bloomberg (Birgit Jennen): “Joerg Asmussen, former European Central Bank Executive Board member, says ECB doesn’t have responsibility to overcome banks’ risk aversion. It’s job of development banks in individual euro-area countries to channel liquidity to private sector. Sees no liquidity problem in euro area in view of targeted ECB measures…”
Geopolitical Watch:
July 1 – New York Times (Rod Nordland): “Sunnis and Kurds walked out of the first session of the Iraqi Parliament on Tuesday, imperiling efforts to form a new government in the face of a bitter offensive by Sunni militants. Underscoring the threat from the militants, the United Nations announced that June had been the deadliest month in Iraq for many years.”
July 1 – Bloomberg (Michelle Kaske): “President Vladimir Putin said Tuesday developments of the Ukrainian crisis testified to Western countries' lasting attempts to contain Russia. ‘We must understand clearly that the developments, provoked in Ukraine, are a concentrated manifestation of the notorious policy of containment,’ Putin told Russian ambassadors and permanent envoys.”
July 1 – Bloomberg (Henry Meyer, Stepan Kravchenko and Anton Doroshev): “Russian President Vladimir Putin accused the U.S. of blackmailing France to scrap a contract to sell Russia Mistral warships by offering to cut a record $8.97 billion fine against BNP Paribas SA. ‘We know about the pressure which our U.S. partners are applying on France not to supply the Mistrals to Russia,’ Putin told Russian diplomats… ‘And we even know that they hinted that if the French don’t deliver the Mistrals, they would quietly get rid of the sanctions against the bank, or at least minimize them,’ he said… ‘What is that if not blackmail?’ Putin said.”
July 1 – Financial Times (Sam Jones): “The industrial control systems of hundreds of European and US energy companies have been infected by a sophisticated cyber weapon operated by a state-backed group with apparent ties to Russia, according to a leading US online security group. The powerful piece of malware known as ‘Energetic Bear’ allows its operators to monitor energy consumption in real time, or to cripple physical systems such as wind turbines, gas pipelines and power plants at will. The well-resourced organisation behind the cyber attack is believed to have compromised the computer systems of more than 1,000 organisations in 84 countries in a campaign spanning 18 months.”
July 3 – Bloomberg (David Tweed): “Admiral Zheng He is everywhere in China these days, even though he died almost 600 years ago. The government is promoting him to remind its people -- and Asia -- that China’s destiny is to be a great naval power. Almost a century before Christopher Columbus discovered America, Zheng in 1405 embarked on a series of voyages with ships of unrivaled size and technical prowess, reaching as far as India and Africa. The expeditions are in the spotlight in official comments and state media as China lays claim to about 90% of the South China Sea and President Xi Jinping seeks to revive China’s maritime pride. In doing so he risks setting up confrontations with Southeast Asian neighbors and the U.S., whose navy has patrolled the region since World War II. Geopolitical dominance of the South China Sea would give China control of one of the world’s most economically and politically strategic areas. ‘The Chinese believe they have the right to be a great power,’ said Richard Bitzinger, a senior fellow at the S. Rajaratnam School of International Studies… ‘What we are seeing is a hardening of China’s stance about its place in the world.’”
June 28 – Bloomberg: “China’s President Xi Jinping reiterated his call for a new security framework for Asia, as the country’s assertion to disputed territory increasingly challenges U.S. alliances in the region. Xi warned against any single power’s attempt to dominate international affairs and said China will never seek hegemony no matter how strong it becomes. He spoke at a conference in Beijing to mark the 60th anniversary of the Five Principles of Peaceful Coexistence, policies that have directed the nation’s external relations since the 1950s. China is seeking to cast itself as a major power in the Asia-Pacific and end decades of U.S. economic and military dominance in the region where it’s embroiled in tussles with Vietnam, Japan and the Philippines over territorial claims. U.S. Defense Secretary Chuck Hagel warned last month that China’s actions in parts of the disputed South China Sea are destabilizing the region.”
July 4 – Bloomberg: “China is replacing imported servers after the successful trial of a local brand by a state-owned bank as the nation steps-up a campaign for information security, the official People’s Daily newspaper reported… Inspur Group Ltd.’s Tiansuo K1 system has replaced imported servers ‘in large quantity’ after its successful use by China Construction Bank Corp.’s Xinjiang branch… The paper is the official newspaper of China’s Communist Party.”
China Bubble Watch:
July 1 – Bloomberg: “China’s Premier Li Keqiang has promised to cut credit while also meeting a 7.5% economic growth target. Record bond sales last quarter show which pledge he’s prioritizing. Issuance jumped 54% from the previous three months to 1.55 trillion yuan ($250 billion)… When Premier Li took office last year he stressed the need for painful reforms to pare the influence of the state, wean industries with overcapacity from debt and ease access to funds for smaller enterprises. The latest filings of more than 4,000 publicly traded non-financial Chinese companies show $2.05 trillion of obligations, up from $1.8 trillion at the end of 2012, with the 10 biggest state-owned borrowers accounting for 18% of the liabilities.”
July 2 – Bloomberg (Michelle Kaske): “Property developers in two of China’s weakest housing markets are offering to buy back homes above the purchase price to boost sales as demand slows. In Hangzhou, where home prices fell the most in May among 70 Chinese cities watched by the government, Shanheng Real Estate Group is giving homebuyers an option to sell back their apartments in five years for 40% above the purchase price. In Wenzhou, DoThink Group is offering to repurchase homes at three of its projects for 120% of the purchase price after three years. The offers are the latest strategy by developers across China, including reducing prices, delaying project launches and offering incentives to potential buyers, as they seek to maintain sales targets.”
July 4 – Bloomberg (Justina Lee): “The threat of financial contagion posed by a repayment bulge this year for China’s trust funds has been delayed rather than dealt with, industry data suggest. Credit Suisse Group AG, analyzing figures from Chinese data provider Wind Information Co., estimates policies are due to repay 1.5 trillion yuan ($241 billion) in the first quarter of next year, compared with the about 1.3 trillion yuan this quarter. Nomura Holdings Inc. also predicts the maturity peak, at about 1 trillion yuan, is now more likely to come in 2015 than this quarter. China’s $1.9 trillion trust fund industry sparked turmoil in emerging markets in January as a near-default prompted Moody’s… to draw parallels to the complex financial instruments that preceded the 2008 financial crisis. The opaque bailout that avoided that failure formed a pattern for subsequent refinancings.”
July 1 – New York Times (Keith Bradsher): “Huge crowds of people held one of the largest marches in Hong Kong’s history on Tuesday to demand greater democracy, defying intermittent tropical downpours and Beijing’s dwindling tolerance for challenges to its control. A nearly solid river of protesters, most of them young, poured out of Victoria Park through the afternoon and into the evening, heading for the heart of the city… By nightfall, protesters were staging a sit-in on Chater Road, in Hong Kong’s central business district, where they vowed to stay until morning… The march came days after nearly 800,000 residents participated in an informal vote on making the selection of the city’s top official more democratic, a vote Beijing dismissed as illegal. It also followed the Chinese cabinet’s release three weeks ago of a so-called white paper that asserted broad central government authority over Hong Kong, angering many residents.”
India Watch:
July 2 – Reuters (Suvashree Dey Choudhury and Siddesh Mayenkar): “India's central bank said… it has sought quotes from banks to swap gold in its own vaults for international-standard gold, aiming to improve the management of its reserves. The Reserve Bank of India said the operation would ‘standardise the gold available with RBI in India with respect to international standards’ and the gold acquired would be delivered to its overseas custodian, the Bank of England… Under the leadership of Governor Raghuram Rajan, appointed last year, the RBI has sought to modernise its market operations and improve the management of gold and foreign currency reserves that are worth a total of around $315 billion.”
Global Bubble Watch:
July 1 – Bloomberg (Adam Janofsky): “ Corporate bond sales worldwide capped the busiest first half of a year on record as borrowers take advantage of investor demand stoked by central banks’ unprecedented stimulus measures. Oracle Corp. and Goldman Sachs… pushed offerings during the first six months of 2014 to $2.29 trillion, beating the previous peak of $2.28 trillion issued during the same period in 2009… Central banks’ actions to depress short-term lending rates have impelled institutional investors to seek higher-yielding company debt.”
June 30 – Wall Street Journal (Dana Cimilluca): “After years of false starts, the mergers-and-acquisitions market finally returned to its pre-financial-crisis health in the second quarter… After fluctuating in a range roughly between $500 billion and $800 billion for three years, global M&A volume broke out. As the quarter drew to a close, $1.06 trillion in announced deals had been struck, the highest total since the second period of 2007, according to Dealogic. Looked at another way, merger volume leapt 72% from the second quarter of last year. The U.S. led the charge, with volume here more than doubling to $472.6 billion. …There have been 20 merger deals valued at more than $10 billion this year, the biggest total for the period since the first half of 2007, according to Dealogic.”
June 20 – Financial Times (Ed Hammond and Arash Massoudi): “Deal frenzy, animal spirits, merger mania – call it what you like, it is back. The value of global mergers and acquisitions hit $1.75tn in the first six months of the year, a 75% rise on the same period last year and the highest since 2007. The increase highlights a shift in thinking in the US, Europe and Asia. Risk aversion and organic expansion, embraced after the financial crisis, are being pushed aside as the belief returns that growth can be more easily bought than built. The value of M&A soared on all three continents during the six months as companies, many flush with cash, took on transactions with vigour. In the US, M&A announced in the year to date stands at $748.5bn, up almost three-quarters on a year earlier. In Asia-Pacific, deals hit $327.8bn, up 85% and the best year-to-date period for dealmaking in the region since Thomson Reuters began recording the data in 1980. In Europe, M&A is back with a bang: the $509bn of deals announced mark a more than doubling over 2013 levels.”
July 3 - CBS MoneyWatch (Constantine Von Hoffman): “Initial public offerings are back, big-time. The first half of 2014 saw a record number of IPOs around the globe, with U.S. companies occupying six of the 10 best-performing initial stock offerings. The first three months saw 82 IPOs, the most of any first quarter since 2000, according to… Renaissance Capital. However, the pace then picked up, and the second quarter saw 127 offerings, tying the record for most launches in any quarter since the heyday of the tech bubble. So far, the total value of this year's IPOs is $90.6 billion. This is an enormous increase over the first half of 2013, which saw 115 launches generate $58.9 billion in value.”
July 3 – Bloomberg (Ian King, Brooke Sutherland and Alex Sherman): “Chipmakers are rushing to find partners or buyers in the busiest year for industry deals since 2011. Almost $11 billion in North American semiconductor transactions were announced in the first half of 2014… At least a dozen more chipmakers have had merger discussions this year, according to people familiar with the companies’ plans.”
June 30 – Bloomberg (John Glover): “Emerging-market companies that took on more than $2 trillion of foreign borrowing since 2008 are vulnerable to an evaporation of funding at the first sign of trouble, according to the Bank for International Settlements. Bond investors willing to lend generously when conditions are good can pull out in a crisis or when central banks tighten monetary policy, analysts led by Claudio Borio, head of the monetary and economic department, wrote… Emerging-market companies that lose access to external debt markets may then be forced to withdraw bank deposits, depriving domestic lenders of funding as well, they said. Low interest rates and central bank stimulus in developed nations, combined with a retreat in global bank lending, have encouraged emerging-market borrowers to raise debt abroad, according to the… BIS… ‘Like an elephant in a paddling pool, the huge size disparity between global investor portfolios and recipient markets can amplify distortions,’ the analysts… ‘It is far from reassuring that these flows have swelled on the back of an aggressive search for yield: strongly pro-cyclical, they surge and reverse as conditions and sentiment change.’”
June 30 – Financial Times (Steve Johnson): “Hedge funds’ correlation with the equity market has risen back to pre-financial crisis highs, raising fears that the $2.7tn industry could again suffer sharp losses in the event of a market slide. The level of correlation may also raise questions about the high fees of hedge funds, given that investors can get equity market exposure, or ‘beta’, very cheaply via passive tracker funds.”
July 2 – Bloomberg (Scott Hamilton): “London home prices jumped the most in 27 years in the second quarter as Nationwide Building Society warned that Bank of England measures to cool the U.K. property market won’t stem further gains in the short term. Values in the capital surged 26% in the three months through June from the same period a year earlier, the biggest increase since 1987, Britain’s third-largest mortgage lender said in a statement. At an average 400,404 pounds ($686,700), prices in the city stand 30% above their 2007 peak.”
EM Bubble Watch:
July 1 – Financial Times (Vivianne Rodrigues): “Argentina called a US court decision to block payments on its restructured debt a violation of international law and an infringement of its sovereign rights as it teetered on the brink of technical default for the second time in less than 15 years. Payments on the South American nation’s bonds were due Monday, but a New York federal court has forbidden it to pay interest on its restructured debt without also paying so-called holdout creditors, who refused to take part in the restructurings.
June 30 – Bloomberg (Camila Russo): “Argentina is poised to miss a bond payment today, putting the country on the brink of its second default in 13 years, after a U.S. court blocked the cash from being distributed until the government settles with creditors from the previous debt debacle. The nation has a 30-day grace period after missing the $539 million debt payment to seek an accord with a group of defaulted bondholders led by billionaire Paul Singer’s NML Capital Ltd. and prevent a default on its $28.7 billion of performing global dollar bonds… A decade-long battle between Argentina and holdout creditors from the country’s $95 billion default in 2001 is coming to a head. The U.S. Supreme Court on June 16 left intact a ruling requiring the country pay about $1.5 billion to holders of defaulted debt at the same time it makes payments on restructured bonds. Argentina last week transferred funds to its bond trustee to pay the restructured notes, only to have U.S. District Court Judge Thomas Griesa order the payment sent back while the parties negotiate.”
June 30 – Bloomberg (Onur Ant): “Fighting between Iraqi govt forces and al-Qaeda splinter group ISIL may cause Turkish current- account deficit to widen as exports hit, Moody’s says… ‘Iraqi crisis is credit negative for Turkey’: Moody’s. Large part of Turkey’s $10b exports to Gulf Cooperation Council member states, Jordan goes through regions of Iraq seeing fighting… Prolonged conflict in Iraq, spillover into Kurdish-controlled area in north ‘would have a material effect on Turkish exports.’”
June 30 – Bloomberg (Matthew Malinowski): “Brazilian bond traders are growing increasingly skeptical of the central bank’s commitment to its inflation target after the board signaled it won’t reinitiate rate increases even as consumer prices surge. Traders pushed up their expectations for annual cost-of- living increases… to a two-month high of 6.39% on June 26.”
July 4 – Bloomberg (Anna Andrianova): “Russian inflation soared to the fastest since August 2011 as the ruble weakened. Consumer prices rose 7.8% in June from a year earlier after gaining 7.6% in May… Prices grew 0.6 percent on the month. Russian policy makers are laboring to curtail inflation after raising their benchmark interest rate 200 basis points since February. Sanctions by the U.S. and its allies over the conflict in Ukraine exacerbated capital outflows and stoked the ruble’s decline.”
Europe Watch:
June 30 – MarketNews International: “The European Central Bank said… that private sector loan growth contracted more than expected in May even as the Bank's broadest measure of money supply around the currency area expanded, raising troubling questions about the willingness of lenders to support credit growth amid a fragile recovery… Its gauge of private sector loans… showed a -2.0% contraction in May, compared to the -1.7% expected in the MNI median forecast and -1.8% in April.”
