Saturday, November 1, 2014

09/09/2011 Crumbling Pillars *

For the week, the S&P500 declined 1.7% (down 8.2% y-t-d), and the Dow fell 2.3% (down 5.1%). The S&P 400 Mid-Caps declined 1.2% (down 9.2%), and the small cap Russell 2000 fell 1.4% (down 14.0%). The Banks dropped another 2.1% (down 30.6%), and the Broker/Dealers lost 3.7% (down 31.5%). The Morgan Stanley Cyclicals declined 1.6% (down 21.1%), and the Transports sank 3.6% (down 14.4%). The Morgan Stanley Consumer index dipped 1.2% (down 7.8%), and the Utilities declined 1.7% (up 3.2%). The Nasdaq100 slipped only 0.2% (down 2.4%), and the Morgan Stanley High Tech index dipped 0.5 % (down 15.2%). The Semiconductors rallied 2.0% (down 15.4%). The InteractiveWeek Internet index dipped 0.6% (down 10.6%). The Biotechs were unchanged (down 11.5%). Although bullion was down $27, the HUI gold index increased 1.6% (up 9.6%).

One month Treasury bill rates ended the week at zilch and 3-month bills closed at one basis point. Two-year government yields were down 3 bps to 0.17%. Five-year T-note yields ended the week down 6 bps to 0.80%. Ten-year yields dropped 7 bps to 1.92%. Long bond yields fell 5 bps to 3.25%. Benchmark Fannie MBS yields dropped 7 bps to 3.11%. The spread between 10-year Treasury yields and benchmark MBS yields was unchanged at 119 bps. Agency 10-yr debt spreads declined one to 4 bps. The implied yield on December 2012 eurodollar futures increased one basis point to 0.565%. The 10-year dollar swap spread increased 2 to 22 bps. The 30-year swap spread increased 2 to negative 28 bps. Corporate bond spreads widened meaningfully. An index of investment grade bond risk jumped 10 bps to 131.5 bps. An index of junk bond risk surged 57 bps to 732 bps.

Debt issuance bounced back, at least for a week. Investment-grade issuers included Schlumberger $3.0bn, Toyota Motor Credit $2.5bn, Time Warner $2.25bn, Lockheed Martin $2.0bn, Enbridge Energy $1.14bn, HJ Heinz $700 million, Fluor $500 million, Associated Banc $430 million, Wisconsin Electric $300 million, XCEL Energy $250 million, PG&E $250 million, Public Service New Hampshire $160 million and Detroit Edison $140 million.

Junk bond funds saw inflows of $576 million (from Lipper). Junk issuance included American International Group $2.0bn, Fresenius Medical Care $400 million, and Calumet Special Products $200 million.

I saw no convertible debt issued.

International dollar bond issuers included Daimler $3.5bn, Toronto Dominion Bank $5.0bn, Rentenbank $1.5bn, Chile $1.0bn, Export-Import Bank of Korea $1.0bn, France Telecom $2.0bn, and Banco Credito $350 million.

Another week of tumult for European debt markets. Greek two-year yields ended the week up 852 bps to 53.05% (up 4,081bps y-t-d). Greek 10-year yields surged 194 bps to 19.52% (up 706bps). German bund yields sank 24 bps to a record low 1.77% (down 119bps), and U.K. 10-year gilt yields fell 18 bps this week to 2.26% (down 125bps). Italian 10-yr yields rose 13 bps to 5.39% (up 58bps) and Spain's 10-year yields increased 3 bps to 5.14% (down 30bps). Ten-year Portuguese yields jumped 85 bps to 10.87% (up 429bps). Irish yields were unchanged at 8.45% (down 61bps). The German DAX equities index sank 6.2% (down 25% y-t-d). Japanese 10-year "JGB" yields fell 6 bps to 1.00% (down 12bps). Japan's Nikkei declined 2.4% (down 14.6%). Emerging markets were weak. For the week, Brazil's Bovespa equities index declined 1.4% (down 19.5%), and Mexico's Bolsa fell 3.8% (down 12.3%). South Korea's Kospi index lost 2.9% (down 11.6%). India’s equities index increased 0.3% (down 17.8%). China’s Shanghai Exchange declined 1.2% (down 11.1%). Brazil’s benchmark dollar bond yields jumped 15 bps to 3.61%, while Mexico's benchmark bond yields were little changed at 3.40%.

Freddie Mac 30-year fixed mortgage rates were down 10 bps to 4.12% (down 23bps y-o-y). Fifteen-year fixed rates declined 6 bps to 3.33% (down 50bps y-o-y). One-year ARMs fell 5 bps to 2.84% (down 62bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 7 bps to 4.80% (down 58bps y-o-y).

Federal Reserve Credit expanded $5.0bn to $2.841 TN. Fed Credit was up $433bn y-t-d and $554bn from a year ago, or 24%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 9/7) dropped $9.3bn to $3.478 TN. "Custody holdings" were up $127bn y-t-d and $257bn from a year ago, or 8.0%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $1.654 TN y-o-y, or 19.3% to a record $10.226 TN. Over two years, reserves were $3.029 TN higher, for 42% growth.

M2 (narrow) "money" supply jumped $30.4bn to a record $9.570 TN. "Narrow money" has expanded at a 12.4% pace y-t-d and 10.3% over the past year. For the week, Currency added $1.7bn. Demand and Checkable Deposits rose $19.6bn, and Savings Deposits increased $19.0bn. Small Denominated Deposits declined $3.3bn. Retail Money Funds fell $6.6bn.

Total Money Fund assets increased $6.9bn last week to $2.644 TN. Money Fund assets were down $166bn y-t-d, with a decline of $195bn over the past year, or 6.9%.

Total Commercial Paper outstanding sank $32bn (8-wk decline of $171bn) to $1.066 Trillion. CP was up $94bn y-t-d, or 11.6% annualized, with a one-year rise of $7bn.

Global Credit Market Watch:

September 8 – Bloomberg (Abigail Moses): “Credit-default swaps on Greek government debt surged to a record, signaling there’s a 91% probability the nation won’t meet debt commitments, after its economy shrank more than previously reported.”

September 9 – Bloomberg (Alan Crawford): “Chancellor Angela Merkel’s government is preparing plans to shore up German banks in the event that Greece fails to meet the terms of its aid package and defaults, three coalition officials said. The emergency plan involves measures to help banks and insurers that face a possible 50% loss on their Greek bonds if the next tranche of Greece’s bailout is withheld… The successor to the German government’s bank-rescue fund introduced in 2008 might be enrolled to help recapitalize the banks… The existence of a ‘Plan B’ underscores German concerns that Greece’s failure to stick to budget-cutting targets threatens European efforts to tame the debt crisis rattling the euro… Greece is ‘on a knife’s edge,’ German Finance Minister Wolfgang Schaeuble told lawmakers at a closed-door meeting in Berlin on Sept. 7… If the government can’t meet the aid terms, ‘it’s up to Greece to figure out how to get financing without the euro zone’s help,’ he later said in a speech to parliament.”

September 9 – Bloomberg (Matthew Brockett and Jeff Black): “Juergen Stark resigned from the European Central Bank’s Executive Board after protesting the bank’s bond purchases on a conference call earlier this week, said a euro-area central bank official familiar with the meeting. During the Sept. 4 call, Stark, 63, expressed his strong opposition to the program, which was expanded last month when the ECB started buying Italian and Spanish bonds… Stark was supported by the central banks of Austria and the Netherlands, the person said… Stark’s resignation, less than two months before President Jean-Claude Trichet’s term ends, suggests policy makers are increasingly split over the best way to fight Europe’s debt crisis… ‘There is quite a severe row going on,’ said Juergen Michels, chief euro-region economist at Citigroup Inc. in London. ‘It seems that it went too far.’”

September 6 – Bloomberg (Rainer Buergin and Tony Czuczka): “German Finance Minister Wolfgang Schaeuble called on euro-area governments to fully implement curbs on debt, saying that only fiscal ‘solidity’ will help tame financial-market turmoil. Schaeuble’s comments to lawmakers in Berlin today seek to raise the pressure on euro-area states to follow Germany and clamp down on debt to tackle the core cause of the sovereign crisis that is rocking markets worldwide. Financial markets are in ‘a state of anxiety,’ requiring ‘a new mentality’ rather than short-term stimulus, he said. ‘Markets are not the problem, excesses are,’ Schaeuble said… The constitutionally mandated debt ceiling enacted by Germany and now being emulated by France and Spain is ‘of fundamental importance,’ he said. Only ‘financial-policy solidity will win the confidence of markets.’”

September 9 – Bloomberg (John Fraher): “Almost 13 years after its demise, the deutsche mark retains enough potency to haunt Jean-Claude Trichet’s final days as European Central Bank president. Trichet, 68, lost his cool yesterday with a reporter who asked whether Germany should abandon the euro and return to the mark as Europe’s debt crisis roils markets and spooks voters. ‘I would like very much to hear the congratulations for an institution which has delivered price stability in Germany for almost 13 years,’ Trichet said… in an uncharacteristically raised voice. ‘It’s not by chance we have delivered price stability,’ he said. ‘We do our job, it’s not an easy job.’ Trichet has been at the forefront of efforts to save the region’s single currency. As Greece’s fiscal crisis ricocheted through European markets, he has spent much of the last two years shuttling back and forth between Frankfurt and national capitals for private meetings and a series of marathon summits.”

September 7 – Bloomberg (Abigail Moses): “Italian government debt is more expensive to insure than Spain’s for the first time in two years on concern Premier Silvio Berlusconi’s austerity measures will fail to resolve the nation’s budget crisis. …credit-default swaps on Italy cost 456 bps, compared with 424 bps for Spain.”

September 7 – Bloomberg (Angeline Benoit): “Spain is ‘worried’ that euro-area countries such as Italy and Greece are contributing to instability on debt markets by wavering on budget-deficit plans, Development Minister Jose Blanco said. ‘We are very worried because certain countries are in a very difficult situation and aren’t meeting their targets,’ Blanco said… citing Greece and Italy for putting austerity measures into question days after announcing them.”

September 7 – Bloomberg (Flavia Rotondi and Lorenzo Totaro): “Italy may need a new budget- adjustment plan next month because a 54 billion-euro ($76bn) austerity package to be voted on today won’t convince the European Central Bank to continue buying the nation’s bonds, the chairman of the Senate Finance Committee said. ‘How long can the ECB continue to buy Italian Treasury bonds?’ Mario Baldassarri said… ‘We may need another adjustment in three, four weeks which will be the real answer to the European Commission and to markets.’”

September 9 – Bloomberg (Esteban Duarte, Joe Brennan and Gabi Thesing): “ The European Central Bank plans to dilute a proposal to wean distressed banks off its emergency funding on concern it would exacerbate the region’s debt crisis, said two euro-area officials familiar with the deliberations. Instead of imposing higher interest rates on emergency loans to penalize Greek, Irish and Portuguese banks, the ECB and national central banks would ask financial institutions to detail how they will repay the money…”

September 7 – Bloomberg (Shannon D. Harrington and Sapna Maheshwari): “Fear is overpowering greed in the $7.6 trillion U.S. corporate bond market, with investors pricing in the biggest reversal in credit quality in more than two decades as the economy falters and Europe’s debt crisis worsens. While Moody’s… raised the ratings on 12 investment-grade companies in August and lowered seven, relative yields on corporate debt jumped more than half a percentage point, the third-largest increase since at least 1989, Deutsche Bank AG strategists say. At no point in at least 22 years has the difference between bond spreads and the ratio of upgrades to downgrades been greater, according to Deutsche Bank.”

September 7 – Bloomberg (Johan Carlstrom and Kim McLaughlin): “Swedish Finance Minister Anders Borg said the government may force the country’s banks to curb their reliance on dollar funding through law changes as a global liquidity crisis shows signs of reigniting. ‘Developments during the last few days underline the importance that we actually do something about the liquidity situation,’ Borg told reporters… ‘There’s a far too big reliance on dollars in the Swedish banking system and we must eventually move away from that.’”

September 8 – Bloomberg (Paul Dobson): “JPMorgan Chase & Co. said selling Italian and Spanish bonds along with bank stocks and debt, and buying dollars and gold may provide the best protection against the ‘very unlikely’ risk of a euro-area collapse. ‘There are formidable barriers to break-up, which make it less likely, but also mean it would be more disruptive if it did occur,’ Seamus Mac Gorain, a strategist in London, wrote in an investor report… ‘The financial turmoil and economic impact would be most pronounced in the euro area, arguing for broad underweight euro-area equity and credit.’”

Global Bubble Watch:

September 7 – Bloomberg (Candice Zachariahs and Garfield Reynolds): “Federal Reserve Chairman Ben S. Bernanke risks causing a decline in longer-term lending by holding down benchmark interest rates, Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said in an opinion piece on the Financial Times website. If the Fed seeks to drive down longer-maturity yields, as some are anticipating, then the central bank may ‘destroy leverage and credit creation in the process,’ Gross wrote in the piece, which was titled ‘Helicopter Ben’ Risks Destroying Credit Creation.’ The Fed on Aug. 9 pledged to keep the benchmark rate near zero until at least mid-2013. ‘Borrowing short-term at a near risk-free rate and lending at a longer and riskier yield has been the basis of modern-day finance,’ Gross wrote. ‘The further out the Fed moves the zero bound towards a system-wide average maturity of seven to eight years the more credit destruction occurs.’”

September 5 – Financial Times (Nicole Bullock and Helen Thomas ): “Concerns are rising that turbulence in financial markets will make it more difficult to carry out billions of dollars of forthcoming debt sales to raise money for buy-outs and other deals struck this year. As merger and acquisition activity picked up earlier this year, private equity groups took advantage of buoyant credit markets, signing up a run of buy-outs soon to be marketed to investors… Bankers say there is as much as $20bn-$25bn in loan offerings and junk bond issues in the pipeline in coming months tied to M&A transactions…”

September 7 – Bloomberg (Saburo Funabiki): “U.S. banks may face a ‘heavy burden’ if the Federal Reserve embarks on a third round of bond buying because it would boost the excess reserves lenders hold at the central bank, Totan Research Co. said…Another bout of quantitative easing, or so-called QE3 probably would expand excess reserves and lead to a deterioration of banks’ debt- to- equity ratios and returns on assets, as well as an increase in deposit-insurance premiums, according to Izuru Kato, chief economist…at Totan… allied with ICAP Plc, the world’s largest inter-dealer broker.”

Currency Watch:

September 7 – Bloomberg (Simon Kennedy and Emma Charlton): “Switzerland opened a new round in a global currency war as fading economic growth forces policy makers to step up efforts to spur expansion. The Swiss National Bank’s decision yesterday to cap the franc’s rate for the first time since 1978 marked a bid to protect trade hurt by the currency that last month strengthened to records against the euro and the dollar. The franc plunged 8.1% yesterday…”

The U.S. dollar index surged 3.3% this week to 77.20 (down 2.3% y-t-d). For the week on the downside, the Swiss franc declined 10.8%, the euro 3.9%, the Danish krone 3.8%, the South African rand 3.1%, the New Zealand dollar 3.1%, the Norwegian krone 2.7%, the Swedish krona 2.3%, the Mexican peso 2.2%, the British pound 2.1%, the Singapore 2.0%, the Brazilian real 2.0%, the Australian dollar 1.6%, the South Korean won 1.3%, the Canadian dollar 1.1%, Japanese yen 1.0%, and Taiwanese dollar 0.7%.

Commodities and Food Watch:

September 6 – Bloomberg (Chanyaporn Chanjaroen): “Gold’s rally above $1,900 an ounce shows no signs of a ‘bubble’ as central banks continue to boost money supply that has helped spur bullion to a record, according to investor Marc Faber. ‘I don’t think that gold is in a bubble,’ Faber, publisher of the Gloom, Boom and Doom report, said… ‘When you buy gold, it’s an insurance against systematic failure and problems in the financial markets.’”

The CRB index declined 1.1% this week (up 0.4% y-t-d). The Goldman Sachs Commodities Index slipped 0.3% (up 4.4%). Spot Gold fell 1.4% to $1,856 (up 31%). Silver dropped 3.4% to $41.62 (up 35%). October Crude gained 79 cents to $87.24 (down 4%). October Gasoline declined 2.4% (up 13%), while October Natural Gas gained 1.1% (down 11%). December Copper fell 3.0% (down 10%). September Wheat dropped 4.0% (down 12%), and September Corn fell 3.2% (up 15%).

China Bubble Watch:

September 7 – Bloomberg: “China’s banks plan to raise as much as 160 billion yuan ($25bn) selling dim sum bonds to boost capital in a market where sales have quadrupled this year. China Citic Bank Corp. announced on Aug. 29 it plans to raise as much as 30 billion yuan selling debt in Hong Kong, and China Construction Bank Corp. said last month that most of the lender’s proposed bond issuance totaling 80 billion yuan may be sold in the city. Chinese banks raised 48.7 billion yuan in the market this year, up from 11.3 billion yuan in 2010…”

Japan Watch:

September 8 – Bloomberg (Masaki Kondo, Yumi Ikeda and Saburo Funabiki): “Foreign lenders have boosted their surplus reserves at the Bank of Japan to the most in almost six years, forgoing higher interest rate payments elsewhere to benefit from gains in the yen. Overseas banks’ excess reserves… reached 6.14 trillion yen ($79bn) in July, the highest since October 2005…”

India Watch:

September 7 – Bloomberg (Jeanette Rodrigues and Anoop Agrawal): “The cost of protecting debt issued by India’s state-run banks against default has climbed to a two-year high, spurred by concern that the lenders may have to set aside more money to cover bad loans. Five-year credit-default swaps on State Bank of India, the nation’s biggest lender, rose 102 basis points this quarter to 290 bps…”

Unbalanced Global Economy Watch:

September 6 – Bloomberg (Jeff Black): “Factory orders in Germany, Europe’s largest economy, fell more than economists forecast in July, led by a drop in export demand as the global economy cooled. Orders… dropped 2.8% from June, when they rose 1.8%...”

Central Bank Watch:

September 7 – Bloomberg (Johan Carlstrom): “Sweden’s central bank abandoned a planned interest-rate increase as global recovery prospects deteriorate, while policy makers held on to the option of raising rates in the largest Nordic economy once more this year. The benchmark repo rate was left unchanged at 2%...”

Fiscal Watch:

September 6 – Bloomberg (Angela Greiling Keane): “The U.S. Postal Service may lose $10 billion in the fiscal year ending Sept. 30, more than it had predicted, as mail volume continues to drop, Postmaster General Patrick Donahoe said… The loss will leave the… service unable to make required payments to the federal government and puts it at risk of default as it reaches its $15 billion borrowing limit, Donahoe said… ‘We are at a critical juncture,’ Donahoe, who is also the service’s chief executive officer, wrote in his testimony. Action from Congress is sorely needed by the close of this fiscal year.’”

Muni Watch:

September 7 – Bloomberg (James Kraus): “Rhode Island may cut pension benefits for 51,000 public employees and retirees to cope with a $6.8 billion shortfall in funding, the Washington Post reported…”

Crumbling Pillars:

When it comes to central banking, I’m increasingly feeling relegated to the realm of a “moderate.”  I may be a harsh critic of Federal Reserve doctrine and policymaking, but the last thing I’d suggest is to “abolish the Fed.”  From my perspective, it is not so much that central banking is the problem as much as it is how contemporary central bankers have governed contemporary finance.  As a student of central banking and financial history, I’m a big fan of William McChesney Martin (Chairman of the Federal Reserve 1951-1970).  He was the consummate principled, disciplined and conservative central banker/public servant.  His Fed was unequivocally dedicated to monetary stability – and sternly independent and out of the fray of politics.

I also have the highest regard for ECB President Jean-Claude Trichet.  Mr. Trichet is one of the preeminent central bankers of this era.  Listening to his press conference yesterday, I was again in awe of his intellect and analytical framework, along with his command of the critical roles of central banking and monetary stability.   I am at the same time saddened that the European crisis is spiraling outside of his, the ECB’s and European policymaker’s control.  It’s certainly no way to end such a distinguished career (Mr. Trichet’s term ends in October).

Greek Credit Default Swaps (CDS) surged 659 bps today to a new record 3,470 bps, as the market prepares for imminent default.  Greek 2-year yields jumped 852 basis points this week.   Italian 10-yr yields rose 13 bps this week to 5.39%.  The euro sank 1.5% today and was down 3.9% this week.

Juergen Stark resigned from the ECB’s executive board today.  According to Bloomberg news, Dr. Stark’s resignation follows his recent expression of “strong opposition” to the ECB’s bond buying program.  Stark was vice chairman of the German Bundesbank from 2002 to May 2006, before departing to assume responsibilities at the European Central Bank.  His resignation follows Bundesbank President Jens Weidmann’s recent criticism of ECB Italian and Spanish bond purchases, and is the second prominent German central banker to back away from the ECB this year (following Axel Weber's decision not to pursue the ECB presidency).

The ECB has been a pillar of strength for a euro currency that has been a pillar of strength - in a global backdrop of acute monetary instability.  These pillars seemed to start crumbling this week, much to the detriment of global financial stability.  Confidence in the euro was sustained throughout the first Greek debt crisis, as contagion effects engulfed Europe’s entire periphery, and even more recently when Italian bond yields spiked higher.  But the weight of an expanding debt crisis, limited policy options, increasingly divided policymakers, and unstable global markets has become just too much to bear. 

When the Credit Bubble burst in Greece and in the European periphery last year, the ECB intervened to avert a financial crisis with the potential to destabilize European monetary integration.  Financial and economic systems in Europe and around the world were still fragile from the 2008 crisis.  The ECB clearly believed that extraordinary circumstances demanded extraordinary measures.  Their policy course will be analyzed and debated for decades to come.  The bottom line is that the ECB aggressively intervened in the markets, and over time accumulated huge exposures to Greek and other troubled debt.  In his press conference, Mr. Trichet yesterday cited “benign neglect” - both from politicians and the markets - as the major factor that fostered the problematic accumulation of debt globally.  I can’t disagree, although “activist” global central bankers clearly share major responsibility. 

Perhaps history will be somewhat sympathetic, viewing that the ECB was dragged into a monetary muck created largely from the negligent mismanagement of the world’s reserve currency.  All the same, with Greece on the precipice of default and Italian and Spanish yields again surging higher, it would appear the ECB’s gambit is failing.  If so, there’ll be a huge price to pay.

The markets have been clamoring for a German-backed “Eurobond” that would provide troubled European governments access to inexpensive borrowings (sustaining debt issuance, maladjusted economic structures and market prices).  The consensus view has been that the German’s would eventually succumb to acute market stress and agree to backstop eurozone debt.  They would have no alternative from a cost vs. benefit perspective, it was thought.  It has been my view that the more German officials - and citizens - saw of the unfolding global debt debacle the more determined they would be to protect the stability of their Credit system.  Bloomberg news today reported that the German government has prepared a plan to protect its financial institutions in the event of a Greek default. 
That Dr. Stark would resign today, in the blistering heat of crisis, is a stunning development and provides additional confirmation that the German contingent is anything but backing down.  Perhaps it’s too strong to suggest that this throws ECB strategy into disarray.  But the market will question the sustainability of the ECB’s support for Italy’s and Spain’s bond markets.  And, no doubt, a Greek default would open a Pandora’s Box of debt problems for global financial institutions, not excluding the ECB. 

The currency markets turned increasingly chaotic this week.  With its commitment to link its currency to the (faltering) euro, the Swiss National Bank (SBN) with the stroke of a press release essentially destroyed the Swiss franc’s long-held safe haven status in the marketplace.  The franc dropped 10.8% this week against the dollar and 7.2% against the euro, in another notable example of a policy response that only exacerbates market instability.  On the back of euro and franc weakness, dollar momentum gained intensity as the week progressed.  It would appear that dollar short positions (i.e. “carry trades” and such) came under heightened pressure, with euro weakness, dollar strength and general market tumult all feeding upon themselves.

Dollar strength broadened notably.  This week saw many “emerging” currencies falter, including a decline in the Polish zloty of 6.0%, the Hungarian forint 5.5%, the Romanian leu 4.6%, the Czech koruna 4.0%, the Bulgarian lev 3.6%, the South African rand 3.0%, the Russian ruble 3.0%, Turkish lira 2.3%, and the Brazilian real 2.2%.   To what extent “hot money” inflows had previously stoked these currencies, markets and economies remains unclear.  But it would appear that global de-risking and de-leveraging dynamics broadened and intensified this week.  And it becomes only more difficult to envisage a scenario where stability returns to the markets – currency, equity, fixed-income or commodities.

Whether it’s monetary or fiscal policy - at home or abroad – there seems to be confirmation everywhere that policymaking has become largely ineffectual and, increasingly, incapacitated. This is fundamental to my bearish thesis.  With each passing market day it seems to take a greater leap of faith to believe that additional monetary and fiscal stimulus will ameliorate a sovereign debt crisis fomented by ultra-loose monetary and fiscal policies. Increasingly, it appears impossible for policies that fomented monetary instability to now somehow engender a return to market stability.  Liquidity-challenged global markets are convulsing through a problematic period of de-risking and de-leveraging, and once such a process commences it basically has to run its course.  Efforts to intervene in the marketplace, as we’ve been witnessing, are likely to beget only greater uncertainty and instability.  Fed take note.

09/02/2011 Confidence Wearing Thin *

For the week, the S&P500 slipped 0.2% (down 6.7% y-t-d), and the Dow lost 0.4% (down 2.9%). The S&P 400 Mid-Caps declined 0.4% (down 8.2%), and the small cap Russell 2000 declined 1.2% (down 12.8%). The Banks declined 2.0% (down 28.4%), and the Broker/Dealers fell 2.2% (down 28.9%). The Morgan Stanley Cyclicals dipped 0.2% (down 19.9%), and the Transports slipped 0.3% (down 13.0%). The Morgan Stanley Consumer index gained 0.7% (down 6.8%), and the Utilities added 0.7% (up 4.9%). The Nasdaq100 gained 0.3% (down 2.3%), and the Morgan Stanley High Tech index increased 0.1% (down 14.7%). The Semiconductors declined 1.2% (down 17.1%). The InteractiveWeek Internet index rallied 1.6% (down 10.1%). The Biotechs added 0.6% (down 11.5%). With bullion rallying $55, the HUI gold index gained 3.5% (up 7.8%).

One month Treasury bill rates ended the week at one basis point and 3-month bills at 2 bps. Two-year government yields were up one basis point to 0.20%. Five-year T-note yields ended the week down 8 bps to 0.86%. Ten-year yields dropped 20 bps to 1.99%. Long bond yields sank 24 bps to 3.30%. Benchmark Fannie MBS yields fell 12 bps to 3.18%. The spread between 10-year Treasury yields and benchmark MBS yields widened 8 to 119 bps. Agency 10-yr debt spreads increased 5 to 6 bps. The implied yield on December 2012 eurodollar futures was little changed at 0.51%. The 10-year dollar swap spread increased 3 to 20 bps. The 30-year swap spread increased 5 to negative 30.5 bps. Corporate bond spreads narrowed. An index of investment grade bond risk declined 4 bps to 122 bps. An index of junk bond risk dropped 50 bps to 675 bps.

Debt issuance has slowed to almost a trickle. Investment-grade issuers included Coca-Cola $3.0bn, Commonwealth Edison $600 million, Praxair $500 million and USAA Capital $250 million.

Junk bond funds saw outflows of $96 million (from Lipper). I saw no junk issuance again this week.

I saw no convertible debt issued.

International dollar bond issuers included America Movil $4.0bn.

German bund yields dropped 15 bps to 2.01% (down 95bps y-t-d), and U.K. 10-year gilt yields declined 6 bps this week to 2.44% (down 107bps). Greek two-year yields ended the week up 275 bps to 44.52% (up 3,229bps). Greek 10-year yields rose 30 bps to 17.59% (up 513bps). Italian 10-yr yields jumped 21 bps to 5.27% (up 45bps) and Spain's 10-year yields rose 12 bps to 5.11% (down 33bps). Ten-year Portuguese yields sank 86 bps to 10.02% (up 344bps). Irish yields declined 18 bps to 8.45% (down 60bps). The German DAX equities index was little changed (down 19.9% y-t-d). Japanese 10-year "JGB" yields added 2 bps to 1.06% (down 6bps). Japan's Nikkei rallied 1.7% (down 12.5%). Emerging markets were mostly higher. For the week, Brazil's Bovespa equities index jumped 6.0% (down 18.4%), and Mexico's Bolsa recovered 3.2% (down 8.9%). South Korea's Kospi index surged 5.0% (down 8.9%). India’s equities index rallied 5.8% (down 18%). China’s Shanghai Exchange declined 3.2% (down 10%). Brazil’s benchmark dollar bond yields dropped 16 bps to 3.61%, while Mexico's benchmark bond yields were little changed at 3.41%.

Freddie Mac 30-year fixed mortgage rates were unchanged at 4.22% (down 10bps y-o-y). Fifteen-year fixed rates declined 5 bps to 3.39% (down 44bps y-o-y). One-year ARMs slipped 4 bps to 2.89% (down 61bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 7 bps to 4.87% (down 62bps y-o-y).

Federal Reserve Credit declined $6.7bn to $2.836 TN. Fed Credit was up $428bn y-t-d and $549bn from a year ago, or 24%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 8/31) decreased $4.2bn to $3.487 TN. "Custody holdings" were up $137bn y-t-d and $276bn from a year ago, or 8.6%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $1.593 TN y-o-y, or 18.6% to a record $10.153 TN. Over two years, reserves were $2.885 TN higher, for 40% growth.

M2 (narrow) "money" supply rose $17.9bn to a record $9.540 TN. "Narrow money" has expanded at a 12.2% pace y-t-d and 10.2% over the past year. For the week, Currency added $2.0bn. Demand and Checkable Deposits jumped $18.1bn, while Savings Deposits declined $3.3bn. Small Denominated Deposits fell $3.6bn. Retail Money Funds rose $4.6bn.

Total Money Fund assets increased $8.0bn last week to $2.637 TN. Money Fund assets were down $173bn y-t-d, with a decline of $191bn over the past year, or 6.8%.

Total Commercial Paper outstanding fell $19.3bn (7-wk decline of $138bn) to a 22-week low $1.098 Trillion. CP was up $126bn y-t-d, or 16% annualized, with a one-year rise of $33bn.

Global Credit Market Watch:

August 31 – Bloomberg (Brian Parkin and James G. Neuger): “Europe’s rescue fund would have to wait for an official request from a debt-hit government before buying its bonds in the secondary market, rules prepared for ratification by the 17 euro-area governments show. The extra step, along with German lawmakers’ demand for control, add political layers that risk making the fund, known as the European Financial Stability Facility, less responsive than the European Central Bank, which has bought 115.5 billion euros ($167 billion) of bonds in the past 16 months… ‘What’s clear is that even if the EFSF is ostensibly equipped to react swiftly in an emergency, it will be much less dynamic than the ECB,” said Daniela Schwarzer, senior analyst at the Berlin-based German Institute for International Politics and Security. “Faced with an emergency I would be inclined to put my money on the bank taking the reins of rescue action -- as it has done and is doing.’”

August 31 – Bloomberg (Angeline Benoit): “Spain and Italy have joined a growing list of European Union governments pledging to enshrine fiscal discipline in legislation, a move investors say is insufficient to contain the region’s debt crisis. The Spanish parliament on Sept. 2 votes on including ‘the principle of budget stability’ in the constitution, while Italy pledged this month to change its magna carta to adopt a balanced-budget amendment… ‘Rules have been broken before,’ said Olaf Penninga, who helps manage 140 billion euros ($202 billion) at Robeco Group… ‘Markets will remain skeptical until they see countries really stick to them in difficult times.’”

September 2 – Bloomberg (Sapna Maheshwari): “U.S. company bond sales fell 40% this week, capping the slowest month of issuance since May 2010, as signs mount the economic recovery is faltering.”

September 1 – Bloomberg (Tim Catts): “The worst month for global corporate bond offerings since May 2010 has set the stage for a September bounce… Sales from the U.S. to Europe and Asia tumbled 27% to $149.7 billion last month, from $206.3 billion in July… Issuance fell 36% from $233.4 billion a year earlier, making it the poorest August for bond sales since… 2004.”

August 31 – Bloomberg (Lorenzo Totaro and Chiara Vasarri): “The Italian government has dropped proposed changes to pension rules agreed to this week from a 45.5 billion-euro ($65.5bn) austerity plan being discussed in parliament that aims to balance the budget by 2013. Giorgia Meloni, minister for youth and sport policy… did not say how the government would make up the 5 billion euros of lost revenue from the original plan…”

August 31 – Bloomberg (Emma Ross-Thomas): “Spain expects a ‘chain of turbulence’ in the next two months and must fight ‘tooth and nail’ to avoid having to seek a bailout, Elena Valenciano, the ruling Socialist party’s campaign chief, said… ‘We’re probably going to get back into a chain of financial turbulence in September and October… An intervention in Spain would be a great misfortune for the country.’”

August 31 – Bloomberg (Angeline Benoit): “Spain’s region of Castilla-La Mancha, run by the People’s Party that polls suggest will win control of the central government in November, vowed to cut the nation’s highest regional deficit by 2012 without raising taxes. Castilla-La Mancha, which had a budget gap of 6.5% of gross domestic product last year, will slash spending by 1.7 billion euros ($2.5bn) to achieve a deficit of 1.3% of GDP next year…”

September 1 – Bloomberg (Paul Tugwell): “Greek retail sales fell at the fastest rate in three years in the key summer period between mid-July and the end of August, when price-discounts are permitted, the National Federation of Greek Commerce said. Sales of goods such as furniture, books and footwear fell by an average of 25% from a year ago…”

August 31 – Bloomberg (Christine Idzelis): “Companies raised the least amount of leveraged loans this month since 2008… Companies sold $3.02 billion of the debt this month, down from $27.6 billion in July and this year’s peak of $69.5 billion in February, according to Standard & Poor’s…”

September 1 – Bloomberg (Lisa Abramowicz): “The riskiest bonds are diverging from higher-quality debt by the most since October 2009 as investors lose confidence that the U.S. economy will expand enough to sustain the neediest borrowers.”

Global Bubble Watch:

September 1 – Reuters (Marc Jones): “Bundesbank President Jens Weidmann said… that trust in the European Central Bank could be lost if the euro zone central bank persists with crisis-fighting policies that go beyond its conventional role. …Weidmann renewed the Bundesbank's attack on steps taken by the ECB such as buying bonds of debt-strained euro zone members, a tactic some argue oversteps Europe's no-bailout principles. He said the lines between central bank monetary policy and governments' fiscal policy had been blurred as a result of the financial and euro zone debt crises. ‘In the long run this strains the trust in the central banks, and therefore for monetary policy it matters that the additional risks that have been taken on reduced again.’ ‘Decisions over whether to take on further additional risks would have to be made by governments and parliaments; only they are legitimised democratically to do so…’”

September 1 – Bloomberg (Anchalee Worrachate): “Italy and Spain sold bonds this week at lower yields than previous auctions, suggesting record debt purchases by the European Central Bank in the secondary market have helped to contain the nations’ borrowing costs… The ECB’s mandate prevents it from buying bonds directly from governments at auctions, so it purchases them in the so-called aftermarket. ‘It’s the ECB that virtually sets these borrowing costs for them, and not the market,’ said Michael Leister, a fixed- income strategist at WestLB AG… ‘Demand for these bonds remains weak. The ECB has been absolutely crucial in bringing Italian and Spanish yields down, enabling these countries to fund themselves at substantially lower rates than in the previous auctions.’”

September 2 – Bloomberg (Inyoung Hwang): “Investors increased their use of U.S. exchange-traded funds by the most since January 2008 last month, as concern the economy is slowing prompted a shift toward bets on the direction of the entire market and industries instead of individual companies. Average daily trading volume for ETFs jumped 83% from July to 2.24 billion shares… The SPDR S&P 500 ETF Trust… saw a 105% jump to 394 million per day.

Currency Watch:

August 29 – Bloomberg (Scott Reyburn): “The classic-car market is dividing between the best models, whose prices are racing to records, and others that are faltering on the sales’ start line, dealers say. Auction totals are beating forecasts and some sellers made bigger returns from their Ferraris this month than from volatile financial markets… ‘The market has polarized,’ Geneva-based auto adviser Simon Kidston said… ‘Big-ticket cars are making more and more money. The rest is becoming much more difficult to sell.’”

August 31 – Bloomberg (Ilan Kolet): “A license to drive a New York City taxi is not only worth more than its weight in gold, investing in a yellow cab has been more lucrative than the yellow metal. The… cost of a New York City taxicab license has increased more than 1,000% since 1980. The individual ‘medallion’ -- the transferable aluminum plate found on the hood of all cabs -- sold for $678,000 in July… up from $2,500 in 1947.”

The U.S. dollar index gained 1.2% this week to 74.71 (down 5.5% y-t-d). For the week on the upside, the Swiss franc increased 2.3%, the South Korean won 1.8%, the South African rand 1.2%, the New Zealand dollar 0.9%, the Australian dollar 0.7%, the Mexican peso 0.4%, and the Taiwanese dollar 0.2%. On the downside, the Brazilian real declined 2.3%, the euro 2.0%, the Danish krone 2.0%, the Swedish krona 1.5%, the British pound 1.5%, the Norwegian krone 0.5%, the Canadian dollar 0.4%, the Japanese yen 0.2%, and the Singapore dollar 0.1%.

Commodities and Food Watch:

August 29 – Bloomberg (Luzi Ann Javier and Supunnabul Suwannakij): “Rice may rally 22% by yearend as Thailand, the world’s largest exporter, buys the grain from farmers at above-market rates, pushing up costs for importers and fanning global inflation even as economic growth slows.”

The CRB index gained 0.8% this week (up 1.6% y-t-d). The Goldman Sachs Commodities Index rose 1.9% (up 6.1%). Spot Gold rallied 3.0% to $1,883 (up 33%). Silver jumped 5.0% to $43.07 (up 39%). October Crude gained $1.08 to $86.45 (down 5%). October Gasoline added 1.9% (up 16%), while October Natural Gas declined 1.0% (down 12%). December Copper was little changed (down 7%). September Wheat dropped 4.2% (down 8%), and September Corn slipped 0.3% (up 19%).

China Bubble Watch:

August 29 – Bloomberg: “China has accelerated a program giving subsidies to low-income households to help maintain social stability as the fastest inflation in three years erodes consumers’ spending power. The government has brought forward a deadline for local authorities nationwide to link a range of welfare payments for low-income families to local inflation rates… Faster inflation in the aftermath of an unprecedented monetary expansion during the last global slump is adding to living costs and eroding the savings of China’s 1.3 billion people.”

August 31 – Bloomberg: “Chinese consumer lending will probably triple in five years, driven by rising personal incomes, the Boston Consulting Group Inc. said. The balance of consumer lending… may rise to 21 trillion yuan ($3.3 trillion) in 2015 from 7 trillion yuan in 2010…”

September 1– Bloomberg (Sanat Vallikappen): “China’s millionaires will account for about half of Asia’s rich and hold more than half of the region’s wealth by 2015, according to a study by Julius Baer Group and CLSA Asia Pacific Markets. Asia’s millionaires will more than double in number to 2.8 million, with 1.4 million high net worth people in China… Chinese millionaires will hold $8.76 trillion of the $15.81 trillion that the region’s millionaires are expected to have…”

Japan Watch:

September 2 – Bloomberg (Sachiko Sakamaki and Takashi Hirokawa): “New Japanese Prime Minister Yoshihiko Noda faced political oblivion 15 years ago. His comeback required the kind of perseverance he will need to last longer than the five men since 2006 who preceded him. In 1996, Noda was defeated in his re-election bid for parliament, losing by 105 votes. For almost four years he was unemployed, occasionally without enough money to buy shoes for his sons, he recalled in a speech this week. He kept his profile afloat through a bare-bones campaign office and his practice of going to local train stations every weekday morning to talk with constituents. The result is a leader who buys dinner for volunteers and gets $13 haircuts.”

India Watch:

August 31 – Bloomberg (Kartik Goyal): “India’s economy grew faster than estimated last quarter, maintaining pressure on the central bank to extend its record interest-rate increases even as the global recovery weakens. Gross domestic product rose 7.7% in the three months ended June 30 from a year earlier…”

September 1 – Bloomberg (Tushar Dhara): “India’s food inflation accelerated to a four-month high and exports surged, sustaining pressure on the central bank to raise interest rates even as growth slows. An index measuring wholesale prices of farm products including rice and wheat rose 10.05% in the week ended Aug. 20 from a year earlier…”

Asia Bubble Watch:

September 1 – Bloomberg (William Sim and Eunkyung Seo): “South Korea’s inflation accelerated to the fastest pace in three years in August on rising food prices, adding to pressure on the central bank to increase borrowing costs. Consumer prices rose 5.3% from a year earlier, after a 4.7% gain in July…”

August 31 – Bloomberg (William Sim): “South Korea’s industrial production expanded at the slowest pace in 10 months as weakness in global growth threatens the outlook for exports. Output rose 3.8% from a year earlier after gaining a revised 6.5% in June…”

August 31 – Bloomberg (Sanat Vallikappen): “The domestic loan book of banks in Singapore grew 27.8% in July, the fastest in the 12 years…”

September 1 – Bloomberg (Suttinee Yuvejwattana): “Thailand’s inflation rate accelerated in August to the fastest pace since 2008 as rising food prices countered a decline in oil costs. An index of consumer prices climbed 4.29% from a year earlier…”

Latin America Watch:

September 1 – Bloomberg (Matthew Bristow and Gabrielle Coppola): “The Brazilian real weakened the most in a week and yields on interest-rate futures contracts fell after the central bank surprised economists by cutting the benchmark lending rate yesterday in a bid to protect the economy from a worldwide slump.”

August 29 – Bloomberg (Laura Price): “Brazilian mortgage-backed bond sales are soaring to a record as state-controlled lender Caixa Economica Federal plans more offerings to fund President Dilma Rousseff’s home ownership plan. Sales of the securities more than doubled to 6.17 billion reais ($3.9 billion) in the first seven months of 2011…”

September 1 – Bloomberg (Daniel Cancel and Charlie Devereux): “Venezuelan President Hugo Chavez ordered the removal of Irish cardboard maker Smurfit Kappa Group Plc from all its farm land in an agricultural state as he deepens a push to seize large land holdings from private owners.”

August 29 – Bloomberg (John Quigley): “Peru’s economy expanded at the slowest pace in more than a year in the second quarter as companies curtailed spending on concern President Ollanta Humala’s economic policies may limit private investment. Gross domestic product grew 6.6% from a year earlier, after expanding 8.7% in the first quarter…”

Unbalanced Global Economy Watch:

August 31 – Bloomberg (Greg Quinn): “Canada’s economy shrank in the second quarter for the first time since the recession two years ago… Gross domestic product fell at a 0.4% annualized pace during the April-June period following a 3.6% gain in the first three months of the year…”

August 31 – Bloomberg (Theophilos Argitis): “Canadian house prices rose at their fastest pace in almost two years in June, led by gains in Toronto… Prices climbed 1.7% during the month… Housing prices rose 4.5% in June from a year earlier.”

August 29 – Bloomberg (Dara Doyle): “The share of Irish private home loans in arrears or restructured rose to 12% in the three months through June, according to data published by the country’s central bank.”

September 1 – Bloomberg (Janina Pfalzer): “Swedish manufacturing contracted for the first time since May 2009 as orders and production declined in the largest Nordic economy.”

September 1 – Bloomberg (Josiane Kremer): “Norway’s annual credit growth was 6.3% in July…”

September 1 – Bloomberg (Michael Heath): “A gauge of Australian manufacturing slumped to the lowest level in more than two years last month as a surging currency hurt exports and the highest borrowing costs in the developed world curbed demand at home.”

U.S. Bubble Economy Watch:

September 1 – Bloomberg (Anna-Louise Jackson and Anthony Feld): “More than 1 million self-employed Americans are no longer in business almost four years after the last recession began, as the economy constrains entrepreneurial activity and small-business job creation. The 18-month contraction that started in December 2007 initially resulted in more would-be business owners, as the number of people who work for themselves grew to 16.3 million in July 2008 from 15.7 million at the end of 2007… Since then, the total has fallen about 10% to 14.7 million in July…”

Fiscal Watch:

August 31 – Bloomberg (David J. Lynch): “Ten years after the Sept. 11 terrorist attacks, the Pentagon confronts a new enemy that will require it to embrace an unfamiliar strategy: spending less money. Forget Islamic radicals or even an ascendant China; the ‘biggest threat to our national security is our debt,’ says Admiral Mike Mullen, chairman of the Joint Chiefs of Staff. Indeed, the Congressional Budget Office expects that by 2021 the U.S. will be spending almost as much on interest payments each year as on national security…”

August 31 – Bloomberg (Jeff Bliss and Catherine Dodge): “Eric Cantor, the No. 2 House Republican, is pressing for budget cuts to cover the cost of cleaning up after Hurricane Irene and other disasters. Senate Democrats said funding shouldn’t be delayed by political bickering. Both Republicans and Democrats said more funding is needed to help communities rebuild. The Federal Emergency Management Agency redirected money in a $792 million disaster fund to states hit by Irene from yet-to-be-approved rebuilding projects related to previous natural disasters.”

California Watch:

September 1 – Bloomberg (James Nash): “About $11.6 billion in California tax-allocation bonds are at risk of a downgrade, Moody’s… said, due to ‘substantial uncertainty’ over the future of redevelopment agencies in the most-populous state. Two new laws that divert money from California’s 400 redevelopment agencies and eliminate tracking of revenue used to repay their bonds may diminish the credit quality of the debt, Moody’s said… Governor Jerry Brown signed the laws as part of a deal to balance California’s $86 billion budget for 2011-12 in June.”

Muni Watch:

August 29 – Bloomberg (Michelle Kaske and Darrell Preston): “New York Local Government Assistance Corp., State of New York Mortgage Agency and Tampa, Florida, lead $1.45 billion of municipal bond sales, marking the slowest week before Labor Day in at least eight years.”

September 1 – Bloomberg (Simone Baribeau): “U.S. state tax revenue grew at its fastest pace in six years in the second quarter, led by personal and corporate levies, as governments begin to recover from the longest recession since World War II. Revenue rose 11.4% from the same three months a year earlier…”

Real Estate Watch:

September 2 – Bloomberg (Bob Van Voris and Patricia Hurtado): “Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. were among the 17 lenders sued by the Federal Housing Finance Agency for allegedly misleading Fannie Mae and Freddie Mac about billions of dollars of residential mortgage-backed securities. In lawsuits filed today… the agency also named as defendants Barclays Plc, Nomura Holdings Ltd., HSBC Holdings Plc Societe General SA, Morgan Stanley, Ally Financial, Royal Bank of Scotland, Credit Suisse Group AG, Deutsche Bank AG and First Horizon National Corp.”

Confidence Wearing Thin: 

“I favor being much clearer and specific about the economic markers that it would take to alter [the course of policymaking]… In fact, I argued for something like this just recently… We could allow rates to remain low until the unemployment rate fell to a certain level or if inflation became tremendously unacceptable at a higher rate.”  Chicago Federal Reserve President Charles Evans (interviewed by CNBC’s Steve Liesman)

September 1 – Reuters (Marc Jones):  “Bundesbank President Jens Weidmann said… that trust in the European Central Bank could be lost if the euro zone central bank persists with crisis-fighting policies that go beyond its conventional role…  He said the lines between central bank monetary policy and governments' fiscal policy had been blurred as a result of the financial and euro zone debt crises. ‘In the long run this strains the trust in the central banks, and therefore for monetary policy it matters that the additional risks that have been taken on [are] reduced again…’ Noting that the debt problems of weaker euro zone countries had been shared by the bloc's stronger states, he said this was not the way to maintain incentives for solid fiscal policy.  ‘Such a solution is not suitable to curtail the uncertainty on financial markets. Moreover, it exposes monetary policy to pressure to have a loose bias.’”

Global monetary policymaking is a complete mess.  As for the Fed, I won’t this week be profiling Chicago Federal Reserve President Evans’ interview with CNBC’s Steve Liesman.  In what is a really wacky idea, a dovish Mr. Evan’s suggested the Fed could consider targeting a specific unemployment rate when setting monetary policy.  Dr. Bernanke has been a longtime advocate of having monetary policy target a pre-determined inflation rate (“inflation targeting”), and I have fully expected that such a mechanism at some point would be used to justify additional “accommodation”/monetization.  However, at 3.6% y-o-y current elevated consumer price inflation creates an inopportune backdrop for proposing such a targeting mechanism.  So, then, why not the unemployment rate – or home values or stock prices?

In Europe, the ECB now confronts a very serious dilemma.  Ongoing (and evolving) financial crisis has forced the central bank to sidestep its policymaking doctrine, circumvent rules and dangerously expose itself to market, political and capital pressures.  They today hold enormous quantities of securities and loans to European periphery governments and banks, exposure they had no intention of holding for anything other than for short-term liquidity-supporting purposes.  Not only are they now stuck with these “trades-turned-long-term investments,” they face overwhelming pressure for ongoing liquidity injections.  In particular, they are left holding the bag filled with big exposure to Greek debt, as Greece Bailout II unravels and 2-year Greek yields surge to 47%.

More problematically for the ECB, the European banking system, and global financial markets, a side deal struck early last month between the ECB and Italian President Berlusconi’s government appears in peril. Apparently, the ECB agreed to support Italian debt in the marketplace in exchange for a commitment to more aggressive austerity measures from the Italians.  After surging to a high of 6.20% on August 4, ECB buying was instrumental in pressing Italy’s 10-year yields below 5% by mid-month.  Now, under intense political pressure, the Berlusconi government has backed away from key austerity measures.  Complicating matters, Berlusconi leadership is jeopardized by ongoing criminal investigations and rising unpopularity.  Mr. Trichet today warned that Italian fiscal and economic reform commitments were “extremely important” and “it is therefore essential that the objectives announced for the improvement of public finances be fully confirmed and implemented.”

The ECB is said to have purchased almost $55bn of Italian and Spanish bonds in the open market over the past few weeks.  This has elicited strong rebuke from the German Bundesbank, especially after the ECB-induced bond rally took the pressure off Italian politicians.  Italy’s 10-year yields jumped 21 bps this week to 5.27%, with this afternoon’s 397 bps a record close for 5-year Italian Credit Default Swap (CDS) prices.  Having aggressively intervened in the marketplace, the ECB now faces the risk of market tumult if it shies away from its bond buying program.  At home and abroad, central bankers have allowed themselves to be taken hostage by (increasingly desperate) markets.  

Come to the markets’ rescue and there will be no turning back, especially in a Bubble backdrop.  And global central bankers will more vocally protest the state of fiscal mismanagement and “dysfunctional” markets, yet they largely have themselves to blame.  For too long, central bankers have accommodated both reckless sovereign borrowing and highly speculative markets, which ensures a fateful day of reckoning.  To be sure, experimental monetary policy has been instrumental in promoting the increasingly vulnerable “global government finance Bubble.”  

“Activist” central banking has been the nucleus for overstating the effectiveness - and over-promising – with respect to both monetary and fiscal policymaking.  Markets and citizens alike had over years been conditioned to believe that enlightened policy ensured economic stability and rising asset prices.  Accordingly, risk and leverage were readily embraced.  These days, central bankers are trapped – the markets fully appreciate that they have them trapped – and it’s going to be fascinating and unnerving to watch how this all plays out.

And while the ECB has badly deviated from its core principles, it does at least have some to anchor policymaking.  The Bernanke Fed is completely lost at sea.  Markets will now anxiously anticipate the FOMC’s September 20/21 meeting.  A divided Fed will contemplate additional stimulus measures, including more quantitative easing.  There will be intense pressure to do more to support a faltering “jobless” recovery, with the expectation that Chairman Bernanke will carry the day and ensure a backdrop sufficiently loose to accommodate additional fiscal stimulus.  

Unlike the Europeans, the markets have yet to impose austerity on Washington.  And while both European and American economies have demonstrated recent weakness, in contrast to Europe our feeble recovery will continue to be underpinned by lavish federal spending.  US stocks have significantly outperformed European bourses this year, and there remains considerable confidence that our monetary and fiscal measures can support economic expansion and higher stock prices.  As I wrote a few weeks back, it is not difficult for most U.S. investors to remain complacent.

At the same time, the global financial system comes under added stress each passing week.  The euro again came under pressure this week.  The euro has been notably resilient for the past several months, but I worry that this has only provided an opportunity for additional hedging in the marketplace to protect against potential euro weakness.  Part of my analysis is that huge derivative protection (put options and such) has accumulated that would tend to increase the vulnerability of the euro to an abrupt and destabilizing decline (if key technical support levels are broken).  

It has been part of my thesis that the global financial system has been especially vulnerable to de-risking and de-leveraging dynamics.  I believe markets have absorbed the first phase of de-risking/de-leveraging, with meaningful stock market declines, surging Treasury prices, a widening of Credit spreads, a tightening of general financial conditions and a downshift in economic activity.  Importantly, this “first phase” was accompanied by significant currency market volatility - but not dramatic changes in most currency values.  In particular, the euro and U.S. dollar have traded in relatively tight trading ranges for several months now, at least partially explained by ongoing market faith that global central bankers are keen to ensure liquid and stable markets. 

If current financial tumult evolves more into a 2008-style event, I would expect the next phase of de-risking/de-leveraging to be accompanied by increasing signs of dislocation in currency markets more generally.  The big question remains unanswered:  how big are global currency “carry trades” (short low-yielding dollar instruments to fund higher-returning assets abroad)?  And an important part of the thesis is that we’ve reached the point where reflationary policymaking will tend to only increase uncertainty and further destabilize unsettled financial markets.  Both the Fed and ECB are at respective policy crossroads and markets have ample reason to fret.  Confidence is wearing thin.

08/26/2011 Valuable Insight from Jackson Hole *

For the week, the S&P500 rallied 4.7% (down 6.4% y-t-d), and the Dow jumped 4.3% (down 2.5%). The Banks surged 7.4% (down 27%), and the Broker/Dealers rose 5.0% (down 27.3%). The Morgan Stanley Cyclicals jumped 5.7% (down 19.7%), and the Transports gain 5.7% (down 12.7%). The Morgan Stanley Consumer index gained 3.3% (down 7.4%), and the Utilities added 1.9% (up 4.2%). The S&P 400 Mid-Caps rose 6.1% (down 7.9%), and the small cap Russell 2000 jumped 6.2% (down 11.7%). The Nasdaq100 gained 6.1% (down 2.5%), and the Morgan Stanley High Tech index rose 6.0% (down 14.8%). The Semiconductors rallied 6.0% (down 16%). The InteractiveWeek Internet index jumped 6.7% (down 11.5%). The Biotechs increased 3.4% (down 12.1%). With a hyper-volatile bullion ending down $25, the HUI gold index gained 2.7% (up 4.1%).

One and two-month Treasury bill rates remained at zero, nothing, nada. Two-year government yields were unchanged at 0.19%. Five-year T-note yields ended the week up 4 bps to 0.94%. Ten-year yields rose 13 bps to 2.19%. Long bond yields jumped 14 bps to 3.53%. Benchmark Fannie MBS yields increased 10 bps to 3.30%. The spread between 10-year Treasury yields and benchmark MBS yields narrowed 3 to 111 bps. Agency 10-yr debt spreads dropped 9 to one basis point. The implied yield on December 2012 eurodollar futures increased 3 bps to 0.51%. The 10-year dollar swap spread increased 3 to 13.75 bps. The 30-year swap spread was unchanged at negative 35 bps. Corporate bond spreads widened further. An index of investment grade bond risk rose 3 bps to 126 bps. An index of junk bond risk jumped 24 bps to 726 bps.

Investment-grade issuers included Pepsico $1.25bn, Illinois Tool Works $1.0bn, John Deere $500 million, Duke Energy $500 million, Yum Brands $350 million, and Arizona Public Service $300 million.

Junk bond funds saw outflows of $127 million (from Lipper). I saw no junk issuance this week.

I saw no convertible debt issued.

International dollar bond issuers included Swedbank Hypotek $1.0bn and Eksportfinans $750 million.

German bund yields rose 5 bps to 2.15% (down 81bps y-t-d), and U.K. 10-year gilt yields jumped 11 bps this week to 2.50% (down 101bps). Greek two-year yields ended the week up 570 bps to 41.78% (up 2,954bps). Greek 10-year note yields jumped 113 bps to 17.29% (up 483bps). Italian 10-yr yields increased 14 bps to 5.06% (up 24bps) and Spain's 10-year yields rose 4 bps to 4.99% (down 45bps). Ten-year Portuguese yields jumped 56 bps to 10.88% (up 430bps). Irish yields fell 63 bps to 8.63% (down 43bps). The volatile German DAX equities index increased 1.0% (down 19.9% y-t-d). Japanese 10-year "JGB" yields jumped 5 bps to 1.04% (down 8bps). Japan's Nikkei rallied 0.9% (down 14%). Emerging markets were mostly higher. For the week, Brazil's Bovespa equities index gained 1.7% (down 23%), and Mexico's Bolsa rallied 2.7% (down 11.7%). South Korea's Kospi index jumped 2.0% (down 13.3%). India’s equities index dropped 1.8% (down 22.7%). China’s Shanghai Exchange rallied 3.1% (down 7.0%). Brazil’s benchmark dollar bond yields rose 6 bps to 3.61%, and Mexico's benchmark bond yields rose 4 bps to 3.41%.

Freddie Mac 30-year fixed mortgage rates rose 7 bps to 4.22% (down 14bps y-o-y). Fifteen-year fixed rates jumped 8 bps to 3.44% (down 42bps y-o-y). One-year ARMs increased 7 bps to 2.93% (down 59bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 4 bps to 4.95% (down 37bps y-o-y).

Federal Reserve Credit declined $5.7bn to $2.843 TN. Fed Credit was up $435bn y-t-d and $548bn from a year ago, or 23.9%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 8/25) increased $12.5bn to a record $3.491 TN. "Custody holdings" were up $141bn y-t-d and $294bn from a year ago, or 9.2%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $1.599 TN y-o-y, or 18.7% to a record $10.136 TN. Over two years, reserves were $3.048 TN higher, for 43% growth.

M2 (narrow) "money" supply gained $5.1bn to a record $9.522 TN. "Narrow money" has expanded at a 12.3% pace y-t-d and 10.1% over the past year. For the week, Currency added $1.1bn. Demand and Checkable Deposits fell $11.7bn, while Savings Deposits rose $6.0bn. Small Denominated Deposits declined $3.6bn. Retail Money Funds increased $13.4bn.

Total Money Fund assets slipped $2.1bn last week to $2.629 TN. Money Fund assets were down $181bn y-t-d, with a decline of $204bn over the past year, or 7.2%.

Total Commercial Paper outstanding fell $29.5bn to a 17-week low $1.117 Trillion. CP was up $146bn y-t-d, or 19% annualized, with a one-year rise of $30bn.

Global Credit Market Watch:

August 26 – Bloomberg (Tony Czuczka): “German Chancellor Angela Merkel said that markets are trying to ‘blackmail’ governments. Merkel made the comments… at an election rally in Brandenburg, Germany.”

August 22 – Bloomberg (Christian Vits and Jeff Black): “Germany’s Bundesbank criticized European leaders’ handling of the region’s debt crisis, saying their latest decisions threaten to weaken the euro’s institutional framework and compromise the inflation-fighting role of the European Central Bank. ‘By shifting extensive additional risks to the countries providing assistance and to their taxpayers, the euro area has taken a major step toward pooling risks arising from unsound public finances,’ the Frankfurt-based Bundesbank said… ‘Overall, the decisions of July 21 threaten to reduce the consistency of the initially agreed institutional framework of the currency union,’ the Bundesbank said. Fiscal policy is still determined by national parliaments, ‘but risks and burdens are increasingly being dealt with by the community, and in particular by financially strong states,’ it said.”

August 25 – Bloomberg (John Glover): “Finland’s demands for collateral on loans to Greece may trigger a default on 18 billion euros ($26bn) of bonds sold by Europe’s most-indebted country. The securities, which represent less than 7% of Greece’s 286 billion euros of bonds, are governed by English, not Greek, law, and include conditions that insist on equal treatment for all investors. Giving collateral to Finland as a condition for aid may breach the requirement that fresh debt doesn’t win repayment priority over existing notes.”

August 25 – Bloomberg (Sapna Maheshwari): “Speculative-grade bonds are at risk of erasing this year’s gains with the debt headed for its worst month since November 2008 as the faltering economy threatens the neediest borrowers. Hawker Beechcraft…, PMI Group… and NewPage… are leading high-yield, high-risk bonds worldwide to a 5.2% loss this month, trimming this year’s gains to 0.4%...”

August 26 – Bloomberg (Sapna Maheshwari and Tim Catts): “U.S. company bond sales are falling, with speculative-grade issuance headed for the slowest month since December 2008, on growing signs the economy is faltering. PepsiCo… led $5.7 billion of sales this week, a 72% decline from $20.4 billion in the period ended Aug. 19… There were no offerings of high-yield, high-risk bonds this week, leaving August’s total at $1 billion, compared with the monthly average this year of $28.5 billion.”

August 23 – Bloomberg (Krista Giovacco): “Wall Street banks are being forced to sell buyout loans at the steepest discounts since the third quarter of 2010 after committing $24.2 billion to finance mergers and acquisitions. The average original-issue discount needed to sell the debt is at 98.5 cents on the dollar this quarter, down from 99.4 cents in the first three months of the year…”

August 25 – Bloomberg (Esteban Duarte): “The ‘vast majority’ of European collateralized loan funds will wind down in the next three years, casting doubt on the ability of borrowers to refinance $88 billion of maturing debt and threatening defaults, Standard & Poor’s said… CLOs, the primary source of funding for European leveraged loans, are disappearing as managers face hurdles from regulators and lack of investment.”

August 25 – Bloomberg (David Yong and Yumi Teso): “A dollar-supply crunch in Europe is creating a shortage in Asia’s financial centers, pushing up the cost of obtaining the greenback through the swap market. …Singapore’s five-year basis swap and Hong Kong’s one-year contract dropped to the lowest since at least 1999 this month, which means parties paying for the U.S. Currency must accept a discount to benchmark interbank rates for their local currency…. ‘European banks are having difficulties with their dollar funding and that has spread to Asia, but it isn’t yet as bad as in 2008,’ said Tetsuo Yoshikoshi, a senior economist at Sumitomo Mitsui Banking…”

August 22 – Bloomberg (Jody Shenn): “Investors should avoid taking risk in all categories of U.S. securitized debt because American and European policy makers may damage financial markets as they respond to a slowing economy and government deficits, according to Bank of America Merrill Lynch analysts. ‘Rather than a repeat of 2010, when the Fed saved the day with QE2, we think we are moving closer to a repeat of 2008, when major policy errors devastated the economy,’ the analysts led by Chris Flanagan wrote… ‘The pressure to ‘do something’ is now far more likely to result in more desperate or radical measures, even if it is bad policy.’”

August 26 – Bloomberg: “The cost of insuring China’s banks against default rose the most of the largest emerging nations this month as executives failed to convince investors during earnings presentations that they can curb bad loans. Credit-default swaps on debt of Bank of China Ltd. Jumped 88 bps this month to 241 bps, the biggest increase since October 2008…”

August 25 – Bloomberg (Doug Alexander): “Canadian companies sold C$2.04 billion ($2.07bn) in debt in August, on pace for the slowest month for corporate issuance in almost three years after relative borrowing costs rose to a two-year high.”

Global Bubble Watch:

August 22 – Bloomberg (Esteban Duarte): “Citigroup Inc. and Bank of America Corp. were the reigning champions of finance in 2006 as home prices peaked, leading the 10 biggest U.S. banks and brokerage firms to their best year ever with $104 billion of profits. By 2008, the housing market’s collapse forced those companies to take more than six times as much, $669 billion, in emergency loans from the U.S. Federal Reserve. The loans dwarfed the $160 billion in public bailouts the top 10 got from the U.S. Treasury, yet until now the full amounts have remained secret. Fed Chairman Ben S. Bernanke’s unprecedented effort to keep the economy from plunging into depression included lending banks and other companies as much as $1.2 trillion of public money, about the same amount U.S. homeowners currently owe on 6.5 million delinquent and foreclosed mortgages.”

August 23 – Bloomberg (Bradley Keoun): “As markets convulsed in September 2008, Morgan Stanley Treasurer David Wong briefed the Federal Reserve on a ‘dark’ scenario in which the U.S. firm would need at least $10 billion of emergency loans from the central bank. It got 10 times darker by month’s end. Morgan Stanley borrowed $107.3 billion, the most of any bank, according to data compiled by Bloomberg News… Morgan Stanley’s borrowing -- more than twice the amount all banks got from the Fed in the market squeeze that followed the Sept. 11 terrorist attacks -- peaked after hedge funds pulled $128.1 billion from the firm in two weeks, documents released by the Financial Crisis Inquiry Commission show.”

August 24 – Bloomberg (Jim Brunsden): “Regulators said they might not have enough information to assess the threat over-the-counter derivatives pose to the financial system. Shortfalls in available data may undermine attempts to use so-called trade repositories as a tool to improve market oversight, the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions said… The lack of details on the value of trades ‘presents a potential gap in the data that authorities may require to fulfill’ their mandates, the organizations said… The value of outstanding OTC derivatives was about $601 trillion at the end of last year…”

August 23 – Bloomberg (John Simpson): “The crisis threatening the global financial system exceeds the capabilities of developed nations and requires a new International Monetary Fund ‘debt facility,’ former IMF head H. Johannes Witteveen said. ‘Unusual problems require unconventional solutions,’ Witteveen wrote in an opinion piece in the Financial Times today. ‘The world’s financial system is threatened by a new crisis that could be even worse than that of 2008.” He was IMF managing director from 1973 to 1978.”

August 26 – Bloomberg (Cormac Mullen): “Norwegian, Spanish, Belgian financials performed best; Irish, Greek and Danish financials worst in an analysis of one-month returns post QE-related Fed speeches, according to Bloomberg data…”

Currency Watch:

The U.S. dollar index slipped 0.4% this week to 73.71. (down 6.7% y-t-d). For the week on the upside, the New Zealand dollar increased 2.8%, the Norwegian krone 1.8%, the Australian dollar 1.6%, the Swedish krona 1.5%, the Canadian dollar 0.7%, the Danish krone 0.7%, the Singapore dollar 0.6%, the South African rand 0.6%, and the South Korean won 0.5%. On the downside, Swiss franc declined 2.6%, the Mexican peso 1.3%, the British pound 0.6%, the Brazilian real 0.2%, the Taiwanese dollar 0.2%, and the Japanese yen 0.1%.

Commodities and Food Watch:

August 24 – Bloomberg (Whitney McFerron): “A yearlong drought from Kansas to Texas has created the driest conditions on record for farmers preparing to plant winter wheat, dimming crop prospects for a second straight year in the U.S., the world’s largest exporter. Dry weather already has cut output of hard, red winter wheat, the most common U.S. variety, by 22% from 2010… If drought persists into the planting months of September and October, next year’s harvest will be even smaller, and prices on the Kansas City Board of Trade may jump 50% to $13 a bushel, said Dan Manternach, a wheat economist with researcher Doane Advisory Services…”

August 26 – Bloomberg (Jeff Wilson, Justin Doom and Whitney McFerron): “The hottest summer since 1955 in Iowa and Illinois is eroding yield prospects for corn and soybean crops in the U.S., the largest grower and exporter.”

The CRB index increased 1.8% this week (up 0.7% y-t-d). The Goldman Sachs Commodities Index jumped 2.6% (up 4.1%). Spot Gold declined 1.4% to $1,826 (up 29%). Silver dropped 3.6% to $41.39 (up 34%). September Crude rallied $3.07 to $85.48 (down 7%). September Gasoline gained 3.2% (up 20%), and September Natural Gas increased 0.5% (down 10%). December Copper rallied 2.9% (down 7%). September Wheat gained 4.3% (down 4%), and September Corn jumped 5.8% (up 20%).

China Bubble Watch:

August 22 – Reuters (Chris Buckley): “The ‘Black Death’ of debt crisis across the Euro zone will hurt China by sapping demand for exports, although Beijing's relatively small holdings of euro assets will limit any damage to foreign exchange reserves, the nation's top official newspaper said… The bleak diagnosis for the euro's prospects appeared in the overseas edition of the People's Daily, the top newspaper of China's ruling Communist Party… About a quarter of China's record foreign currency reserves of more than $3 trillion are held in euro assets, analysts estimate.”

August 26 – Bloomberg (Sapna Maheshwari and Tim Catts): “China should urge the U.S. government to reduce its fiscal deficit as part of measures to protect China’s foreign-exchange reserves, the Financial News reported… citing Wang Tianlong, a researcher at the China Center For International Economic Exchanges.”

August 26 – Bloomberg (Stephanie Tong): “China’s five biggest banks posted first-half profits that surpassed the total of their 14 largest U.S. and European rivals, highlighting the Asian nation’s financial power as other economies falter. Industrial & Commercial Bank of China Ltd. said… net income rose 29% to a record $17 billion, pushing combined profits of the nation’s biggest banks to $57 billion… China’s banks have increased profits as the world’s second-largest economy sustained growth of more than 9%, helped by a record credit boom that powered its rebound from the global recession.”

August 25 – Bloomberg: “In the Lakeville apartment complex overlooking Shanghai’s downtown bar and shopping district, the yellow jade bathroom sink alone would cost the average Chinese worker three years’ pay. The entire four-bedroom, ground-floor apartment with a terrace, which sold in May for 60 million yuan ($9.4 million), would take 3,140 years of toil. Such luxurious properties are in demand for the swelling ranks of millionaires chasing status and a hedge against soaring inflation even as the government steps up curbs on real estate investment. High-end home prices rose 17.4% in Beijing last quarter from a year earlier…”

August 25 – Bloomberg: “Beijing’s state-owned infrastructure companies face a record amount of bonds maturing next year as China’s capital city pays the bills for the $70 billion 2008 Olympic Games. Fifteen local government financing units based in Beijing must pay 16.2 billion yuan ($2.5 billion) next year plus interest to investors, breaking last year’s record 12 billion yuan… A further 11.6 billion yuan matures in 2013 and 37.6 billion yuan in 2014.”

August 23 – Bloomberg (Sophie Leung): “Hong Kong’s inflation surged to the fastest pace since 1995, encouraging workers to press for higher pay even as the economy teeters on the edge of recession. The consumer price index rose 7.9% from a year earlier after a 5.6% increase in June…”

Japan Watch:

August 25 – Bloomberg (Toru Fujioka and Aki Ito): “Japan unveiled a $100 billion effort to help companies cope with a surging yen, signaling that officials may be resigned to the currency remaining high. The government will release foreign-exchange reserves to the state-run Japan Bank for International Cooperation for funding to aid exporters and spur purchases overseas… The announcement came hours after Moody’s… lowered the nation’s debt rating one step to Aa3, with a stable outlook.”

Latin America Watch:

August 22 – Bloomberg (Bill Faries and Matthew Bristow): “Morgan Stanley cut its forecast for Latin American economic growth this year and next, saying the region is ‘unlikely to be spared’ from a global slowdown. The region’s economies will expand 3.6% next year from a previous forecast of 4.6%, as slower growth in Europe and the U.S. takes its toll on demand for the region’s commodities…”

Unbalanced Global Economy Watch:

August 26 – Bloomberg (Jennifer Ryan): “U.K. economic growth slowed in the second quarter as manufacturing shrank and services showed signs of losing momentum… Gross domestic product rose 0.2% from the first quarter…”

August 22 – Bloomberg (Maud van Gaal): “House prices in the Netherlands fell the most in 14 months as buyers were discouraged by rising interest rates, lending restrictions and Europe’s debt crisis. Prices of existing residential properties dropped 2.3% in July from a year earlier…”

August 22 – Bloomberg (Jeffrey Donovan): “Italy’s austerity drive, enacted in exchange for European Central Bank bond purchases driving down borrowing costs, may backfire as it chokes the economic growth needed to ease Europe’s second-biggest debt burden. Prime Minister Silvio Berlusconi’s Cabinet approved 45.5 billion euros ($66bn) in deficit reductions in Rome on Aug. 12, the nation’s second austerity package in a month, to balance the budget in 2013 and convince investors that Italy can trim debt of about 120% of gross domestic product.”

August 25 – Bloomberg (Angeline Benoit): “Spain’s producer-price inflation rate accelerated to a four-month high in July as commodity costs increased. Prices of goods leaving Spain’s factories, mines and refineries rose 7.4% from a year earlier…”

U.S. Bubble Economy Watch:

August 25 – Bloomberg (Natalie Doss): “U.S. trucking companies may face a 30% surge in wage bills by 2014 as rising demand for freight shipments threatens to push the industry’s driver shortage to the longest on record.”

Central Banking Watch:

August 26 – Bloomberg (Kartik Goyal and Anoop Agrawal): “The Federal Reserve’s decision to keep record-low interest rates and the possibility of further steps to spur the U.S. economy may stoke commodity prices and fan inflation in India, the Asian nation’s central bank said. ‘Given the fiscal limitations and growing signs of weakness in the U.S., the Fed has already indicated that it will pursue its near-zero rate policy at least till mid-2013… It has also hinted at another dose of quantitative easing. This policy stance may keep the commodity prices elevated.’”

Real Estate Watch:

August 23 – Bloomberg (Prashant Gopal): “New York City construction starts plunged almost 40% in the first half as building weakened following a surge last year, according to an analysis by the New York Building Congress. About $6.4 billion of building projects began in the first six months of 2011, down from $10.6 billion a year earlier…All types of construction had ‘significant declines’ from last year, the group said.”

Valuable Insight from Jackson Hole: 

I’ve been an outspoken critic of Federal Reserve policymaking.  Yet I do have great respect for Federal Reserve Bank of Kansas City President Tom Hoenig, soon to retire after a 20-year tenure at the helm of the Kansas City Fed and almost 40 years of service at the Federal Reserve.  Dr. Hoenig is a statesman in an age where they are in too short supply.  It is my hope that, as a private citizen, he will become more outspoken.  I thought CNBC’s Steve Liesman did an outstanding job interviewing Dr. Hoenig in Jackson Hole.  I have excerpted from the CNBC transcript of this insightful chat:

CNBC’s Steve Liesman: “Tom, let’s just start off with the easy part, which is talk about the conference and what we're trying to figure out here. 

Federal Reserve Bank of Kansas City President Tom Hoenig: I hope it's obvious, but one thing you tend to do in periods like this is move from one crisis to the next, one short-term event to the next. And the only way you solve problems is to begin to look to the long run.  Where do you need to be, so you can begin to map how you get there? And that's really what we want to do with this conference. Take a moment, even though we have all this activity whirling around us.  We need to begin to think a little bit longer term and see what kinds of solutions might be out there that will actually solve the problem. 

And if you go back and think about it, we have gone through well over a decade… as a nation, the United States and maybe other parts of the world have systematically consumed more than they produce. And so we've been able to do that by increasing our debt, increasing leverage. Increasing leverage of the consumer, increasing leverage and debt of states, increasing leverage of the federal government - again, increasing leverage of our financial institutions.  Living, in a sense, beyond our means. So there's not going to be an overnight solution to that. We can pour liquidity into the market, yes, but that doesn't really solve the debt problem and the need to rebalance our national and our international economies. So what about the long run? How might we begin charting a course towards that? That's the goal of our conference. 

Mr. Liesman:  You've obviously thought a lot about this. What are your thoughts? How do you end up reducing the amount of debt? Is it a government thing? Is the about the Fed's interest rate? 

Dr. Hoenig:  It's not something you can do overnight. Everyone knows that. My own view is that we have an opportunity with the plan that Simpson-Bowles put forward last December. It was a long-term plan, 25 years or more. It began to show how you both reduce spending and do some revenue reforms and so forth. And I think if we started with that, and taking that as a starting point, it would give us the real opportunity to begin to map a way out of this. There's no quick fix. And I think they realize that, and that's why they gave us a very reasonable long-term plan. That's what we need to begin to focus on again. 

Otherwise, you build the debt. You kind of push for aggregate demand increases. I understand that. But what you're doing is keeping interest rates very low.  You're encouraging debt over time to help demand.  But all that does, then, is help continue to build more debt for the future. Those are not solutions that will get us to where we need to be in the long run. 

Mr. Liesman: The question has been raised by some. Are we pushing for an economic growth number that is beyond our means? 

Dr. Hoenig: Well, I think the potential growth rate in the economy hasn't changed a lot. I mean, over the hundred years or so, our average growth rate in this nation, real growth rate, is about 3% - just a little more. There's no reason why we can't continue to maintain that in the long run. But it doesn't come automatically just because you name it. If you begin to think about the policies that encourage production - I mean, people talk about jobs, but jobs come from increasing production, either of things or some kind of goods. That means you have to give an environment for business, not just a zero interest rate, but an environment where you know what your costs are going to be - [where] you can think longer-term… 

Mr. Liesman: And let's talk about the near-term a little bit. There's been a lot of weak data out there… Are you concerned about a recession? 

Dr. Hoenig: Well, first of all some of the surveys that were done that have been reported on, Philadelphia and so forth - were done during the most volatile week that we had. So I want to wait for a little more data than came out that particular week… I have always said we would have modest growth. It's going to take time because of the leverage. It's not going to be straight-up. We need to be mindful of that. So yeah, we have a long path ahead of us, a long, if you will, almost struggle to rebuild our confidence in our economy, to rebuild our economy. But I am confident we can do that if we look a little further down the road and choose policies that are more long-term focused. 

Mr. Liesman: Do you think the debt ceiling debate had a direct impact on the economy? 

Dr. Hoenig: I think it did. Yes. It made people wonder, "Can we agree? Can we look forward? Is there a solution? Why have they ignored other solutions?" I think it did have a negative impact. People were less sure of where things are going to be now, and they don't see necessarily a clear path forward… 

Mr. Liesman: What's your opinion of those members of Congress who refused to increase the debt ceiling because they opposed any revenue increases? 

Dr. Hoenig: I don't have an opinion. Because… here's my issue. I think people are - politics being what politics are - I think people are well-intentioned. I think people who see the debt growing are concerned, and maybe-- very concerned. And so they're saying, "We can't live like this, so the only way out of this will be that we inflate our way out. So I don't want to see it…”  I don't criticize that. I understand that. And other people say, "Yes, but if we clamp down now, forcefully, we may actually-- put ourselves into a recession." I understand that. There's the well-intentioned. 

That’s why I am disappointed in a lot of individuals for not picking up… Simpson-Bowles. A long-term plan that recognizes we cannot go on as we have; that we have to make change; here's how we go about doing it. Yes, it is longer-term, but it is firm. It is thought through. Here are the consequences. We need to bring our spending down. We need to reform. And go along this track.   I think it would raise the confidence of businesses; it would raise the confidence of consumers, and the idea of shared sacrifice. We talk about it, but unless we all know we're all in it together, then we piecemeal it.  And so, “Why should I talk to many people in agriculture? Why should I give up my subsidies when no one else will? Why should I give up the house-- the home mortgage-- deduction when no one else will?” That's why you have to come together, and it has to be a firm plan, legislated eventually. 

Mr. Liesman: Let's talk about the recent [FOMC] meeting… There were two huge developments. One was a pretty severe downgrade of the economy, and the other was the extension of the exceptionally low language till mid-2013. I wonder if I can get your opinion on those… What's your opinion of the sense of the FOMC statement that downgraded the economy? 

Dr. Hoenig: Well, I think it acknowledges that these recent events have been traumatic. We can see it in the volatility of the market. And I think it says we need to be thinking about this. To me, it also says to others - Congress and others - that let's come on. People need assurances. We need that long-term plan. So I think in that way it's a good message… 

Mr. Liesman: The language that extended the exceptionally low language till mid-2013? 

Dr. Hoenig: Well, I didn't like the extended-period language to begin with.  So I can’t say that I was enamored with this at all. I don't think you can give guarantees to some parts of the market and not to others. I think it encourages speculation. “Oh, yeah, you're safe. Here's a safe haven.” I think people have to make calculated judgments based on events. And that forces the markets to run more efficiently. One of the things… that we've had as a consequence of these very low interest rates, extended period, I see it in my region. You get these artificial asset price movements. You get misallocations of resources. When I see land that goes from $6,000 to $12,000 an acre and I can’t get the cash flows to work on it.  That's a speculative bubble. When I see bond markets that have yields that are so low that it doesn't make sense, then it doesn't make sense. And I don't think we necessarily are going to have good outcomes… I don't see how good outcomes will follow from that. 

Mr. Liesman: The ten year is around 2%. 

Dr. Hoenig: That’s my point. 

Mr. Liesman: Is that a result of Fed policy? Is that a result of the economic [backdrop]? 

Dr. Hoenig: Any price is a result of a combination of things. So part of it is Fed policy, obviously. Part of it is the uncertainty, the safe haven movements of funds. Hard to sort out how much can be attributed to which cause, but they all play a role. But [the yield] is incredibly low, and I think only time will tell - what were the more dominant causes of that.  But I still think monetary policy itself needs to move away from zero and needs to move away from extended-period language. I think it would allow the credit markets to give better signals, still knowing that things are unstable and unsettled.  But it would give better signals that would help lead us over time on a better path of growth long-term. 

Mr. Liesman: And just so I understand your position right, you would have been in favor throughout this period of a weak economy, of a 1% Fed funds rate, that would’ve been a sort of floor that you think the Fed ought to adopt? 

Dr. Hoenig: Well, here’s what I've said in many a speech. What I wanted to do early on was as liquidity went into the market and as the liquidity crisis… You begin, then, to re-normalize and you would try and move to 1% in a fairly expeditious manner. And I think it was in the spring when I said by fall… you pause and you say, “All right. How's the economy? What are the signals? The Fed is confident we’re moving. It’s going to be modest growth, we know that, but it’s systematic.” And then you begin to think about can you move that towards 2%, which is a more normalized, historic level? 

And then you watch the economy and you start making decisions, then, based on where the economy is moving at that time. That allows you, in a sense, to recalibrate and to judge the economy as it evolves, and then to say, “Yeah. Here's what's happening now, but here’s where we are and here’s where we're looking for to the long run. And we will judge our policy based on how those two are in synch or out of synch.” 

Mr. Liesman: So if you were able to set the rate right now, it would be at 1%? That would be your level for now? 

Dr. Hoenig: Well, I wouldn’t do it overnight… 

Mr. Liesman: You would’ve been there already? 

Dr. Hoenig: Right. I would’ve done it.

Mr. Liesman: But when I read your speeches… what’s clear to me is you don’t like zero. And the point you made in the recent congressional testimony was [the] market can't set a price at zero.

Dr. Hoenig: Right. 

Mr. Liesman: You don’t like this zero to a quarter? 

Dr. Hoenig: I do not like it because you're misallocating resources. I mean, it contributes to that. And that's not healthy for an economy. I mean, we have… I'm not saying there’s a bubble, but if prices are misaligned in particular segments, they have to correct. And the longer you allow the misalignment to continue, the harsher the correction. And maybe I am a product of my own experiences because I was in bank supervision in the ‘80s and I can't tell you how many farms were closed, how many banks - we closed 350 banks. How many commercial real estate projects collapsed in front of us; how many people lost their jobs as a result.  It's that concern, that part that you can’t see now because you're focused right here, that you’ve got looking right in front of you. You can't see what’s over the hill, and sometimes what’s over the hill is pretty difficult terrain. 

Mr. Liesman: I just want to be clear about this. You would've dissented from that vote? 

Dr. Hoenig: Well, I'm not saying what I would’ve done because I didn’t vote. You know, you’ve got to be careful. But my record would suggest that I probably would have [dissented]. But I think it's important to push forward, and that it is the role of monetary policy to give you an environment where prices are stable, where resources are allowed to be allocated based on proper price signals.  And when you try and do more than that's capable of doing, you can get distortions and you can pay a price. Because a capitalistic economy - if you really believe in its long-term benefits - has cycles. People do make mistakes. See, the market is valuable not because it's the smartest in the world, but because it's the harshest. It captures mistakes and punishes and forces a correction. It’s when you then interfere with that that you allow the path to go off longer and the correction to be more severe and harder on people.  And that's what you can't lose sight of when you say you're for Capitalism, but not really. 

Mr. Liesman: I thought the market was better than government. 

Dr. Hoenig: Well, but that doesn't make it smart. 

Mr. Liesman: Right. 

Dr. Hoenig: It just makes it better than government. 

Mr. Liesman: Let me ask you how the market should think about these [FOMC] descents. We haven’t been here in 20 years. Does it mean the Fed is divided? Is there then… what's the right word? Is there uncertainty to the [rate] guarantee… because of all this descent? 

Dr. Hoenig: Nonsense. If everyone always agreed, you don't need everyone. Debate is healthy. Discussion is healthy. Different views are healthy. And then you come to a conclusion, the majority carries the day, but you’ve had this big-risk debate.  Would it be credible to the American people to say—“It’s 100%, everyone agreed,” and no one believe it? Then you would say, “Well, what’s going on behind the scenes? …It would undermine people’s confidence in the very institution that they’re relying on. Debate is what leads to good decisions over time, and when you stifle that and when you’re afraid of it, people might misunderstand. I have too much regard for people. Those who have interest to read about it, study it, have an opinion of their own, I have too much regard for them to be afraid of descent. 

Mr. Liesman: But what should we make of this? Should we make that the policy is not very certain? 

Dr. Hoenig: I think you should make of the fact that people are struggling with a very difficult time. Volatility is everywhere. And that there are those of us who are thinking that this has consequences, and we weigh [the] short run and long run different than others on the committee. And therefore, we should express that view, and people should know about that view. And yet, the majority carry the day. They have this view. And the American people should know that. It doesn't mean that people don't have confidence in the leadership. It means that we have rigorous debate. If it's a one-man show, then I think we're really open to serious error. 

Mr. Liesman: Presidential candidate Rick Perry used the word “treasonous” to talk about Chairman Ben Bernanke and additional quantitative easing. What’s your response to that? 

Dr. Hoenig: I don’t have a response, but I think the best reply was from another individual who was a critic of the Federal Reserve, and that's Ron Paul who said, “Well, I would never say you were treasonous. I have accused him of counterfeiting for some time now.” You know, everyone’s got an opinion. And I think we’ll see how it all plays out over time. 

And, yesterday from Bloomberg:  “…Thomas Hoenig said there’s a limit to how much more the central bank can help the U.S. economy and that the focus should now be on solving the country’s fiscal problems.  ‘We can’t do it all,’ Hoenig, the central bank’s longest- serving policy maker, said… ‘We have a problem in this country with debt’ and ‘if we don’t turn to the long run, we will be dealing with overnight crises for as far as the eye can see… Monetary policy is an important tool, it is a valuable tool, but it is not an exclusive tool… it does not solve all problems.’”