Saturday, July 18, 2015

Weekly Commentary: Lessons of 2004

I’ve had similar feelings before, though I recall being less apprehensive.  The years 1999 and 2007 are etched upon my mind.  The bustling of automobiles and trucks on the roads.  Crowded retailers.  Full restaurants and airliners.  Economic data supporting the bullish view that times are good.  Ebullient markets that had grown content to disregard what should have been conspicuous warning signs.

The fundamental problem I’ve had over the years remains unresolved:  The underlying finance fueling the economic boom is not good.  Very few – then as now - appreciated that finance was in reality fatefully unsound.  In the past, U.S. finance was my primary focus. Nowadays it’s global.

In Thursday’s press conference, ECB president Mario Draghi repeated the contemporary central bank mantra: The ECB is ready to respond to any “tightening of financial conditions.”  His wording was almost identical to that uttered by Bernanke back during a period of 2013 market unrest.  This phrase has changed the markets and the world – altered history.  Global central bankers remain determined to backstop the markets – even near all-time highs.  And such comments at this point fail to even raise an eyebrow.

How did a little country like Greece come to accumulate several hundred billion of debt that it cannot service (let alone ever repay)?  The answer lies in a dysfunctional global financial “system” and hopelessly unsound global finance on an unprecedented scale.  It’s not really about the euro and European integration.  The Germans are not to blame.  Or, are the euro and German policies as well responsible for the Chinese Bubble, Japan, the energy sector boom and bust, Puerto Rico, Brazil, Argentina and so on?

In an eighteen hour meeting that ran into Monday morning, European leaders agreed to a framework for a third bailout that would leave Greece in the euro.  A compromise was reached, although Greek leadership is opposed to it as much as the Germans.  The IMF argues the obvious: the new agreement, even if the Greeks follow through on commitments, is not viable.  Greece has way too much debt and the ongoing cost of stabilizing the Greek banks and the economy is massive and unknowable.  Previous bailout “money” has gone to money heaven.  Current bailout funds will vanish more quickly.

The Germans have been absolutely pilloried over the Greek fiasco.  German finance minister Schauble continues to argue the case that it would be in Greece’s interest to pursue a debt writedown outside of the euro.  As I wrote last week, the “Greek” crisis will not be resolved anytime soon.  I still have no sense for the timing of Grexit.

I’m apparently one of the few that finds irony in the Germans today being on the receiving end of much of the blame for Greek and European woe.  They, after all, have been virtually the lone voice over the years warning of the risks of unsound money and Credit.  They lost the debate (first to the U.S. and then to their European partners and the world), and yet now the Germans are held responsible for the consequences.  They are the bad guys for are arguing against printing endless quantities of “money” and tossing them down the Greek rat hole.  It is the Germans and their “hard money” colleagues in Europe that have fought to keep the Draghi ECB from completely discarding the last vestiges of sound “money” principles.

All the while, the emboldened adherents to inflationism miss no opportunity to attack, ridicule and discredit.   And who will foot the bill for Greece’s new $90bn plus bailout?  The dogmatic (or worse) Germans be damned.  Just print.

Highlighting comments made Wednesday by Kansas City Fed president Esther George, the FT ran the headline “Fed Risks Repeat of Rate Rise Mistakes – Some Experts Say US Central Bank Has Not Learnt From the Lessons of 2004.”  “By moving too slowly in 2004, the Fed under then-chairman Alan Greenspan allowed core inflation to move ‘persistently’ above 2%, and the labour market to overheat ‘amid one of the most historic credit bubbles in US history’, she said. Today things may look different, but ‘economic trends and experience suggest otherwise’, she warned darkly, urging the central bank to act now.”

I will darkly warn that the current “rate rise mistake” goes so far beyond 2004 that they’re only faintly comparable.  The article quoted Jim O’Sullivan from High Frequency Economics: “They are a bit behind the curve.” Having chronicled and criticized Fed policy throughout that period, policies over recent years bring new meaning to the entire notion of central bankers waiting too long to tighten.

It was a catastrophic error for the Greenspan and Bernanke Feds to target mortgage Credit growth for policies to reflate consumer spending and economic growth.  It was at the time experimental New Age central bank management.  And I do believe it was a case of a flawed analytical framework and being slow to recognize excesses and Bubble momentum.  Things got away from them.  The economic community could not conceptualize the degree of market, financial system and economic fragility that was building.  The Fed moved belatedly and timidly.  They did, however, at least attempt to actually tighten policy.

After the mortgage finance Bubble boom and bust experience, there is no excuse for policymakers leaving rates near zero for going on seven years now.  The doctrine of targeting higher assets should have been disgraced.  Moreover, I would posit that a promoter of asset price inflation sacrifices its capacity to be an effective financial regulator.

Importantly, the scope of today’s global Bubble ensures that policies are now locked in ultra-loose.  When the Fed (with a $2.1 TN balance sheet) was discussing its “exit strategy” back in 2011, I countered that there’d be “No Exit.”  This week, with chair Yellen discussing tightening in a “prudent and gradual” manner, I can confidently predict that there will be No Tightening.

Global financial markets have grown only more dominant over economies.  Speculation has taken more control over global finance.  Moreover, market-based Credit and leveraging have come to play an only more profound role in system-wide Credit growth and “wealth creation.”  Sustaining this scheme is possible only in ultra-loose.    

There’s always an ebb and flow to markets.  Greed and Fear are such powerful emotions.  It’s also inherent to over-liquefied securities markets to “overshoot” – for excesses that mount on the euphoric upside to be inevitably rectified on the depressing downside.  As such, there are serious issues when securities markets inflate to multiples of real economies.  Recognizing that Credit is inherently unstable, there are extremely serious problems when market-based Credit comes to dominate a nation’s financial system - and then the world.  It was previously unthinkable that central banks would perpetuate ultra-loose monetary policies for years specifically to spur asset price inflation and market-based Credit expansion.

A few years back the world had already passed the point where a bout of de-risking/de-leveraging would have major consequences for markets and economies.  And this gets to the serious issues I have with central bankers “pushing back against a tightening of financial conditions.”  Such language basically signals that central bankers will not tolerate market “ebbing” – for any semblance of market self-regulation and adjustment.  And it was a similar dynamic in the late-twenties that nurtured a historic Bubble that crashed fatefully in 1929.

With the Germans, 2004 and deflationary pressures in the news this week, I was again reminded of comments from eminent German economist Otmar Issing back in 2004.  The ECB’s Chief Economist wrote a WSJ op-ed, “Money and Credit,” in a pushback to Fed policies that were clearly promoting asset Bubbles (CBB “Issing v. Greenspan, February 20, 2004).

Issing from the WSJ:  “Huge swings in asset valuations can imply significant misallocations of resources in the economy and furthermore create problems for monetary policy. Not every strong decline in asset prices causes deflation, but all major deflations in the world were related to a sudden, continuing and substantial fall in values of assets. The consequences for banks, companies and households can be tremendous… Prevention is the best way to minimize costs for society from a longer-term perspective. Central banks are confronted with this responsibility, but there is no easy answer to this challenge. So far, only some tentative conclusions can be drawn. First, in their communication, central banks should certainly avoid contributing to unsustainable collective euphoria and might even signal concerns about developments in the valuation of assets. Second, the argument that monetary policy should consider a rather long horizon is strengthened by the need to take into account movements of asset prices.”

“Huge swings in asset valuations can imply significant misallocations of resources in the economy and furthermore create problems for monetary policy.”  He was prescient.  More than 11 years ago Dr. Issing recognized the key issue for 2015.  “Prevention is the best way to minimize costs for society” went unheeded – in Greece, the U.S., China and the world. “All major deflations in the world were related to a sudden, continuing and substantial fall in values of assets.” Time will tell.

It was another market week with well-defined Bubble Dynamics.  With Grexit at least off the table for a number of weeks, speculation ran wild.  Stocks reversed sharply higher, and the more speculative the stock or sector the more spectacular the move.  Biotech stocks (BTK) surged 6.2%.  The Morgan Stanley High Tech Index jumped 5.0%.  Google added $65bn of market capitalization - on Friday alone.  The Nasdaq Composite ended the week at another all-time record high.  MarketWatch: “Nasdaq surge is triggering tech-bubble flashbacks.”

Flashbacks indeed.  I’ve argued that Bubbles are actually more rational than the crazy manias portrayed in historical accounts.  And as speculators, traders and others this week jumped on board inflating tech and biotech Bubbles, there was desperate liquidation of precious metals, energy and commodities generally.   Gold sank to the low since 2010.  Copper and platinum fell to the lows since 2009.  The HUI gold stock index sank 9.3%, underperforming Biotechs by 1,550 bps in as single week.  There was, once again, prominent career risk in being short stocks or long commodities.  Those who hedged risk fell behind the pack.

At this point, central bank efforts to sustain the Bubble rather conspicuously feed Bubble excess.  And in the post-Bubble post-mortem, there will be a strong case to be made that central bank measures to fight deflation risks were self-defeating.  The end result was only bigger Bubbles, greater resource misallocation, more acute fragility and heightened risk of a global deflationary bust.

Kings dollar and renminbi jumped 2.3% this week.  And while this further enriched the “carry trade” Crowd, this dynamic is increasingly detrimental to global growth.  It cannot be encouraging that the commodity currencies were again hammered.  The bulls can continue to fixate on equities as the signal that all is well.  I suspect the more accurate indicator comes from commodities and currencies:  the global financial “system” is in the midst of precarious late-cycle dysfunctionality.   Excess liquidity flows unchecked into myriad unsustainable Bubbles, only exacerbating The Haves vs. The Have Nots Dilemma on myriad levels.

Chinese shares rallied further.  Yet there were articles supporting the view that foreign investor confidence has been badly shaken.  Chinese shares have stung a number of hedge funds.  Credit data confirmed an uptick in China's Credit expansion, but there are doubts that rapid Credit growth can be sustained now that stocks have faltered.  The stakes are tremendously high in China – for Chinese and global markets, and for the Chinese and global economy.

July 17 – Bloomberg (Ye Xie): “Capital outflows from developing countries reached $120 billion last quarter, the most since 2009, fueled by an exodus from China amid concern over the strength of the country’s economy, according to JPMorgan… It was a reversal from the first quarter when emerging markets had $80 billion of inflows, analysts led by Nikolaos Panigirtzoglou wrote… Investors pulled $142 billion from China between April and June. That extended the total outflow from the world’s second-largest economy over the past five quarters to $520 billion, wiping out all the inflows since 2011 when the country’s growth started to slow, the analysts said.

For the Week:

The S&P500 rallied 2.4% (up 3.3% y-t-d), and the Dow gained 1.8% (up 1.5%). The Utilities surged 4.8% (down 5.1%). The Banks rose 3.2% (up 6.7%), and the Broker/Dealers increased 2.3% (up 9.8%). The Transports gained 1.1% (down 9.3%). The S&P 400 Midcaps added 0.3% (up 3.8%), and the small cap Russell 2000 gained 1.2% (up 5.2%). The Nasdaq100 surged 5.5% (up 10.0%), and the Morgan Stanley High Tech index jumped 5.0% (up 4.5%). The Semiconductors recovered 1.2% (down 2.9%). The Biotechs surged 6.2% (up 28.9%). With bullion hit $32, the HUI gold index sank 9.3% (down 21.6%).

Three-month Treasury bill rates ended the week at two bps. Two-year government yields rose three bps to 0.67% (unchanged y-t-d). Five-year T-note yields added a basis point to 1.67% (up two bps). Ten-year Treasury yields fell five bps to 2.35% (up 18bps). Long bond yields dropped 11 bps to 3.08% (up 33bps).

Greek 10-year yields sank 214 bps to 10.78% (up 104bps y-t-d). Ten-year Portuguese yields fell 20 bps to 2.61% (down one basis point). Italian 10-yr yields dropped 22 bps to 1.91% (up 2bps). Spain's 10-year yields fell 20 bps to 1.92% (up 31bps). German bund yields declined 10 bps to 0.79% (up 25bps). French yields sank 21 bps to 1.07% (up 24bps). The French to German 10-year bond spread narrowed 11 bps to 28 bps. U.K. 10-year gilt yields were unchanged at 2.08% (up 33bps).

Japan's Nikkei equities index surged 4.4% (up 18.3% y-t-d). Japanese 10-year "JGB" yields slipped two bps to 0.42% (up 10bps y-t-d). The German DAX equities index rallied 3.2% (up 19.0%). Spain's IBEX 35 equities index surged 4.0% (up 11.7%). Italy's FTSE MIB index jumped 3.6% (up 25%). Most emerging equities markets rallied. Brazil's Bovespa index slipped 0.5% (up 4.7%). Mexico's Bolsa added 0.9% (up 5.1%). South Korea's Kospi index rose 2.2% (up 8.4%). India’s Sensex equities index jumped 2.9% (up 3.5%). China’s Shanghai Exchange rose 2.0% (up 28.2%). Turkey's Borsa Istanbul National 100 index was little changed (down 3.4%). Russia's MICEX equities index gained 1.6% (up 18.1%).

Junk funds this week saw inflows jump to $1.232bn (from Lipper).

Freddie Mac 30-year fixed mortgage rates rose five bps to 4.09% (up 22bps y-t-d). Fifteen-year rates bps to 3.2% (up 10bps). One-year ARM rates bps to 2.5% (up 1bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates up three bps to 4.17% (down 11bps).

Federal Reserve Credit last week expanded $6.9bn to $4.449 TN. Over the past year, Fed Credit inflated $100.2bn, or 2.3%. Fed Credit inflated $1.638 TN, or 58%, over the past 140 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt dropped $22.8bn last week to $3.345 TN. "Custody holdings" were up $51.5bn y-t-d.

M2 (narrow) "money" supply rose $12.6bn to a record $12.038 TN. "Narrow money" expanded $684bn, or 6.0%, over the past year. For the week, Currency declined $1.9bn. Total Checkable Deposits fell $8.9bn, while Savings Deposits jumped $23.7bn. Small Time Deposits declined about $1.0bn. Retail Money Funds were little changed.

Money market fund assets slipped $1.4bn to $2.632 TN. Money Funds were down $100.5bn year-to-date, while gaining $67bn y-o-y (2.6%).

Total Commercial Paper gained $7.5bn to $1.028 TN. CP was little changed over the past year.

Currency Watch:

The U.S. dollar index jumped 2.3% to 97.96 (up 8.5% y-t-d). For the week on the upside, the South African rand increased 0.7% and the British pound 0.5% For the week on the downside, the euro declined 3.0%, New Zealand dollar 3.0%, Swedish krona 2.7%, the Canadian dollar 2.5%, the Swiss franc 2.4%, the Norwegian krone 2.1%, the Mexican peso 1.4%, the Japanese yen 1.1%, the Australian dollar 1.0% and the Brazilian real 0.9%.

Commodities Watch:

July 17 – Bloomberg (Luzi-Ann Javier): “There are few places left to hide from the commodity meltdown that’s dragging down shares of miners and energy producers and sending gold prices to their lowest since 2010. The Bloomberg Commodity Index fell in a four-day selloff that’s the worst losing streak in three months. Brent oil is headed for the longest run of weekly declines since January, copper is languishing near its lowest since 2009 and wheat fell for a sixth session. Bulls suffering through the rout can blame expanding inventories, with U.S. crude stockpiles remaining almost 100 million barrels above the five-year average for this time of the year. A stronger dollar has also cut the appeal of commodities as alternative assets, and looming concerns over China’s economy threaten to shrink demand further.”

The Goldman Sachs Commodities Index sank 2.6% (down 3.2% y-t-d). Spot Gold lost 2.7% to $1,132 (down 4.5%). September Silver dropped 4.2% to $14.83 (down 5%). August Crude fell $1.85 to $50.89 (down 5%). August Gasoline sank 4.3% (up 31%), while August Natural Gas rallied 3.6% (down 1%). September Copper declined 1.6% (down 12%). September Wheat sank 3.8% (down 6.1%). September Corn fell 3.3% (up 6%).

Greece Crisis Watch:

July 17 – Wall Street Journal (Viktoria Dendrinou): “Eurozone finance ministers said Thursday they decided to grant in principle a new bailout to Greece after the country’s parliament passed a first round of painful austerity measures, though several top officials expressed deep reservations about whether Athens could see the overhauls through. The decision by finance ministers is just one more hurdle the deal has to pass before further talks can even start. …But Greek Prime Minister Alexis Tsipras has publicly said he doesn't fully believe in the agreement. He has also lost support from a significant number of lawmakers in his left-wing Syriza party, and needed help from the opposition to get it through parliament. ‘I welcome the positive vote of the Greek parliament, but this is the easier part of the deal,’ Slovak Finance Minister Peter Kazimir said… ‘The real trouble and challenges may come later. No majority, no ownership could dent implementation of measures [and] reforms.’ Other eurozone decision makers have cast doubt on how long Greece will be able to hold on in the euro… The IMF has repeatedly called for more debt relief for Greece to make the country’s debt level sustainable. But German Finance Minister Wolfgang Schäuble… insisted Thursday that a haircut—a write-down on the face value of Greek government bonds—wasn’t legally possible as long as it remained a member of the currency area. He stressed eurozone members now had a duty to start negotiating with Greece about the terms of the new bailout as long as Athens fulfilled the conditions it agreed to, but said Greece’s situation is ‘extraordinarily difficult,’ given its already high debt level and need for another aid package. ‘I don’t know, nobody knows at the moment how this should be possible without a haircut,’ he said. ‘And everybody knows that a haircut is incompatible with a membership in the monetary union.’”

July 17 – Bloomberg (Ian Wishart and Matthew Campbell): “The last-ditch agreement that’s supposed to keep Greece in the euro almost never happened. Even now, its designers are unconvinced it will work. It will take ‘a small miracle,’ Slovak Prime Minister Robert Fico said after the 17-hour summit that ended Monday. ‘There’s little faith in the current Greek government,’ Dutch Prime Minister Mark Rutte told his Parliament… The deal promises to further degrade a shattered economy through spending cuts and tax increases; it relies for implementation on a self-described party of the radical left; it counts on sales of state assets that Greece’s economy minister says ‘do not exist;’ it leaves untouched a debt load the International Monetary Fund believes will never be repaid. If anything, Greece and its creditors are further apart than ever, with the country’s leaders arguing they accepted a bad deal under duress. ‘It’s clearly a Band-Aid solution,’ Ian Bremmer, president of Eurasia Group, a political-risk consulting firm, said… ‘I’d love to say we’ll be back here in a year or two. It’s more likely to be a few months.’”

July 15 – New York Times (Jack Ewing): “The International Monetary Fund said what everyone knew but would not admit when it laid out in gory detail late Tuesday how Greece could be crushed by its staggering debt unless creditors agreed to lighten the load. The I.M.F. was not saying anything different from what it and its chief, Christine Lagarde, had quietly told eurozone leaders last weekend. But by going public with its warnings, the fund was putting the world on notice: Without some relief that might enable Greece to grow its way out of debt, the I.M.F. is unwilling to continue throwing good money after bad. The question in the next couple of days will be whether that frank appraisal helps or hinders attempts to keep Greece in the eurozone. The I.M.F. report on Greece’s debt said the country had a financial shortfall of 85 billion euros, or $93 billion, and predicted that within two years the country’s i.o.u.s could be twice the size of its annual economic output — an unsustainable burden, in the fund’s view.”

July 14 – Reuters (Tom Koerkemeier): “Some members of the German government would have preferred a temporary Greek exit from the euro zone to another bailout deal, German Finance Minister Wolfgang Schaeuble said…, without saying if he was among them. Initial drafts of the agreement European leaders reached with Greece early on Monday included a German proposal to make Greece take a ‘time-out’ from the euro zone if it failed to meet conditions. The idea was dropped from the final version as not all leaders shared the idea, with a senior EU source saying such a measure would have been illegal. ‘There are many people, including in the federal government, who are quite convinced that in the interests of Greece and the Greek people what we wrote down would have been much the better solution,’ Schaeuble said when asked about the proposal. ‘We wrote down all the possibilities to solve the problem and we discussed that too,’ Schaeuble told a news conference. He added the negotiations for a new aid package and finding temporary financing for Greece were going to be very difficult. Agreeing on a new deal would take about four weeks, he said.”

July 15 – Dow Jones: “International Monetary Fund chief Christine Lagarde said she still had hope that the eurozone would provide Greece with a substantial restructuring of the country's debt but warned of difficult negotiations as officials seek to complete a bailout deal. Ms. Lagarde's comments came a day after the fund warned in a report that Greece needed much more debt relief than European officials have so far considered—an apparent effort to pressure Germany into concrete commitments on debt restructuring. Normally, the fund reserves its most honest assessments for secret, high-level meetings. But by taking the highly unusual step of making public its bleak appraisals of Greece's economy, Ms. Lagarde and her lieutenants are drawing a red line for the eurozone: Agree to substantial debt relief or lose the fund's support and risk a Greek exit from the eurozone. ‘What I very much hope is that we can all keep to a very tight timetable and we can respond to a challenge that is colossal,’ Ms. Lagarde said…”

July 15 – Financial Times (Peter Spiegel, Shawn Donnan and Anne-Sylvaine Chassany): “The International Monetary Fund has warned that it might not be able to participate in Greece’s bailout if the programme does not include substantial debt relief, setting itself on a collision course with the country’s eurozone creditors. The move particularly raises the pressure on Germany, which has opposed any debt relief, just as it prepares to seek the approval of its parliament to negotiate the details of a new bailout hashed out in a summit at the weekend… In the three-page memo, sent to EU authorities at the weekend and obtained by the Financial Times, the IMF said recent turmoil in the Greek economy would lead debt to peak at close to 200% of economic output over the next two years. At the start of the eurozone crisis, Athens’ debt stood at 127%. The memo, prepared for EU leaders ahead of the summit on Greece, argues that only through large-scale debt relief — something eurozone officials have fiercely resisted — could Greece see its debt fall to levels where it would be able to return to the financial markets.”

July 15 – Financial Times (Peter Spiegel, Alex Barker and Elizabeth Rigby): “The European Commission has submitted a formal proposal to use an EU-wide rescue fund to rush aid to Greece to ensure Athens does not default on €7bn it owes on Monday, a proposal that will require Britain to rally allies if it wants to block it. According to an EU official, the commission submitted the plan to use the European Financial Stability Mechanism late on Tuesday after deciding that it was the best option to avoid Greece defaulting on a €3.5bn bond Athens owes the European Central Bank and €3.6bn it owes the International Monetary Fund. If Athens were to default on the ECB bond, the eurozone central bank would be forced to pull emergency loans keeping the Greek banking sector afloat. ‘It’s the most European, politically and economically sound, readily available option,’ said the EU official. ‘Without it, there is a risk the euro summit [agreement] won’t work.’ The commission’s decision comes despite angry objections to the plan by George Osborne, the UK chancellor, who at a meeting of EU finance ministers in Brussels on Tuesday called it ‘a non-starter’. London is furious that the commission is risking inflaming British public opinion ahead of the UK’s referendum on EU membership, which will be held by 2017.”

July 13 - Reuters: “A third bailout for Greece is likely to take around four weeks to negotiate, euro zone officials said on Monday following a meeting of finance ministers, and a green light for talks could come on Friday. ‘We know time is critical for Greece but there are no shortcuts,’ Klaus Regling, head of the European Stability Mechanism (ESM), told a news conference. Jeroen Dijsselbloem, the chairman of the euro zone finance ministers, said it would take four, rather than two weeks and even with that timetable, ‘some people call me an optimist.’”

July 13 – Bloomberg (Matthew Campbell, Nikos Chrysoloras and Fabio Benedetti-Valentini): “Greece’s last-ditch bailout requires the country to sell 50 billion euros ($55bn) of assets, an ambition it hasn’t come close to achieving under previous restructuring plans. The government of then-Prime Minister George Papandreou in 2011 set the same financial goal, which it sought to achieve by hawking airports, seaports, and beachside real estate. Since then, such deals have yielded just 3.5 billion euros… Making the asset-sale math work as the economy contracts will be difficult for Greek Prime Minister Alexis Tsipras… Half the money from asset disposals is earmarked to pay off emergency loans for teetering Greek banks. They need cash to rebuild their capital buffers and without it may no longer be able to operate. ‘Fifty billion euros is a very unrealistic target,’ said Diego Iscaro, an economist at… IHS Inc. ‘Asset prices have been badly hit by the economic depression and we do not expect them to significantly recover any time soon.’”

China Bubble Watch:

July 13 - Bloomberg: “China’s broadest measure of new credit increased the most since January after the government stepped in to boost provincial finances and the central bank accelerated monetary easing. Aggregate financing, which includes bank loans and off-balance-sheet credit, was 1.86 trillion yuan ($300bn) in June… The pick-up suggests that relaxed rules for local authorities to get financing and record-low interest rates are boosting demand for credit. China’s leadership strengthened its policy response in the face of a slowdown in growth -- estimated at 6.8% last quarter -- and a stock-market rout that at one stage had wiped almost $4 trillion off equity valuations.”

July 17 – Bloomberg: “China has made 2.5 trillion yuan to 3 trillion yuan ($483bn) of funding available for government agency China Securities Finance Corp. to support the stock market, people familiar with the matter said. The funding is to offer liquidity support to brokers and to purchase stocks and mutual funds… Chinese stocks rose the most in a week as the government gains ground in efforts to stabilize a stock market that plummeted in the past month after a debt-fueled boom. The Shanghai Composite Index advanced 3.5%. The support ‘shows there’s plenty of ammunition in the market,’ said Zhang Qi, an analyst at Haitong Securities Co.”

July 17 – Financial Times (Gabriel Wildau): “China’s biggest state-owned banks have lent a combined Rmb1.3tn ($209bn) to the country’s margin finance agency in recent weeks to staunch a freefall in the stock market, casting doubt on whether the recent equities rebound is sustainable without government support. China Securities Finance Corp was established in 2011 to lend to securities brokerages to support their margin lending to stock investors. Amid the tumble in equities beginning in late June, however, the government has deployed CSF as a conduit for injecting rescue funds into the stock market. CSF has lent to brokerages to finance their investment in shares and has also purchased mutual funds directly. But the latest revelations indicate that state support for the stock market is much larger than previously disclosed.”

July 17 – Bloomberg: “China injected $48 billion into China Development Bank Corp., according to people familiar with the matter, strengthening the lending power of a bank that’s channeled funding to low-income housing. The People’s Bank of China provided the money from its foreign-exchange reserves, according to one of the people, who asked not to be identified… Asked at a briefing Thursday about a possible capital injection, CDB chief economist Liu Yong had said the PBOC might announce details sometime later.”

July 15 – Bloomberg (Ye Xie and Belinda Cao): “While China's economic expansion beat analysts' forecasts in the second quarter, the country's debt levels increased at an even faster pace. Outstanding loans for companies and households stood at a record 207% of gross domestic product at the end of June, up from 125% in 2008… China's stimulus, including interest rate and reserve-ratio cuts to shore up growth, threatens to delay the country's efforts to reduce its debt, posing risks to the financial stability of the world's second-largest economy. Nonperforming loans had already climbed by a record 140 billion yuan ($23bn) in the first quarter as the expansion in gross domestic product slowed. ‘It's quite an alarming issue,’ says Bo Zhuang, a China economist at London research firm Trusted Sources. ‘The government is trying very hard to slow down the pace of the leveraging up, but they are not deleveraging. The debt-to-GDP ratio will continue to go up.’”

July 14 - Bloomberg: “China is considering allowing another 1 trillion yuan ($161bn) of local government debt swaps, according to people familiar with the matter. The plan has yet to be finalized because the Ministry of Finance needs to discuss it with the National People’s Congress and seek State Council approval…The new quotas will be in addition to the 2 trillion yuan already granted as part of a program to convert high-cost existing debt maturing this year into low-yielding municipal bonds. Local authorities have 1.86 trillion yuan of debt that matures in 2015, as well as a further 919.3 billion yuan in contingent liabilities, according to a government audit report based on data as of June 2013.”

July 14 – Wall Street Journal (Mia Lamar and Laurence Fletcher): “Hedge funds investing in China are seeing their big gains eroded by the market selloff, exposing the downside of investing in an environment where managing risks is difficult and government actions are unpredictable. Battered Chinese shares in Shanghai and Hong Kong were hit by selling again Tuesday, cutting short a three-day rebound. The benchmark Shanghai Composite Index remains down 24% from its seven-and-a-half year high hit on June 12. Several hedge funds, playing in a market still dominated by mom-and-pop investors, and with scant opportunity to make money when markets are falling, have suffered steep losses.”

July 14 - Reuters: “China's top graft-busting agency has lambasted the country's powerful state-owned industries as being riddled with corruption and nepotism, saying the origins of the problem could partly be traced back to the chaos of the Cultural Revolution. As part of President Xi Jinping's battle against corruption, anti-graft inspectors have over the past few months visited dozens of strategic central government-owned groups, where top executives hold the rank of deputy ministers. In a statement reported by most state media on Tuesday, the Communist Party's Central Commission for Discipline Inspection said the inspections had found certain leaders abusing their power and helping relatives for corrupt purposes. ‘Some people embezzled state assets under the name of carrying out reforms, while others tried to corrupt senior officials, using illegally obtained state resources,’ it said. ‘Some are still breaking the rules, spending vast sums on luxurious holiday homes and taking their wives and children out golfing on the public dime,’ the watchdog added. Leaders at some state firms are ignoring party promotion procedures, deciding themselves who to promote, and ‘forming cliques’, it said…”

Fixed Income Bubble Watch:

July 17 – Bloomberg (Tracy Alloway): “Options on indexes comprised of credit default swaps (CDS) have been a sleeper hit over the past few years. While trading indexes comprised of CDS tied to a basket of corporate names can give investors a cheap and easy way to trade corporate credit at a time when the cash market is said to be illiquid, options written on those same indexes can do one better. The options give investors the right to buy or sell CDS indexes such as Markit's CDX or iTraxx series. It's particularly useful since options -- by definition -- give investors additional leverage. That means they can amplify returns from corporate credit, or offer a cheaper way of hedging for a big blow-up event in bonds than simply buying CDX protection itself. Precise data on CDS index options volumes is difficult to come by… Back in 2005, Citigroup estimated that about $2 billion worth of credit index options were trading per month, or roughly $24bn over the course of the year. Last December, the same Citi analysts figured that about $1.4 trillion of the instruments had exchanged hands in all of 2014, compared with $573 billion worth in 2013. If correct, that would be a more than 5,000% jump in activity over the course of a decade.”

July 13 – Bloomberg (Lisa Abramowicz): “Junk-bond investors are getting more and more desperate for liquidity as the Federal Reserve moves closer to ending its era of unprecedented stimulus. The proof is in the hefty price they’re willing to pay to own the most frequently traded bonds, which have steadily returned less than the broader $1.7 trillion U.S. high-yield market for more than three years. They’re also increasingly turning to exchange-traded funds to enter and exit the market, as evidenced by bigger trade sizes. ‘People will say, ‘I just need a liquid way to gain exposure or reduce exposure,’’ said Oleg Melentyev, a credit strategist at Deutsche Bank… ‘The more liquid part of the market is trading at more of a premium.’”

July 15 – Bloomberg (Lisa Abramowicz): “If a company has too much debt and too little income, it’s going to struggle to pay its bills, regardless of when its bonds come due. This is a lesson that investors are learning as distressed U.S. bonds suffer their worst performance since 2008. The notes have plunged 7.5% so far this year and 3.2% this month alone, with some of the biggest losers being the debt of Lightstream Resources Ltd., Peabody Energy Corp. and Cliffs Natural Resources Inc….It’s a painful wakeup call for investors who’ve gotten used to high-yield debt being synonymous with big returns in an era of unprecedented Federal Reserve stimulus… Indeed, the speculative-grade default rate has already begun ticking up from historically low levels, even though most existing corporate bonds don’t have to be repaid for another four years or more. Take American Eagle Energy Company, which filed for bankruptcy after missing the first coupon on a bond it issued just seven months earlier.”

July 17 – Bloomberg (Matt Scully): “Bond buyers have been warned, again. Moody’s… is cautioning for at least the second time this year that investors are at risk from potential defaults in newly issued U.S. commercial mortgage bonds, as record real-estate prices push a measure of leverage in the market past a pre-financial-crisis high. One problem is that loan originators’ appraisals don’t take into account peaking commercial property prices, Tad Philipp, the rating company’s head CMBS analyst, wrote… That echoes the way lenders measured loan-to-value ratios in the run-up to the collapse of Lehman Brothers Holdings Inc. in 2007. ‘This history has largely been repeated,’ Philipp said… That method of underwriting masks risks, which now necessitate a ‘significant cushion’ to protect against potential losses in new bonds, Moody’s said… The loan-to-value ratio on debt in new commercial mortgage-backed securities, as measured by Moody’s, rose to 117.8% on average in the second quarter. The pre-crisis peak was 117.5% in mid-2007, and the ratio was less than 100% as recently the first quarter of 2013.”

Federal Reserve Watch:

July 15 – Bloomberg (Matthew Boesler and Craig Torres): “The Federal Reserve doesn’t see signs of liquidity problems in U.S. bond markets, despite warnings from investors to the contrary. ‘While market commentary increasingly pointed to a possible deterioration in liquidity in these markets, a variety of liquidity metrics -- including bid-asked spreads and bid sizes -- have displayed no notable signs of liquidity pressures over the past half-year,’ the Fed board said… U.S. regulators said in a report Monday that sharp swings in the Treasury market on Oct. 15 were in part caused by the abrupt withdrawal of buy offers by banks, exacerbated by multiple orders from high-frequency traders that canceled each other out.”

U.S. Bubble Watch:

July 16 – Bloomberg (Michelle Kaske): “Puerto Rico said one of its agencies didn’t provide funds needed to cover debt payments as the cash-strapped commonwealth reels from an escalating fiscal crisis. The Public Finance Corp. didn’t direct money due Wednesday to a bond trustee because the legislature failed to appropriate the funds when it passed the budget last month… It’s unclear whether Puerto Rico will still make a $36.3 million payment on bonds maturing Aug. 1 that was to be covered with the money… If it doesn’t pay investors next month, that would mark the first time Puerto Rico has defaulted on a debt payment and would come as it’s seeking to negotiate with creditors to restructure $72 billion of obligations.”

July 14 – Bloomberg (Michelle Kaske and Erik Schatzker): “Puerto Rico bondholders may receive an average of just 60 cents on the dollar if the commonwealth wins the ability to restructure its $72 billion in obligations, according to BlackRock Inc.’s head of municipal debt. The Caribbean island and its agencies need to cut their debt to $40 billion, Peter Hayes, who helps oversee about $116 billion of munis at the world’s biggest money manager, said… That would mean an average recovery of about 60% on its securities, which include general-obligation bonds, sales-tax debt and those from its electric utility, he said. ‘They have all this debt that they can’t afford,’ said Hayes… ‘How do you get out of debt? You either grow your way out -- they’re not growing -- or you restructure. So from the point of view of its citizens, it’s the best outcome.’”

July 17 – Bloomberg (Brian Chappatta): “The cost to American cities for their cash-strapped pension funds is starting to look a lot worse, and it’s not because the stock-market rally may be losing steam. Houston was warned by Moody’s… this month that it may be downgraded because of mounting retirement bills, the latest municipality put on notice as the company ignores bookkeeping gimmicks that let cities mask the size of their debt for years. The approach foreshadows accounting rules for even top-rated issuers that are poised to cause pension shortfalls to swell as new financial reports are released… Janney Montgomery Scott has said growing retirement costs are ‘the largest cloud overhanging’ the $3.6 trillion municipal-bond market, where investors are demanding higher yields from borrowers under the greatest strain.”

July 17 – Bloomberg (John Gittelsohn): “Homes in the San Francisco Bay area sold last month at the fastest pace in almost nine years and prices approached a record as growing consumer confidence, historically low mortgage rates and job growth propelled sales. A total of 9,386 new and existing houses and condominiums changed hands in nine Northern California counties, up 16% from a year earlier and the most for any month since August 2006, CoreLogic Inc. said… The median price was $660,000, up 6.8% from a year earlier and 0.8% below the peak of $665,000 reached in June and July of 2007…”

July 17 – Bloomberg (Victoria Stilwell): “New-home construction in the U.S. climbed in June to the second-highest level since November 2007 as builders stepped up work on apartment projects. Housing starts rose 9.8% to a 1.17 million annualized rate from a revised 1.07 million in May… Ground-breaking on multifamily dwellings jumped 29.4%. Building permits for single and multifamily properties, a gauge of future construction, climbed to an almost eight-year high…”

July 16 – Bloomberg (Jody Shenn and Matt Scully): “It’s no secret Americans are having trouble paying off their record $1.2 trillion in student loans. What’s less known is that the trend is turning a typically sleepy corner of the bond market into a potential hazard zone. People who borrowed money for education before the financial crisis are taking longer than forecast to repay their debt, thanks in part to relief programs. That’s creating a risk for holders of securities created by bundling the loans -- which are government guaranteed -- because the bonds may not be retired by maturity. As a result, Moody’s… and Fitch… are considering cutting their rankings on almost $40 billion of securities, possibly dropping top-rated debt to junk status. The potential downgrades threaten to unleash an unusual situation where fundamentally sound bonds with minuscule coupons that reflect their low default risk would need to find new buyers, potentially crushing their prices.”

Global Bubble Watch:

July 16 – Financial Times (Joe Rennison and Joel Lewin): “Corporate debt investors face the prospect of rising debt defaults from China and the US junk bond market, according to Standard & Poor’s, a twin threat representing an ‘inflexion point’ in the current credit cycle. China ranks as the world’s largest corporate debt market and continues to grow, with its current debt pile representing 160% of the country’s economy. S&P estimates companies will need to sell $57tn of debt between now and 2019, with 40% representing China and 21% of sales coming from the US… S&P expects default rates will accelerate, and may well prompt government support for state-owned enterprises. ‘Rapid debt growth, opacity of risk and pricing (partly due to bank loans dominating funding), very high debt to GDP, and the moral hazard risk of the Chinese market make it a high risk to credit,’ said Jayan U Dhru, analyst at S&P. In the US, years of low interest rates have facilitated companies financing their activities through loans and bonds. Companies with low credit ratings have been able to gain access to financing, as asset managers and hedge funds have sought returns above those offered by high-quality bonds. ‘The vast volume of institutional and retail money flowing into speculative-grade bonds also suggests vulnerability,’ said Mr Dhru.’”

July 16 – Bloomberg (Beth Jinks and Simone Foxman): “Hedge fund manager Paul Singer said that China’s debt-fueled stock market crash may have larger implications than the U.S. subprime mortgage crisis, echoing warnings from fellow billionaire money managers Bill Ackman and Jeffrey Gundlach. ‘This is way bigger than subprime,’ Singer, founder of hedge fund Elliott Management, said… in response to a question about China’s crash potentially affecting other markets. Singer said it may not be big enough to cause a global financial market conflagration. China’s stock market has dropped from a June 12 peak wiping out almost $4 trillion in value in less than a month after investors who borrowed to buy shares had to unwind trades. Markets tumbled even as President Xi Jinping’s government ramped up efforts to stem the rout, including preventing share sales of companies. The threat to markets from the country is a bigger concern to Ackman, who runs Pershing Square Capital Management, than Greece. ‘China is a bigger global threat by far,’ Ackman said… ‘The Chinese stock market is a fairly remarkable phenomenon and I think kind of a frightening one.’”

July 12 – Bloomberg (Cecile Gutscher and Anchalee Worrachate): “If you’re worried the Federal Reserve will topple the debt markets, consider this: there’s rarely been so much cash available in the world to buy assets such as bonds. While the prospect of higher U.S. interest rates sent bonds worldwide to the biggest-ever quarterly loss, JPMorgan… says the excess money in the global economy -- about $5 trillion -- will support demand and bolster asset prices. Since 1990, there have been four periods when households, companies and investors held such a surplus. Each time, markets rallied. ‘The world is awash with unprecedented excess liquidity,’ said Nikolaos Panigirtzoglou, a strategist at JPMorgan…‘Fed tightening won’t change that.’”

July 14 – Wall Street Journal (Gregor Stuart Hunter): “Global investors are turning away from Chinese stocks after aggressive efforts by Beijing to halt the market’s plunge—steps some fund managers say have undermined plans to overhaul the market. Overseas buyers have pulled capital out of Chinese stocks via the Stock Connect trading link between Hong Kong and Shanghai for seven straight trading days, the longest stretch of net outflows since the program began in November. Some fund managers… say they have liquidated their holdings in Chinese domestic stocks, known as A-shares. Chinese regulators ‘shot themselves in both feet,’ first allowing trillions of yuan of margin finance—loans used to invest in shares—to inflate an enormous stock-price bubble, then undoing previous attempts at market reform by intervening when the bubble popped, wrote Michael Lai, investment director at GAM… ‘The final straw was allowing half the companies listed to be suspended from trading, effectively turning A-shares into an uninvestable market,’ he wrote. …The unexpected suspensions will make global investors reluctant to buy China shares, said Francis Cheung, head of strategy for China and Hong at CLSA. ‘They’re not going to be actively investing in the A-share market because they have a fiduciary responsibility,’ he said. ‘They’ll scale back what they do.’”

July 17 – Bloomberg (Michael J Moore and Pamela Roux): “Goldman Sachs… made hundreds of partners rich when it went public in 1999. Its performance since then has turned Lloyd Blankfein into a billionaire. The chief executive officer of the Wall Street bank for the past nine years, Blankfein has seen his net worth surge to about $1.1 billion as the firm’s shares quadrupled since the initial public offering…”

Europe Watch:

July 17 – Financial Times (Peter Spiegel): “Now that eurozone finance ministers have approved reopening bailout talks with Greece, the long slog to negotiating a €86bn deal begins. And one of the remaining unanswered questions is just how Greece’s bailout creditors plan to pay for it. Klaus Regling, who heads the eurozone’s €500bn rescue fund, told German television this week that his European Stability Mechanism was preparing a loan of “perhaps €50bn” for Greece’s third bailout. That would leave as much as €36bn to scrape together from other sources. The second largest source of bailout funding throughout the Greek crisis has always been the International Monetary Fund, which is still in the middle of a five-year €28bn rescue. That IMF programme has distributed €11.6bn so far, leaving €16.4bn that the new bailout could tap. But the recent update of the IMF’s debt sustainability analysis, published by the Fund on Tuesday, makes clear that they are in no mood to disburse any of those funds unless there is a full-scale debt restructuring – which Germany and other eurozone creditor countries have fiercely resisted.”

July 14 – The Guardian (Rowena Mason, Phillip Inman, Helena Smith and Jennifer Rankin): “David Cameron has ruled out British taxpayers providing any funding for a Greek bailout, despite speculation the UK could be asked to contribute as much as £1bn towards the bill. The prime minister’s official spokeswoman said… that Cameron did not believe that UK cash should be on the line, and there was currently no proposal on the table for this to happen. George Osborne, the chancellor, said earlier that he would block any EU move to draw on an emergency fund containing British money for the new bailout programme. Arriving in Brussels for a meeting of European finance ministers, Osborne said: ‘Britain is not in the euro, so the idea that British taxpayers will be on the line for this Greek deal is a complete non-starter. The eurozone needs to foot its own bill.’”

July 17 – Financial Times (Tobias Buck): “One of the most infamous chapters of Spain’s economic crisis on Friday appeared to be drawing to a farcical conclusion, after a Chinese investor bid just €10,000 in an auction to buy the ghost airport of Ciudad Real. The Chinese group was the only bidder for the vast-but-vacant airport built in the thinly populated Castilla-La Mancha region of southern Spain for a reported €1bn. Ciudad Real boasts a 4km runway — long enough to handle an Airbus A380m, the world’s largest passenger jet — and a terminal building designed to accommodate 10m customers a year.”

EM Bubble Watch:

July 16 – Bloomberg (Andrea Jaramillo): “Just when it looked like the Colombian peso was starting to rebound, it’s taken a fresh leg down to the weakest level in more than a decade. The culprit, once again, is oil. While Colombia isn’t even among the world’s top 15 producers, its reliance on energy exports has boosted the peso’s correlation with crude to the highest in emerging markets. So when oil prices started to recover in the middle of March, the peso gained. But as crude resumed its slide over the past month, Colombia’s currency posted the biggest decline among developing nations… Policy makers cut growth forecasts twice this year and now predict the slowest expansion since 2009, while the current-account deficit is poised for a three-decade high.”

Geopolitical Watch:

July 16 – Bloomberg (David Tweed): “China said Japan’s approval of ‘unprecedented’ legislation to expand its military role risked unsettling the region’s security. China, which along with Korea bore the brunt of Imperial Japan’s expansion in the early 20th Century, said… that the legislation could spur a major change in the pacifist military stance adopted by the country after World War II. The bills, which would allow Japan to defend other countries under attack, passed Japan’s lower house, leaving them on the verge of becoming law. ‘The passage of the bills was an unprecedented move in the post-World War II era, and would have complex effects on the regional security environment,’ the Ministry of National Defense said… ‘We will closely watch how Japan makes its next move.’”

Russia and Ukraine Watch:

July 16 – BBC: “The EU has warned of increased tensions amid claims that Russia has redrawn a section of Georgia's de facto border with South Ossetia. Georgia says Russian troops installed signs marking the ‘state border’ of the breakaway region of South Ossetia further inside Georgian territory. The move has left a small portion of the Baku-Supsa oil pipeline under Russia's effective control. Russia has brushed off accusations about its role. Its troops have been patrolling the administrative border since the 2008 Russian-Georgian war over South Ossetia. An EU foreign policy spokesperson said the installation of new signposts ‘had led to tension in the area, with potentially negative effects on the local population, their livelihood and freedom of movement’.”

Japan Watch:

July 17 – BBC: “The Japanese government has decided to scrap its controversial design for the stadium for the 2020 Tokyo Olympics and Paralympics. Prime Minister Shinzo Abe said his government would ‘start over from zero’. The original design, by British architect Zaha Hadid, had come under criticism as estimated building costs almost doubled, reaching $2bn. Mr Abe says the new stadium will still be completed in time for the games. However, the delay means that the stadium will no longer be ready in time for the 2019 Rugby World Cup, which Japan is also hosting… Japanese officials say the contract with Zaha Hadid's architecture firm will be cancelled, and a new design chosen within six months.”