Friday, October 24, 2014

06/25/2010 Bond Bubble *

For the week, the S&P500 fell 3.6% (down 3.4% y-t-d), and the Dow dropped 2.9% (down 2.7% y-t-d). The Banks declined 1.7% (up 15.2%), while the Broker/Dealers fell 2.2% (down 9.7%). The Morgan Stanley Cyclicals sank 3.5% (up 0.3%), and the Transports were hit for 4.3% (up 3.5%). The Morgan Stanley Consumer index sank 4.1% (down 2.4%), and the Utilities fell 4.3% (down 7.3%). The S&P 400 Mid-Caps dropped 3.7% (up 2.6%), and the small cap Russell 2000 sank 3.3% (up 3.2%). The Nasdaq100 was clobbered for 3.9% (down 1.2%), and the Morgan Stanley High Tech index sank 4.6% (down 6.1%). The Semiconductors fell 5.2% (down 2.2%). The InteractiveWeek Internet index was hit for 4.2% (unchanged). The Biotechs fell 1.7%, reducing 2010 gains to 14.6%. With bullion little changed, the volatile HUI gold index slipped 0.2% (up 14.7%).

One-month Treasury bill rates ended the week at 3 bps and three-month bills closed at 12 bps. Two-year government yields dropped 8 bps to 0.61%. Five-year T-note yields sank 14 bps to 1.83%. Ten-year yields dropped 11 bps to 3.11%. Long bond yields fell 8 bps to 4.06%. Benchmark Fannie MBS yields declined 11 bps to 3.84%. The spread between 10-year Treasury yields and benchmark MBS yields was unchanged at 73 bps. Agency 10-yr debt spreads widened 2 bps to 32 bps. The implied yield on December 2010 eurodollar futures was little changed at 0.81%. The 10-year dollar swap spread increased 1.5 to 6.75. The 30-year swap spread increased one to negative 18.5. Corporate bond spreads widened. An index of investment grade spreads widened 4 to 114 bps, and an index of junk bond spreads widened 31 to 683 bps

Debt issuance slowed from last week. Investment grade issuers included Wrigley $1.8bn, GE Capital $1.0bn, Erac USA Finance $1.0bn, Cantor Fitzgerald $300 million, Jefferies Group $400 million, Genworth Financial $400 million, Private Export Funding $400 million, Puget Sound Energy $250 million, Realty Income $250 million and Penn Mutual Life $200 million.

Junk issuers included Case New Holland $1.5bn, Capella Healthcare $500 million, Michael Foods $430 million and Entertainment Properties $250 million.

I saw no converts issued.

International dollar debt sales included Shell $2.75bn, HSBC $2.0bn, Covidien $1.5bn, Export-Import Bank of Korea $1.25bn, Canadian Imperial Bank $1.25bn, Bank of Montreal $1.0bn, International Bank of Reconstruction & Development $1.0bn, and Grupo Bimbo $800 million.

U.K. 10-year gilt yields dropped 16 bps to 3.38%, and German bund yields declined 12 bps to 2.61%. Greek 10-year bond yields surged 99 bps to 10.41%, and 10-year Portuguese yields rose 13 bps to 5.72%. The German DAX equities index fell 2.4% (up 1.9% y-t-d). Japanese 10-year "JGB" yields declined 5 bps to 1.14%. The Nikkei 225 sank 2.6% (down 7.7%). Emerging markets were mixed. For the week, Brazil's Bovespa equities index increased 0.6% (down 5.5%), while Mexico's Bolsa slipped 0.6% (up 1.5%). Russia’s RTS equities index fell 4.5% (down 3.7%). India’s Sensex equities index was unchanged (up 0.6%). China’s Shanghai Exchange rallied 1.6% (down 22.1%). Brazil’s benchmark dollar bond yields declined 3 bps to 4.71%, and Mexico's benchmark bond yields fell 13 bps to 4.57%.

Freddie Mac 30-year fixed mortgage rates declined 6 bps last week to 4.69% (down 73bps y-o-y), the lowest rate since 1971. Fifteen-year fixed rates dropped 7 bps to 4.13% (down 74bps y-o-y). One-year ARMs dropped 5 bps to 3.77% (down 116bps y-o-y), the lowest level since the spring of 2004. Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 6 bps to 5.52% (down 104bps y-o-y).

Federal Reserve Credit rose $6.3bn last week to $2.328 TN. Fed Credit was up $108bn y-t-d (10.1% annualized) and $332bn, or 16.6%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 6/23) increased $10.1bn to a record $3.090 TN. "Custody holdings" have increased $135bn y-t-d (9.5% annualized), with a one-year rise of $326bn, or 11.8%.

M2 (narrow) "money" supply declined $37.5bn to $8.564 TN (week of 6/14). Narrow "money" has increased $52bn y-t-d. Over the past year, M2 grew 1.4%. For the week, Currency added $0.2bn, while Demand & Checkable Deposits fell $24.5bn. Savings Deposits declined $4.0bn, and Small Denominated Deposits dropped $4.0bn. Retail Money Fund assets decreased $5.1bn.

Total Money Market Fund assets (from Invest Co Inst) rose $12bn to $2.818 TN. In the first 25 weeks of the year, money fund assets sank $476bn, with a one-year decline of $891bn, or 24.0%.

Total Commercial Paper outstanding jumped $15.4bn last week to $1.099 TN. CP has declined $71bn, or 12.7% annualized, year-to-date, and was down $56bn from a year ago (4.8%).

International reserve assets (excluding gold) - as tallied by Bloomberg’s Alex Tanzi – were up $1.609 TN y-o-y, or 23.7%, to a record $8.406 TN.

Global Credit Market Watch:

June 25 - Bloomberg (Christine Harper): “Legislation to overhaul financial regulation will help curb risk-taking and boost capital buffers. What it won’t do is fundamentally reshape Wall Street’s biggest banks or prevent another crisis, analysts said. A deal reached by members of a House and Senate conference early this morning diluted provisions from the tougher Senate bill, limiting rather than prohibiting the ability of federally insured banks to trade derivatives and invest in hedge funds or private equity funds. Banks ‘dodged a bullet,’ said Raj Date, executive director for Cambridge Winter Inc.’s center for financial institutions policy… The overhaul, which still requires approval from the full Congress, won’t shrink banks deemed ‘too big to fail,’ leaving largely intact a U.S. financial industry dominated by six companies with a combined $9.4 trillion of assets. The changes also do little to solve the danger posed by leveraged companies reliant on fickle markets for funding, which can evaporate in a panic like the one that spread in late 2008.”

June 23 - Bloomberg (John Glover): “Greece’s banks have borrowed about 89.4 billion euros ($110bn) in so-called repurchase agreements with the European Central Bank, according to Moody’s… Greek banks turned to the ECB for cash after the global financial crisis that peaked in 2008 and this year’s sovereign fiscal debacle curbed their access to wholesale funding and bond markets.”

June 22 - Bloomberg (Anchalee Worrachate and Paul Dobson): “U.K. gilt sales may fall 28% this fiscal year as Chancellor of the Exchequer George Osborne cuts spending to reduce the budget deficit and safeguard the nation’s top credit rating. The government will issue 165 billion pounds ($246bn) of gilts in the year ending March 31… Osborne will present his emergency budget on June 22…”

June 24 - Bloomberg (Simone Meier): “Moritz Kraemer, head of the sovereign ratings group for Europe, Middle East and Africa at Standard & Poor’s, said euro-region governments are facing a ‘huge challenge’ on cutting their budget deficits. ‘It’s quite difficult, it’s a huge challenge,’ Kraemer told Bloomberg… ‘We must not underestimate the task ahead at all. We have accumulated imbalances and in some places excesses.’"

June 24 - Bloomberg (Patricia Kuo): “More than 80% of the collateralized loan obligation managers in Europe may not survive after raising no new funds since 2008, according to David Forbes-Nixon, chairman of Alcentra Group Ltd., Europe’s largest CLO manager. ‘Over the next 12 months there should be significant consolidation,” Forbes-Nixon said… ‘There will probably be only 10 to 12 survivors in Europe, out of 60. If you haven’t got at least $3 billion under management, you don’t have a viable business.’”

June 22 - Bloomberg (Joshua Gallu and Jody Shenn): “ICP Asset Management LLC and its founder were sued by U.S. regulators for their role in selling mortgage-backed securities to vehicles insured by American International Group Inc. as the housing market declined.”

Global Government Finance Bubble Watch:

June 24 - Bloomberg (Jody Shenn): “Mortgage securities with U.S.-backed guarantees are trading at record high prices on speculation homeowner refinancing will fail to accelerate and as supply of the bonds remains limited…‘It’s gotten insane,’ said Scott Simon, the head of mortgage-backed securities at… Pacific Investment Management… ‘This is rarefied air.’

Currency Watch:

June 24 - Bloomberg (Warren Giles): “Swiss banks, the haven of choice for the wealthy until last year’s purge against financial secrecy, are winning funds as mounting debt in Europe spooks investors… ‘While we’re not seeing huge inflows, there’s a clear trend for clients wanting to have custody of their assets in Switzerland,’ said Anne-Marie de Weck, a managing partner at Lombard Odier… ‘There’s an increasing interest that wasn’t there six or 12 months ago.’”

The dollar index slipped 0.4% to 85.32 (up 9.6% y-t-d). For the week on the upside, the Japanese yen increased 1.6%, the British pound 1.5%, the Swiss franc 1.3%, the New Zealand dollar 1.1%, the Taiwanese dollar 0.3%, the Australian dollar 0.3%, the Swedish krona 0.1%. For the week on the downside, the South African rand declined 1.6%, the Norwegian krone 1.3%, the Canadian dollar 1.3%, the South Korean won 1.0%, the Mexican peso 0.9%, the Brazilian real 0.5%, and the Euro 0.1%.

Commodities Watch:

The CRB index rose 1.0% (down 6.3% y-t-d). The Goldman Sachs Commodities Index (GSCI) increased 0.3% (down 2.4% y-t-d). Spot Gold was little changed at $1,255 (up 14.4% y-t-d). Silver dipped 0.7% to $19.10 (up 13.4% y-t-d). August Crude added 91 cents to $79.19 (down 0.2% y-t-d). July Gasoline gained 1.0% (up 5.7% y-t-d), while July Natural Gas fell 2.7% (down 12.7% y-t-d). September Copper surged 6.9% (down 7.3% y-t-d). September Wheat declined 1.4% (down 13% y-t-d), and September Corn fell 5.5% (down 16% y-t-d).

China Watch:

June 24 - Bloomberg (Katrina Nicholas): “China’s record loan growth and the repackaging and selling of debt by its banks has raised credit risks ‘considerably,’ and might lead to another financial crisis, Fitch… said. ‘Credit is disappearing from bank balance sheets, resulting in a pervasive understatement of credit growth and credit exposure,’ Charlene Chu, Fitch’s senior director of financial institutions for China, said… ‘But credit risk has not disappeared, merely been transferred to investors.’ …Growing numbers of Chinese banks are entering increasingly complex transactions designed to circumvent regulations, according to Fitch. They involve banks selling loans to a trust company, which then creates a wealth-management product around them and gives these back to the bank to distribute. Banks then sell on the product to investors and with the money, pay off the loan, the risk assessor said.”

June 23 - Bloomberg: “Chinese banks’ surge in loan growth since late 2008 has raised their exposure to credit risk and future asset quality deterioration is ‘a near certainty,’ according to Fitch… The majority of new loans have gone to local government projects and real estate and both have ‘questionable returns over the medium-term,’ Charlene Chu… director at Fitch, said… ‘Chinese banks’ financial positions are more strained than it appears, which could complicate the implementation of additional stimulus in the event of a ‘double-dip’ recession,” Chu said.”

June 23 - Bloomberg (Makiko Kitamura, Yuki Hagiwara and Takako Iwatani): “Toyota Motor Corp. and Honda Motor Co. halted production at factories in southern China after two suppliers’ plants were closed by strikes, extending disputes at parts makers in the nation to at least eight in the past month.”

June 24 - Bloomberg: “Yu Jiang looks into the front window at his two-bedroom apartment in the center of Kangbashi, in China’s Inner Mongolia, and says he may buy another. The place has been empty for three years, as are as many as 90% of the units near it. Designed for 300,000 people, Kangbashi, the new urban center of Ordos prefecture west of Beijing, may have only 28,000 residents, Bank of America-Merrill Lynch said… Standard Chartered Bank called it ‘the Dubai of northern China’ for its vacant skyscrapers and more than 1.1 trillion yuan ($161bn) worth of new public buildings and local wealth.”

India Watch:

June 24 - Bloomberg (Shobhana Chandra and Unni Krishnan): “India’s rising prices are a concern that the central bank will have to weigh against the risks to growth from the European debt crisis, Finance Minister Pranab Mukherjee said. Inflation ‘is a matter of concern,’ Mukherjee said… India’s benchmark wholesale-price inflation unexpectedly accelerated 10.16% in May from a year earlier…”

Asia Bubble Watch:

June 24 - Bloomberg (Chinmei Sung and Yu-huay Sun): “Taiwan’s central bank unexpectedly raised its benchmark interest rate for the first time since 2008, joining Asian policy makers from China to Malaysia… Governor Perng Fai-nan and his board increased the discount rate… to 1.375% from a record-low 1.25%...”

June 24 - Bloomberg (Eunkyung Seo): “South Korea will ‘normalize’ its accommodative policies and take pre-emptive steps against inflation as the economy is set to grow faster than previously forecast amid a global rebound, the Finance Ministry said. The ministry raised its economic growth forecast for this year to 5.8% from the 5% projected in December… exports will grow 25%, it said. ‘The economy may be able to achieve better than’ the government’s growth projection this year, Finance Minister Yoon Jeung Hyun told reporters…”

June 24 - Bloomberg (Chinmei Sung): “Chen-Hsu Liyu, who sells pig’s blood cakes from a suitcase-sized steamer in Taipei’s Monga Night Market, expects to profit from China’s decision to relax the yuan’s peg to the dollar. About 54 million Chinese may travel abroad this year, and a stronger yuan may boost their spending in Taiwan… Travelers from mainland China… increased their spending 21% to $43.7 billion last year…”

June 23 - Bloomberg (Stephanie Phang): “Singapore’s inflation held at a 14-month high in May as the island’s economic rebound boosted food, housing and car prices. The consumer price index climbed 3.2% from a year earlier…”

June 23 - Bloomberg (Joyce Koh, Alexis Leondis and Warren Giles): “Asia-Pacific’s number of millionaires equaled Europe’s for the first time last year… according to… Capgemini SA and Merrill Lynch… The number of individuals with at least $1 million of investable assets in Asia-Pacific rose 26% to 3 million in 2009, matching Europe and almost overhauling North America’s 3.1 million… Asia ‘continues to lead the global economic recovery and this has benefited many of the markets in the region in terms of both growth and wealth creation,’ Ong Yeng Fang, market managing director for Indonesia, Philippines and Thailand at Merrill Lynch Wealth Management, said…”

Unbalanced Global Economy Watch:

June 25 - Bloomberg (Bryant Urstadt): “The Olympics are over, and the Village is for sale. The complex in Vancouver, British Columbia, that housed the athletes during the 2010 Winter Olympics has been converted into 1,100 luxury condos… An 815-square-foot, one-bedroom apartment is on sale for C$879,000 ($845,270), which works out to C$1,078 a square foot, or $12 higher than the average price in Manhattan…”

June 24 - Bloomberg (Tracy Withers): “New Zealand’s economy expanded for a fourth straight quarter as exports strengthened, adding to the case for the central bank to raise interest rates further. Gross domestic product increased 0.6% from the previous three months…”

U.S. Bubble Economy Watch:

June 23 - Bloomberg (Shobhana Chandra and Timothy R. Homan): “Purchases of new homes in the U.S. fell in May to a record low as a tax credit expired, showing the market remains dependent on government support. Sales collapsed a record 33% to an annual pace of 300,000 last month from April… the fewest in data going back to 1963… Demand in prior months was revised down.”

June 22 - Bloomberg (Phil Mattingly): “U.S. bank failures through 2014 will drain $60 billion from the Federal Deposit Insurance Corp. fund that protects customer accounts in the event of a collapse, the agency said… ‘We expect bank failures to peak this year and start tapering off next year as the banking industry continues to heal and recover, but there are some uncertainties that lie ahead,’ FDIC Chairman Sheila Bair said… Regulators are closing banks at the fastest pace since the savings-and-loan crisis ended in the 1990s, seizing 83 lenders through June 18… after shutting 140 in 2009… The surge in failures has pushed the industry-supported fund into a deficit for the first time since early 1990s…”

June 24 - Bloomberg (Stanley Reed): “Oil spill aside, U.S. energy security will suffer if BP Plc goes under or is significantly reduced in size… BP says it’s considering asset sales to help cover the cost of a $20 billion escrow fund President Barack Obama demanded the oil producer set up to handle U.S. claims. The company’s survival may also be in doubt if the financial hit from the Deepwater Horizon rig explosion approaches $100 billion, as some analysts suggest is possible…”

Central Bank Watch:

June 23 - Bloomberg (Scott Hamilton): “Bank of England policy maker Andrew Sentance made the first push for an interest-rate increase in almost two years this month, opening a split among officials… Sentance favored an increase to 0.75%, arguing that inflation was proving to be ‘resilient’ after the recession.”

June 23 - Bloomberg (Omar R. Valdimarsson): “Iceland’s central bank cut the benchmark interest rate by half a point after international lenders said the island’s efforts to rebuild its financial system were on track… Sedlabanki lowered the seven-day collateral lending rate to 8%...”

GSE Watch:

June 24 - Bloomberg (Lorraine Woellert): “Fannie Mae… will temporarily deny new loans to borrowers who deliberately default and walk away from their homes. Borrowers who have the means to make mortgage payments and don’t work with lenders to restructure loans will be banned from obtaining new mortgages backed by Fannie Mae for seven years from the date of foreclosure, the company said… Fannie Mae, along… Freddie Mac, own or guarantee more than half of the $10.7 trillion U.S. mortgage market.”

Fiscal Watch:

June 25 – Financial Times (Edward Luce): “Peter Orszag, Barack Obama’s budget director, resigned this week partly in frustration over his lack of success in persuading the Obama administration to tackle the fiscal deficit more aggressively, according to sources inside and outside the White House. Mr Orszag… is seen as the guardian of fiscal conservatism within the White House. Other members of Mr Obama’s economic team, notably Lawrence Summers… have placed more emphasis on the need for continued short-term spending increases to counteract what increasingly looks like an anaemic economic recovery in the US.”

California Watch:

June 23 - Los Angeles Times (Hector Becerra): “Maywood, a small working-class community south of downtown Los Angeles, plans to lay off virtually all its employees, disband its Police Department and turn over its entire municipal operations to a neighbor -- an action that appears to be without precedent among California cities. Several cities in the state have said that they are close to bankruptcy because of the sharp drop in sales and property tax revenues…”

Muni Watch:

June 25 - Bloomberg (Jeff Kearns and Christopher Palmeri): “The widening gap between the cost of insuring U.S. municipal and federal debt shows investors are betting that state and local governments can’t contain their budget problems, according to Macro Risk Advisors LLC, which predicted the European crisis… ‘People are just starting to wake up to this,’ said Justin Golden, a strategist for the… firm. ‘The market is starting to assign greater levels of fear. The further you go out, things look challenging for a lot of these states.’ With state deficits estimated to total $104 billion in fiscal 2011, ‘it seems likely that the federal government will eventually be faced with the choice of allowing municipal bankruptcies or backstopping the states,’ the report said.”

June 25 - Bloomberg (Edward Robinson): “Californians don’t see much evidence that the worst economic contraction since the Great Depression is coming to an end. Unemployment was 12.4% in May… Lawmakers gridlocked over how to close a $19 billion budget gap are weighing the termination of the main welfare program for 1.3 million poor families or borrowing more than $9 billion in the bond market… Far from rebounding, the Golden State, with a $1.8 trillion economy that’s larger than Russia’s, is sinking deeper into its financial funk. And it’s not alone. Even as the U.S. appears to be on the mend… finances in Arizona, Illinois, New Jersey, New York and other states show few signs of improvement. Forty-six states face budget shortfalls that add up to $112 billion for the fiscal year ending next June, according to the Center on Budget and Policy Priorities… ‘States are going to have to cut back spending and raise taxes the same way Greece and Spain are,’ says Dean Baker, co- director of the Center for Economic and Policy Research…”

June 23 - Bloomberg (Darrell Preston and Jeff Green): “Michigan’s auto-industry collapse, which led to the worst home-price drop among U.S. states, has forced some of its wealthiest and fastest-growing communities to seek state aid to prevent municipal bond defaults. Detroit, slammed by the state’s 74% housing-price decline, warned of bankruptcy when it borrowed in March to cover part of a $280 million deficit. Now, nearby communities in Livingston County such as Hartland Township and Howell Township may need legislation to help make bond payments.”… ‘We’re trying to stem the bleeding,’ said Representative Bill Rogers, a Livingston County Republican and cosponsor of some of the legislation. ‘There’s no way they could pay these with no income coming in.’”

Speculator Watch:

June 24 - Bloomberg (Katherine Burton and Saijel Kishan): “Hedge funds that bet on economic trends are attracting cash at almost double last year’s pace as they seek to profit from events such as Europe’s sovereign debt crisis and China’s decision to let the yuan trade more freely. So-called macro funds pulled in $2.5 billion through April, compared with $4 billion in all of 2009, according to… BarclayHedge…”

Bond Bubble?

“I find it truly amazing to see how many pundits refer to the bond market as if it is in some sort of a bubble. How can a security whose price is constantly projected to decline by the economics community be in a bubble? How can any asset class be in a bubble where the capital is guaranteed and which pays out a coupon twice a year? It makes no sense.” David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates, writing in the Financial Times, June 21, 2010

As an analyst of Bubbles, the economic community’s price sentiment is not high on my list of key Bubble indicators. And it is the nature of Bubbles to flourish specifically because of perceptions of seemingly guaranteed returns (tech stocks only go up, home prices have never gone down, governments don't default, etc.). I have theorized that policymaker response to the 2008 bursting of the Wall Street/mortgage finance Bubble unleashed a Bubble in sovereign debt – the “Global Government Finance Bubble.” I see ongoing evidence supporting this thesis.

Yet there remains a contentious debate on whether Treasury bonds are in a Bubble. The bond bulls – most with strong views anticipating a deflationary backdrop – see Treasury prices well-supported by underlying inflation trends. The best I can tell, the bullish camp doesn’t venture far away from prices when it comes to Bubble analysis. They also tend to view Bubble risk in terms of the probability for imminent major price declines. My Bubble focus is on structural effects, both financial and economic.

I am reminded of the discourse back in the Bubble period 2004-2007. Many, including Federal Reserve Chairman Greenspan, argued forcefully that housing wasn’t in a Bubble. The Bubble apologists were fond of the presumption that “there can’t be a national housing Bubble because real estate markets are always local.” Such shallow commentary ignored the national dynamics of the mortgage Credit marketplace. It also disregarded the speculative dynamics that had come to command both mortgage finance and our real estate markets. And, importantly, the apologists failed to factor in the major structural distortions wrought from trillions of mispriced mortgage Credit.

Bubble analysis must focus first and foremost on the underlying sources, quantity and dynamics of the underlying Credit. Are there unusual supply and/or demand dynamics at work fueling self-reinforcing market distortions? Is over-issuance of Credit fundamental to the market’s perception of minimal asset price risk? Are other dynamics at play providing market participants assurance that risks can be downplayed or even ignored? Bubble analysis should de-emphasize near-term price fluctuations/prospects and instead focus on ongoing structural Credit, market, and economic effects/impairments.

The major rally in Treasurys and the dollar over the past couple of months helped solidify the bullish view that our nation’s fiscal situation is relatively benign and that the U.S. retains its premier safe haven status. An alternative explanation posits that much of the rally has been “technical” - the result of the crowd caught on the wrong side of global leveraged speculations. Moreover, I strongly believe that both Treasurys and the dollar have benefited from the markets’ perception that the U.S. enjoys a competitive advantage in “reflation” – that our policymakers continue to enjoy great flexibility and latitude for both fiscal and monetary stimulus. In stark contrast to Greece, a prevailing bullish view holds that massive ongoing U.S. fiscal and monetary stimulus ensures U.S. assets (debt and equity securities and real estate) retain both an inflationary bias (prices tending to rise) and less downside (Credit dislocation) risk.

Back in November - and in spite of gross borrowing excesses - the markets were fine lending to Greece for two years at about 2%. Two-year Greek yields traded today at 10%, down from as high as 18% last month. Were Greek bonds in a Bubble this past autumn? I would argue an emphatic “yes” and then question why analysts would not contemplate that similar misperceptions and speculative dynamics might be in play in our debt markets.

The markets were convinced that Greek debt was essentially guaranteed by the Eurozone – as well as backstopped more generally by global policy-induced market liquidity excess. As such, underlying fundamentals were not a primary market concern. This fateful market misperception was similar to the mortgage finance Bubble belief that Fannie, Freddie, the Fed and Treasury would ensure uninterrupted liquidity and stability throughout the mortgage, MBS and housing marketplaces.

These are precisely the types of major market distortions that virtually ensure spectacular booms and busts. As long as ample new borrowings – Greek debt or U.S. mortgage Credit – were forthcoming, a semblance of stability and sustainability was maintained. But as soon as market yields rose – and more fundamentally-based risk premiums took hold – the true state of underlying structural debt problems were illuminated and the bubbles soon burst. For an extended period, the market accommodated Bubble excesses, only to see the Bubble falter almost the moment that this accommodation began to wane.

Are Treasury bonds a Bubble? Well, I certainly believe major market misperceptions are deeply ingrained and significantly distorting prices. I see a marketplace where the prospect for ongoing massive issuance is having minimal impact on prices and risk perceptions. I see over-issuance of Treasury debt significantly impacting the pricing and perception of risk throughout our securities and asset markets. The unprecedented expansion on government debt is surely having a major influence on the flow of finance throughout the economy and, over time, having deleterious effects on the underlying financial and economic structures. I see self-reinforcing dynamics where the over-issuance of government Credit foments speculation – in many markets. And I would argue that underlying fundamentals are masked by ongoing Credit excesses and the attendant mispricing of risk. Market underpinnings would deteriorate rapidly with any significant change in market perceptions and a resulting rise in yields.

Market perceptions are in the process of changing. Municipal Credit default swap (CDS) prices jumped again. This week, California CDS prices surged 46 bps to 346 bps. Illinois CDS rose 48 bps to 360 bps. New York State increased 35 bps to 284 bps, and New York City CDS rose 21 bps to 237 bps.

While changing perceptions may not yet be manifesting in higher Treasury yields, it is apparent that the markets are taking a much dimmer view of U.S. debt risks. In particular, muni debt protection costs have risen dramatically, and junk bond spreads have widened about 200 bps over the past six weeks. It is also worth noting that dollar strength has begun to wane. Perhaps subtle, but a case can be made that market concern for structural debt problems is shifting to the U.S. At the early stage of a changing market risk focus, one would expect the marginal borrowers (muni and junk) to begin to suffer (as Treasuries, for now, retain their bulletproof status).

In an op-ed piece in Wednesday’s Financial Times, German Finance Minister Wolfgang Schauble defended Germany’s focus on reining in German and European fiscal deficits:
“To the question of what caused the recent turmoil in the eurozone, there is one simple answer: excessive budget deficits in many European countries. It comes therefore as a surprise, to me at least, that one of the most passionately debated economic issues of the day should be whether Germany is acting prematurely in reining in its deficit and thereby choking the rebound at home and in our neighbours’ markets. My response is an emphatic no.” Later in the article Mr. Schauble wrote, “Behind the calls for us to pursue a more expansionary fiscal course lie two different approaches to economic policymaking on each side of the Atlantic. While US policymakers like to focus on short-term corrective measures, we take the longer view and are, therefore, more preoccupied with the implications of excessive deficits and the dangers of high inflation.”

The Eurozone and the UK now recognize the necessity for a more “austere” approach to government debt growth. The U.S. has not – and likely won’t until the market forces its hand. So there is now a clear policy divide for the markets to contemplate. In Europe, there appears a willingness to accept some short-term pain for the good of long-term stability. Here at home, there remains a stubborn adherence to inflationism.

The markets are still sorting out new post-Greek crisis realities. For some time, the markets have gladly sided with the inflationists. Are the vigilantes quietly coming out of hiding? I would expect the markets to increasingly appreciate that the Europeans are moving in the right direction while we are resisting.

Prior to Greece, the markets perceived rapid government debt growth was a stabilizing force. More recently, the marketplace is coming to grips with the reality that runaway fiscal deficits are destabilizing and problematic. How this appreciation manifests in the markets over the coming weeks and months will be something to watch and analyze. Higher Treasury yields? Do tighter financial conditions throughout the U.S. Credit market stop recovery in its tracks? A weaker dollar? And could renewed dollar weakness – in concert with European stabilization and Asian expansion - help reignite some global reflationary forces? There are at least a few ways Treasurys could disappoint.