Saturday, October 4, 2014

07/31/2009 Facets of Bubble Analysis *

For the week, the S&P500 added 0.8% (up 9.3% y-t-d), and the Dow gained 0.9% (up 4.5% y-t-d). The Morgan Stanley Cyclicals surged 5.5% (up 43.7%), and the Transports added 0.9% (up 4.5%). The Morgan Stanley Consumer index slipped 0.3% (up 6.1%), and the Utilities declined 2.4% (down 1.7%). The Banks jumped 8.4% (down 8.8%), and the Broker/Dealers rose 3.7% (up 40.7%). The S&P 400 Mid-Caps increased 1.0% (up 16.7%), and the small cap Russell 2000 gained 1.5% (up 11.5%). The Nasdaq100 added 0.3% (up 32.3%), while the Morgan Stanley High Tech index dipped 0.2% (up 44.7%). The Semiconductors increased 0.3% (up 42.2%), while the InteractiveWeek Internet index fell 1.3% (up 50.4%). The Biotechs added 0.7% (up 34.5%). With Bullion gaining $2.10, the HUI gold index slipped 0.2% (up 19.2%).

One-month Treasury bill rates ended the week at 11 bps, and three-month bills closed at 17 bps. Two-year government yields rose 5 bps to 1.01%. Five-year T-note yields declined 4 bps to 2.47%. Ten-year yields dropped 18 bps to 3.48%. Long bond yields were 24 bps lower at 4.29%. Benchmark Fannie MBS yields sank a notable 23 bps to 4.37%. The spread between 10-year Treasuries and benchmark MBS narrowed 5 to 89. Agency 10-yr debt spreads declined 4.5 to a tiny 7 bps. The implied yield on December eurodollar futures dipped 3 bps to 0.715%. The 2-year dollar swap spread declined 9 to 35.5 bps; the 10-year dollar swap spread increased 1.75 to 24.25 bps; and the 30-year swap spread increased 7.5 to negative 13.25 bps. Corporate bond spreads tightened further. An index of investment grade bond spreads narrowed 6 bps to 164 (2009 low), and an index of junk spreads narrowed 13 to 822 bps.

Investment grade issuers included CitiBank $5.0bn, Northrop Grumman $850 million, Nexen $1.0bn, and Colgate Palmolive $300 million.

Junk bond fund inflows were strong again at $531 million (from AMG). The list of junk issuers included Ford Motor Credit $1.75 TN, HCA $1.25bn, Capital One $1.0bn, Arch Coal $600 million, Peninsula Gaming $545 million, Pinnacle Entertainment $450 million, Jabil Circuit $312 million, Duane Reade $300 million, USG $300 million, American Airlines $275 million, and Great Atlantic & Pacific $260 million.

I saw no converts issued this week.

International dollar debt issuers included ANZ National $2.2bn, Macquarie Group $1.0bn, Brazil $500 million, Woori Bank $500 million, and Corporativo Javer $180 million.

U.K. 10-year gilt yields sank 16 bps to 3.80%, and German bund yields dropped 18 bps to 3.30%. The German DAX equities index gained 2.0% (up 10.9%). Japanese 10-year "JGB" yields increased 3 bps to 1.41%. The Nikkei 225 surged 4.1% (up 16.9%). For the most part emerging markets remained strong. Brazil’s benchmark dollar bond yields dropped 12 bps to 5.61%. Brazil’s Bovespa equities index increased 0.7% (up 45.8% y-t-d). The Mexican Bolsa rose 1.5% (up 20.8% y-t-d). Mexico’s 10-year $ yields rose 14 bps to 5.77%. Russia’s RTS equities index was about unchanged (up 60.3%). India’s Sensex equities index gained 1.9% (up 62.4%). China’s Shanghai Exchange added 1.2%, increasing 2009 gains to 87.4%.

Freddie Mac 30-year fixed mortgage rates rose 5 bps to 5.25% (down 127bps y-o-y). Fifteen-year fixed rates added one basis point to 4.69% (down 138bps y-o-y). One-year ARMs added 3 bps to 4.80% (down 47bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 2 bps to 6.36% (down 120bps y-o-y).

Federal Reserve Credit slipped $0.6bn last week to $2.010 TN. Fed Credit has declined $236bn y-t-d, although it expanded $1.117 TN over the past 52 weeks (125%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 7/29) jumped $6.2bn to a record $2.793 TN. "Custody holdings" have been expanding at a 19.1% rate y-t-d, and were up $425bn over the past year, or 18.0%.

M2 (narrow) "money" supply rose $8.9bn to $8.343 TN (week of 7/20). Narrow "money" has expanded at a 3.2% rate y-t-d and 8.2% over the past year. For the week, Currency gained $2.3bn, while Demand & Checkable Deposits dropped $15.1bn. Savings Deposits surged $37.9bn, while Small Denominated Deposits declined $5.6bn. Retail Money Funds fell $10.5bn.

Total Money Market Fund assets (from Invest Co Inst) declined $22.0bn to $3.634 TN (low since November). Money fund assets have declined $196bn y-t-d, or 8.9% annualized. Money funds expanded $132bn, or 3.8%, over the past year.

Total Commercial Paper outstanding dropped $27.6bn to $1.066 TN. CP has declined $616bn y-t-d (64% annualized) and $662bn over the past year (38%). Asset-backed CP was little changed at $437.8bn, with a 52-wk drop of $306bn (41%).

International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $31bn y-o-y to a record $7.025 TN. Reserves have now increased $260bn year-to-date.

Global Credit Market Watch:

July 28 – Bloomberg (Anna Rascouet): “The Libor-OIS spread, a gauge of banks’ reluctance to lend, dropped below 30 bps for the first time in 18 months, adding to evidence that the two-year freeze in credit markets is thawing.”

July 29 – Bloomberg (Jennifer Ryan): “U.K. mortgage approvals climbed to a 14-month high in June, adding to signs the housing market is recovering as the recession eases and banks become more willing to lend.”

Government Finance Bubble Watch:

July 29 – Bloomberg (Hui-yong Yu and Sarah Mulholland): “Commercial property companies may sell about $3 billion of mortgage-backed bonds starting in September as part of the U.S. program to revive lending for shopping malls, skyscrapers and hotels. More than a dozen real estate investment trusts are likely to participate in the Federal Reserve’s Term Asset-Backed Securities Loan Facility, or TALF…”

July 29 – Bloomberg (Elizabeth Stanton): “PennyMac Mortgage Investment Trust, which plans to raise $400 million in a stock offering today, is betting that the people who helped create the housing crisis will know how to profit from the cleanup. Chief Executive Officer Stanford L. Kurland… was president and chief operating officer of Countrywide… whose co-founder, Angelo Mozilo, was sued by the Securities and Exchange Commission. Ten other senior officials also worked at Countrywide, whose subprime loans have suffered from a 39% delinquency rate…”

July 29 – Bloomberg (Kateryna Choursina): “Ukraine expects to receive a $3.3 billion loan installment from the International Monetary Fund by the end of the week that will ‘fully balance’ the country’s finances, Prime Minister Yulia Timoshenko said. The money is the third tranche under an agreement that calls for a total of $16.4 billion in loans…”

July 30 – Bloomberg (Adam Brown): “Romania’s government said it will ask the International Monetary Fund to allow it to widen its budget deficit limit for 2009 to make up for dwindling revenue. The Balkan nation, which has agreed to a budget-gap ceiling of 4.6% of gross domestic product this year, is holding talks with the IMF this week…”

July 28 – Bloomberg (Emma Ross-Thomas): “Spain’s central government posted the largest first-half budget deficit in at least nine years… The central government had a deficit of… ($55.1 billion) in the first half… or 3.64% of gross domestic product…”

July 27 – Bloomberg (Paul Abelsky): “Russia may borrow 1.61 trillion rubles ($52 billion) on the domestic and international capital markets next year to cover part of a 3.19 trillion-ruble budget deficit, Vedomosti reported.”

Currency Watch:

July 28 – Bloomberg (Rob Delaney and Rebecca Christie): “Treasury Secretary Timothy Geithner pledged to rein in the U.S. deficit as China underscored concern about preserving the value of its $801.5 billion of Treasury holdings. The U.S. will ensure a ‘sustainable’ deficit by 2013, Geithner said… China is ‘concerned about the security of our financial assets,’ Assistant Finance Minister Zhu Guangyao said.”

July 27 – Market News International (Denny Gulino): “The Federal Reserve agrees with Treasury’s ‘strong dollar’ policy and the way to get there is to have a strong economy, Fed Chairman Ben Bernanke said in a PBS network special… The Sunday night videotaping showed a contained and unflustered Bernanke enthusiastically answering questions... ‘As far as the Fed and the dollar is concerned, the Fed supports the Treasury’s strong-dollar policy. We think the dollar should be strong. And the best way we think to get a strong dollar is to get a strong economy. When the economy’s strong then there’s a lot of good investment opportunities, foreigners want to invest here, and that causes the dollar to rise.’”

The dollar index declined 0.6% this week to a 2009 low 78.31. For the week on the upside, the Swedish krona increased 3.9%, the Australian dollar 2.2%, the Norwegian krone 1.9%, the South Korean won 1.7%, the British pound 1.7%, the Brazilian real 1.7%, the euro 0.4%, the Swiss franc 0.3%, and the Japanese yen 0.1%. On the downside, the South African rand declined 0.2% and the Taiwanese dollar 0.1%.

Commodities Watch:

July 28 – Bloomberg (Thomas Kutty Abraham): “Raw sugar prices may reach a 28-year high in the next six months as a production shortfall in India, the world’s biggest user, worsens a global deficit for a second year, the nation’s largest producer said.”

Gold ended the week up 0.2% to $953 (up 8.1% y-t-d). Silver added 0.3% to $13.92 (up 23.2% y-t-d). August Crude gained $1.00 to $69.05 (up 55% y-t-d). August Gasoline jumped 6.7% (up 92% y-t-d), while September Natural Gas fell 5.3% (down 35% y-t-d). September Copper jumped 4.0% (up 86% y-t-d). September Wheat rallied 2.3% (down 13% y-t-d), and August Corn surged 7.4% (down 17% y-t-d). The CRB index increased 2.2% (up 12.2% y-t-d). The Goldman Sachs Commodities Index (GSCI) rose 2.1% (up 31% y-t-d).

China Reflation Watch:

July 27 - Financial Times (Jamil Anderlini): “Chinese regulators… ordered banks to ensure unprecedented volumes of new loans are channelled into the real economy and not diverted into equity or real estate markets where officials say fresh asset bubbles are forming. The new policy requires banks to monitor how their loans are spent and comes amid warnings that banks ignored basic lending standards in the first half of this year as they rushed to extend Rmb7,370bn in new loans, more than twice the amount lent in the same period a year earlier. Beijing’s concerns are echoed in other countries across the region, most notably South Korea, where the government says it is taking steps to cool a real estate bubble, and Vietnam, where the government has ordered state banks to cap new lending to head off inflation. The situation in much of Asia is very different from most Western economies, where governments have flooded the financial system with liquidity to encourage unwilling banks to lend more."

July 30 – Bloomberg (Chia-Peck Wong): “Home prices in China will rise 20% by the end of 2010, boosted by economic growth and loans to property developers, UBS analyst Eric Wong told reporters...”

July 27 – China Knowledge: “China’s power generation declined 1.7% to 1.64 trillion kilowatt hours in the first half of this year… In June, power generation rose 5.2% year on year, ending a string of eight consecutive monthly drops.”

July 29 – Bloomberg: “China State Construction Engineering Corp. jumped 56% on its first trading day in Shanghai as confidence in the nation’s economic recovery stoked demand for the world’s largest initial public offering in 16 months.”

July 31 – Bloomberg (Michael Patterson): “The value of shares traded in China surpassed the combined amount in the U.S., U.K. and Japan for the first time on record, a sign of ‘speculative mania’ among investors who pushed the Shanghai Composite Index up 82% this year, according to Grantham Mayo Van Otterloo & Co.’s Edward Chancellor.”

July 29 – Bloomberg: “China, the world’s largest steelmaking nation, said 71 of its largest mills posted a combined profit of 3.55 billion yuan ($520 million) in June, the second monthly gain after seven straight months of losses.”

July 29 – Bloomberg (Sophie Leung): “China Development Bank Corp., the state-run bank for public works projects, opened its first branch outside the mainland in Hong Kong… and plans offices in Russia, Egypt and Brazil as part of a global expansion push… The… bank agreed in May to lend $10 billion to Brazil’s state-controlled oil company, helped finance a fund in Africa and extended loans in June to Russia’s development bank.”

July 27 – Bloomberg (Nipa Piboontanasawat and Chia-Peck Wong): “New mortgage loans approved in Hong Kong jumped to a record HK$38.4 billion ($5 billion) in June… The value of new home loans rose 36.5% last month from May…”

July 27 – Bloomberg (Chia-Peck Wong): “Hong Kong’s home prices may rise 32% by the end of 2010 as ample liquidity and low interest rates drive investors to buy property, UBS AG analysts said… Office prices may increase by 29%...”

Japan Watch:

July 29 – Bloomberg (Toru Fujioka): “Japan’s retail sales fell for a 10th month in June, extending the longest losing streak since 2003… Sales slid 3% from a year earlier…”

July 30 – Bloomberg (Jason Clenfield): “Japanese manufacturers increased production for a fourth month in June, capping the fastest quarterly output expansion in more than half a century… Production rose 2.4% from May… Output gained 8.3% last quarter from the first three months of 2009, the most since 1953.”

India Watch:

July 27 – Bloomberg (Cherian Thomas): “India’s economy may grow at a faster pace than earlier forecast this year, the central bank said… Asia’s third-largest economy may expand 6.5% in the year ending March 31… ‘The macroeconomic outlook of the Indian economy, based on various business expectation surveys indicates that the earlier decline in overall business sentiment has reversed,’ the central bank said…”

Asia Bubble Watch:

July 30 – Bloomberg (Sangim Han): “South Korea plans to keep its expansionary fiscal policies in place, the nation’s Strategy and Finance Ministry said. ‘It’s premature to discuss measures to absorb excessive liquidity’ and the government will stick to policies supporting growth ‘for the time being,’ the ministry said…”

July 29 – Bloomberg (Clarissa Batino): “The Philippine central bank said it has started to consider ending more than half a year of monetary policy easing and pledged to act ‘deftly’ in response to changing inflation conditions.”

Latin America Watch:

July 28 – Bloomberg (Telma Marotto and Iuri Dantas): “Brazilian outstanding bank lending expanded at the fastest pace this year last month signaling economic growth is picking up, the central bank said. Total outstanding loans rose 1.3% to a record 1.28 trillion reais ($679 billion) in June from 1.26 trillion reais in May… Lending climbed 19.7% from the same month last year. ‘Yesterday, I was saying Brazil would be the first out of this crisis, today I say we are out,’ Planning and Budget Minister Paulo Bernardo said…”

Unbalanced Global Economy Watch:

July 31 – Bloomberg (Alexandre Deslongchamps): “Canada’s economy contracted for a 10th month in May because of falling manufacturing output, and declines in the mining and energy industries. Gross domestic product dropped 0.5% during the month…”

July 29 – Dow Jones (Natasha Brereton): “Holdings of M4 by the U.K. household sector and lending to it grew at the lowest rates in June since records began in 1997, while M4 lending to businesses shrank at its fastest pace, showing little trace of the central bank’s money creating policy.”

July 28 – Bloomberg (Milda Seputyte): “Lithuania’s economy plunged a preliminary 22.4% in the second quarter, the worst recession since 1990 independence, as output crashed and retail sales slumped.”

Bursting Bubble Economy Watch:

July 31 – Bloomberg (Shobhana Chandra): “The U.S. economy shrank at a better- than-forecast 1% annual pace in the second quarter as a jump in government spending masked a deeper retrenchment by consumers.”

July 29 – Bloomberg (Dina Bass): “Microsoft Corp., coping with its first annual sales drop, will make frugality a new way of life, CFO Chris Liddell said. ‘This is not a crash diet where you stop eating for a couple of quarters -- this is a new diet regime where you slim down and stay slim… It’s actually about dialing up the importance of costs.’”

Central Banker Watch:

July 27 - Dow Jones: “The central bank’s ability to pay interest on reserves means it won’t have to resort to a hasty rate hike to head off inflation, New York Federal Reserve President William Dudley said… ‘We’re not going to be in a situation where we have to tighten prematurely,’ Dudley told a breakfast meeting… Questions from the audience focused in part on concerns that the Fed’s balance sheet, which Dudley expects to peak around $2.5 trillion, could stoke inflation… ‘The expansion of the balance sheet isn’t inflationary in an environment where we can pay interest on reserves,’ he said. This payment gives banks an economic incentive to keep funds out of the system, that is, not extend credit, unless the interest rate on their lending exceeds the Fed’s rate on their deposits.”

July 29 – Bloomberg (Scott Lanman and Michael McKee): “New York Federal Reserve Bank President William Dudley said officials should dispel any concerns that their policies may spur inflation, while asserting it’s ‘premature’ to discuss when to raise interest rates. ‘Policy makers need to take seriously any concerns that the Fed’s actions might conceivably lead to an inflation problem,’ Dudley said… Still, ‘concern about ‘when’ the Fed will exit from its current monetary policy stance is, in my view, very premature,” he said.”

July 29 – Bloomberg (Craig Torres): “The financial-overhaul plan before Congress leaves the Federal Reserve in the business of lending to everyone from General Electric Co. to investors in student loans. That makes it harder for Chairman Ben S. Bernanke to keep Congress from second-guessing what he does. Bernanke is trying to deflect a bill, co-sponsored by 276 members of the House of Representatives, that would require audits of central bank operations, including monetary policy decisions, by the Government Accountability Office. Audits wouldn’t be ‘consistent with independence,’ Bernanke said… ‘I don’t think the American people want Congress running monetary policy.’”

Real Estate Bust Watch:

July 30 – Bloomberg (David M. Levitt): “About $2.2 trillion of U.S. commercial properties bought or refinanced since 2004 are now worth less than the original price, raising the threat of more foreclosures, Real Capital Analytics said. Prices have fallen so far that about $1.3 trillion of properties have either lost their owners’ down payment or are close to it…the… firm said…”

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

July 24 – Bloomberg (Jody Shenn): “Standard & Poor’s downgraded $235.2 billion of Alt-A mortgage bonds amid increasing delinquencies and falling home prices. Ratings were lowered on 6,198 classes of 611 deals… Rating companies have cut at least once about 92% of the $593 billion of Alt-A mortgage securities outstanding excluding bonds backed by ‘option’ adjustable-rate mortgages…”

July 27 – Bloomberg (Abigail Moses): “Collateralized debt obligations experienced a ‘significant increase’ in downgrades in Europe in the second quarter, according to Standard & Poor’s. The… firm cut grades on 1,706 structured finance products, primarily CDOs… S&P also lowered its outlook to negative on 2,458 deals…”

GSE Watch:

July 30 – Bloomberg (Dawn Kopecki): “Fannie Mae and Freddie Mac, operating under a federal conservatorship since September, won’t be able to repay all of the $84.9 billion in federal aid they have received, the companies’ regulator said. ‘Some assets and senior preferreds will have to be left behind as they come out of conservatorship, and that means some of those losses will never be repaid,’ Federal Housing Finance Agency Director James Lockhart said... With Fannie Mae and Freddie Mac owning or guaranteeing almost half of the U.S. residential mortgage debt, the government seized the companies in September as losses mounted and pledged $100 billion for each to keep them afloat. In February, the government doubled its capital commitment for each company to $200 billion…”

Speculator Watch:

July 29 – Bloomberg (Shamim Adam and Jonathan Burgos): “Temasek Holdings Pte… said the value of its assets slumped by more than S$40 billion ($27.7bn) and that Singapore’s sovereign fund may allow public investment for the first time.”

Crude Liquidity Watch:

July 30 – Bloomberg (Arif Sharif): “Bahrain’s central bank took over administration of Awal Bank BSC and The International Banking Corp. after the lenders, owned by Saudi Arabia’s Saad and Algosaibi groups, defaulted on loans. The central bank ‘has assumed the administration’ of Awal Bank and TIBC, the Manama… The Algosaibi group owes a total of 34 billion Saudi riyals ($9 billion) in syndicated and bilateral loans…”

Facets of Bubble Analysis:

A couple years back I received an email from a unimpressed reader with the following message: “Doug, when you’re a hammer everything looks like a nail.” He was referring to my thesis back then that Bubbles had sprung loose from the U.S. Credit system and had begun propagating around the world.

Months back I posited that a Government Finance Bubble had emerged from the smoking ashes of the Wall Street/mortgage finance Bubble. I understand why some might see me as a dreary hammer out searching for nails. All the same, the backdrop merits further discussion of facets of Bubble analysis.

Many see Bubbles in terms of an unsustainable overvaluation of asset prices. And many would view today’s “post-Bubble” landscape and find my ongoing Bubble premise borderline ridiculous. But I’ve always viewed Bubbles as a Credit phenomenon. Inflating assets prices are actually only one of many consequences of an overexpansion of Credit. Rapid asset inflation is almost a sure sign of underlying Credit excess, though analysts should downplay asset prices while focusing keenly on underlying Credit and speculative dynamics. Huge Credit growth, market price distortions (especially the under-pricing of risk), highly speculative markets, and prolonged asset inflation are inevitably indicative of some underlying monetary/Credit disorder.

I want policymakers out of the business of targeting or tinkering with the asset markets and market yields. Instead, the focus should be on creating a backdrop of stable money and Credit. The problem today is that central bankers for years ignored a historic expansion of Credit (much of it directed to the asset markets) and the resulting Monetary Disorder. Now, to avert systemic implosion central bankers at home and abroad have resorted to unprecedented measures to expand Credit and intervene in the markets' pricing of Credit. Instead of a movement toward constructing a more stable global Credit system and backdrop, policymakers have instead jumped farther into the uncharted waters of unconstrained Credit expansion. Such a backdrop is ultra-conducive for ongoing speculation, Bubbles, and general disorder.

Again, Bubbles are first and foremost a Credit phenomenon. Fundamental to the nature of Credit, expansion generally fosters more expansion. Credit excess begets only greater Credit excess. And Credit excess notoriously begets speculative excesses. Importantly, Credit is inherently self-reinforcing – both on the upswing and downswing. In today’s “system” of unrestrained Credit, rising demand for borrowings does not dictate an increasing price for this Credit. Indeed, an unlimited supply of Credit will tend to satisfy rising demand at a lower price. And this gets right to the heart of a huge Bubble – and policymaking - dilemma.

The bottom line is that unrestrained Credit is inherently unstable, and few seem to appreciate the unique nature of today’s unfettered global Credit environment. There is no international gold monetary regime for which to discipline lenders, central banks, governments or economies. The dollar reserve system self-destructed over decades of undisciplined Credit expansion. And the breakdown of U.S. discipline – and the resulting massive dollar devaluation – has unleashed domestic Credit systems from China to Brazil. Never have “developing” Credit systems (and currencies) enjoyed such freedom to inflate financial claims.

It’s with this backdrop in mind that I contemplate the likelihood that we have entered an especially dangerous period of Credit excess and attendant Bubbles. Fundamentally, the massive intrusion of the Treasury and Federal Reserve into the marketplace has only further distorted the pricing of finance throughout our economy - as well as globally. Despite record debt issuance, the market will lend the Treasury three-month money at about 11 basis points. Two-year borrowings come at cost of about 100 bps. The price of Treasury notes and bonds inflates in spite of enormous deficits as far as the eye can see. Moreover, the marketplace is happy to lend to Fannie and Freddie at only a slight premium to the U.S. Treasury, with the prices of their obligations inflating in the face of these institutions’ ongoing financial implosions. Today’s price distortions go right to the heart of system “money.”

Fannie Mae’s Book of Business (mortgage holdings and MBS guaranteed) jumped $43.9bn during June to $3.194 TN. This was the biggest growth since December 2007. Freddie’s Book of Business increased $12.2bn last month. According to Bloomberg’s issuance tally, the GSEs (Fannie, Freddie and Ginnie) issued $168bn of MBS in July, down somewhat from June’s huge $236bn and May’s $212bn. At $1.102 Trillion, year-to-date agency MBS issuance has already almost matched 2008 and 2007. The government is quietly accumulating dangerous Credit and interest rate risk in its ongoing mortgage operations.

During the Wall Street/mortgage finance Bubble, seemingly no amount of Credit creation and debt issuance would place upward pressure on the cost of borrowings (or reduced the price of the underlying debt instruments). Importantly, the bigger this Bubble inflated the more confident the savvy market operators became that an inevitable crisis would force policymakers to explicitly back GSE obligations and aggressively slash interest rates. Market yields remained artificially low and increasingly detached from escalating risks. Fundamentally, a market trapped in Bubble dynamics had lost is capacity for adjustment and self-regulation.

The massive expansion of GSE obligations, coupled with a speculative marketplace’s anticipation of yet another major government-induced reflation, severely distorted the marketplace and provided the bedrock for a historic mortgage finance Bubble. Today, the government’s intrusion into the marketplace is greater than ever. The markets readily accommodate a couple Trillion of annual issuance – as if the U.S. economy and Credit system were on solid footing. And I would argue that today’s mispricing of government finance reinforces the market’s perception that U.S. policymakers will successfully reflate the economy. This Bubble distortion, then, fosters a problematic explosion of government debt issuance – and a most dangerous case Minskian “Ponzi finance.”

There are a number of reasons why the government finance Bubble is even more dangerous than the Wall Street/mortgage finance Bubble. First of all, the $2 TN or so of “government” issuance over the past year is greater than the $1.4 TN peak total mortgage Credit growth during 2005 and 2006. I would expect another $2 TN next year and the year after. Government debt enjoys the attribute of “moneyness” in the marketplace to a much greater capacity than mortgage securities did during the boom. The risks associated with debasing this “moneyness” are momentous. And there is, as well, the dynamic where the greater the government finance Bubble inflates the more convinced the marketplace becomes that the Federal Reserve will do everything within its power to accommodate the debt markets (ultra-loose monetary conditions for the duration). And destabilizing speculation can return to all markets…

The government finance Bubble is a global dynamic. There were pertinent Bubble-related comments out of China this week:

July 30 – Dow Jones (J.R. Wu): “China’s central bank will emphasize market-based systems, rather than administrative controls, in guiding the appropriate growth of credit, People’s Bank of China Vice Governor Su Ning said. The statement… came just hours after Chinese shares posted their biggest one-day percentage fall in over eight months on fears that loan growth may start to pull back… ‘We should pay attention to the use of market-oriented means - rather than controlling the size - and flexibly use various monetary policy tools to guide the appropriate growth of credit,’ Su said… He said ‘the mind and action’ of all financial institutions should ‘be as one’ with the government’s goal, and financial institutions should properly handle the relationship between supporting the economy’s development and preventing financial risks. Su’s comments appeared to signal the PBOC wasn’t about to set loan curbs in the second half of this year to cool explosive lending growth, as it did in 2008 when it used the blunt tool of loan quotas for banks to hold down inflationary pressures that were building at the time… But Su said the central bank will resolutely maintain its moderately loose monetary policy. He said the foundation for China’s economic recovery isn’t firm yet and many uncertain factors still exist in both the external and domestic environment.”

Similar to the Federal Reserve, I see Chinese authorities increasingly held hostage to Bubble Dynamics. I found it fascinating that a top People’s Bank of China official would mention emphasizing “market-based systems” for guiding Credit growth. I suspect this may be a most inopportune time to begin relying on market mechanisms. As we have witnessed, market-based processes can be particularly unreliable Credit regulators after Bubbles have reached an overheated state. It is my view that only decisive action by Chinese policymakers will at this point have much impact at restraining excess. Central to the analysis of unfolding precarious Bubble Dynamics is my view that few, if any, policymakers anywhere around world will be willing to act decisively to tighten Credit conditions and address increasingly speculative financial markets.