Sunday, December 14, 2014

Weekly Commentary, January 17, 2014: Historic Year 2014 Thesis

I’m proceeding with the view that 2014 is poised to be a key year in economic/financial history. Actually, I suspect future historians will look back at 2013 as a critical juncture. Last year saw the Fed and Bank of Japan combine for almost $2 TN of QE. Of significant consequence, an over-liquefied and increasingly speculative marketplace shifted its sights to stocks. “Money” flooded into U.S. and (predominantly “developed”) global equities, working at the same time to spur flows and excess in corporate debt. Speculative dynamics took firm hold, with potentially profound ramifications for global financial flows and stability. Real economies became an only bigger side show. Will central banks have the resolve to pull back?

From a flow of funds basis, the Fed fatefully decided to stick with its $85bn monthly liquidity injection, in the face of overheated markets. Across the globe, Chinese officials also fatefully granted the “terminal phase” of their historic Credit Bubble an extended lease on life. Significant cracks appeared in the China/EM Bubbles, Bubbles that have been a primary “beneficiary” throughout more than five years of unprecedented global monetary inflation.

Massive ongoing global liquidity injections coupled with historic Chinese Credit growth for the most part held the unwind of these Bubbles at bay in 2013. While it’s of course early, 2014 market trends thus far are to sell EM currencies, to sell the so called “commodity-currencies” and buy global bonds that might be viewed as safe havens in a backdrop of mounting disinflationary risks.

My “Historic Year 2014 Thesis” rests significantly on the premise that inflated and destabilized global risk markets (particularly the EM “periphery”) have become highly vulnerable to waning Federal Reserve liquidity injections and an impending Credit downturn in China. As such, considerable ongoing attention will be directed to the issues of Fed policymaking and Chinese Credit.

On the China Credit front, there were further indications of trouble brewing. December Credit data were released (see “China Credit Bubble Watch”) showing, on the one hand, a meaningful slowdown in bank lending and, on the other, continued rampant growth of “shadow banking” finance. Short-term market yields spiked this week ahead of the Chinese New Year holidays, while concerns arose of a potential default in a prominent “shadow bank” investment vehicle.

January 17 – Bloomberg: “Industrial & Commercial Bank of China Ltd. is rejecting calls to bail out a troubled 3 billion- yuan ($495 million) trust product, a bank official with knowledge of the matter said, stoking concern that the nation’s first default on such high-yield investments may be looming. ICBC, which distributed the product sold by a trust company to raise funds for Shanxi Zhenfu Energy Group, won’t assume primary responsibility after the coal miner collapsed, according to the executive… China’s largest bank may be forced to repay investors, most of whom were Beijing-based ICBC’s own private banking clients, Guangzhou Daily reported… A default on the investment product, which comes due Jan. 31, may shake investors’ faith in the implicit guarantees offered by trust companies to lure funds from wealthy people. Assets managed by China’s 67 trusts soared 60% to $1.67 trillion in the 12 months ended September… ‘Nobody wants this default to become a trigger for a financial crisis,’ Xue Huiru… analyst at SWS Research Co., said… ‘Breaking the implicit guarantee may help the long-term development of China’s financial system, but the short-term pain would be too much for the economy to take.’”

Here at home, it was another intriguing week of comments, discussions and speeches from key Federal Reserve officials. The Statesman, Federal Reserve Bank of Philadelphia President Charles Plosser, again made his case for fundamental changes in Fed policymaking with his “Perspectives on the Economy and Monetary Policy.” Richard Fisher, Statesman and President of the Federal Reserve Bank of Dallas, made his compelling case to wind down QE with his “Beer Goggles, Monetary Camels, the Eye of the Needle and the First Law of Holes.” The so-called “hawks” are actively building a very strong case. The academic “doves” are fated to profess “deflation!”

On some key issues, Fisher and Plosser seem to be reading from the same script. The Fed needs to get out of the business of printing "money" and distorting markets. Fisher went out of his way to signal that a market correction would not dissuade him from voting to quickly wind down QE operations. Plosser again argued persuasively that the Fed has little power over structural economic issues, including the declining labor participation rate. And he “wants more commitment the Fed will truly end bond buying,” echoing Fisher’s concern that the Fed has been too quick to reverse course at the first sign of market angst.

The monetary policy debate is commonly viewed from the perspective of the “doves” versus the “hawks.” Today, a more fruitful vantage point might be between the academics and those with a broader real world and market focus. The FOMC has been called “the most academic in history.” And especially when it comes to QE and other experimental policies, the FOMC has relied heavily on abstract academic models (note Williams’ response to the Hilsenrath question below).

This week saw the launch of the Hutchins Center on Fiscal and Monetary Policy (Brookings Institute), with interesting discussions that touched upon some of the most important financial issues of our day. I have included excerpts below.

It’s worth noting the widely divergent view (from the academics) of Dallas’ Fisher, whose illustrious career includes years at Wall Street firm Brown Brothers, Harriman, along with stints at the U.S. Department of Treasury. I’ll assume it’s a first for a Fed official to use the phrase “beer goggles.” I’ll include a brief excerpt but encourage all to read his well-crafted and thought-provoking speech in its entirety.

Fisher: “For those of you unfamiliar with the term ‘beer goggles,’ the Urban Dictionary defines it as ‘the effect that alcohol … has in rendering a person who one would ordinarily regard as unattractive as … alluring.’ …Things often look better when one is under the influence of free-flowing liquidity. This is one reason why William McChesney Martin, the longest-serving Fed chairman in our institution’s 100-year history, famously said that the Fed’s job is to take away the punchbowl just as the party gets going...

When money available to investors is close to free and is widely available, and there is a presumption that the central bank will keep it that way indefinitely, discount rates applied to assessing the value of future cash flows shift downward, making for lower hurdle rates for valuations. A bull market for stocks and other claims on tradable companies ensues; the financial world looks rather comely.

Market operators donning beer goggles and even some sober economists consider analysts like [Peter] Boockvar party poopers. But I have found myself making arguments similar to his and to those of other skeptics at recent FOMC meetings, pointing to some developments that signal we have made for an intoxicating brew as we have continued pouring liquidity down the economy’s throat.

Among them: Share buybacks financed by debt issuance that after tax treatment and inflation incur minimal, and in some cases negative, cost; this has a most pleasant effect on earnings per share apart from top-line revenue growth. Dividend payouts financed by cheap debt that bolster share prices. The ‘bull/bear spread’ for equities now being higher than in October 2007. Stock market metrics such as price-to-sales ratios and market capitalization as a percentage of gross domestic product at eye-popping levels not seen since the dot-com boom of the late 1990s. Margin debt that is pushing up against all-time records.

In the bond market, investment-grade yield spreads over ‘risk free’ government bonds becoming abnormally tight. 'Covenant lite’ lending becoming robust and the spread between CCC credit and investment-grade credit or the risk-free rate historically narrow. I will note here that I am all for helping businesses get back on their feet so that they can expand employment and America’s prosperity: This is the root desire of the FOMC. But I worry when ‘junk’ companies that should borrow at a premium reflecting their risk of failure are able to borrow (or have their shares priced) at rates that defy the odds of that risk. I may be too close to this given my background. From 1989 through 1997, I was managing partner of a fund that bought distressed debt… Today, I would have to hire Sherlock Holmes to find a single distressed company priced attractively enough to buy.”

Sherlock Holmes would be hard-pressed these days to locate attractively-prices stocks, bonds, upper-end homes, commercial real estate, farm properties, art and collectables, bitcoins, etc. The Fed’s move to zero short-term rates and a $4 TN balance sheet has fueled virtually systemic inflation of asset prices coupled with a general collapse in risk premiums.

Below I’ve also included noteworthy comments from two leading Federal Reserve academics, the retiring chairman and Federal Reserve Bank of San Francisco President John Williams. Both remain staunch supporters of QE, keen to highlight the benefits while downplaying associated risks. It is worth noting that Williams, residing in the epicenter of another tech and housing boom in San Francisco, believes “our financial system is still in a risk-averse mode.” And is it even credible to state "I don’t think that the low interest rates were an important contributor to the housing bubble"?

I’m most fascinated by Bernanke’s discussion of QE risks. While downplaying the risk of inflation, he does at least recognize the potential risk Fed policy is having on financial stability. Bernanke: “But at this point we don’t think that – and I think I can speak for my colleagues on this – we don’t think that financial stability concerns should at this point detract from the need for monetary policy accommodation which we are continuing to provide.” Fisher, Plosser, Esther George, Jeffrey Lacker and others might today take exception with the view that QE benefits still outweigh the risks.

Away from the Fed, I’d like to commend the ongoing efforts of Harvard’s Martin Feldstein in the monetary policy debate. From a panel discussion this week at the Hutchins Center for Fiscal and Monetary Policy:

Feldstein: “John (Williams) reminds us that the standard textbook theory implies that LSAPs (large-scale asset purchases/QE) cannot affect asset prices and interest rates. We now know that that theory is wrong. The Fed’s massive purchases of Treasury bonds and mortgage backed securities drove the yield on 10-year Treasuries to just 1.7% in May of 2013. The announced plan to end the purchase program was enough to drive that rate back to 3%... But missing in all of this (Williams and others’) analysis is a balancing of the potential output gains of LSAPs against the risks generated by sustaining abnormally low long-term interest rates. Those risks include, one, potential price bubbles in equities, land and other assets. Two, portfolio risks as investors reach for yield with junk bonds, emerging market debt, uncovered options and the like. Three, creditor risks as lenders make loans to less qualified borrowers, ‘covenant-lite’ loans and bonds, long-term mortgages at insufficient interest rates and so on. And four, long-term inflation risks as commercial banks acquire a large portfolio of low-yielding assets at the Federal Reserve that could be converted to commercial loans. In its conclusion, in his paper and in his remarks, John (Williams) asks whether LSAPs should be a standard tool when short rates are at the zero lower bound. I think it is at best too soon to tell. We will know more when we see the outcome of the risks that the LSAP’s created.”

Things are falling into place for a momentous policy showdown between the “hawks” and the “doves.” This debate pits the complacent academics, committed to their models and ideology, versus the more reality-based officials that have seen enough to appreciate that the Fed’s untested monetary experiment is increasingly inflating and distorting securities and asset markets.

Interestingly, IMF managing director Christine Lagarde, in a speech this week in Washington, strongly warned of the global risk of deflation: “If inflation is the genie, then deflation is the ogre that must be fought decisively.” “With inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery.” She clearly decided to interject herself into the unfolding Federal Reserve policy debate.

Let’s briefly return to the “Historic Year 2014 Thesis.” Policymakers do indeed already confront a historic dilemma. Increasingly, there are downward pressures on some global prices. There is growing excess capacity to produce too many things. Moreover, unprecedented Credit Bubbles in China, Brazil, India, Turkey and EM generally are today at heightened – perhaps acute - risk. These (“periphery”) Credit systems and economies were the “global growth locomotives” at the heart of the “global reflation trade.” Meanwhile, the Trillions of “money” unleashed by global central bankers gravitate to inflating asset market Bubbles, now predominantly in the “developed” (“core”) economies. Even within EM, Chinese Credit system stress and attendant higher market yields provide a powerful magnet attracting enormous financial inflows, as destabilizing outbound flows appear likely for other key EM systems.

Notably, January is turning out to be a colossal month of debt issuance, with potentially record volumes of dollar-denominated international debt issuance. It is incredible to speak of “deflation” in the face of such liquidity abundance, generally ultra-loose (“still dancing”) financial conditions and myriad indications of excessive risk-taking. Is more “money” the solution?

And the unfolding policy dilemma seems to come into clearer focus by the week: Do central banks, in their incessant war against their perceived villain, the “deflation ogre”, continue to flood global financial markets with destabilizing liquidity? Or will they begin to take into account the true enemy of financial stability: increasingly conspicuous financial Bubbles (at the “core”)?

Curiously, Bernanke and the academics avoid discussing the key risk associated with QE – the risk that has remained at the forefront of my analysis for several years now: once aggressive monetary inflation has been commenced it becomes extremely difficult to stop. Will the Fed hawks succeed in trying to rein in the Fed’s runaway balance sheet growth? Or, as exuberant market participants assume, will central banks remain the prisoners of asset market and speculative Bubble fragilities?

Q&A from a panel discussion at the Hutchins Center on Fiscal and Monetary Policy, Brookings Institute, January 16, 2014:

David Wessel: “What about the risk that what you’re doing now is sowing the seeds of the next bout of financial instability?”

Federal Reserve Bank of San Francisco President John Williams: “In terms of these issues of greater risks?”

Wessel: “Yes, how much do you worry that what you’re doing now, because we’re clearly missing both the inflation and unemployment target that you’ve set – the mandate, risk is creating the financial instability that will give Janet Yellen a lot of headaches in her job?”

Williams: “We take this very seriously. Obviously, we’ve all learned the lessons of the past decade or so. We follow very carefully what’s happening in financial markets, both in the banking part of the financial system but most importantly…this is a capital markets-based economy. So it’s just not the banks. You have to think about the shadow banking system and the rest of the system. So we’re clearly studying this. We clearly have really increased our monitoring and our analysis around this. My argument would be the first line of defense regarding issues of growing financial risk is really around micro and macro prudential policies – both by having the right policies and implementing them… I think we’ve made incredibly important strides in terms of financial stability, in terms of the stress test, in terms of our implementation of Dodd Frank. So to my mind, we are on the job on that. We are studying that carefully. And we are balancing the costs and benefits around our QE policies. I view very strongly that the macroeconomic benefits far outweigh some of these issues right now. Risk aversion today in the markets generally – you can find specific examples, farm land prices or leveraged loan prices – but broadly defined, our financial system is still in a risk-averse mode and not a risk-loving mode. So I think these concerns today are still perhaps not as prevalent as some people think.”

Jon Hilsenrath, Wall Street Journal: “John (Williams) a question for you. The Fed employed a low for longer approach after the tech bubble burst. Several years later we had a housing bubble. I wanted to ask you, what is the risk, specifically, a low for longer policy could contribute to bubbles? Does it disturb you at all that it doesn’t seem that the (Michael) Woodford models, upon which low for longer is based, take much account for the creation of bubbles. And how should this factor into the Fed’s thinking now as it employs a low for longer policy again?”

Williams: “I agree with Marty (Feldstein) on this point. Our models that we use do not take seriously that there’s a complex financial system out there that can have endogenous changes in leverage, in risk-taking. And I would also add to that our models tend to assume highly rational agents who have a full understanding of things. So bubbles never occur. So I do think in our thinking about these issues we have to broaden our minds to more of an approach that allows for the fact that these things can happen; that asset markets can get away from fundamentals for significant periods of time. Financial markets can get disrupted. My answer to your question is I don’t think that the low interest rates were an important contributor to the housing bubble. I think fundamentally flawed aspects of our regulatory environment were the key part of that story about the housing bubble. I think Dodd Frank and Basel III and a lot of things we’re doing are addressing those concerns in a very important way. That said, I do think that we have to have open minds about understanding how low interest rates for a long period of time do affect risk-taking, leverage and asset prices, as Marty (Feldstein) said. “

Brookings Institution: January 16, 2014, Liaquat Ahamed: “We know what the benefits [from LSAPs/QE] are, because they’re lower long-term rates, lower mortgage rates. So what are the costs that you most worry about?’

Federal Reserve chairman Ben Bernanke: “Well I think that some of the costs that people talk about are not really costs, and I’ll mention a couple. One cost that gets talked about is, ‘is this going to be inflationary?’ While of course it’s always possible for the Fed to raise rates too late or too early and so on, I think we have plenty of tools now at this point – we’ve developed all the tools we need to manage interest rates – to tighten monetary policy even if the balance sheet stays where it is or gets bigger. And because we can do that, that means that we can run monetary policy in a normal way, and avoid any risk of any undue inflation or other such problems. So I don’t think that’s a concern and those who have been saying for the last five years that we’re just on the brink of hyperinflation – I think I would just point them to this morning’s CPI number and suggest that inflation is just not really a significant risk of this policy.

Another concern that people have talked about is the idea that the Fed might take capital losses, which of course is not impossible. But I would say that from a social point of view we have already not only helped the economy but we’ve actually helped the fiscal situation quite significantly with the hundreds of billions of dollars we’ve remitted to the Treasury – and that doesn’t even take into account the benefits for the public fiscal of a stronger economy, more tax revenues and the like. So that risk is again not a true social economic risk. It is, if anything perhaps, a public relations risk for the Fed. But it’s not a serious economic risk.

The main risk that my colleagues have pointed to is various aspects of financial stability – or potential for financial instability. There’s always some concern, really, for any kind of easy monetary policy, that after a period of time maybe some reaching for yield or some mis-valuation of assets. And given what happened of course just five years ago, we’re extraordinarily sensitive to that risk. Now, of course, that’s really for different kinds of monetary policy. QE in addition works on term premiums to a significant extent and we simply have less knowledge and information as to how term premiums are determined, and therefore there’s an additional concern, volatility associated with the management of QE. So there are certainly some risks there.

Our strategy, though, has been to not distort monetary policy in order to address those risks directly. Indeed, insufficient monetary policy accommodation, if it leads to a weaker economy and bad credit outcomes, etc., it’s also a financial stability risk. So our basic approach has been, at least for the first, second and third lines of defense, to rely on supervision, regulation, monitoring, macro-prudential policies – that whole set of tools that we have and are developing to try to avoid potential problems. We also look very carefully at the implications of any potential kind of financial imbalance. For example, is that asset class heavily levered – is it supported heavily by leverage, which would in turn mean that a sharp drop in that valuation would lead to other types of problems. Those are the kinds of things we look at, and we greatly increased our ability to monitor and analyze those types of situations. So our goal is to address financial instability concerns primarily, at least in the first instance, through supervision, regulation and other microeconomic types of tools. But it is something that I think of the various costs that have been ascribed to QE, I think it’s the only one that I find personally credible, frankly. And it’s the one we have spent the most time thinking about and trying to make sure that we can address it the best we can.”

Ahamed: “The bottom line, for the moment you’re not worried about too much froth in financial markets?”

Bernanke: “Well, it’s always of course bad luck to make any forecast about any particular market. But the markets currently seem to be broadly within the metrics of market valuation– valuation seems to be broadly within historical ranges. The financial system is strong. The key financial institutions are well-capitalized. So we are watching this very vigilantly. We’ve developed tremendous additional capacity for doing that. But at this point we don’t think that – and I think I can speak for my colleagues on this – we don’t think that financial stability concerns should at this point detract from the need for monetary policy accommodation which we are continuing to provide.”

For the Week:

The S&P500 slipped 0.2% (down 0.5% y-t-d), while the Dow increased 0.1% (down 0.7%). The Utilities declined 0.4% (up 0.1%). The Banks lost 0.7% (up 1.5%), while the Broker/Dealers added 0.4% (up 0.5%). The Morgan Stanley Cyclicals were little changed (down 0.7%), while the Transports declined 0.5% (up 0.4%). The S&P 400 Midcaps were down slightly (up 0.4%), while the small cap Russell 2000 gained 0.3% (up 0.4%). The Nasdaq100 rose 0.7% (unchanged), and the Morgan Stanley High Tech index jumped 2.1% (up 1.6%). The Semiconductors gained 0.8% (up 0.6%). The Biotechs surged another 3.5% (up 10.2%). Although bullion was up only $6, the HUI gold index jumped 6.5% (up 9.9%).

One-month Treasury bill rates ended the week at zero, and three-month rates closed at 3 bps. Two-year government yields were unchanged at 0.37% (down one basis point y-t-d). Five-year T-note yields were little changed at 1.63% (down 12bps). Ten-year yields declined 4 bps to 2.82% (down 21bps). Long bond yields fell 5 bps to 3.75% (down 22bps). Benchmark Fannie MBS yields slipped 3 bps to 3.44% (down 17bps). The spread between benchmark MBS and 10-year Treasury yields increased one to 62 bps. The implied yield on December 2014 eurodollar futures was unchanged at 0.425%. The two-year dollar swap spread increased 2 to 14 bps, and the 10-year swap spread increased 2 to 11 bps. Corporate bond spreads were somewhat wider. An index of investment grade bond risk increased one to 65 bps. An index of junk bond risk jumped 7 to 317 bps. An index of emerging market (EM) debt risk declined one to 317 bps.

Debt issuance was strong. Investment-grade issuers included Bank of America $9.15bn, JPMorgan Chase $2.0bn, Wells Fargo $1.5bn, Toyota Motor Credit $1.25bn, One Gas Inc $1.2bn, Simon Properties $1.2bn, New York Life $600 million, John Deere $500 million and Legg Mason $400 million.

Junk bond funds saw small inflows of $65 million (from Lipper). Junk issuers included CBS Outdoor Americas $1.0bn, Blueline Rental Finance $700 million, Ply Gem Industries $500 million, Laredo Petroleum $450 million, Credit Acceptance $300 million and Harbinger Group $200 million.

Convertible debt issuers included Jinkosolar $130 million.

The very long list of international dollar debt issuers included Petroleos Mexicanos $4.0bn, KFW $4.0bn, Royal Bank of Canada $2.5bn, Poland $2.0bn, Romania $2.0bn, Credit Agricole $1.75bn, ABN Amro Bank $1.75bn, Banque Federative du Credit Mutuel $1.6bn, BPCE $1.5bn, Westpac Banking $1.5bn, Coca Cola Femsa $1.5bn, Korea Development Bank $1.5bn, VTR Finance $1.5bn, Electricite de France $6.3bn, Societe Generale $1.0bn, Network Rail Infrastructure $1.0bn, Korea National Oil $1.0bn, Bank of Baroda $750 million, Banco Credito $720 million, Dexia Credit $700 million, BNP Paribas $600 million, Stena $600 million, International Bank of Reconstruction & Development $550 million, Braskem Finance $500 million, Masonite International $500 million, Inter-American Development Bank $500 million, Stackpole $380 million, Compania Minera Ares $350 million, Banco Regional $300 million, Bahamas $300 million, Vitality RE $200 million and Barclays Bank $100 million.

Ten-year Portuguese yields sank 14 bps to 5.23% (down 90bps y-t-d). Italian 10-yr yields were down 9 bps to 3.82% (down 30bps). Spain's 10-year yields dropped another 10 bps to 3.71% (down 44bps). German bund yields fell 9 bps to 1.75% (down 18bps). French yields declined 9 bps to 2.41% (down 15bps). The French to German 10-year bond spread was unchanged near a six-month high 66 bps. Greek 10-year note yields rose 14 bps to 7.85% (down 57bps). U.K. 10-year gilt yields declined 4 bps to 2.83% (down 19bps).

Japan's Nikkei equities index fell 1.1% (down 3.4% y-t-d). Japanese 10-year "JGB" yields declined 3 bps to 0.67% (down 7bps). The German DAX equities index jumped 2.9% (up 2.0% y-t-d). Spain's IBEX 35 equities index added another 1.7% (up 5.5%). Italy's FTSE MIB index rose 2.1% (up 5.3%). Emerging markets were mostly lower. Brazil's Bovespa index fell 1.0% (down 4.5%), and Mexico's Bolsa dropped 1.3% (down 1.9%). South Korea's Kospi index increased 0.3% (down 3.3%). India’s Sensex equities index rallied 1.5% (down 0.5%). China’s Shanghai Exchange declined 0.4% (down 5.25%). Turkey's Borsa Istanbul National 100 index sank 3.4% (down 3.2%)

Freddie Mac 30-year fixed mortgage rates fell 10 bps to 4.41% (up 103bps y-o-y). Fifteen-year fixed rates declined 9 bps to 3.45% (up 79bps). One-year ARM rates were unchanged at 2.56% (down on bp). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down 11 bps to 4.60% (up 60bps).

Federal Reserve Credit jumped $24.7bn last week to a record $4.007 TN. Over the past year, Fed Credit increased $1.077 TN, or 36.8%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $761bn y-o-y, or 7.0%, to a record $11.694 TN. Over two years, reserves were $1.509 TN higher for 15% growth.

M2 (narrow) "money" supply jumped $24.6bn to a record $11.015 TN. "Narrow money" expanded 5.1% ($530bn) over the past year. For the week, Currency increased $1.6bn. Total Checkable Deposits declined $6.4bn, while Savings Deposits jumped $33.9bn. Small Time Deposits fell $4.2bn. Retail Money Funds were unchanged.

Money market fund assets fell $14.0bn to $2.701 TN. Money Fund assets were unchanged from a year ago.

Total Commercial Paper fell $23.7bn to $1.036 TN. CP was down $97bn over the past year, or 8.6%.

Currency Watch:

The U.S. dollar index gained 0.7% to 81.23 (up 1.5% y-t-d). For the week on the upside, the Brazilian real increased 0.7%, the Swedish krona 0.2% and the South Korean won 0.2%. For the week on the downside, the Australian dollar declined 2.4%, the Mexican peso 2.1%, the South African rand 2.1%, the Danish krone 1.0%, the euro 0.9%, the Singapore dollar 0.9%, the Swiss franc 0.9%, the Canadian dollar 0.7%, the New Zealand dollar 0.6%, the British pound 0.4%, the Taiwanese dollar 0.3%, the Norwegian krone 0.2% and the Japanese yen 0.1%.

Commodities Watch:

January 14 – Bloomberg (Cheyenne Hopkins): “The Federal Reserve is poised to take a preliminary step toward limiting banks’ activities with commodities amid congressional scrutiny, according to three people briefed on the discussions. The Federal Reserve is planning to release a notice seeking information on ways to curb banks’ ownership and trading of some commodities as it tries to cut risk for deposit-taking banks, said the people, who requested anonymity because the talks are private.”

The CRB index increased 1.1% this week (down 0.6% y-t-d). The Goldman Sachs Commodities Index gained 0.9% (down 2.6%). Spot Gold rose 0.4% to $1,254 (up 4.0%). March Silver added 0.4% to $20.30 (up 4.8%). February Crude jumped $1.65 to $94.37 (down 4.1%). February Gasoline declined 1.8% (down 5.9%), while February Natural Gas jumped 6.7% (up 2.3%). March Copper was little changed (down 1.5%). March Wheat fell 1.0% (down 6.9%). March Corn dropped 2.0% (up 0.5%).

U.S. Fixed Income Bubble Watch:

January 14 – Financial Times (Vivianne Rodrigues and Nicole Bullock): “The US should re-examine oversight of the $4tn municipal bond market, where states and municipalities raise money, according to a task force co-chaired by Paul Volcker… Funding practices in the muni bond market have been thrust into the spotlight after Detroit last year filed the largest municipal bankruptcy and concerns arose that Puerto Rico risked defaulting on $70bn of debt that it accumulated predominantly in the muni market. Both continued to borrow over the past decade even as their finances foundered. The so-called Tower Amendment to the Securities Exchange Act of 1934 limits the jurisdiction of the Securities and Exchange Commission in the municipal bond market to fraud cases. Unlike corporate issuers, municipal bond borrowers are not required to register securities with the SEC nor are they held to the same standards of disclosure. But muni issuers agree to file annual financial statements and disclose significant events, such as ratings downgrades or missed interest payments.”

January 15 – Bloomberg (Lisa Abramowicz): “Firms that use borrowed money to lend to the smallest and riskiest companies are attracting cash at the fastest pace since before the crisis, wooing buyers with returns that are triple those of the broader junk-debt market. Investors from retirees to wealthy individuals plowed $4.1 billion into publicly traded business development corporations last year, the most since 2007, as the firms known as BDCs gained an average 16.4%. The entities are juicing returns by borrowing about 50 cents for every dollar raised from equity investors, up from 36 cents in 2011…”

January 15 – Bloomberg (Brian Chappatta): “Municipalities are set to extend the biggest wave of taxable bond sales since 2010 as issuers favor the unrestrained use of proceeds and target buyers beyond U.S. borders. While overall sales in the $3.7 trillion local-debt market dropped 15% to $299 billion in 2013, taxable offerings jumped 11% to $31 billion… Such deals should rise by more than 10% again in 2014, George Friedlander at Citigroup Inc. said… Local governments sell taxable bonds when the issues don’t meet Internal Revenue Service standards for tax-exemption, such as for pension funding because the money is invested to make a profit, or if a certain amount of proceeds goes toward commercial use. Michigan’s Saginaw County plans to sell taxable pension debt this week, reviving an August sale that was postponed after Detroit’s bankruptcy filing.”

Federal Reserve Watch:

January 14 – Wall Street Journal (Rob Curran): “Federal Reserve Bank of Dallas President Richard Fisher said he wanted to signal to markets that he would vote to continue tapering unless there was a dramatic change to the trajectory of the real economy. ‘As far as my vote is concerned, we’re going to continue down this [tapering] path,’ Mr. Fisher said… The Fed's rate-setting committee ‘expects to take continued measured steps...I’m going to push on that,’ he said. Mr Fisher said: ‘What happens picks up? We’re going to have to titrate [policy], very tightly control it, so we don’t give rise to inflation."

January 14 – Reuters: “The Federal Reserve should pare its bond buying as quickly as possible, even if doing so sends stock prices tumbling, because more bond buying risks inflation and makes an eventual exit from easy policies more difficult…, Richard Fisher, president of the Dallas Federal Reserve Bank and one of the Fed's most hawkish policymakers, said that continued purchases by the U.S. central bank of Treasuries and mortgage-backed securities carries the risk of fueling an asset price bubble… ‘Were a stock market correction to ensue while I have the vote, I would not flinch from supporting continued reductions in the size of our asset purchases as long as the real economy is growing, cyclical unemployment is declining and demand-driven deflation remains a small tail risk,’ Fisher said…. ‘I would vote for continued reductions in our asset purchases, with an eye toward eliminating them entirely at the earliest practicable date,’ said Fisher… His biggest concern, he said, is that Fed policymakers fail to remove stimulus fast enough because they fear criticism for creating such a situation. ‘As soon as feasible, we should change tack,’ Fisher said in tones that were unusually strident even for the straight-talking Texan. ‘I plan to cast my votes at (Fed) meetings accordingly.’”

January 13 – Wall Street Journal (ByMichael S. Derby): “Federal Reserve Bank of Dallas President Richard Fisher said… that while he’s glad the central bank has begun to wind down its bond-buying stimulus program, he would have preferred a more aggressive start to the effort, in remarks that also suggested unease with current levels in the stock market… ‘I was pleased with the decision to finally begin tapering our bond purchases, though I would have preferred to pull back our purchases by double the announced amount,’ Mr. Fisher said… That said, ‘the important thing for me is that the committee began the process of slowing down the ballooning of our balance sheet,’ the size of which he is very concerned about. Mr. Fisher warned in his speech that the Fed’s aggressive provision of liquidity has caused a number of asset markets to rise more than economic fundamentals would indicate. He said central bank policy has in effect put ‘beer goggles’ on investors, in reference to how excessive alcohol consumption can make the homely appear alluring to the amorously-inclined drinker. The Fed has made ‘an intoxicating brew as we have continued pouring liquidity down the economy’s throat,’ Mr. Fisher said. He pointed to rising stock prices and bond market developments as a concern to him. ‘I want to make clear that I am not among those who think we are presently in a ‘bubble’ mode for stocks or bonds or most other assets,’ Mr. Fisher said. ‘Markets for anything tradable overshoot and one must be prepared for adjustments that bring markets back to normal valuations,’ he said, noting ‘this need not threaten the real economy.”

January 16 – MarketNews International (Brai Odion-Esene): “Former Federal Reserve Vice Chairman Donald Kohn… issued a warning regarding the threat to central bank independence from political interference, and highlighted the roadblocks the Fed will face when it decides to begin withdrawing monetary stimulus from the economy. In a paper about Fed independence after the 2008 financial crisis, the now-Brookings Institution fellow noted ‘the crisis and the actions the Federal Reserve felt compelled to take during the crisis weakened public support for the institution and its independence, and led to some unusually stiff attacks from prominent politicians.’”

U.S. Bubble Economy Watch:

January 14 – Bloomberg (William Selway): “U.S. state revenue isn’t rising fast enough to keep up with the cost of funding pensions, health care and public works projects, underscoring financial strains that persist during the economic recovery, according to a report. Paying for worker benefits is taking money from schools and other needs, according to the report, issued today by a privately funded panel of budget specialists led by former Federal Reserve Chairman Paul Volcker and ex-New York Lieutenant Governor Richard Ravitch…”

January 15 – Bloomberg (James Nash): “Newport Beach, California, where four ranking lifeguards earned more than the town’s $109,677 median household income in 2012, may partially disband its municipal ocean rescue to deal with rising pension costs.”

Global Bubble Watch:

January 14 – Bloomberg (Sandrine Rastello): “International Monetary Fund Managing Director Christine Lagarde urged policy makers in advanced economies to fight risks of deflation that would threaten a global recovery she called ‘feeble.’ Less than a week before the Washington-based fund releases its new global growth forecasts, Lagarde said momentum in the second half of last year should strengthen in 2014 as developed economies gain pace. While the fund plans to raise its forecast for the global economic expansion on Jan. 21, it remains below potential of about 4%, she said… ‘If inflation is the genie, then deflation is the ogre that must be fought decisively,’ she said.”

EM Bubble Watch:

January 16 – Bloomberg (Matthew Malinowski and Arnaldo Galvao): “Brazil’s central bank signaled it will extend the world’s biggest interest rate increase after last year’s surge in consumer prices made slowing inflation a greater concern to policy makers than reviving economic growth. The bank’s board, led by President Alexandre Tombini, yesterday lifted the benchmark interest rate to 10.5 percent from 10 percent, marking the sixth straight half-percentage point increase. The statement accompanying the unanimous decision said the move extended a tightening cycle started in April 2013, signaling borrowing costs will rise again in February, said Fernando Fix, chief economist at Votorantim Asset Management.”

January 15 – Financial Times (Ralph Atkins): “An abrupt unwinding of central bank support for advanced world economies could cause capital flows to emerging markets to contract by as much as 80%, inflicting significant economic damage and throwing some countries into crises, the World Bank has warned. Capital flows into emerging markets are influenced more by global than domestic forces, leaving them vulnerable to disorderly changes in policy by the US Federal Reserve, concludes a study by World Bank economists. It highlights the risk of a repeat on a larger scale of last year’s turmoil in emerging markets after Ben Bernanke, Federal Reserve chairman, first hinted in May at plans to ‘taper’ the central bank’s asset purchase programme.”

January 14 – Bloomberg (Vladimir Kuznetsov): “The ruble weakened for a second day, heading toward its lowest close in almost five years against a dollar-euro basket, after the central bank cut its so-called target interventions… The central bank yesterday cut the so-called daily targeted interventions to zero from $60 million, removing yet another support for the ruble as part of its plan to make the currency free-floating by next year.”

Turkey Watch:

January 17 – Bloomberg (Benjamin Harvey): “Arresting the lira’s freefall would require Turkey’s central bank to do something that Prime Minister Recep Tayyip Erdogan says would amount to surrendering to those trying to overthrow him: raise interest rates. The central bank will keep its three main rates unchanged at next week’s meeting, according to surveys… by Bloomberg. The lira is the world’s worst-performing currency over the past month, tumbling to a record yesterday… Two-year yields rose the most among 18 emerging markets tracked by Bloomberg since the crisis erupted on Dec. 17.”

China Bubble Watch:

January 17 – Bloomberg (David Yong): “China’s benchmark money-market rate jumped the most in almost a month on speculation banks are hoarding funds to meet withdrawals before holidays amid concern the nation could see its first trust-product default. The gauge of interbank funding availability rose for a second day to the highest this year after the central bank refrained from adding cash to markets this week…”

January 17 – Bloomberg: “The People’s Bank of China will monitor regional debt risks and ‘clean up’ local government financing vehicles, it said in a statement. The central bank said the focus will be on LGFVs that have ‘poor trustworthiness, unclear functions and unsustainable financial conditions,’… The bank said it will also promote preparations for a municipal bond market and expand financing channels for urban construction… The PBOC said it will follow the principal of ‘blocking the side door and opening the main route’ to push ahead technical preparations for a municipal bond market.”

January 15 – New York Times (Keith Bradsher): “Move over, Janet Yellen and Ben Bernanke. Step aside, Mario Draghi and Haruhiko Kuroda. Compared with Zhou Xiaochuan, the longtime governor of the People’s Bank of China, they are all lightweights when it comes to monetary stimulus. The latest data… shows that the country’s rapid growth in money supply has continued. Mr. Zhou and his colleagues have only begun the difficult and dangerous task of reining it in… China’s money supply, broadly measured, has now tripled the money sloshing around its economy since the end of 2006… China’s tidal wave of money has driven asset prices through the roof. Housing prices have soared, feeding fears of a bubble while leaving almost everyone else feeling poor.”

January 15 – Wall Street Journal (Lingling Wei and Bob Davis): “China's effort to rein in runaway credit is being hampered by infighting between the central bank and the nation's banking regulator, say officials at both institutions, with the two agencies sparring especially over how hard to press so-called shadow bankers. The officials say that the People's Bank of China, concerned about banks finding ways to move loans off their books, has been frustrated at what it sees as the unwillingness of the China Banking Regulatory Commission to toughen regulation of banks' dealings with shadow lenders… The differences highlight the competing interests of the PBOC, which looks at overall financial stability, and the CBRC, which oversees the formal banking sector. Neither has clearly defined authority over shadow lending, the fastest-growing part of China's financial sector that often lends to borrowers considered too risky for traditional banks, including local governments, property developers and big companies burdened by overcapacity… The fastest part of the lending surge has been among shadow lenders, which include banks' off-balance-sheet lending arms, trust companies, leasing firms, insurance firms, pawnbrokers and other informal lenders. Between 2010 and 2012—a period during which traditional banks scaled back lending—shadow credit doubled to 36 trillion yuan ($6 trillion), or about 69% of China's gross domestic product in 2012, estimates J.P. Morgan…”

January 15 – Bloomberg (Brian Chappatta): “China’s broadest measure of new credit fell in December while money-supply growth and new yuan loans trailed estimates amid a cash crunch and government efforts to curb speculative lending. Aggregate financing was 1.23 trillion yuan ($204BN)… That compared with 1.63 trillion yuan a year earlier. China’s foreign-exchange reserves… rose to a record $3.82 trillion at the end of December from September’s $3.66 trillion… The jump in reserves highlights China’s challenge in coping with capital inflows while trying to reduce intervention in the currency. ‘The picture going forward is for a slowdown in credit growth,’ said Yao Wei, China economist at Societe Generale… ‘The central bank has been intervening on a very large scale -- there’s obviously immense pressure for the yuan to rise,’ she said, commenting on the larger currency reserves.”

January 15 – Wall Street Journal (Bob Davis and Dinny McMahon): “Chinese credit growth slowed in the second half of last year… but that did little to dent a buildup of debt that has left the nation's financial system increasingly vulnerable. The People's Bank of China on Wednesday said new credit issued in the Chinese economy fell by 10.7% to 7.135 trillion yuan (about $1.18 trillion) in the second half of 2013 compared with the year-earlier period. But for all of 2013, overall credit rose 9.7% to 17.29 trillion yuan compared with 2012. The central bank's data concerns total social financing, a broad measure of credit in the Chinese economy… Powering China's climbing debt is lending by what are known as shadow bankers—an assortment of trust companies, securities firms, insurance companies and other informal lenders… In 2013, lending by shadow banking institutions rose 43% to 5.165 trillion yuan compared with 2012… It doubled to 2.865 trillion yuan in first half of the year compared with the 2012 period, but fell 5.1% in the second half.”

January 15 – Financial Times (Tom Mitchell): “The rise of China’s shadow banking sector has been thrown into sharp relief by data from the central bank showing that it now accounts for nearly one-third of aggregate financing in the world’s second-biggest economy. Funding from trust companies and other entities in the shadow sector rose to its highest level on record and accounted for 30% of the Rmb17.3tn ($2.9tn) in total credit issued last year…, up from a 23% share of aggregate financing in 2012. ‘This shows that financial institutions’ off-balance sheet business is developing relatively fast and providing strong capital support to the economy,’ Sheng Songcheng, head of the PBoC’s statistical department, said…”

January 13 – Bloomberg (Brian Chappatta): “The death of China Railway Group Ltd.’s president left his successor an escalating challenge: collecting on unpaid construction-work bills in an industry plagued by record debt as borrowing costs surge. Shares in China’s second-biggest builder of railways have fallen 4.9% in Hong Kong since the company said Jan. 5 that President Bai Zhongren had died in an accident… The yield on 2023 dollar-denominated debt of a company unit reached an eight-week high of 5.03% on Jan. 9, up from 3.88% when they were sold last January… China Railway Group’s liabilities and accounts receivable both more than doubled in the past five years, an increase Sun Hung Kai Financial Ltd. said reflects difficulty collecting payments on time from China Railway Corp., the operator of a network plagued by corruption probes and fatal accidents.”

January 13 – Bloomberg (Brian Chappatta): “Some Chinese peer-to-peer lending websites collapsed last year and others may need restructuring in 2014 to curb fraud in an industry that has grown rapidly with little regulatory oversight, Xinhua News Agency said. About 800 such online operations emerged in China just last year with outstanding loans of 26.8 billion yuan ($4.4bn), Xinhua reported… Peer-to-peer lending has taken off in China since 2011 as traditional methods of private lending among family and acquaintances, part of the country’s unregulated $6 trillion shadow-banking system, move online. Loans brokered on the Web increased to 105.8 billion yuan last year from 20 billion yuan in 2012, Xinhua said.”

Japan Watch:

January 14 – Bloomberg (Andy Sharp and Toru Fujioka): “Japan’s current-account deficit widened to a record in November as imports climbed, underscoring challenges for Prime Minister Shinzo Abe as he tries to drive a sustained economic rebound. The 592.8 billion yen ($5.7 billion) shortfall in the widest measure of trade… was larger than the median forecast of 368.9 billion yen… The deficit is the biggest in comparable data back to 1985. Weakness in the yen and extra demand for energy because of nuclear-plant shutdowns are driving up Japan’s import bill, highlighting drags on the recovery that will also include a sales-tax increase in April. A longer-term risk for the nation is any shift to a sustained deficit that would undermine investor confidence in Japanese government debt.”

January 17 – Bloomberg (Andy Sharp and Masaaki Iwamoto): “Japan’s success in rekindling inflation is raising the stakes for policy makers to map out the endgame for monetary stimulus, given the risk of a surge in yields when the Bank of Japan winds down bond purchases. With the BOJ’s benchmark inflation gauge past halfway to Governor Haruhiko Kuroda’s 2% target, yields on 10-year government securities are still the world’s lowest at 0.67% -- held down by central bank purchases of unprecedented scale.”