Page 1 of 3 CREDIT BUBBLE BULLETIN
Pick-up in store - without US shoppers
Commentary and weekly watch by Doug Noland
The global reflation thesis has been somewhat under fire of late. Chinese
stocks dropped about 25% from trading highs set earlier this month. An abrupt
slowdown in bank lending - and even discussion of more stringent bank capital
requirements - has many now questioning the underpinnings of Chinese recovery.
Here at home, a bevy of data on household spending, confidence, and job losses
point to stubborn consumer frugality. Can global reflation make headway without
a recovery in US consumption?
As the year has progressed, optimistic adherents to the global
reflation/recovery thesis have multiplied. Of late, however, the reflation
protagonists have been roused. Many hold the view that the Chinese situation is
much more tenuous than advertised. Moreover, this camp views global recovery as
impossible in the
era of the stingy American consumer. Talk of deflation risk has turned more
boisterous.
My view differs from both the bullish consensus reflation viewpoint and that of
the protagonists/"deflationists". To cut to the chase, I do believe a period of
global reflation can evolve in the face of weak US consumption, and while a
troubled bond market would likely halt reflation in it tracks, a downtrodden
American consumer is an impediment to be hurdled with a powerful boost from
ultra-easy global "money". Indeed, deep underlying US fragility - and resulting
market assurance that the Fed is indefinitely wedded to ultra-loose policy - is
a critical facet of my global reflation thesis.
Fundamentally, it is my view that the nexus of global reflation emanates from
irreparable structural impairment to the international dollar reserve system.
The global dollar monetary "regime" some time back stopped functioning as a
disciplining or restraining force for credit systems around the world. Today,
even in this nervous post-crisis landscape, the prospect of an unending
expansion of dollar reserves works to foment synchronized credit and
speculative excesses. The deeply maladjusted US bubble economy ensures heavy
ongoing non-productive US debt issuance that manifests as enormous trade and
speculative dollar financial flows - to further inundate the saturated world.
The unfolding breakdown in this dollar "system" is the genesis of global
inflationary forces.
I've read and listened to the view that an imminent dollar rally will
rejuvenate global deflation. While the dollar and currency markets will surely
fluctuate, I view nothing on the horizon that will alter the fundamental issue
of massive outgoing dollar flows. Policymaking is now trapped in a scheme of
promoting excess in the name of system stabilization. The Federal Reserve is
poised to again retain a loose policy stance for a far too extended period, and
there will be no let up in the massive issuance of federal (Treasury, agency,
and government-sponsored entities' mortgage-backed securities) debt.
A central aspect of my global reflation thesis holds that China, Asia and the
"emerging" economies are this cycle's asset class with the strongest
inflationary biases - hence the areas most prone to immediate and spectacular
inflationary manifestations. These "hot-money" magnets then work to rejuvenate
animal spirits throughout the global leveraged speculating community, with
rapidly recovering credit systems and economies spurring a more general rebound
in global activity. The more commodity-oriented and manufacturing-driven
economies are the first to benefit. The services and housing-centric US economy
badly lags in this reflationary scenario.
Many analysts who do recognize US vulnerability also see troubling aspects to
the Chinese economy and financial system. I see them also; they just don't
alter my fear that China has likely entered a precarious period where credit,
speculation, and spending excesses tend to really run amuck.
Expect increasing concern from China's policymakers - and lots of tinkering
(bank capital requirements, lending restraint pronouncements, warnings against
speculation, interest-rate adjustments, etc). Also expect markets in China and
around the world to grapple mightily with the course of Chinese policy
responses.
Keep in mind that the terminal phase of credit bubble excess is notorious for
outflanking fainthearted policymaking. It is indeed acute financial, economic
and social vulnerabilities that I suspect will restrain Chinese policymakers
from applying the type of tough measures necessary to rein in traditionally
unwieldy late-cycle excesses.
It is the combination of deep structural issues and vulnerabilities in the US
and China that have the reflation antagonists and deflationists energized. They
see confirmation in their view from recent US economic data and Chinese
developments. Yet it remains a preeminent challenge of credit bubble analysis
to recognize that fundamental issues can inhibit, repress and check excess -
but there are circumstances when system maladjustment and fragility instead
tend to cultivate a backdrop of policymaking and market tolerance.
As I've written over the years, major credit bubbles invariably evolve from
some underlying source of monetary disorder. Stable and sound credit systems
are simply not breeding grounds for bubbles. The greatest bubbles are fashioned
when profound money and credit distortions meld with policymaker confusion and
acquiescence. As we've witnessed - at home, in China and around the world -
acute financial and economic fragility has engendered a backdrop of
unprecedented global policymaking accommodation.Predictably accommodating
policymakers have cultivated an environment of synchronized global marketplace
reflation accommodation.
It is with this analysis in mind that I am analytically forced to give global
reflation the strong benefit of the doubt. I will be dismissive of deflation
chatter as long as the markets readily accommodate trillions of US debt
issuance here at home and tolerate excesses within domestic credit systems
across the globe.
At the end of last week, the dollar index traded below 78 and crude traded
above $74. The bond market is understandably unsettled. Ten-year yields traded
at 3.72% on July 27, dropped to 3.48% on July 31, jumped to 3.85% on August 7,
sank to 3.43% yesterday and closed today at 3.57%.
I'll posit that artificially low interest rates everywhere are global
reflation's greatest champion. It is the nature of bubbles that the longer
markets misprice risk the greater the pain when the bubble eventually bursts.
Credit and market analysis could not be more challenging or fascinating.
WEEKLY WATCH
For the week, the S&P500 gained 2.2% (up 13.6% y-t-d), and the Dow rose
2.0% (up 8.3% y-t-d). The Banks jumped 2.8% (up 6.3%), and the Broker/Dealers
added 1.2% (up 43.4%). The Morgan Stanley Cyclicals increased 1.5% (up 51.7%),
and the Transports gained 1.7% (up 6.5%). The Morgan Stanley Consumer index
jumped 3.0% (up 11.4%), and the Utilities rose 2.0% (up 0.7%). The S&P 400
Mid-Caps rallied 2.1% (up 22.5%), and the small cap Russell 2000 surged 3.1%
(up 16.4%). The Nasdaq100 gained 1.6% (up 35.2%) and the Morgan Stanley High
Tech index rose 1.7% (up 48.3%). The Semiconductors increased 2.3% (up 42.0%),
and the InteractiveWeek Internet index gained 1.6% (up 53.7%). The Biotechs
jumped 2.4% (up 35.9%). With Bullion up $5.60, the HUI gold index added 0.3%
(up 18.5%).
One-month Treasury bill rates ended the week at 10 bps, and three-month bills
closed at 16 bps. Two-year government yields rose 4 bps to 1.05%. Five-year
T-note yields increased 5 bps to 2.54%. Ten-year yields were little changed at
3.57%. Long bond yields were bps at 4.4%. Benchmark Fannie MBS yields rose 4
bps to 4.55%. The spread between 10-year Treasuries and benchmark MBS widened 4
to 98. Agency 10-yr debt spreads widened 9 to 19 bps. The implied yield on
December eurodollar futures was little changed at 0.59%. The 2-year dollar swap
spread increased 3.75 to 43.75 bps; the 10-year dollar swap spread increased
4.75 to 26.75 bps; and the 30-year swap spread increased 5.5 to negative 10.0
bps. Corporate bond spreads were mixed. An index of investment grade bond
spreads widened 2 bps to 173, while an index of junk spreads dropped 20 to 692
bps.
Investment grade issuers included American Express $1.5bn, Watson
Pharmaceutical $850 million, Viacom $850 million, Yum Brands $500 million, Air
Products & Chemicals $400 million, Baxter Intl $400 million, Meadwestvaco
$400 million, and Boardwalk Pipeline $350 million.
Junk bond funds saw outflows of $130 million (from AMG). Junk issuers included
Donnelley & Sons $350 million.
I saw no convert issues.
International dollar debt issuers included Royal Bank of Scotland $2.0bn and
BNP Paribas $1.7bn.
U.K. 10-year gilt yields declined 4 bps to 3.64%, while German bund yields were
little changed at 3.31%. The German DAX equities index gained 2.9% (up 13.6%).
Japanese 10-year "JGB" yields sank 7 bps to 1.305%. The Nikkei 225 fell 3.4%
(up 15.6%). Emerging markets were mixed to higher. Brazil's benchmark dollar
bond yields rose 4 bps to 5.62%. Brazil's Bovespa equities index increased 1.9%
(up 53.7% y-t-d). The Mexican Bolsa rallied 1.6% (up 26.5% y-t-d). Mexico's
10-year $ yields jumped 9 bps to 5.70%. Russia's RTS equities index slipped
0.9% (up 66.2%). India's Sensex equities index declined 1.1% (up 58.0%).
China's Shanghai Exchange fell another 2.8%, lowering 2009 gains to 62.6%.
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