Page 1 of 3 CREDIT BUBBLE BULLETIN Dollar dilemma
Commentary and weekly watch by Doug Noland
Renewed US dollar weakness has evoked calls for Washington to implement a true
strong-dollar policy. Larry Kudlow is calling for a supply-side cut of marginal
corporate tax rates and for the Federal Reserve to increase interest rates 25
basis points (bps) in support of the currency. He knows "none of this is gonna
happen". Others believe the focus should be trimming our massive federal
deficit. A move to fiscal and monetary restraint is surely needed to help
stabilize the dollar. Restraint is not going to happen.
Perhaps Federal Reserve chairman Ben Bernanke tossed a tiny bone to the
currency markets late last week. Yet everyone in the world knows US policymaker
focus is on aggressive short-term stimulus with the objective of jump-starting
rapid economic recovery. Officials from both the Federal Reserve and the US
Treasury have stated their view that a strong US economy is the best
prescription for a strong dollar.
Simple enough. So perhaps they'll increasingly be compelled to tweak their
comments in hope of influencing currency trading. But don't hold your breath
waiting for a meaningful shift in strategy - say aggressively boosting rates or
slashing spending - to protect the value of our currency. Current policy is not
the primary issue anyway.
Non-productive credit expansion/inflation is the bane of currency stability.
The dollar's fundamental problem these days lies with the underlying structure
of the US economy. As much as near zero interest-rates and trillion dollar
deficits don't improve the situation, they are symptomatic of much broader
systemic issues. Indeed, ultra-loose monetary policy, scary deficits, and
ongoing dollar devaluation are all consequences of deep structural
maladjustments to the services and consumption-oriented US "bubble" economy.
This maligned economic structure has been the driver for both policy and dollar
weakness. With the collapse of the Wall Street/mortgage finance bubble, acute
structural fragilities required unprecedented stimulus in order to stem
implosion. Once stabilized, policy focus turned immediately to short-term
performance - positive gross domestic product (GDP) growth, spending recovery
and job creation. Not surprisingly, the focus remains on finding a quick fix,
with scant attention to structural issues.
As it relates to the dollar stability, I would argue that the central policy
issue should be to create a backdrop conducive to far-reaching adjustment and
repair to the economic structure. Aggressive stimulus would be expected to spur
short-term performance gains. However, this would be at the cost of delaying
necessary structural corrections. This dynamic may help explain why the bulls
have been right on stocks this year but wrong that US recovery would boost the
dollar. Washington may believe that big GDP growth numbers will support a
strong dollar, but global markets (and policymakers) seem to recognize clearly
that the course of US policy undermines the long-term value of our currency
(and their dollar holdings).
Decades of credit excess cultivated an economic structure that produces too
little and survives on too much credit. The credit inflation/dollar debasement
dilemma was masked for years. The dollar indulged both in its global reserve
status and the world's keen desire to participate in our financial asset
bubble. For years, the US "private"-sector credit apparatus (Wall Street
securitizations, government-sponsored enterprie - or GSE - obligations,
derivatives, and so on) was the global "asset class" demonstrating the
strongest (most alluring) inflationary bias. As fast as our credit system
inundated the world with dollar liquidity, these financial flows would as
quickly be recycled right back into US securities. The dollar was king on the
back of reflexive speculative flows.
The dollar was not ok - it was fundamentally weak - but it looked OK
relatively, in a world of weak currencies and expansive global speculation. As
long as this recycling mechanism functioned smoothly, the US credit system
could easily expand credit on an annual basis sufficient to boost various types
of "output" that tallied in GDP. With Wall Street and mortgage credit at the
heart of the US credit bubble, financial excess fed a self-reinforcing boom in
lending, asset inflation, consumption, business investment and government
expenditures. Moreover, any bout of financial turmoil would see US yields
collapse and a virtual buying panic for agency and mortgage-related securities
- rapidly reflating our bubbles.
Many things changed with the bursting of the Wall Street/mortgage finance
bubble. For one, our "private"-sector credit mechanism was no longer capable of
creating sufficient credit to sustain inflated real estate bubbles or the
inflation-distorted bubble economy structure. For two, the US credit system
decisively relinquished its status as the most alluring global "asset class".
Years of dollar debasement had already worked to sway the inflationary biases
away from the US toward energy, gold, commodities and the "emerging" markets
and economies. The unfolding post-Wall Street bubble reflation has found - for
the first time - the "developing" and commodities worlds supplanting the US as
the favored destination for speculative finance. This is big.
Granted, deleveraging and unwinding of dollar-bearish bets initially propelled
the dollar higher. Yet I would argue that the global crisis will be looked back
on as a seminal event for our currency. Our policymakers have much less
flexibility in the new financial and economic landscape. Both fiscal and
monetary measures have lost potency. Trillions of dollars of deficits, zero
interest rates and a US$2 trillion Fed balance sheet today get less system
response than hundreds of billions and a few percent would have achieved
previously. This hurts the dollar. Acute financial and economic fragilities
ensure extreme policy measures will remain in place for much longer than would
have previously been necessary. This also hurts dollar confidence.
Meanwhile, the "developing" world currencies, markets and economies
dramatically outperform the United States. Global reflationary dynamics have
put a premium on asset markets in China, Asia and the developing world. This
robust inflationary bias, then, places a premium on things consumed in - and
demand from - these economies.
So much of our economic structure evolved during - and for - a different era.
Our bubbles were inflating; market dynamics had created great power and
flexibility for policymaking; the US consumer was the king; and our securities
and economic booms were the focus globally. While some of our multinational
companies will benefit, too much of our economic structure is poorly positioned
for today's new global landscape. Not only does our maladjusted economic
structure today require too much non-productive credit creation, it lacks the
type of real economic returns necessary to attract global financial flows. This
is a big predicament not easily remedied.
It is worth noting that Australia's central bank was last week the first major
central bank to begin the process of removing monetary stimulus. Global markets
reacted by pushing the dollar even lower. The "commodity" currencies, gold,
energy, commodities and global equities surged higher.
I'll take the markets' reaction to uncommon central banking rationality as
early confirmation that attempts to tighten ultra-loose monetary conditions
globally will be impeded by speculative inflows already bent against the
dollar. This dynamic reinforces already strong reflationary forces in
non-dollar markets, while intensifying speculative selling pressure against the
greenback. Expect foreign central banks to be pressured to buy a lot more
dollars, and global markets to experience even more destabilizing monetary
disorder.
WEEKLY WATCH
For the week, the S&P500 jumped 4.5% (up 18.6% y-t-d), and the Dow rose
4.0% (up 14.4% y-t-d). The Morgan Stanley Cyclicals surged 7.5% (up 58.6%), and
Transports increased 5.0% (up 9.6%). The Banks surged 5.8% (up 7.0%), and the
Broker/Dealers jumped 6.6% (up 60.1%). The Morgan Stanley Consumer index gained
2.6% (up 18.1%), and the Utilities advanced 2.2% (down 1.0%). The broader
market was quite strong. The S&P 400 Mid-Caps jumped 5.8% (up 30.5%), and
the small cap Russell 2000 rose 6.0% (up 23.1%). The Nasdaq100 gained 3.9% (up
42.6%) and the Morgan Stanley High Tech index surged 5.1% (up 59.0%). The
Semiconductors rose 6.5% (up 53.9%). The InteractiveWeek Internet index gained
4.6% (up 65.1%). The Biotechs added 2.8% (up 41.2%). With Bullion rising $46,
the HUI gold index surged 13.0% (up 47.5%).
One-month Treasury bill rates ended the week at 3 bps, and three-month bills
closed at 7 bps. Two-year government yields jumped 9 bps to 0.85%. Five-year
T-note yields rose 13.5 bps to 2.28%. Ten-year yields were 16 bps higher to
3.38%. Long bond yields surged 23 bps to 4.23%. Benchmark Fannie MBS yields
rose 17 bps to 4.28%. The spread between 10-year Treasuries and benchmark MBS
yields widened one to 90 bps. Agency 10-yr debt spreads narrowed 3 to 6 bps.
The implied yield on December 2010 eurodollar futures jumped 12.5 bps to
1.755%. The 2-year dollar swap spread increased one to 36.5 bps; the 10-year
dollar swap spread increased 1.25 to 17.5 bps; and the 30-year swap spread
increased 2.75 to negative 9.25 bps. Corporate bond spreads were narrower. An
index of investment grade bond spreads narrowed 3 bps to 142, and an index of
junk spreads sank another 21 bps to a 13-month low 594 bps.
Corporate debt issuance remains strong. Investment grade issuers included New
York Life $1.0bn, Protective Life $700 million, United Airlines $660 million,
Boston Properties Pipeline Funding Co. $500 million, Diamond Offshore $500
million, and RPM International $300 million.
Junk bond funds enjoyed inflows of $516 million (from AMG). Junk issuers
included Hovnanian $785 million, Sempra Energy $750 million, Wynn Las Vegas
$500 million, Solutia $400 million, Hercules Offshore $300 million, Comstock
Resources $300 million, and GEO Group $250 million.
I saw no converts issued.
International dollar-denominated debt issuers included Commercial Bank of
Australia $3.5bn, Statoilhydro $900 million, America Movil $750 million, Amal
$400 million and Nova Chemicals $700 million.
U.K. 10-year gilt yields added one basis point to 3.45%, and German bund yields
rose 8 bps to 3.20%. The German DAX equities index jumped 4.5% (up 18.7%
y-t-d). Japanese 10-year "JGB" yields increased 3 bps to 1.28%. The Nikkei 225
rallied 2.9% (up 13.1%). Emerging markets were mostly much higher. Russia's RTS
equities index surged 11.4% (up 115.9%). India's Sensex equities declined 2.9%
(up 72.5%). China's Shanghai Exchange jumped 4.8% today after their holiday
break, boosting 2009 gains to 59.9%. Brazil's benchmark dollar bond yields
dropped 17 bps to 4.91%. Brazil's Bovespa equities index jumped 4.7% to a 2009
high (up 70.6% y-t-d). The Mexican Bolsa rose 4.7%, also to a 2009 high (up
34.2% y-t-d). Mexico's 10-year $ yields sank 24 bps to 5.05%.
Freddie Mac 30-year fixed mortgage rates fell 7 bps to a 20-wk low 4.87% (down
107bps y-o-y). Fifteen-year fixed rates dipped 3 bps to 4.33% (down 130bps
y-o-y). One-year ARMs increased 4 bps to 4.53% (down 62bps y-o-y). Bankrate's
survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 5 bps
to 6.06% (down 106bps y-o-y).
Federal Reserve Credit slipped $652 million last week to $2.120 TN. Fed Credit
has declined $127bn y-t-d, although it expanded $625bn over the past 52 weeks
(42%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week
(ended 10/7) increased $5.6bn to a record $2.860 TN. "Custody holdings" have
expanded at a 17.8% rate y-t-d, and were up $375bn over the past year, or
15.1%.
M2 (narrow) "money" supply jumped $47.5bn to $8.357 TN (week of 9/28). Narrow
"money" has expanded at a 2.7% rate y-t-d and 5.5% over the past year. For the
week, Currency added $0.5bn, and Demand & Checkable Deposits increased
$13.2bn. Savings Deposits surged $52.6bn, while Small Denominated Deposits fell
$10.7bn. Retail Money Funds declined $8.2bn.
Total Money Market Fund assets (from Invest Co Inst) increased $16.7 to $3.446
TN. Money fund assets have declined $384bn y-t-d, or 13.0% annualized. Money
funds declined $12bn, or 0.3%, over the past year.
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