Page 1 of 3 CREDIT BUBBLE BULLETIN The next collapse
Commentary and weekly watch by Doug Noland
Bloomberg's Laura Litvan reported on August 19: "The US Congressional Budget
Office predicted the budget deficit for fiscal year 2011 will be $1.066
trillion, revised up from an estimate of $996 billion in March ... CBO Director
Doug Elmendorf said the agency's projections haven't changed significantly
since its March forecast ... 'Unfortunately, this is a case where no news is
not good news,' Elmendorf said. 'The country faces serious budget problems and
serious economic problems.' ... The CBO said ... the deficit for the current
fiscal year ending Sept 30 will be $1.34 trillion. That is 9.1% of GDP, or the
second largest shortfall in the past 65 years, exceeded only by last year's
9.9%."
On the same day, John Shaw of MarketNews International reported: "Congressional
Budget Office director Doug Elmendorf
said ... his agency's new fiscal report may 'significantly underestimate' the
nation's short-term deficit outlook because of the requirements of budget
estimating. ... Elmendorf emphasized that under budget law the CBO must make
its baseline estimates by assuming that current tax and spending laws are
unchanged. He added the US fiscal outlook would be 'quite different' if other,
arguably more plausible, assumptions were made. ... 'This is an extraordinarily
high level of debt' when viewed in the context of American history, he said ...
"
"It's important to be a diplomat for the diplomatic corps, it's not so
important for a central bank. I think it's very important for central banks to
be clearly focused and also, if necessary, to deliver undiplomatic messages to
governments." Bundesbank President Axel Weber, August 20, 2010 (interviewed by
Bloomberg).
Push the inflation/deflation debate to the backburner. The critical issue these
days is whether global debt markets have succumbed to bubble dynamics. Are
investors and speculators, once again, participating in a historic bout of
(Hyman Minsky) "Ponzi Finance"? Is flawed policymaking fomenting yet another
dangerous speculative bubble and period of deepening economic maladjustment?
Are central bankers and markets accommodating history's greatest
expansion/inflation of non-productive government debt?
As an analyst who has for some time been warning of mounting risks associated
with a global government finance bubble, it now seems obvious that the
situation has taken a decided turn for the worst: bubble dynamics have become
more entrenched and dangerous, while policymaking has reached the precipice of
outright failure.
There reaches a point in the evolution of a credit bubble where things really
begin to get out of hand; the "terminal phase of excess". If policymakers fail
to act forcefully to rein in "terminal" government borrowing excesses, they
will be held hostage to escalating risks from an out of control bubble (think
mortgage finance bubble 2005-06). There would be no turning back. A consensus
view is taking shape that would amount to the worst-case policy scenario from a
credit bubble analysis perspective.
Some claim (reminiscent of views held back in 2002) that "fat tail" deflation
risk is the critical issue. They argue forcefully for more extreme inflationary
policymaking - larger deficits and additional Federal Reserve monetization.
With inflation now effectively out of the picture, they believe the only policy
risk is a lack of resolve for inflating/stimulating sufficiently. There is
increasing contempt and ridicule directed at the Federal Reserve,
administration and congress for not stimulating more aggressively.
Some argue that the Federal Reserve has a profound duty to balloon its balance
sheet by monetizing Treasury debt. They state that the Fed has a profound duty
to sacrifice its independence, as it works in concert with extreme fiscal
measures to eliminate deflation risk. This is no more than New Age theorizing
and experimental policymaking lacking of any historical basis of support. It
is, at the same time, a skillfully sophisticated version of age-old
inflationism propaganda and monetary quackery.
Nowhere from this (inflationists) camp do we see any recognition of the
potentially catastrophic bubble that - after years of migrating from one market
to the next - has finally found its home right in the heart of our monetary
system. Indeed, the inflationists have deep disdain for bubble analysis. They
write off the mortgage finance bubble as a housing boom led astray by one-off
failures in underwriting standards and supervision. Such analysis ignores the
key policy, monetary, and global market dynamics that only a few years ago were
allowed to destroy the creditworthiness and market confidence in our system's
(non-government guaranteed) mortgage credit (almost bringing down the global
financial system).
I have posited that the 2008 bursting of the mortgage/Wall Street finance
bubble unleashed an even bigger ("mother of all ... ") bubble throughout global
fixed-income marketplaces. I trace today's bubble back at least to the Alan
Greenspan Fed's 1987 post-crash systemic reliquefication. Resulting
late-eighties' excess led to severe early-90's banking system impairment;
followed by an another aggressive monetary policy response; the 1992/93 bond
market bubble; the 1994 bond bust and Mexican crisis; expanded monetary
largess; the Southeast Asian bubbles and collapses; additional policy
accommodation; the Russian and Long-Term Capital Management fiascos; more
extreme monetary stimulus; the resulting technology bubble; and historic
monetary stimulus and reliquefication leading to the mortgage/Wall Street
bubble. Recent history of monetary disorder fueling serial boom and bust cycles
is unequivocal.
From my analytical perspective, we're in the midst of history's greatest and
most perilous financial bubble. And I am beside myself that nobody in a
position of influence seems to care. We've witnessed momentous analytical and
policy errors over the years - and these blunders are allowed to repeat
themselves without thorough analysis and review. All this talk about fighting
deflation and helping Main Street misses the point - and only feeds the bubble.
I'm fed up with ideology trumping sound analysis.
Why is there no consensus recognizing that the number one priority must be to
protect the soundness of our government debt market - the heart of contemporary
"money". For me, talk emanating from bond fund managers about how to help the
average guy rings hollow. It is fundamental to our nation's future that we
stabilize the government debt bubble and secure the integrity of our monetary
system. The chorus of calls for larger deficits and greater Fed monetization is
fueling distortions that risk financial calamity.
The Treasury Department's conference last week on housing finance overhaul
epitomizes the dysfunctional backdrop. These days, Fannie Mae, Freddie Mac,
Ginnie Mae, the Federal Housing Administration, etc, ensure that mortgage
borrowing costs are quite low and mortgage credit is reasonably available. The
mortgage market has already essentially been nationalized, and such
government-sponsored enterprises are an unmitigated financial black hole.
Enough already. Yet policy proposals are presented that include a massive
refinancing of current mortgages to reset at today's historic low rates. The
idea seems impractical. Yet such notions - proving that there are no longer any
bounds on policy reasonableness or government intrusion - along with the
possibility for a tsunamis of mortgage refis throw additional weight upon the
Treasury yield collapse, while spurring general market instability (and big
profits for those on the right side of the trade).
The US housing mania was historic - and it's over. Mortgage credit will not
provide a meaningful source of system credit expansion for some years to come.
This post-bubble reality is misdiagnosed as "deflation". As we've already
witnessed, even enormous fiscal and monetary stimulus does little to incite
mortgage borrowing. Just as post-tech bubble reflation bypassed the technology
sector in favor of inflating mortgage credit, the mortgage-backed securities
(MBS) marketplace, and housing prices, today's reflationary forces flow
vigorously to government (and related) debt markets.
I found it interesting that hedge fund legend Stanley Druckenmiller announced
his retirement last week, ending an incredible 30-year run in hedge fund
management. And Friday's New York Times ran a story highlighting the ongoing
difficulties suffered by the "quant" hedge funds. Massive government stimulus
may be benefiting bond fund managers, but it's certainly not improving the
overall functioning of the financial markets. I would not be surprised if
sophisticated market operators such as Mr Druckenmiller look at the current
backdrop and are content to exit the game before the bloody havoc of the next
bursting bubble.
As the great German economist Kurt Richebacher was fond of saying, "The only
cure for a bubble is not to allow it to inflate." Regrettably, there is little
government policymaking can do in the short run to improve the situation. There
is, however, a great deal policymakers are doing to make a bad situation worse.
The current backdrop - certainly impacted by the Greek debt crisis, related
market tumult and a faltering US recovery - has created an elevated risk of
further policy mistakes.
A multi-decade credit bubble badly distorted our economy's underlying
structure. The harsh reality is that this structural maladjustment can only be
rectified gradually over a period of many years. There's just no quick fix.
Ongoing massive fiscal and monetary stimulus only exacerbates our economy's
ills. Moreover, it risks an inevitable crisis of confidence in our debt markets
and monetary system.
The economy is muddling through right now. It's frustrating and discouraging
but, under the circumstances, this is about the best we could have hoped for. I
am increasingly troubled by the direction (and tone) of economic analysis and
policy discussion. All the inflationism histrionics, including the notion that
the Fed and congress are committing a dereliction of duties by not stimulating
more aggressively, are unhelpful. Describing fiscal policy as increasingly
"austere" is ridiculous. But mostly, calls for the (un-independent) Federal
Reserve to monetize a massive federal spending plan are as irresponsible as
they are dangerous.
An increasing weight of evidence supports the global government finance bubble
thesis. But, of course, there's nothing like the euphoria associated with
rapidly inflating asset prices (in this case bonds) to embolden those
dismissive of bubble analysis. All the more reason that it is imperative that
we not ignore this bubble as we did the mortgage/Wall Street finance bubble.
The risks and costs today are infinitely greater.
WEEKLY WATCH
For another volatile week, the S&P500 slipped 0.7% (down 3.9% y-t-d), and
the Dow declined 0.9% (down 2.1%). The Banks dropped 2.5% (up 4.9%), and the
Broker/Dealers slipped 0.2% (down 10.1%). The Morgan Stanley Cyclicals lost
0.8% (down 1.2%), while the Transports added 0.2% (up 2.8%). The Morgan Stanley
Consumer index declined 1.3% (down 1.4%), and the Utilities dipped 0.6% (down
2.3%). The S&P 400 Mid-Caps added 0.3% (up 1.4%), and the small cap Russell
2000 increased 0.2% (down 2.3%). The Nasdaq100 added 0.4% (down 1.9%), and the
Morgan Stanley High Tech index rallied 2.2% (down 6.3%). The Semiconductors
jumped 1.6% (down 8.9%). The InteractiveWeek Internet index rose 3.5% (up
7.3%). The Biotechs declined 0.6%, reducing 2010 gains to 13.8%. With bullion
gaining $12, the HUI gold index gained 3.2% (up 8.9%).
One-month Treasury bill rates ended the week at 14 bps and three-month bills
closed at 14 bps. Two-year government yields fell 2.5 bps to 0.485%. Five-year
T-note yields were little changed at 1.42%. Ten-year yields declined 6 bps to
2.62%. Long bond yields dropped 20 bps to 3.66%. Benchmark Fannie MBS yields
rose 6 bps to 3.49%. The spread between 10-year Treasury yields and benchmark
MBS yields widened a notable 12 bps to 87 bps. Agency 10-yr debt spreads
widened 3 bps to 24 bps. The implied yield on December 2010 eurodollar futures
sank 8 bps to 0.39%. The 10-year dollar swap spread increased 4.25 to 2.0. The
30-year swap spread increased 7.5 to negative 35.5. Corporate bond spreads were
little changed. An index of investment grade spreads added less than one basis
point to 109 bps. An index of junk bond spreads was unchanged at 573 bps.
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