By Doug Noland
"I favor being much clearer and specific about the economic markers that it would take to alter [the course of policymaking]... In fact, I argued for something like this just recently... We could allow rates to remain low until the unemployment rate fell to a certain level or if inflation became tremendously unacceptable at a higher rate." - Chicago Federal Reserve president Charles Evans (interviewed by CNBC's Steve Liesman)
On September 1, Marc Jones of Reuters reported: "Bundesbank President Jens Weidmann said... that trust in the European Central Bank could be lost if the euro zone central bank persists with crisis-fighting policies that go beyond its conventional role... He said the lines between central bank monetary policy and
governments' fiscal policy had been blurred as a result of the financial and euro zone debt crises. 'In the long run this strains the trust in the central banks, and therefore for monetary policy it matters that the additional risks that have been taken on [are] reduced again... ' Noting that the debt problems of weaker euro zone countries had been shared by the bloc's stronger states, he said this was not the way to maintain incentives for solid fiscal policy. 'Such a solution is not suitable to curtail the uncertainty on financial markets. Moreover, it exposes monetary policy to pressure to have a loose bias.'"
Global monetary policymaking is a complete mess. As for the US Federal Reserve, I won't this week be profiling Chicago Federal Reserve president Evans' interview with CNBC's Steve Liesman. In what is a really wacky idea, a dovish Evan's suggested the Fed could consider targeting a specific unemployment rate when setting monetary policy. Fed chairman Ben Bernanke has been a long-time advocate of having monetary policy target a pre-determined inflation rate ("inflation targeting"), and I have fully expected that such a mechanism at some point would be used to justify additional "accommodation"/monetization. However, at 3.6% year-on-year current elevated consumer price inflation creates an inopportune backdrop for proposing such a targeting mechanism. So, then, why not the unemployment rate - or home values or stock prices?
In Europe, the European Central Bank (ECB) now confronts a very serious dilemma. Ongoing (and evolving) financial crisis has forced the central bank to sidestep its policymaking doctrine, circumvent rules and dangerously expose itself to market, political and capital pressures. They today hold enormous quantities of securities and loans to European periphery governments and banks, exposure they had no intention of holding for anything other than for short-term liquidity-supporting purposes. Not only are they now stuck with these "trades-turned-long-term investments", they face overwhelming pressure for ongoing liquidity injections. In particular, they are left holding the bag filled with big exposure to Greek debt, as Greece Bailout II unravels and two-year Greek yields surge to 47%.
More problematically for the ECB, the European banking system, and global financial markets, a side deal struck early last month between the ECB and Italian President Silvio Berlusconi's government appears in peril. Apparently, the ECB agreed to support Italian debt in the marketplace in exchange for a commitment to more aggressive austerity measures from the Italians. After surging to a high of 6.20% on August 4, ECB buying was instrumental in pressing Italy's 10-year yields below 5% by mid-month.
Now, under intense political pressure, the Berlusconi government has backed away from key austerity measures. Complicating matters, Berlusconi leadership is jeopardized by ongoing criminal investigations and rising unpopularity. ECB president Jean-Claude Trichet on Friday warned that Italian fiscal and economic reform commitments were "extremely important" and "it is therefore essential that the objectives announced for the improvement of public finances be fully confirmed and implemented".
The ECB is said to have purchased almost $55 billion of Italian and Spanish bonds in the open market over the past few weeks. This has elicited strong rebuke from the German Bundesbank, especially after the ECB-induced bond rally took the pressure off Italian politicians. Italy's 10-year yields jumped 21 basis points (bps) last week to 5.27%, with Friday afternoon's 397 bps a record close for five-year Italian Credit Default Swap (CDS) prices. Having aggressively intervened in the marketplace, the ECB now faces the risk of market tumult if it shies away from its bond-buying program. At home and abroad, central bankers have allowed themselves to be taken hostage by (increasingly desperate) markets.
Come to the markets' rescue and there will be no turning back, especially in a bubble backdrop. Global central bankers will more vocally protest the state of fiscal mismanagement and "dysfunctional" markets, yet they largely have themselves to blame. For too long, central bankers have accommodated both reckless sovereign borrowing and highly speculative markets, which ensures a fateful day of reckoning. To be sure, experimental monetary policy has been instrumental in promoting the increasingly vulnerable global government finance bubble.
"Activist" central banking has been the nucleus for overstating the effectiveness - and over-promising - with respect to both monetary and fiscal policymaking. Markets and citizens alike had over years been conditioned to believe that enlightened policy ensured economic stability and rising asset prices. Accordingly, risk and leverage were readily embraced. These days, central bankers are trapped - the markets fully appreciate that they have them trapped - and it's going to be fascinating and unnerving to watch how this all plays out.
And while the ECB has badly deviated from its core principles, it does at least have some to anchor policymaking. The Bernanke Fed is completely lost at sea. Markets will now anxiously anticipate the rate-setting Federal Open Market Committee's September 20/21 meeting. A divided Fed will contemplate additional stimulus measures, including more quantitative easing. There will be intense pressure to do more to support a faltering "jobless" recovery, with the expectation that chairman Bernanke will carry the day and ensure a backdrop sufficiently loose to accommodate additional fiscal stimulus.
Unlike in Europe, the markets have yet to impose austerity on Washington. And while both European and American economies have demonstrated recent weakness, in contrast to Europe our feeble recovery will continue to be underpinned by lavish federal spending. US stocks have significantly outperformed European bourses this year, and there remains considerable confidence that our monetary and fiscal measures can support economic expansion and higher stock prices. As I wrote a few weeks back, it is not difficult for most US investors to remain complacent.
At the same time, the global financial system comes under added stress each passing week. The euro again came under pressure this week. The euro has been notably resilient for the past several months, but I worry that this has only provided an opportunity for additional hedging in the marketplace to protect against potential euro weakness. Part of my analysis is that huge derivative protection (put options and such) has accumulated that would tend to increase the vulnerability of the euro to an abrupt and destabilizing decline (if key technical support levels are broken).
It has been part of my thesis that the global financial system has been especially vulnerable to de-risking and de-leveraging dynamics. I believe markets have absorbed the first phase of de-risking/de-leveraging, with meaningful stock market declines, surging Treasury prices, a widening of credit spreads, a tightening of general financial conditions and a downshift in economic activity. Importantly, this "first phase" was accompanied by significant currency market volatility - but not dramatic changes in most currency values. In particular, the euro and US dollar have traded in relatively tight trading ranges for several months now, at least partially explained by ongoing market faith that global central bankers are keen to ensure liquid and stable markets.
If current financial tumult evolves more into a 2008-style event, I would expect the next phase of de-risking/de-leveraging to be accompanied by increasing signs of dislocation in currency markets more generally. The big question remains unanswered: how big are global currency "carry trades" (short low-yielding dollar instruments to fund higher-returning assets abroad)?
An important part of the thesis is that we've reached the point where reflationary policymaking will tend to only increase uncertainty and further destabilize unsettled financial markets. Both the Fed and ECB are at respective policy crossroads and markets have ample reason to fret. Confidence is wearing thin.
For the week, the S&P500 slipped 0.2% (down 6.7% y-t-d), and the Dow lost 0.4% (down 2.9%). The S&P 400 Mid-Caps declined 0.4% (down 8.2%), and the small cap Russell 2000 declined 1.2% (down 12.8%). The Banks declined 2.0% (down 28.4%), and the Broker/Dealers fell 2.2% (down 28.9%). The Morgan Stanley Cyclicals dipped 0.2% (down 19.9%), and the Transports slipped 0.3% (down 13.0%). The Morgan Stanley Consumer index gained 0.7% (down 6.8%), and the Utilities added 0.7% (up 4.9%). The Nasdaq100 gained 0.3% (down 2.3%), and the Morgan Stanley High Tech index increased 0.1% (down 14.7%). The Semiconductors declined 1.2% (down 17.1%). The InteractiveWeek Internet index rallied 1.6% (down 10.1%). The Biotechs added 0.6% (down 11.5%). With bullion rallying $55, the HUI gold index gained 3.5% (up 7.8%).
One month Treasury bill rates ended the week at one basis point and 2-month bills at 2 bps. Two-year government yields were up one basis point to 0.20%. Five-year T-note yields ended the week down 8 bps to 0.86%. Ten-year yields dropped 20 bps to 1.99%. Long bond yields sank 24 bps to 3.30%. Benchmark Fannie MBS yields fell 12 bps to 3.18%. The spread between 10-year Treasury yields and benchmark MBS yields widened 8 to 119 bps. Agency 10-yr debt spreads increased 5 to 6 bps. The implied yield on December 2012 eurodollar futures was little changed at 0.51%. The 10-year dollar swap spread increased 3 to 20 bps. The 30-year swap spread increased 5 to negative 30.5 bps. Corporate bond spreads narrowed. An index of investment grade bond risk declined 4 bps to 122 bps. An index of junk bond risk dropped 50 bps to 675 bps.
Debt issuance has slowed to almost a trickle. Investment-grade issuers included Coca-Cola $3.0bn, Commonwealth Edison $600 million, Praxair $500 million and USAA Capital $250 million.
Junk bond funds saw outflows of $96 million (from Lipper). I saw no junk issuance again this week.
I saw no convertible debt issued.
International dollar bond issuers included America Movil $4.0bn.
5.0% (down 8.9%). India's equities index rallied 5.8% (down 18%). China's Shanghai Exchange declined 3.2% (down 10%). Brazil's benchmark dollar bond yields dropped 16 bps to 3.61%, while Mexico's benchmark bond yields were little changed at 3.41%.
Freddie Mac 30-year fixed mortgage rates were unchanged at 4.22% (down 10bps y-o-y). Fifteen-year fixed rates declined 5 bps to 3.94% (down 44bps y-o-y). One-year ARMs slipped 4 bps to 2.89% (down 61bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 7 bps to 4.87% (down 62bps y-o-y).
Federal Reserve Credit declined $6.7bn to $2.836 TN. Fed Credit was up $428bn y-t-d and $549bn from a year ago, or 24%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 8/31) decreased $4.2bn to $3.487 TN. "Custody holdings" were up $137bn y-t-d and $276bn from a year ago, or 8.6%.
Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.593 TN y-o-y, or 18.6% to a record $10. TN. Over two years, reserves were $2.885 TN higher, for 40% growth.
M2 (narrow) "money" supply rose $17.9bn to a record $9.540 TN. "Narrow money" has expanded at a 12.2% pace y-t-d and 10.2% over the past year. For the week, Currency added $2.0bn. Demand and Checkable Deposits jumped $18.1bn, while Savings Deposits declined $3.3bn. Small Denominated Deposits fell $3.6bn. Retail Money Funds rose $4.6bn.
Total Money Fund assets increased $8.0bn last week to $2.637 TN. Money Fund assets were down $173bn y-t-d, with a decline of $191bn over the past year, or 6.8%.
Total Commercial Paper outstanding fell $19.3bn (7-wk decline of $138bn) to a 22-week low $1.098 Trillion. CP was up $126bn y-t-d, or 16% annualized, with a one-year rise of $33bn.
Global Credit Market Watch
August 31 - Bloomberg (Brian Parkin and James G. Neuger): "Europe's rescue fund would have to wait for an official request from a debt-hit government before buying its bonds in the secondary market, rules prepared for ratification by the 17 euro-area governments show. The extra step, along with German lawmakers' demand for control, add political layers that risk making the fund, known as the European Financial Stability Facility, less responsive than the European Central Bank, which has bought 115.5 billion euros ($167 billion) of bonds in the past 16 months... 'What's clear is that even if the EFSF is ostensibly equipped to react swiftly in an emergency, it will be much less dynamic than the ECB," said Daniela Schwarzer, senior analyst at the Berlin-based German Institute for International Politics and Security. "Faced with an emergency I would be inclined to put my money on the bank taking the reins of rescue action - as it has done and is doing.'"
August 31 - Bloomberg (Angeline Benoit): "Spain and Italy have joined a growing list of European Union governments pledging to enshrine fiscal discipline in legislation, a move investors say is insufficient to contain the region's debt crisis. The Spanish parliament on Sept. 2 votes on including 'the principle of budget stability' in the constitution, while Italy pledged this month to change its magna carta to adopt a balanced-budget amendment... 'Rules have been broken before,' said Olaf Penninga, who helps manage 140 billion euros ($202 billion) at Robeco Group... 'Markets will remain skeptical until they see countries really stick to them in difficult times.'"
September 2 - Bloomberg (Sapna Maheshwari): "US company bond sales fell 40% this week, capping the slowest month of issuance since May 2010, as signs mount the economic recovery is faltering."
September 1 - Bloomberg (Tim Catts): "The worst month for global corporate bond offerings since May 2010 has set the stage for a September bounce... Sales from the US to Europe and Asia tumbled 27% to $149.7 billion last month, from $206.3 billion in July... Issuance fell 36% from $233.4 billion a year earlier, making it the poorest August for bond sales since... 2004."
August 31 - Bloomberg (Lorenzo Totaro and Chiara Vasarri): "The Italian government has dropped proposed changes to pension rules agreed to this week from a 45.5 billion-euro ($65.5bn) austerity plan being discussed in parliament that aims to balance the budget by 2013. Giorgia Meloni, minister for youth and sport policy... did not say how the government would make up the 5 billion euros of lost revenue from the original plan... "
August 31 - Bloomberg (Emma Ross-Thomas): "Spain expects a 'chain of turbulence' in the next two months and must fight 'tooth and nail' to avoid having to seek a bailout, Elena Valenciano, the ruling Socialist party's campaign chief, said... 'We're probably going to get back into a chain of financial turbulence in September and October... An intervention in Spain would be a great misfortune for the country.'"
August 31 - Bloomberg (Angeline Benoit): "Spain's region of Castilla-La Mancha, run by the People's Party that polls suggest will win control of the central government in November, vowed to cut the nation's highest regional deficit by 2012 without raising taxes. Castilla-La Mancha, which had a budget gap of 6.5% of gross domestic product last year, will slash spending by 1.7 billion euros ($2.5bn) to achieve a deficit of 1.3% of GDP next year... "
September 1 - Bloomberg (Paul Tugwell): "Greek retail sales fell at the fastest rate in three years in the key summer period between mid-July and the end of August, when price-discounts are permitted, the National Federation of Greek Commerce said. Sales of goods such as furniture, books and footwear fell by an average of 25% from a year ago... "
August 31 - Bloomberg (Christine Idzelis): "Companies raised the least amount of leveraged loans this month since 2008... Companies sold $3.02 billion of the debt this month, down from $27.6 billion in July and this year's peak of $69.5 billion in February, according to Standard & Poor's... "
September 1 - Bloomberg (Lisa Abramowicz): "The riskiest bonds are diverging from higher-quality debt by the most since October 2009 as investors lose confidence that the US economy will expand enough to sustain the neediest borrowers."
Global Bubble Watch
September 1 - Reuters (Marc Jones): "Bundesbank President Jens Weidmann said... that trust in the European Central Bank could be lost if the euro zone central bank persists with crisis-fighting policies that go beyond its conventional role. ... Weidmann renewed the Bundesbank's attack on steps taken by the ECB such as buying bonds of debt-strained euro zone members, a tactic some argue oversteps Europe's no-bailout principles. He said the lines between central bank monetary policy and governments' fiscal policy had been blurred as a result of the financial and euro zone debt crises. 'In the long run this strains the trust in the central banks, and therefore for monetary policy it matters that the additional risks that have been taken on reduced again.' 'Decisions over whether to take on further additional risks would have to be made by governments and parliaments; only they are legitimised democratically to do so... '"
September 1 - Bloomberg (Anchalee Worrachate): "Italy and Spain sold bonds this week at lower yields than previous auctions, suggesting record debt purchases by the European Central Bank in the secondary market have helped to contain the nations' borrowing costs... The ECB's mandate prevents it from buying bonds directly from governments at auctions, so it purchases them in the so-called aftermarket. 'It's the ECB that virtually sets these borrowing costs for them, and not the market,' said Michael Leister, a fixed- income strategist at WestLB AG... 'Demand for these bonds remains weak. The ECB has been absolutely crucial in bringing Italian and Spanish yields down, enabling these countries to fund themselves at substantially lower rates than in the previous auctions.'"
September 2 - Bloomberg (Inyoung Hwang): "Investors increased their use of US exchange-traded funds by the most since January 2008 last month, as concern the economy is slowing prompted a shift toward bets on the direction of the entire market and industries instead of individual companies. Average daily trading volume for ETFs jumped 83% from July to 2.24 billion shares... The SPDR S&P 500 ETF Trust... saw a 105% jump to 394 million per day.
August 29 - Bloomberg (Scott Reyburn): "The classic-car market is dividing between the best models, whose prices are racing to records, and others that are faltering on the sales' start line, dealers say. Auction totals are beating forecasts and some sellers made bigger returns from their Ferraris this month than from volatile financial markets... 'The market has polarized,' Geneva-based auto adviser Simon Kidston said... 'Big-ticket cars are making more and more money. The rest is becoming much more difficult to sell.'"
August 31 - Bloomberg (Ilan Kolet): "A license to drive a New York City taxi is not only worth more than its weight in gold, investing in a yellow cab has been more lucrative than the yellow metal. The... cost of a New York City taxicab license has increased more than 1,000% since 1980. The individual 'medallion' - the transferable aluminum plate found on the hood of all cabs - sold for $678,000 in July... up from $2,500 in 1947."....lol