CREDIT BUBBLE BULLETIN
The bill will fall due
Commentary and weekly watch by Doug Noland
Asia Times Online :: Asian news and current affairs
The return of bubble dynamics was the overriding thesis coming into 2010. The extraordinary global fiscal and monetary response to the 2008 bursting of the mortgage/Wall Street finance bubble had unleashed the global government finance bubble. This bubble analysis implied bi-polar outcome possibilities: the bubble would gain further momentum - or it would burst.
"Muddling through" is simply not a bubble earmark. We're not witnessing some "new normal" at work, but rather "the latest abnormal" in a prolonged cycle of policy-induced boom and bust dynamics. For this phase of the cycle, the bubble has invaded the very heart of the credit system. Normal does not apply.
It is the nature of bubbles that, if accommodated by loose finance, they expand, broaden and gain increasing momentum. In a world
of loose "money", unchecked speculation will have a propensity for evolving into intense speculative excess. Yet fragile underpinnings - for global economies, credit systems and markets - ensured acute vulnerability and the return to crisis conditions in the event of faltering confidence in marketplace liquidity conditions or waning faith in government stimulus measures.
Bullish optimism was running high to begin the New Year. With the United States coming off of a spectacular stock market rally and 5.0% GDP growth in Q4 2009, the consensus view was calling for the type of typically robust recovery that would follow a steep economic pullback. Financial conditions were abnormally loose and mortgage rates unusually low, seemingly implying a strong recovery for the nation's battered housing markets. Home sales had gained a head of steam into year-end 2009, and it appeared the worst of the storm had passed. A housing recovery was expected to work wonders on the financial sector and real economy.
The bears saw things differently. The most popular bearish view focused on ongoing mortgage troubles and deleveraging. Some of the more vocal bears spoke of persistent credit contraction. Indeed, contracting household mortgage debt and stagnant corporate borrowings were leading to a highly unusual decline in private-sector credit. Emboldening this line of analysis, bank credit was continuing to contract and "money" supply growth remained tepid.
Yet the conventional bearish view tended to downplay the impact from the massive expansion of government debt. From my analytical perspective, a debt expansion of such magnitude should be the analytical centerpiece. Total non-financial debt actually expanded 3.0% in 2009 and then accelerated to 4.3% annualized in Q1 2010 and 4.7% in Q2. On the back of unprecedented (double-digit to GDP) peacetime federal borrowings, total system credit was expanding - not contracting. The bearish credit collapse thesis was flawed.
Massive government borrowing and spending stabilized incomes, home prices, securities markets, household net worth, consumption and corporate earnings. And the unprecedented expansion of the Fed's (and global central banks') balance sheet ensured the type of liquidity overabundance necessary for the marketplace to accommodate our government's insatiable borrowing appetite.
There was a lingering problem, however, in that the Federal Reserve expected to actually begin unwinding its crisis-period liquidity operations. I don't believe policymakers had any plans for ongoing market intervention and liquidity support mechanisms. Fed chairman Ben Bernanke went to some lengths to explain the Fed's so-called "exit strategy". It was not to be.
Global markets were hit with another ill-timed shock when the Greek debt crisis became a systemic issue in late-April. Prior to the Greek crisis, the markets (especially within the global leveraged speculating community) presumed that policymakers had things well under control. Concerted global fiscal and monetary stimulus was supposed to have ensured highly-liquid markets and a sustainable recovery. "Risk on" was back on.
Suddenly, the market convulsed and the leveraged players were again caught on the wrong side of faltering markets. The credit default swap (CDS) market for European sovereign debt dislocated and the entire debt marketplace was hit with another destabilizing bout of illiquidity. This wasn't supposed to happen; governments couldn't actually be shut out of the debt market and, perhaps, even default - could they? Deleveraging and de-risking returned with vengeance. Risk aversion and liquidity issues quickly resurfaced in the US debt markets, jeopardizing the stock market and economic recoveries. Cracks were again forming in the foundation of the entire global credit system.
What happened next will be debated for decades. The Federal Reserve began discussing - and later implementing - a second massive monetization of US debt securities (in this case, $600 billion of US Treasuries). And I would add that, in this matter, size didn't really matter all that much. What was critical was that the Federal Reserve had completely scrapped the notion of removing crisis-period stimulus - and was instead content to solidify the markets' premise that the Fed had become a steadfast backstop for marketplace liquidity. The Fed's dramatic move - along with various market support measures by the European Central Bank, the Bank of Japan and others - provided the missing piece for the unfolding global government finance Bubble.
The prospect of QE2 weakened the dollar and supported price inflation for risk assets the world over. And the weaker the dollar - the more required buying and "recycling" of surfeit global dollar balances right back into the Treasury market. The Treasury marketplace was pushed to even greater bubble excess - in the process emboldening the analysts that had been trumpeting deflation risk. "Money" flooded out of money fund and deposits and into US and global bond funds. Like tech stocks that could never go down and home prices that could only go up, the view took hold that bond yields would only go lower.
Meanwhile, dollar weakness and attendant global liquidity excess set off a major run in commodities markets (certainly not unlike the policy-induce reflation after the subprime eruption in the autumn of 2007). Both the precious and industrial metals went on a record run, although some of the biggest gains were posted by the agriculture commodities. Energy prices lagged somewhat but crude ended the year above US$91. The CRB commodities index closed the year at the high since 2008. And by the end of the year it was clear that China, India and greater Asia had serious inflation and "hot money" issues. Cautious little baby-step policy moves aren't going to get the job done.
QE2 was met with rebuke at home and from abroad. As global equities surged higher, these protests mostly subsided. Looking at Treasury yields and commodities prices, a decent case can be made that QE2 was counterproductive. The last thing the US household sector needs right now is higher mortgage rates and gas prices. But these issues were trumped by the stunning fourth-quarter gains posted by US stocks, and there's nothing like a surging stock market to incite optimistic analysis and embolden the bulls.
From my bearish perspective, the marketplace has been disregarding some important developments. For starters, despite the massive $4 trillion increase in government liabilities in just nine quarters, an extended period of near zero interest rates, and unprecedented Federal Reserve quantitative easing, the unemployment rate will end the year near 9.8%. And despite extremely low mortgage yields, our nation's housing market is barely treading water. Developments - or lack of them - in the real economy are disconcerting and supportive of the secular bear thesis.
There is also the important issue of rising global yields. Moreover, the debt markets have become increasingly discriminating. A few months back - in the heat of the euphoric "endless liquidity for everybody forever" backdrop - the markets were content to readily finance just about any borrower. More recently, in somewhat of a return to sobriety, the marketplace has looked increasingly askance at borrowers such as Ireland, Spain and US municipalities. This is a serious development for the global government finance bubble - but perhaps not as serious in the short-term.
The US financial system these days is being completely dominated by the expansion of federal borrowings. This creates different financial and economic dynamics than we're used to analyzing. In contrast to when mortgage credit was playing a predominate role during that bubble period, a rise in market yields today will have virtually no near-term impact on the quantity of (government) credit being issued. And especially with the extension of Bush era tax cuts along with additional stimulus measures, the speculative US stock market has taken great comfort from the seeming sustainability of the tepid (government-dominated) US economic recovery.
I have written that policymakers were more than content in 2010 to kick the can down the road. In fact, it was a year where policymaking became completely unbounded. The 26% gain in the small cap Russell 2000 and 26% advance in the S&P400 Mid-Cap index support our contention that bubble dynamics more than persevered through year 2010.
The Bernanke Fed certainly ensured that financial speculation gained at the expense of savers. And the municipal debt market now confronts the dilemma resulting from bubble-related risk distortions, misperceptions and investor disappointment - and a problematic flow reversal out of the sector. Was year-end dollar weakness a harbinger of things to come?
CREDIT BUBBLE BULLETIN: The bill will fall due
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