<blockquote>
'Back in 2007, I found it ironic that the eruption of the subprime crisis was a catalyst for big rallies in agency debt and MBS. As the great mortgage finance Bubble burst, the market flocked to fundamentally vulnerable mortgage-related debt instruments. These securities, with their implicit or explicit federal guarantees, enjoyed safe haven status. On the surface, much of the debt marketplace benefited, which seemed to suggest the underlying Credit foundation was sound. Today, the Treasury, agency debt and MBS marketplaces lend support to the view that the U.S. is immune to global debt fears. However, I would caution that, similar to 2007, dynamics below the market’s surface are creating systemic fissures.
U.S. junk and municipal debt markets were notable for lagging during this week’s rally in global risk assets. In particular, the cost of protecting against defaults by some of our largest states remained stubbornly high. The cost of California (310bps) and Illinois (332bps) CDS are significantly above the levels for Portugal (265bps) and Spain (213bps). If I am correct that market focus is shifting from European to U.S. structural debt issues, I would expect our expansive municipal debt markets to become a key analytical focal point. And the loss of Credit Availability for our marginal state and corporate borrowers would be a blow both to the U.S. recovery and the perception of the dollar as safe haven.
...
And what about China and Asia? If (and perhaps it’s a big “if”) global markets stabilize, I don’t think it will take much for sentiment to shift to a more constructive stance on near-term Chinese economic prospects. Weak global markets – and the Chinese authorities’ move to somewhat rein in mortgage lending excesses – has engendered talk of real estate collapses and bursting Bubbles. I’m content to stick with my view that the current “terminal phase” of Chinese Bubble excess can be expected to – as they tend to do – surprise both on duration and the scope of excesses. Moreover, the global crisis may prove an impetus for Beijing erring on the side of further stimulus and Bubble accommodation.'</blockquote>
A ScenarioBy Doug Noland
July 09, 2010
SourceMy macro thesis holds that the Greek debt crisis provided the catalyst for the piercing of the “global government finance Bubble.” This Bubble’s “terminal phases of excess” was unleashed by global policymakers through their unprecedented fiscal and monetary response to the 2008 collapsing of the U.S. mortgage/Wall Street finance Bubble. I have noted parallels between the Greek crisis and the initial breakdown of the market for subprime mortgages back in 2007.
More than a year passed before the subprime crisis had seriously affected the core of the U.S. Credit system. It would not be surprising if the global government debt crisis similarly evolves over months, with ebbs and flows in markets - and marketplace sentiment. To be sure, today’s backdrop creates extraordinary uncertainty and analytical challenges.
It is worth noting that a semblance of stability has returned to European debt markets. The Euro traded this week at a two-month high versus the dollar. The cost of Greek Credit default swap (5-yr CDS) protection declined 59 bps this week to 841 bps, now 285 bps below last month’s peak of 1,126 bps. Portugal CDS ended the week at 265 bps, down 23 bps for the week and almost 200 bps below the May high. Spain CDS ended the week at 213 bps and Italy at 171 bps, high by historical standards but not indicative of acute systemic crisis.
It’s been a couple of dismal months for global risk markets. The “world” was positioned for ongoing reflationary dynamics, confident that policymakers had things well under control. Prior to Greece, perceptions held that global policies ensured liquid markets and an inflationary bias among most classes of risk assets. Greece’s crisis shattered this Bubble perception. The hedge funds and global speculating community were caught on the wrong side of trades across the spectrum of global markets. Markets have been stumbling through a difficult period of de-risking and de-leveraging.
Commodities caught a bid this week. Crude jumped $4.23. Copper surged 5.2% and nickel rose 3.0%. The Goldman Sachs Commodities Index rallied 4.3%. The commodity currencies also posted strong gains. The Australian dollar surged 4.3%, the Canadian dollar 2.8%, the New Zealand dollar 3.3%, and the South African rand 1.8%. The Morgan Stanley Cyclical index rallied 6.6% this week.
Recent market tumult emboldened those anticipating global deflation. At the end of the day, this view may prove correct. The jury is definitely still out. The dollar lost some ground this week, and I would posit that a great deal depends on the future course of our currency. Over the past few months, a surging dollar placed acute pressure on commodities prices - and was likely a critical impetus for the unwind of myriad “carry trades” (borrowing/shorting in low-yielding currencies, such as the dollar, to speculate in higher-returning assets) and other leveraged speculations. De-leveraging created pockets of acute liquidity shortages.
Perceptions of a fundamentally weak dollar have for some time provided great support to global reflation dynamics. For years now, our massive Current Account Deficits have been a major source of inflationary finance for global markets and economies. Moreover, ongoing dollar devaluation and an extended period of extraordinarily low rates also encouraged enormous speculative flows from the dollar out to global risk assets (debt, equities, commodities, and capital investment). Trade and “hot money” flows combined to help finance historic booms in China, Brazil, India, Asia and the emerging markets more generally.
The Greek crisis has reshaped the financial world. I’m just not convinced that it has altered what evolved a few years back into an unrelenting – and self-reinforcing - flood of finance from the “Core” (U.S. Credit system) out to the “Periphery.” Over the past couple of months, we’ve witnessed important changes in market risk perceptions, which incited speculator de-leveraging and pressured global markets. There was a bout of enormous demand for dollars. But have global dynamics revamped the powerful “Core” to “Periphery” Monetary Process?
The rally in the dollar and Treasurys – in the face of European currency and debt market tumult – nurtured a consensus view that the U.S. once again enjoys a “King Dollar” safe haven status. This implies that a deepening global crisis would entail (nineties-style) robust flows to the dollar and our securities markets, possibly reversing the “Core” to “Periphery” dynamic. Such a development would support the global deflation thesis.
A differing view holds that the dollar and Treasury rallies were more technically driven in the (speculative, leveraged and complex) marketplace, rather than indicating a fundamental change in market perceptions regarding dollar soundness and U.S. creditworthiness. Especially in the case of the dollar, a short squeeze was likely a powerful market dynamic. It is worth noting that during the 2008 crisis the dollar index rallied from a low of about 71 to almost 90 – on its way back to about 75 by the end 2009. The dollar closed today at about 84, down from the June high of 88.7.
I have offered the theory that the dollar and Treasurys benefited from the market perception that the U.S. enjoyed a post-Greece competitive advantage in reflationary policymaking. While the markets were imposing harsh discipline on Greece – and increasingly on Portugal, Spain and all of Europe – our Treasury lavishly borrowed for several months at a few basis points and for 10 years at less than 3%. I do believe the dollar and U.S. marketable debt have benefited from market faith that Washington’s unending capacity to borrow, spend and monetize will continue to support our market and economic recoveries.
So, what’s it going to be? Does the dollar win or lose from the unfolding environment? Safe haven - or does the world’s newfound keen focus on structural debt issues put our currency, markets and economy at heightened risk?
Back in 2007, I found it ironic that the eruption of the subprime crisis was a catalyst for big rallies in agency debt and MBS. As the great mortgage finance Bubble burst, the market flocked to fundamentally vulnerable mortgage-related debt instruments. These securities, with their implicit or explicit federal guarantees, enjoyed safe haven status. On the surface, much of the debt marketplace benefited, which seemed to suggest the underlying Credit foundation was sound. Today, the Treasury, agency debt and MBS marketplaces lend support to the view that the U.S. is immune to global debt fears. However, I would caution that, similar to 2007, dynamics below the market’s surface are creating systemic fissures.
U.S. junk and municipal debt markets were notable for lagging during this week’s rally in global risk assets. In particular, the cost of protecting against defaults by some of our largest states remained stubbornly high. The cost of California (310bps) and Illinois (332bps) CDS are significantly above the levels for Portugal (265bps) and Spain (213bps). If I am correct that market focus is shifting from European to U.S. structural debt issues, I would expect our expansive municipal debt markets to become a key analytical focal point. And the loss of Credit Availability for our marginal state and corporate borrowers would be a blow both to the U.S. recovery and the perception of the dollar as safe haven.
But what would a weakening dollar do for global reflationary forces? Will the market reverse course and begin repricing commodities higher? Would expectations for the emerging markets improve? It is worth mentioning how well emerging debt markets have performed throughout this debt crisis. Brazil dollar bond yields ended today at 4.54% and Mexico at 4.44%, just off of record low yields. At this point, the emerging markets, in general, appear to have retained their robust inflationary biases.
And what about China and Asia? If (and perhaps it’s a big “if”) global markets stabilize, I don’t think it will take much for sentiment to shift to a more constructive stance on near-term Chinese economic prospects. Weak global markets – and the Chinese authorities’ move to somewhat rein in mortgage lending excesses – has engendered talk of real estate collapses and bursting Bubbles. I’m content to stick with my view that the current “terminal phase” of Chinese Bubble excess can be expected to – as they tend to do – surprise both on duration and the scope of excesses. Moreover, the global crisis may prove an impetus for Beijing erring on the side of further stimulus and Bubble accommodation.
There is, indeed, another bearish Scenario possibility outside of deflationary collapse. At least in the short-term, festering U.S. debt problems and a vulnerable dollar could create a backdrop conducive to a surprising counteroffensive from (thought dead and buried) global reflationary forces. Stranger things have happened.