<blockquote>
'For now, QE2 reliably generates additional liquidity for the liquidity-dependant markets. Somewhat ironically – yet altogether Bubble-like - rising bond yields and unfolding problems in municipal finance have bolstered flows into equities. And on the back of ongoing federal spending excess, economic prospects look ok and earnings appear swell. Yet recent developments do beckon for heightened diligence when it comes to monitoring for fissures developing below the surface of our fragile financial system. At least from my perspective, one can now discern unsettling parallels to early 2008.'</blockquote>
Recalling January 2008By Doug Noland
January 21, 2011
SourceThe first few weeks of 2011 have me recalling early-2008. It’s as if someone reached over, flicked a switch and changed market dynamics. Abruptly, last year’s outperformers have come under heavy selling pressure, while the underperformers have in many cases caught strong bids. Things are unsettled and there are divergences. And I’m not just talking U.S. equities.
Peripheral European debt markets have enjoyed a dramatic reversal of fortune. Greek Credit default prices (CDS) are down a notable 173 bps so far this year (down 210 bps in the past 9 sessions). Portugal’s 10-year CDS price was down 116 bps in nine sessions and 64 bps y-t-d. Spanish CDS has declined 94 bps in 9 sessions (down 83bps y-t-d). Peripheral bond spreads (to German bunds) have collapsed. Bond spreads have declined 150bps in Greece, 95bps in Portugal and 49 bps in Spain – in only three weeks!
The dollar index jumped 2.5% the first week of the year, sank 2.3% the second week and declined a further 1.3% this past week. Reminiscent of currency market volatility back in January 2008, the euro has gained 1.8% y-t-d against the dollar, this despite a 3.5% decline the first week of the year. Last year’s strongest currencies have lagged so far in 2011. The “safe haven” Japanese yen and Swiss franc have declined 1.8% and 2.4%, respectively. The “commodities currencies,” also strong 2010 performers, have stumbled out of the blocks. The Australian dollar has declined 3.3% and the New Zealand dollar 2.9%.
After a stellar 2010, the precious metals stocks have suffered thus far in 2011. Silver has been hit for 11.30% and gold is down 5.5%. Many of the metals stocks have been hit harder. The HUI “Gold Bugs” index is down 12.0% y-t-d. And defying those that had believed that year-end anomalies had created exceptional buying opportunities, municipal bond prices have been slammed further to begin the year.
Equities markets have seen significant volatility and sector divergences. After a big 2010, the broader U.S. stock market is lagging. The small cap Russell 2000 has declined 1.3%, while the S&P400 Mid-Cap index is up only 0.8%. Some of last year’s laggards have sprung to life. The S&P Homebuilding index has gained 6.5%. The NYSE Financials have outperformed, gaining 3.8%. The Semiconductors are up 4.8% y-t-d.
Selling pressure in the stock market has certainly not been as heavy as that experienced in January 2008. Yet the past few weeks have been reminiscent of how volatility and rather abrupt changes in market underpinnings caught market players – especially the leveraged speculating community – flat footed.
Players began 2008 out of synch, with trading conditions across various asset classes turning challenging - and progressively frustrating. Almost overnight, uncertainty seemed to take root throughout equities, fixed-income, currency and commodities markets. Breathtaking moves and abrupt market reversals began to subtly take their toll. Things that had worked quit working. An increasingly uncomfortable crowd of speculators saw their various long exposures lag and their shorts outperform.
And it wasn’t all that long before losses began to mount and defensiveness became the order of the day – with inflated markets hanging in the balance. De-risking and de-leveraging then fueled atypically high correlations amongst various markets, causing considerable angst for the leveraged players and others dependent upon "quant" models. The “wrecking ball” of high volatility and highly-synchronized global risk markets began working against systemic stability. This dynamic fed - and was being fed by - the concurrent rapid slowing of mortgage Credit. Instability took on a life of its own, as markets dependent upon abundant liquidity and speculation began to suffer withdrawals.
There have been various recent reports suggesting that hedge fund assets and leverage have returned to near pre-crisis levels. Record industry assets seem reasonable to me; near record leverage does not. A major increase in speculative leverage is not apparent from ongoing stagnation in Wall Street balance sheets, bank Credit, and reported “repo” positions. There is, at the same time, the huge unknown of “carry trade” leverage embedded throughout global currency and fixed-income markets. And while I doubt the leveraged players are today the marginal source of marketplace liquidity to the extent they were in 2008, they are surely a major force to be reckoned with.
I’ll assume that many leveraged players came into the year positioned short the euro, short peripheral Europe CDS, short European financials, and long precious metals, mining and energy stocks. In global equities, those short Spanish (IBEX 35 up 9.8% y-t-d) and Italian (FTSE MIB up 9.5% y-t-d) equities have suffered losses. Those caught short some of the major European banks have been badly stung. There are also some losses for those long U.S. small caps and American retailers and/or short banks and homebuilders.
With parallels to 2008, the success or failure of the leveraged players takes on additional prominence now that there are cracks in the global government finance Bubble. On the margin, global yields continue to have an upward bias. Our ten-year Treasury yield is up 11 bps so far in January, while the long-bond has seen yields jump 23 bps to a near nine-month high 4.58%. Few sectors, however, are showing the effects of waning marginal liquidity than U.S. municipal finance.
The Bloomberg 20-year municipal bond yield composite index has jumped 33 bps in three weeks to a near 2-year high 4.72%. Muni yields are now up 150 bps in about three months. Muni funds saw $3.9bn of outflows this past week (from Lipper), with over $20bn having exited over the last ten weeks. The heated debate regarding the number of prospective defaults misses the point: the important – and vulnerable – U.S. municipal finance sector has suffered a decisive reversal of flows and liquidity dynamics. Whether it turns out to be hundreds of defaults or merely a few, the reality is that market-imposed “austerity” will now provide headwinds against economic growth. This dynamic also creates heighted uncertainty and potential financial instability.
I have argued that the Fed’s “activist” policymaking from the second-half of 2007 actually exacerbated systemic fragilities and contributed directly to the severity of the 2008 crisis. The overabundance of liquidity, coupled with the perception that policymaking would restrain the unfolding debt crisis, proved destabilizing and, inevitably, devastating. They fostered intense speculative excess, inflated market prices, unsustainable financial flows, and Bubble Dynamics. Myriad booms were fun while they lasted, although the heavy costs included heightened uncertainty and fragilities. Last year’s discussion and then implementation of “QE2” has had similar effects.
Marketplace liquidity can be steadfast or fickle. Market confidence varies between incredibly resilient to stunningly fleeting. To be sure, crises of confidence are difficult to predict. But one can monitor and gauge the forces that create susceptibility to abrupt shifts in market sentiment and altered trading conditions. Policymaker responses to structural problems (i.e. zero rates, massive monetization, federal stimulus and “Build America Bonds”) created distortions in risk perceptions and the flow of finance to the muni sector, while in the process delaying needed structural reform. The muni debt issue was allowed to fester; financial market distortions worsened.
For now, QE2 reliably generates additional liquidity for the liquidity-dependant markets. Somewhat ironically – yet altogether Bubble-like - rising bond yields and unfolding problems in municipal finance have bolstered flows into equities. And on the back of ongoing federal spending excess, economic prospects look ok and earnings appear swell. Yet recent developments do beckon for heightened diligence when it comes to monitoring for fissures developing below the surface of our fragile financial system. At least from my perspective, one can now discern unsettling parallels to early 2008.