Bitter taste of fear


by Doug Noland
Asia Times - CREDIT BUBBLE BULLETIN
June 8, 2010


Until last Friday afternoon's sale, there hadn't been a junk bond issued in more than a week. Total dollar corporate bond issuance dropped to about US$5.2 billion (according to Bloomberg), including $2.0 billion sold by Bank of Montreal. Last week's corporate debt sales were down significantly from the 2010 average of about $21 billion. For the month of May, junk issuance fell to $6.8 billion, down about 80% from March and April levels.

Junk bond spreads (to Treasuries) widened a notable 40 basis points (bps) last week to 587 bps, the widest level in six months. During the past month, junk spreads have jumped more than 100 bps. Investment-grade spreads widened 10 bps this week to 126 bps, up from the low earlier this year of 75 bps. Leveraged loan and private-label MBS prices have weakened.

European credit markets last week saw even more dramatic price moves. Europe's credit default swap (CDS) market is in disarray. Default protection (five-year) on Greek bonds jumped 90 bps last week to 740bps. More troubling were big increases in the cost of buying default protection on other European sovereign issuers. Portugal CDS rose 28 bps to 353 bps. Ireland CDS rose 50 bps to 285 bps. Spain CDS jumped 48 bps to 265 bps, and Italy rose 30 bps to 235 bps. It's a rout.

Have financial conditions tightened, and what would this mean for US economic prospects? There is mounting evidence that the overall US economy has slowed over the past month. Friday's jobs data were not encouraging. The 41,000 private-sector payroll gain was down from April's 218,000 and the weakest since January's 16,000. It is worth noting that recent retail sales data have demonstrated a marked slowdown, while weekly mortgage application data have been dismal. The track of global financial conditions is not supportive of growth abroad or at home.

Importantly, there have been changes in some of the key dynamics that were responsible for the historic loosening of financial conditions experienced over the past 18 months or so. I have referred to this extraordinary backdrop as the emergence of global government finance bubble dynamics. A key facet to this latest bubble included market perceptions that government fiscal and monetary policymakers would sustain financial and economic recoveries. They had the right prescription (massive fiscal and monetary stimulus), and there were no near-term impediments to implementing their market-friendly programs - or so the markets thought.

Global markets are rapidly reassessing views regarding the competence, effectiveness, and overall capacity of policymaking. European politicians were incapable of moving capably to thwart and contain the Greek debt crisis. Here in the US, the pendulum had swung with force in the direction of great hopes and expectations for a greater government role in managing the economy. Rather quickly, fragile public faith in the capacity of Washington to resolve problems has faltered. The powerlessness to stop a gushing oil well on the bottom of the Gulf of Mexico - viewed live on the Internet - does not inspire confidence. Less confidence and more uncertainty equate with reduced risk-taking.

Still, most view the US situation in a positive light. There is faith in the underlying strength of the economic recovery. And the consensus view holds that the US financial system is rather immune from European debt problems. This view is bolstered by recent strength in Treasuries and the dollar. The risk of a bursting bubble doesn't appear on anyone's radar.

Gauging overall US financial conditions is no easy endeavor. From the bearish perspective, corporate debt markets have tightened meaningfully. Financial flows have reversed away from risk assets. I would expect these developments to stop any fledgling jobs recovery in its tracks. Traditionally, a crisis-induce collapse in Treasury and MBS yields would at least spur refinancings and home buying. Yet such benefits will surely underwhelm in this post-housing mania environment.

At the same time, we must recognize that corporate and mortgage credit have been playing a significantly lesser role compared with previous recoveries/expansions. While conditions have tightened in corporate credit, they have loosened further for the US Treasury. For now, however, I don't expect lower Treasury yields to engender much benefit to the US economy. Federal spending levels are already incredibly inflated and additional stimulus measures are not yet in the offing. So the flight to Treasuries should not greatly benefit general financial conditions. So far, the abrupt collapse in Treasury yields and the dollar's rally have hurt the leveraged players (carry trades and such) and fostered general market instability.

Bank lending has been stagnant for two years. The economic recovery was instead fueled by a dramatic government-induced loosening of conditions throughout the financial markets. The massive financial bailout, zero interest rates, and a trillion-plus Federal Reserve monetization were all instrumental in the reflating of US and global securities markets. I have argued that this reflation was an especially risky proposition.

Central to the bearish thesis has been the dynamic where global risk markets were inflated with unsustainable market-based financial flows. The nature of such flows creates inherent fragility, and we'll work to gauge ramifications from faltering markets and another round of painful losses. Going forward, I expect rising investor/speculator angst to have a major deleterious impact on general financial conditions in this age of securitized finance.

Admittedly, it is not easy to explain how the dots from Greece are connected rather directly to the US economy. They are affixed through global financial conditions - our New Age financial infrastructure of market-based credit; gigantic risk markets where asset prices play prominently in confidence and spending; the massive pool of performance-chasing speculative finance; and market perceptions that are too often dictated by government policy actions. In this extraordinary age of marketable finance and activist central bank inflationism, the securities markets and market perceptions have become (too) critically important.

When confidence is running high, financial conditions run loose. The marginal borrower - Greece, a highly leveraged US corporation, or perhaps a private-equity fund - enjoys easy credit availability. The tendency of things is for finance to expand, asset prices to inflate and economic "output" to increase. And they all feed merrily on themselves. But - in this unstable financial world - the credit noose begins a rapid tightening the moment confidence is shaken. And the inevitable reversal of financial flows and attendant speculator deleveraging ensures vicious contagion effects, acute fragility, and destabilizing crises of confidence.

One can say that reflations fueled by marketable-based finance are prone to be dynamic and powerful. Unfortunately, once unleashed, these forces are just as powerful on the downside as during expansionary periods. Payback time comes when greed turns to fear and bull falls victim to bear. Finance proves fickle and unreliable. I fear US financial and economic recoveries were built upon inflated expectations and unjustified confidence. Fleeting confidence now creates myriad risks associated with unmet expectations, disappointment and disillusionment.

http://www.atimes.com/atimes/Global_Eco ... 8Dj02.html