Home > Predictions > Doug Noland goes bi-polar

Doug Noland goes bi-polar

Doug Noland – one of the best-researched, most prescient analysts in the world today – nails it again with his Bond Bubble Thesis from today’s PrudentBear.

When Noland speaks, I listen.  He predicted the housing bubble.  He has predicted every bubble.  He watches the numbers like a hawk, but has a great eye for the big picture.

We don’t know when the Bond Bubble with Burst, but this is the last and greatest bubble before a return to gold.

My thesis coming into the year was that 2010 was a “Bubble year.”  The unprecedented global fiscal and monetary policy response to the 2008 bursting of the Mortgage/Wall Street finance Bubble had unleashed the Global Government Finance Bubble.  The “Bubble year” analysis implies bipolar outcome possibilities:  if the Bubble is accommodated by ongoing loose financial conditions, it would demonstrate a propensity to broaden and strengthen.  Fragile underpinnings, however, leave this emerging Bubble susceptible to bursting and the rapid reemergence of financial and economic crises.

Throw into the mix that acute systemic fragilities ensure that policymakers will attack any potential crisis quickly and with overwhelming force.  Such a backdrop would seem to ensure uncertainty and heightened market volatility, and that’s what has transpired thus far in 2010.

I have also posited that the Greece debt crisis was an important inflection point for the Government Finance Bubble, with similarities to the eruption of subprime debt issues in the spring of 2007.  Global markets have certainly awakened to structural debt issues.  Even so, outside of the European periphery sovereign yields have tanked.

It was more than a year before the subprime crisis evolved to the point of fomenting systemic crisis.  There are reasons an even longer gestation period may be in the offing this time around.  In contrast to mortgage-related fragilities, global policymakers will not be caught complacent and unprepared.  Indeed, the markets’ perception that authorities will act forcefully to support debt markets – and marketplace liquidity more generally – is a key reason why the Government Finance Bubble is potentially so dangerous.

The ECB’s forceful response contained the debt crisis in the short-run – and certainly boosted marketplace liquidity.  Here at home, post-Greece market and economic weakness forced an abrupt u-turn at the Fed.  Planning for the so-called “exit strategy” was put on hold – or perhaps forever abandoned.  In a too typical Pavlovian response to the market’s clamoring for additional monetization, the Fed announced it would buy Treasurys to ensure its bloated balance sheet did not become less so.  Comments from Chairman Bernanke, Bank President Bullard and others assured the markets that the Federal Reserve’s commitment to purchase Treasury’s was open-ended.  Talk of (recommendations for) a massive government-induced refi program threw gas on the fire.

The markets now perceive (are convinced) that global central bankers are irreversibly committed to providing government debt markets a (an inexhaustible) “backstop bid.”  This is fundamental to a Bubble’s “terminal phase” expansion and reminiscent of the fateful mortgage finance “backstop bid” provided by Fannie, Freddie, the FHLB, and the Federal Reserve.

Fixed income markets have enjoyed a historic rally.  After touching 4.0% in April, 10-year Treasury yields ended August at 2.47%.  Benchmark MBS yields sank from an April high of 4.67% down to a low of 3.29%.  After slowing sharply during the Greek crisis period, corporate debt issuance bounced back strongly.  Junk bond issuance already equals last year’s record for the entire year ($163bn).

After jumping to a seven month high of 695 bps in June, junk bond spreads (IBOX) ended the week at 554 bps.  Investment grade spreads (IBOX) have declined back to 103 bps after reaching 132 bps in June.  For perspective, junk and investment grade spreads reached respective highs of 1,890 bps and 279 bps at the height of the 2008 Credit crisis.  The collapse of market yields has been across the board.  The Bond Buyer index of municipal bond yields dropped from an April high of 4.45% to this week’s 3.92%.

Global Financial Conditions have loosened markedly over the past month or so.  After jumping above 5.5% in May, Brazilian dollar bond yields dropped to a record low 3.63% in August.  Mexican bond yields dropped to a low of 3.72%, with emerging debt spreads (EMBI) to Treasurys declining to below 300 bps (from a 2008 high above 901).  From a May low of 247, the CRB Commodities index has rallied back to 275.  Most global equities markets have significantly reduced 2010 declines or moved back into positive territory.

After trading to 88.71 on June 7th, the dollar index has settled back down to 82.87.  Renewed dollar weakness has played an instrumental role in the loosening of Financial Conditions.  The Greek crisis caught many on the wrong side of fast-moving markets.  Shorting the (structurally unsound) dollar to go long global risk markets had, again, become too crowded.  European debt problems, the sinking euro and rallying dollar pounded those participating in the “global reflation trade.”  De-risking and de-leveraging fueled a squeeze on the dollar bears that further fed an unwind in commodities, equities, and risk asset markets more generally.

While European problems are anything but resolved, the market has become much more focused on dollar vulnerability.  Talk of QE2, additional fiscal stimulus in the face of massive deficits, and June’s nearly $50bn trade shortfall worked to reenergize the dollar bears.  And renewed dollar weakness – and seemingly endless outflows of dollar liquidity – coincided with a big increase in foreign reserves held in custody at the NY Fed (foreign central banks lapping up excess dollar liquidity).  These holdings increased a remarkable $145bn in only 13 weeks to a record $3.221 Trillion.  It is worth noting that International Reserve Assets (as reported by Bloomberg) are up an incredible $940bn year-to-date to $8.572 Trillion.

I still believe the Greek debt crisis will be viewed as an important infection point with regard to market perceptions of structural debt issues.  At the same time, it is also clear that the backdrop has been extraordinarily supportive of Bubble Dynamics.

Of course, skyrocketing bond prices have given rise to fundamental justification.  Interminable deflation risk is at the top of the list of why bond returns will indefinitely outperform cash.  I am reminded of how technology stocks and home prices were only to go higher.  My analytical framework downplays deflation and focuses instead on a debt Bubble fueled by the Federal Reserve, The People’s Bank of China, the ECB, BOJ, and the approaching one Trillion y-t-d increase in global central bank reserves.  Throw in hedge fund/speculator leveraging and the billions flowing weekly (in search of any yield) into global fixed income and one sees all the necessary financing for a historic Bubble.

Developments and dynamics over the past couple of months have provided important confirmation for the Global Government Finance Bubble thesis.  At the same time, there are numerous fault lines.  Stress has reemerged in European debt markets, with yields rising notably in Greece, Portugal and Ireland.  Here at home, stress continues to build in municipal finance.  To what extent – and for how long – Global Government Finance Bubble Dynamics and attendant liquidity/speculative excesses mitigate some of these crisis points is an open question.

Advertisements
Categories: Predictions
  1. No comments yet.
  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: