Noland

September 14 – Bloomberg (Marianne Stigset, Francine Lacqua and Meera Bhatia):  “Norway’s sovereign wealth fund said it’s taking advantage of volatility to generate better returns as Europe’s largest equity investor adds risk.  ‘If you look at what has happened during the financial crisis, a fund like ours actually came through it quite well and that to some extent increased our risk capacity and our risk willingness,’ Yngve Slyngstad, head of Norges Bank Investment Management, said… ‘In a 30-year horizon you are actually paid for taking volatility; volatility for us is actually a good thing.’”
 

Competitive Monetization:
Ireland’s 10-year government yields jumped 48 bps this week to 6.29%, with the spread to German bunds jumping to a record 386 bps.  Portugal’s yields rose 31 bps to 6.07%, the high since near the peak of the Greek crisis back in early May.  The European debt crisis remains unresolved.  Yet this week the euro gained 2.9% against the dollar and 5.0% against the yen.

U.S. stocks were for the most part content to disregard the reemergence of periphery European bond stress.  So far, the current environment seems to differ importantly from the late-April/May period of bond market contagion, de-risking, de-leveraging and global financial market weakness.

It is worth noting that the backdrop going into the Greek crisis was one of rampant speculation.  Global risk markets were at the time a full year into a historic rally.  Importantly, the leveraged speculators were at the time pressing bets on the “global reflation trade.”  The world was positioned for a weak dollar and inflating prices for most currencies, commodities and securities markets.  Complacency was running high, with the view that global policymakers were firmly in control and that global recovery was assured.

The rapidly escalating European debt crisis, sinking euro (spiking dollar) and dislocation in the Credit default swap market back in late-April caught the speculating crowd positioned poorly for the abrupt reversal in global markets.  While there’s no way of knowing how the leveraged players are positioned these days, one would assume that the crowd has been dispersed and the amount of risk and leverage meaningfully reduced.

One could argue that policymakers had also succumbed to a bout of complacency earlier in the year.  The Federal Reserve and ECB had their sights on reducing stimulus and implementing so-called “exit strategies.”  Market tumult and attendant recovery fears now have American and European central bankers (indefinitely) focused intensively on quantitative easing and additional measures to assure the markets that liquidity will remain in ongoing abundance.

To this point, contagion effects from Ireland and Portugal have been minimal.  I’ll assume this is explained by reduced systemic vulnerability to a leveraged community more cautiously positioned coupled with ECB market liquidity support mechanisms.  Over recent months, buying from the Chinese and sovereign wealth funds have also bolstered European debt markets.  And there is certainly the perception that any development that risks heightened systemic stress would be met head on by Federal Reserve monetization (“quantitative easing”).  Recent and prospective dollar weakness has buoyed euro sentiment, which works to restrain de-risking, contagion effects and bouts of self-reinforcing de-leveraging (for now).

At home and abroad, there are indications of extraordinary marketplace liquidity abundance.   

Today from Bloomberg:  “Speculative-grade companies are selling leveraged loans at the fastest pace this year to pay for acquisitions and buyouts led by Carlyle Group as prices of the debt climb to a four-month high.”  This morning from the Wall Street Journal:  “One of the markets at the heart of the credit bubble has surged back with surprising speed as investors chasing yield are increasingly willing to finance riskier companies. Poster children of the mid-2000s credit bubble, leveraged loans are set to have their busiest year since 2008.”  Also today from Bloomberg:  “Average prices on high-yield debt rose above 100 cents on the dollar yesterday for the first time since June 2007 after falling as low as 55 cents in December 2008…”  According to Bloomberg, this week’s $41.7bn of corporate bond issuance combined with about an equal amount from last week pushed two-week debt sales to the strongest level this year.  With more than three months to go, year-to-date junk issuance is already well into new record territory.

In the face of enormous supply, corporate bond yields have remained extraordinarily low.  Investment grade spreads (IBOX) were little changed this week at 104 bps, while junk spreads (IBOX) narrowed 8 to 546 bps.  California Credit default swap prices fell 8 bps this week to 284 bps.  Emerging market spreads increased 3 this week to 300 bps.  Financial Conditions – while susceptible - remain loose.

The Japanese moved aggressively this week to stanch the yen rally.  Japanese stocks surged.  In China, the talk was of additional government measures to slow Credit growth and to contain mounting inflationary pressures.  Chinese shares fell.  The Reserve Bank of India raised rates for the fifth time this year (to 6.0%), as it continues to do battle with inflationary pressures. Shares, nonetheless, surged.

Here at home, those arguing that deflation holds sway as the prevailing risk have, for now, won the “debate” both in policymaking circles and in the bond market.  All the same, watering down the analysis to some black or white “inflation or deflation” issue misses the complexity of risks today confronting an imbalanced global economy and unstable financial “system.”  Clearly, much of the world (China, India, Argentina, Brazil, Russia and non-Japan Asia, to mention just a “few”) is facing mounting inflation problems.  And if global markets don’t succumb to another period of de-risking and de-leveraging, it’s going to be fascinating to follow developments as global liquidity excess interplays with the robust inflationary biases that have taken hold throughout the “developing” economies/markets.

In the face of this week’s Japanese currency intervention and European debt worries, the dollar was notably unimpressive.  Momentum building for additional quantitative ease is dollar unfriendly, especially with marketplace liquidity already overabundant.  The last thing an unsettled world needs more of right now is additional dollar liquidity flows.

To be sure, prospective Treasury purchases will have much different effects than the Fed’s monetization of MBS, GSE debt and Treasurys had back in late-2008.  That period’s massive expansion of Fed assets was executed in the midst of an unprecedented unwind of leveraged speculations.  In particular, the Fed’s monetization occurred during the reversal of “dollar carry” trades, where unwind of bearish dollar positions incited a huge dollar rally and liquidity shortage.  Moreover, the Fed’s ballooning balance sheet back then accommodated speculator (i.e. Lehman, hedge funds, etc.) de-leveraging.  It was not a case of massive amounts of new liquidity being unleashed upon global markets.  

Going forward, one can envisage a scenario where “QE2” is implemented right into a backdrop of faltering dollar confidence.  In such a scenario, Fed-created liquidity just might seek an immediate exit from the dollar – only exacerbating both dollar weakness and general Monetary Disorder.  It’s reasonable that one facet of such a scenario would have the Japanese, Chinese and other central banks buying/Monetizing an increasingly problematic global surfeit of dollars – creating additional destabilizing liquidity in the process.  And, having watched the way things have tended to unfold, I would see a rising tide of Competitive Monetization as a high probability development. 

Is the dollar a bigger story than Ireland and Portugal?  Perhaps a rapidly rising tide of liquidity has something to do with Gold’s run toward $1,300.  Such a scenario might also help explain surging prices for silver, copper, wheat, corn, rice, soybeans, cattle, hogs, sugar, cotton, coffee, cocoa, etc.  And, for awhile, global liquidity excesses might even continue to inflate global bond prices.  But if this is deflation, it’s an abnormally strange strain.