Doug Noland

Weekly Commentary: The "Neutral Rate"

The neutral (or natural) rate of interest is the rate at which real GDP is growing at its trend rate, and inflation is stable. It is attributed to Swedish economist Knut Wicksell, and forms an important part of the Austrian theory of the business cycle. The neutral rate provides an important benchmark for policymakers to compare with the market rate. When interest rates are neutral the economy is on a sustainable path, and it is deviations from neutrality that cause booms and busts.” (Financial Times/lexicon)

Wicksell based his theory on a comparison of the marginal product of capital with the cost of borrowing money. If the money rate of interest was below the natural rate of return on capital, entrepreneurs would borrow at the money rate to purchase capital (equipment and buildings), thereby increasing demand for all types of resources and their prices; the converse would be true if the money rate was greater than the natural rate of return on capital. So long as the money rate of interest persisted below the natural rate of return on capital, upward price pressures would continue… Price stability would result only when the money rate of interest and the natural rate of return on capital—the marginal product of capital—were equal.” “Wicksell’s Natural Rate”, Federal Reserve Bank of St. Louis Monetary Trends, March 2005

Wicksell’s “natural rate” is a powerful analytical concept. In a more traditional backdrop, I would view the so-called “natural rate” as the price of Credit where supply and demand intersect at a point of relative stability for returns on capital. When economic returns are high, heightened demand for Credit (to fund investment) pushes up its cost. Over time, increased investment will result in an expanded supply of output and lower returns. Weak economic returns then engender less demand for borrowings and a resulting lower cost of Credit.

The hypothetical “natural rate” embodies a self-regulating system. During Wicksell’s time, money and Credit entered into the economic system primarily through lending for capital investment. And, importantly, there were constraints on the supply of “money” available to be lent. Banks were the dominant source of lending, and they were subject to specific restraints on Credit expansion (i.e. bank reserve and capital requirements, the gold standard).

Wicksell’s “natural rate” is incompatible with contemporary finance. These days, finance is introduced into systems (economic and financial) with little association to economic returns. Indeed, the primary mechanisms for the creation of new finance are government (fiscal and monetary) spending and asset-based lending. Furthermore, there are no restrains on the available supply of Credit, so its price is outside the purview of supply and demand. For the most part, the government dictates the price of finance. This system is neither self-adjusting nor self-correcting.

Enter the current monetary debate: Things have not progressed as expected. Years of unthinkable monetary stimulus have failed to achieve either general prosperity or consistent inflation in the general price level. Fragilities are as acute as ever. So policymaker reassessment is long overdue. Not surprisingly, however, there’s no second guessing “activist” (inflationist) monetary doctrine. Central bankers are not about to admit that a policy of zero rates and Trillions of monetization is fundamentally flawed. Apparently, we are to believe that forces outside their control have pushed down the “neutral rate.” The solution, predictably, is lower for longer – along with more government spending and programs. So focus on the “neutral rate” becomes the latest elaborate form of policymaking rationalization/justification.

From Ben Bernanke’s August 8, 2016 blog, “The Fed’s Shifting Perspective on the Economy and its Implications for Monetary Policy”: “Projections of r* can be interpreted as estimates of the ‘terminal’ or ‘neutral’ federal funds rate, the level of the funds rate consistent with stable, noninflationary growth in the longer term… As mentioned, a lower value of r* implies that current policy is not as expansionary as thought… In particular, relative to earlier estimates, they see current policy as less accommodative, the labor market as less tight, and inflationary pressures as more limited. Moreover, there may be a greater possibility that running the economy a bit ‘hot’ will lead to better productivity performance over time. The implications of these changes for policy are generally dovish, helping to explain the downward shifts in recent years in the Fed’s anticipated trajectory of rates.”

Today’s monetary “debate” is reminiscent of Alan Greenspan’s fateful foray into New Paradigm worship. In particular, he viewed (going back to 1996) that technological advancement and attendant productivity gains had fundamentally raised the economy’s “speed limit”. Monetary policy could be run looser than in the past – and run it did. Such fallacious thinking was only temporarily discredited with the the bursting of the “tech” Bubble, as captured in a 2001 WSJ article:

December 28, 2001 – Wall Street Journal (Greg Ip and Jacob M. Schlesinger): “Five years ago, Alan Greenspan began pushing a reluctant Federal Reserve to embrace his New Economy vision of rapid productivity growth and rising living standards. Today, Fed policy makers are debating whether they went too far. The answer could help determine whether the current recession marks a temporary aberration in an era of swift growth, or whether the rapid growth of the late 1990s itself was the aberration. Mr. Greenspan hasn’t lost the faith. ‘New capital investment, especially the high-tech type, will continue where it left off,’ he declared in a speech… He ignored the collapse of so many symbols of the 1990s boom, including Enron Corp., the sponsor of the ‘distinguished public service’ award he received that evening. ‘The long-term outlook for productivity growth, as far as I’m concerned, remains substantially undiminished,’ the Fed chairman asserted.”

New technologies are seductive. Rapid technological advancement coupled with momentous financial innovation proved absolutely engrossing. It was easy to ignore Enron, WorldCom and the like, just as it was to disregard 1994’s bond market tumult, the Mexican meltdown, the SE Asia debacle, the Russian collapse and LTCM. By 2001 it was rather obvious that New Age finance was highly unstable. Yet the 2002 corporate debt crisis along with the arrival of Dr. Bernanke to the the Marriner S. Eccles Building ensured that the FOMC pursued even more egregious policy blunders.

The Federal Reserve has been rationalizing loose monetary policies for 20 years now. Instead of Alan Greenspan’s electrifying productivity miracle, it’s a future of dreadful “secular stagnation.” Enron was little small potatoes compared to the frauds that followed. And the key issue from two decades ago somehow remains unaddressed: over-liquefied and speculative securities markets are incapable of effectively allocating financial and real resources. Moreover, central bank command over both the cost of finance and the performance of securities markets ensures dysfunction both financially and economically.

Contemporary notions of a “neutral rate” are deeply flawed – to the point of being ludicrous. From Bloomberg: “The Fed aims to set short-term interest rates in relation to the ‘natural rate’—the one that would produce full employment without excess inflation.” Yet it’s not the Fed funds rate spawning “full employment,” and central bankers certainly do not control a general price level. It is instead the ongoing historic Bubble in market-based finance that dictates the flow of “money” and Credit throughout the economy. One would have to be a diehard optimist to believe either markets or global economies are on a “sustainable path”. Market participants have been incentivized to take excessive risks and to speculate, with central bankers clearly responsible for inflationary Bubbles that have engulfed global securities and asset markets.

There’s no mystery surrounding the sinking employment rate. Ultra-loose monetary policies (rates and QE) have stoked excess securities market inflation, boosting perceived wealth while fostering extremely loose corporate Credit conditions. Such a backdrop spurs business borrowing, spending and hiring. Still, ongoing pathetic growth and productivity dynamics, along with weakening profits, corroborate the view that resources continue to be poorly allocated.

A low unemployment rate concurrent with mild CPI inflation is no conundrum either. On a global basis, unfettered finance has spurred unprecedented over- and malinvestment, ensuring downward price pressures. To be sure, the proliferation of new technologies and digitized output has fundamentally broadened the available supply of goods. Moreover, at home and abroad, unsound global finance has fomented wealth inequality that plays prominently in the disinflationary backdrop more generally.

A low “neutral rate” might be consistent with an economic boom, or it could just as well be compatible with financial and economic collapse. Causation – the driving force behind either boom or bust – is found with intertwined and closely correlated global securities markets. Two decades of persistently loose monetary policies have created deep economic maladjustment and historic asset price Bubbles. And these days central bankers see resulting stagnation (growth, productivity, pricing power, profits, etc.) as evidence of a historically low “neutral rate” – that is then used to justify their runaway experiment in ultra-loose monetary management.

Back in 2013, in the midst of a bout of market tumult, chairman Bernanke reassured the markets that the Fed was prepared to “push back against a tightening of financial conditions.” In the eyes of the market, this significantly augmented/clarified “whatever it takes.” The Federal Reserve – and global central bankers more generally – could simply not tolerate fledgling risk aversion (“risk off”) in the securities markets that would impinge financial conditions more generally. The Fed would use its rate and QE policy specifically to backstop the securities markets, in the process sustaining Bubble Dynamics.

“Whatever it takes” and “pushing back” unleashed a precarious Terminal Bubble Phase. With economic and market risks now so elevated, even the thought of recession or bear market has become unacceptable to central bankers.

There was a research piece this week from Federal Reserve Bank of San Francisco President John Williams, “Monetary Policy in a Low R-star World:” “The time has come to critically reassess prevailing policy frameworks and consider adjustments to handle new challenges, specifically those related to a low natural real rate of interest. While price level or nominal GDP targeting by monetary authorities are options, fiscal and other policies must also take on some of the burden to help sustain economic growth and stability.” And there was Thursday’s Washington Post op-ed from Larry Summers: “What We Need to do to Get Out of This Economic Malaise.” “I cannot see how policy could go wrong by setting a level target of 4 to 5% growth in nominal gross domestic product and think that there could be substantial benefits.”

Let me suggest what is going wrong.  Even after several years of typical recovery, there would be the issue of mounting imbalances and excesses. With almost eight years of history’s most extreme monetary stimulus – including zero rates, massive monetization and the direct targeting of securities and asset inflation – there is surely an extraordinary degree of underlying economic maladjustment. One should expect an inordinate number of uneconomic enterprises, along with the now typical amounts of fraud and nonsense (that prosper on loose finance).

Historic excess and distortions have for years accumulated throughout the securities markets. The underlying amount of speculative leverage likely exceeds 2008. Eight years of Federal Reserve zero rates and liquidity backstops have severely perverted market risk perceptions. Literally Trillions have flowed into perceived liquid and low-risk securities – fixed-income and equities. Trillions have chased yields and returns, assuming liquidity while being indifferent to risk. The unwieldy global pool of speculative finance has inflated by Trillions. Meanwhile, the Fed’s serial interventions to smother “Risk Off” has undoubtedly cultivated major latent fragilities within the derivatives trading complex.

The current policy objective should be for Fed to begin extricating itself from market dominance. It’s absolutely crucial for the economy and markets to commence the process of learning to stand on their own. At this point, such a transition would not go smoothly. The alternative is only deeper structural impairment and more extreme financial and economic fragility.

The system has been put in a quite precarious position, but it’s time to let Capitalism sorts its way through. The very opposite seems ensured. We’re in the early stage of even more egregious government (fiscal and monetary) intervention in the economy and markets. The election will usher in a surge of deficit spending. Meanwhile, the Federal Reserve appears poised to use a low “neutral rate” as an excuse to cling to ultra-loose monetary policies.

I am often reminded of misguided late-nineties dollar optimism. New Paradigm thinking had the markets content to overlook underlying U.S. financial and economic fragilities, not to mention massive intractable Current Account Deficits. King dollar had become a Crowded Trade, although nothing in comparison to this cycle’s dollar exuberance. Curiously, the dollar index declined 1.2% this week. In the face of Japan’s deep problems and policy shortcomings, the $/yen traded below 100 this week (yen up 16.9% y-t-d). Despite the eurozone’s serious deficiencies, the euro ended the week above 113 (up 4.3% y-t-d). In general, emerging markets are a mess, yet many EM currencies have rallied strongly against the dollar.

Integral to the dollar bull case have been expectations that an outperforming U.S. economy would ensure rising U.S. rates and attractive interest-rate differentials. Yet king dollar excesses (foreign and speculative flows) exacerbated Bubble Dynamics, with market and economic vulnerabilities now having trapped the Yellen Fed in ultra-loose monetary measures. Global markets appear to have begun anticipating a weaker dollar. This would certainly help to explain the big turnarounds in commodities and EM.

If the Fed is hellbent on spurring inflation (at home and abroad), a weaker dollar could go a long way. But policy savants be careful what you wish for. After all, global markets are awash in Crowded Trades betting on dollar strength, disinflationary forces, low bond yields and market stability – as far as the eye can see. There is today no “neutral rate” that could possibly neutralize such a perilous global Bubble.

For the Week:

The S&P500 was unchanged (up 6.8% y-t-d), while the Dow slipped 0.1% (up 6.5%). The Utilities dropped 1.3% (up 16.2%). The Banks jumped 1.7% (down 3.9%), and the Broker/Dealers rose 1.1% (down 6.3%). The Transports advanced 1.6% (up 5.6%). The S&P 400 Midcaps added 0.3% (up 11.7%), and the small cap Russell 2000 increased 0.6% (up 8.9%). The Nasdaq100 was unchanged (up 4.6%), and the Morgan Stanley High Tech index gained 1.2% (up 9.1%). The Semiconductors jumped 2.2% (up 20.1%). The Biotechs declined 0.7% (down 13.0%). Though bullion added $6, the HUI gold index fell 3.6% (up 142%).

Three-month Treasury bill rates ended the week at 30 bps. Two-year government yields rose five bps to 0.75% (down 30bps y-t-d). Five-year T-note yields rose seven bps to 1.16% (down 59bps). Ten-year Treasury yields gained seven bps to 1.58% (down 67bps). Long bond yields increased six bps to 2.29% (down 73bps).

Greek 10-year yields fell 13 bps to 7.86% (up 54bps y-t-d). Ten-year Portuguese yields surged 31 bps to 2.98% (up 46bps). Italian 10-year yields jumped nine bps to 1.13% (down 46bps). Spain’s 10-year yield increased three bps to 0.95% (down 82bps). German bund yields rose seven bps to negative 0.04% (down 66bps). French yields gained seven bps to 0.18% (down 81bps). The French to German 10-year bond spread was unchanged at 22 bps. U.K. 10-year gilt yields rose 10 bps to 0.62% (down 134bps). U.K.’s FTSE equities index declined 0.8% (up 9.9%).

Japan’s Nikkei 225 equities index dropped 2.2% (down 13.1% y-t-d). Japanese 10-year “JGB” yields increased three bps to negative 0.09% (down 26bps y-t-d). The German DAX equities index fell 1.6% (down 1.8%). Spain’s IBEX 35 equities index sank 3.0% (down 11.5%). Italy’s FTSE MIB index was hit 4.0% (down 23.9%). EM equities were mixed. Brazil’s Bovespa index gained another 1.5% (up 36.5%). Mexico’s Bolsa was little changed (up 12.4%). South Korea’s Kospi index added 0.3% (up 4.8%). India’s Sensex equities slipped 0.3% (up 7.5%). China’s Shanghai Exchange jumped 1.9% (down 12.2%). Turkey’s Borsa Istanbul National 100 index was about unchanged (up 8.9%). Russia’s MICEX equities index slipped 0.4% (up 11.3%).

Junk bond mutual funds saw inflows of $889 million (from Lipper).

Freddie Mac 30-year fixed mortgage rates declined two bps to 3.43% (down 54bps y-o-y). Fifteen-year rates slipped two bps to 2.74% (down 52bps). Bankrate’s survey of jumbo mortgage borrowing costs had 30-yr fixed rates up three bps to 3.61% (down 47bps).

Federal Reserve Credit last week expanded $10.4bn to $4.438 TN. Over the past year, Fed Credit declined $22.3bn. Fed Credit inflated $1.627 TN, or 58%, over the past 197 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt increased $2.9bn last week to $3.203 TN. “Custody holdings” were down $153bn y-o-y, or 4.6%.

M2 (narrow) “money” supply last week increased $5.6bn to a record $12.971 TN. “Narrow money” expanded $884bn, or 7.3%, over the past year. For the week, Currency increased $0.8bn. Total Checkable Deposits surged $69.8bn, while Savings Deposits dropped $65.3bn. Small Time Deposits added $1.0bn. Retail Money Funds slipped $0.7bn.

Total money market fund assets dropped $34.9bn to a six-week low $2.710 TN. Money Funds rose $24bn y-o-y (0.9%).

Total Commercial Paper dropped $11.0bn to $1.012 TN. CP declined $45bn y-o-y, or 4.2%.

Currency Watch:

The U.S. dollar index dropped 1.2% to 94.5 (down 4.2% y-t-d). For the week on the upside, the euro increased 1.5%, the Swiss franc 1.4%, the British pound 1.2%, the Japanese yen 1.1%, the New Zealand dollar 1.0%, the Swedish krona 0.8%, the Canadian dollar 0.6%, and the Mexican peso 0.2%. For the week on the downside, the Brazilian real declined 0.4%, the Australian dollar 0.3%, the South African rand 0.3%, and the Norwegian krone 0.1%. The Chinese yuan declined 0.3% versus the dollar (down 2.5% y-t-d).

Commodities Watch:

The Goldman Sachs Commodities Index surged 4.9% (up 18.9% y-t-d). Spot Gold added 0.4% to $1,341 (up 26%). Silver declined 2.1% to $19.31 (up 40%). WTI Crude surged $4.08 to $48.57 (up 31%). Gasoline jumped 10.8% (up 20%), while Natural Gas slipped 0.4% (up 10%). Copper gained 1.8% (up 2%). Wheat surged 5.3% (down 5%). Corn advanced 3.2% (down 4%).

Turkey Watch:

August 14 – Reuters (Humeyra Pamuk): “Turkey will not compromise with Washington over the extradition of the Islamic cleric it accuses of orchestrating a failed coup, Prime Minister Binali Yildirim said…, warning of rising anti-Americanism if the United States fails to extradite.”

August 18 – Reuters (Ayla Jean Yackley): “Turkish authorities ordered the detention of nearly 200 people, including leading businessmen, and seized their assets as an investigation into suspects in last month’s failed military rebellion shifted to the private sector. President Tayyip Erdogan has vowed to choke off businesses linked to U.S.-based Muslim cleric Fethullah Gulen, whom he blames for the July 15 coup attempt, describing his schools, firms and charities as ‘nests of terrorism.’ Tens of thousands of troops, civil servants, judges and officials have been detained or dismissed in a massive purge…”

August 14 – Reuters (Michelle Martin and Humeyra Pamuk): “Turkey could walk away from its promise to stem the flow of illegal migrants to Europe if the European Union fails to grant Turks visa-free travel to the bloc in October, Foreign Minister Mevlut Cavusoglu told a German newspaper. His comments… coincide with rising tensions between Ankara and the West that have been exacerbated by the failed coup attempt… Turkey is incensed by what it sees as an insensitive response from Western allies to the failed putsch, in which 240 people were killed.”

Brexit Watch:

August 13 – Bloomberg (Scott Hamilton and Colin Keatinge): “Monetary policy is only a ‘short-term balm’ that can’t fully insulate the U.K. from the long-term impacts of the vote to leave the European Union, Bank of England Chief Economist Andrew Haldane wrote… The bank’s package of monetary policy measures unleashed earlier this month, including the first interest-rate cut in seven years, are designed to be a shot in the arm for business and consumer confidence after the vote to leave the European Union ‘has thrown up a dust cloud of economic uncertainty, making it harder for companies to plan, with potentially adverse implications for future investment and jobs,’ Haldane said…”

August 15 – Reuters (Ana Nicolaci da Costa): “The price of homes for sale in England and Wales fell in August, posting the biggest drop since November… Asking prices fell by a monthly 1.2%…, after shedding 0.9% in July. The biggest drop was in London and the South East, with asking prices falling by 2.6% and 2.0% respectively.”

August 16 – Bloomberg (Janet Lorin): “Larger investment banks with their European headquarters in London are already making plans for their own withdrawal. Many plan to start the process of moving jobs from the U.K. within weeks of the government triggering Brexit, people briefed on the plans of four of the biggest firms told Bloomberg’s Gavin Finch. That suggests the banks may move faster than their public messages of patience would imply, and reflects dismay with the U.K.’s lack of a clear plan to protect its status as a global financial hub. There are concerns British-based banks will lose the right to sell services freely around the European Union.”

Europe Watch:

August 18 – New York Times (Landon Thomas Jr.): “In Italy, where two decades of economic stagnation have created a long line of barely breathing companies, Feltrinelli, one of the country’s largest booksellers, stands out. Since 2012, the company has chalked up three consecutive years of losses totaling nearly 11 million euros ($12.4 million). Even so, late last year, Feltrinelli was able to secure a fresh €50 million line of credit from a syndicate that included two of Italy’s largest banks, UniCredit and Intesa Sanpaolo, at an interest rate below what top-rated companies in Europe were paying. As Italy and Europe more broadly struggle to come to grips with an escalating problem with bad loans, a new paper by economists connected to the Center for Economic Policy Research… highlights the extent to which Italy’s main banks — known to be the weakest in the eurozone in terms of cash reserves — have stepped up their lending to the country’s most troubled companies.”

Fixed-Income Bubble Watch:

August 14 – Wall Street Journal (Carolyn Cui and Mike Bird): “Bond investment funds that usually have little appetite for riskier debt are boosting their exposure to the developing world, a move that is helping drive this year’s emerging-markets rally. International bond funds run by BlackRock Inc., Legg Mason Inc. and OppenheimerFunds are among the big money managers that have been increasing their positions in emerging-market debt in recent months. That shift reflects how global bond funds are feeling the pinch from low U.S. interest rates and negative rates in Japan and much of Europe.”

Global Bubble Watch:

August 18 – New York Times (Robin Wigglesworth): “Paul Singer, head of $28bn hedge fund Elliott Management, has warned that the global bond market is ‘broken’, and predicted that the end of the current environment is ‘likely to be surprising, sudden, intense, and large’… In his second quarter letter to investors… Mr Singer sounded an ominous warning on the state of the global debt market, with more than $13tn of bonds trading with negative yields. The hedge fund manager said it was ‘the biggest bond bubble in world history,’ and cautioned that investors should shy away from sub-zero yielding debt. ‘Hold such instruments at your own risk; danger of serious injury or death to your capital!’, he wrote… He added that ‘the ultimate breakdown (or series of breakdowns) from this environment is likely to be surprising, sudden, intense, and large’.”

August 16 – Reuters (Claire Milhench): “Global investors have cut their cash holdings sharply and added to emerging market and U.S. stocks in August as global growth expectations have rebounded, a Bank of America Merrill Lynch (BAML) survey indicated… Cash levels dropped to 5.4% from a 15-year high of 5.8% in July… A net 23% of investors now expect the global economy to improve over the next 12 months, an optimism reflected in the overall equity allocation recovering to a net overweight of 9%. This was up from a net 1% underweight last month – the first underweight in four years. Among the biggest beneficiaries of this switch were emerging market stocks, where the allocation rose to a net 13% overweight – the highest level since September 2014. This was up from 10% last month.”

August 16 – Bloomberg (Vincent Cignarella): “This wasn’t supposed to happen. The central banks of Australia and New Zealand lowered benchmark interest rates and their respective currencies promptly strengthened. Traders puzzled by the way foreign-exchange markets are behaving should consider that potential for capital appreciation, in addition to yield, may be a significant driver of recent moves. Investors are engaging in a type of ‘reverse carry trade,’ buying low-yield currencies for high-yield pairs and accepting small interest rate differential losses for potential large capital gains where central banks are cutting rates or buying more domestic bonds. Those moves should push up the price of underlying assets and, in theory, outweigh small losses on interest rate carry.”

U.S. Bubble Watch:

August 18 – The Economist: “WHAT are the most dysfunctional parts of the global financial system? China’s banking industry, you might say, with its great wall of bad debts and state-sponsored cronyism. Or the euro zone’s taped-together single currency, which stretches across 19 different countries, each with its own debts and frail financial firms. Both are worrying. But if sheer size is your yardstick, nothing beats America’s housing market. It is the world’s largest asset class, worth $26 trillion, more than America’s stockmarket. The slab of mortgage debt lurking beneath it is the planet’s biggest concentration of financial risk. When house prices started tumbling in the summer of 2006, a chain reaction led to a global crisis in 2008-09. A decade on, the presumption is that the mortgage-debt monster has been tamed. In fact, vast, nationalised, unprofitable and undercapitalised, it remains a menace to the world’s biggest economy.”

August 18 – Bloomberg (Joe Light): “The hole at the corner of 15th and L streets, in downtown Washington, is deep — and getting deeper. Earth-movers there are laying the foundations of a shiny new headquarters for Fannie Mae, the bailed-out giant of American mortgages. But the sleek design, replete with glass sky bridges, belies a sober reality: Fannie Mae and its cousin, Freddie Mac, are once again headed for trouble. In fact, there’s almost no way around it. On Jan. 1, 2018, the two government-sponsored enterprises will officially run out of capital under the current terms of their bailout. After that, any losses would be shouldered by taxpayers. Granted, few people are predicting a disaster like the one in 2008, when the GSEs had to be thrown a $187.5 billion federal lifeline. But eight years later, people still don’t agree on what to do with these wards of the state… ‘Everyone agreed that this was a broken business model that made no sense,’’ said Douglas Holtz-Eakin, president of the American Action Forum… ‘Now, inertia is driving the way.’”

August 16 – Bloomberg (Sid Verma and Luke Kawa): “Stock buybacks appear to be slowing down, suggesting either corporate America’s outlook has dimmed, stock valuations have become prohibitively high or, most optimistically, that companies are starting to listen to investors and put funds toward other uses. Buybacks announced for the second quarter’s earnings season between July 8 and August 15 totaled an average of $1.8 billion a day, the lowest volume in an earnings season since the summer of 2012, according to TrimTabs Investment Research… In the first seven months of 2016, buybacks totaled $376.5 billion, according to TrimTabs. That’s down 21% from $478.4 billion in the first seven months of last year.”

August 19 – Wall Street Journal (Mike Bird, Vipal Monga and Aaron Kuriloff): “Big companies are handing more of their profits to shareholders than at any time since the financial crisis, as record-low bond yields put a premium on dividends. Payouts at S&P 500 companies for the past 12 months amounted to almost 38% of net income over the period, according to FactSet, the most since February 2009. In the second quarter, 44 S&P 500 companies paid an annual dividend that exceeded their latest 12 months of net income… That is the most in a decade and a practice some analysts deem unsustainable.”

August 12 – Wall Street Journal (Maria Armental): “As U.S. stocks rally, private-equity firms are taking the other side of the trade. The S&P 500, Dow Jones Industrial Average and Nasdaq Composite Index all notched record highs Thursday, a triple-threat that hadn’t occurred since the dot-com boom. Meanwhile, 15 block trades, bulk sales of big chunks of stock, raised a total of $5 billion in the biggest week for such deals since March 2015. Private-equity firms, which use block trades to sell out of companies they previously took public, accounted for nine of the 15 deals.”

August 17 – Bloomberg (Rachel Evans): “Store closures by Macy’s Inc. could hurt more than the mall rats, according to Morningstar Credit Ratings. Almost $30 billion of bonds backed by commercial mortgages are exposed to the retailer, which last week announced plans to shutter 100 outlets, the rating company wrote… More than $3.6 billion in loans would be affected by the closing of 28 stores that Morningstar identifies as most at risk, several of which support multiple asset-backed securities…”

Federal Reserve Watch:

August 17 – Financial Times (Sam Fleming): “A divided Federal Reserve left open the prospect of a further interest rate rise this year even as policymakers insisted they needed more evidence on the durability of the rebound before feeling confident enough to pull the trigger. Minutes to their latest July meeting revealed a hard-fought debate over when to move rates, with a couple of participants urging an immediate move, while others were urging caution amid questions over how rapidly inflation will return to target.”

August 16 – Bloomberg (Matthew Boesler): “The Federal Reserve could potentially raise interest rates as soon as next month, New York Fed President William Dudley said, warning investors that they are underestimating the likelihood of increases in borrowing costs. ‘We’re edging closer towards the point in time where it will be appropriate, I think, to raise interest rates further,’ Dudley… said… Asked whether the FOMC could vote to raise the benchmark rate at its next meeting Sept. 20-21, Dudley said, ‘I think it’s possible.’”

Central Bank Watch:

August 16 – Bloomberg (Jeanna Smialek): “The world made it through the Great Recession. Now it’s entered what you might call the Great Reassessment. High-profile researchers are publicly questioning the most basic tenets of monetary policy in the run-up to the Federal Reserve Bank of Kansas City’s economic symposium in Jackson Hole, Wyoming, which starts Aug. 25. San Francisco Fed President John Williams has issued a call for a major rethink among central bankers and fiscal policy makers, with an eye on scrapping low-inflation targeting. Former Fed Chairman Ben Bernanke analyzes why the Fed has been revising its economic projections. Meanwhile, a new IMF paper assesses both the effectiveness of, and the outlook for, Europe’s negative interest-rate policies.”

August 18 – Bloomberg (Jana Randow and Carolynn Look): “European Central Bank officials ‘widely’ agreed that their immediate reaction to the outcome of the U.K.’s referendum shouldn’t fuel excessive speculation about more stimulus. ‘The view was widely shared that the Governing Council needed to reiterate its capacity and readiness to act, if warranted, to achieve its objective, using all the instruments available within its mandate, while not fostering undue expectations about the future course of monetary policy,’…”

China Bubble Watch:

August 12 – Bloomberg (Paul Panckhurst): “International Monetary Fund staff said that 19 trillion yuan ($2.9 trillion) of Chinese ‘shadow’ credit products are high-risk compared with corporate loans and highlighted the danger that defaults could lead to liquidity shocks. The investment products are structured by the likes of trust and securities companies and based on equities or on debt — typically loans — that isn’t traded… The commentary highlighted the potential for risks bigger to the nation’s financial stability than from companies’ loan defaults. While loan losses can be realized gradually, defaults on the shadow products could trigger risk aversion that’s harder to manage… The ‘high-risk’ products offer yields of 11% to 14%, compared with 6 percent on loans and 3% to 4% on bonds, the commentary said. The lowest-quality of these products are based on ‘nonstandard credit assets,’ typically loans, it said.”

August 15 – Bloomberg: “China’s central bank urged investors not to focus too much on short-term concerns and said the diverging pace of credit expansion doesn’t mean monetary policy is losing steam. July credit growth slowing to a two-year low was a distortion and the reports for August and September will show it rebounding… Markets should avoid over-interpretation of short-term data for a specific month, the PBOC said. The commentary also said the growing gap between two money-supply gauges, M1 and M2, isn’t an indicator of a ‘liquidity trap,’ an economics term for when central bank cash injections into the economy fail to spur growth as monetary policy loses potency.”

August 17 – Reuters (Yawen Chen and Sue-Lin Wong): “China home prices rose 0.8% in July nationwide, but stalled or fell in more cities than in June, adding to concerns that one of the economy’s key growth drivers is losing steam but offering some relief for policymakers worried about property bubbles. A robust recovery in home prices and sales gave a stronger-than-expected boost to the world’s second-largest economy in the first half of the year, helping to offset stubbornly weak exports.”

Japan Watch:

August 14 – Bloomberg (Anna Kitanaka, Yuji Nakamura and Toshiro Hasegawa): “The Bank of Japan’s controversial march to the top of shareholder rankings in the world’s third-largest equity market is picking up pace. Already a top-five owner of 81 companies in Japan’s Nikkei 225 Stock Average, the BOJ is on course to become the No. 1 shareholder in 55 of those firms by the end of next year… BOJ Governor Haruhiko Kuroda almost doubled his annual ETF buying target last month, adding to an unprecedented campaign to revitalize Japan’s stagnant economy.”

August 15 – Reuters (Leika Kihara): “The Bank of Japan’s policy review could put up for debate its target for expanding base money through massive asset purchases, sources say, but the challenge would be to avoid spooking bond markets… The BOJ’s announcement last month of a thorough review of its policy and its effects triggered a sharp bond sell-off as investors feared the central bank, wary of its dwindling policy tools, might lean toward reducing its government bond purchases. It is currently buying roughly 110-120 trillion yen in bonds each year to meet its pledge to expand base money… by an annual 80 trillion yen ($790bn). But after initial successes in the asset-buying program, which is aimed at ending two decades of deflationary pressure, prices are falling again.”

August 16 – Nikkei AR: “Tuesday marked six months since the Bank of Japan introduced negative interest rates, and the effects and drawbacks of the unusual step have come to the fore. The policy has yet to produce falls in the yen’s value, arousing concern about adverse effects on earnings at financial institutions… It thus remains halfway to its target of stimulating the real economy to push up prices. Negative interest rates ‘will help the [Japanese] economy expand by stimulating investment and consumption,’ BOJ Gov. Haruhiko Kuroda said… ‘Together with an increase in inflation expectations, the rate of price growth will move toward 2%,’ he said.”

August 15 – Reuters (Leika Kihara and Tetsushi Kajimoto): “Japan’s economic growth ground to a halt in April-June as weak exports and shaky domestic demand prompted companies to cut spending… The weak reading underscores the challenges policymakers face in ending two decades of crippling deflation, as an initial boost from Abe’s stimulus programs, dubbed ‘Abenomics’, appears to be quickly fading. The world’s third-largest economy expanded by an annualized 0.2% in the second quarter, less than the 0.7% increase markets had expected and a sharp slowdown from a revised 2.0% increase in January-March…”

August 17 – Bloomberg (Connor Cislo): “Japan’s exports declined the most since 2009, with shipments down for a 10th consecutive month. The continued drop highlights the difficulty of kick-starting growth and pulling Japan’s economy out of the doldrums. Overseas shipments fell 14% in July from a year earlier… Imports dropped 24.7%, leaving a trade surplus of 513.5 billion yen ($5.2bn).”

EM Watch:

August 18 – Bloomberg (Marton Eder): “The rout in Ukrainian assets worsened, with the nation’s restructured bonds heading for their worst week since May, on concern a flare-up in fighting between government troops and separatists in the country’s east may be a precursor to a full-blown conflict. The yield on the government’s $1.7 billion Eurobond due 2019 rose 15 bps to 8.51%…, bringing the increase this week to 44 bps. The hryvnia currency slumped toward to the weakest level in three months…”

August 18 – Bloomberg (Ye Xie): “A 40% increase in the amount of corporate debt coming due in developing nations over the next three years is creating a potential default risk if investors start pulling money out of emerging markets, according to the Bank for International Settlements. About $340 billion of debt is maturing between this year and 2018… The total payments due each year during the period is equivalent to the net bond sales by non-financial companies in developing nations in 2015, it said. ‘Given the steep repayment schedule that lies ahead, the refinancing capacity of highly leveraged EME companies is likely to be tested soon, especially if the rise of the U.S. dollar continues,’ economists led by Nikola Tarashev wrote… Debt sold by non-financial companies in developing nations increased to 110% of their gross domestic product by 2015, up from less than 60% in 2006, BIS said…”

August 16 – Bloomberg (Ye Xie and Natasha Doff): “Central banks in developing economies are taking advantage of the biggest rally in their currencies since 2010. Led by Turkey and Thailand, they’re using stronger exchange rates to build up foreign reserves for the first time in two years, replenishing shortfalls created as they attempted to prop up their currencies during recent routs… International reserves have grown by $154 billion, or 1.4%, since the end of March to $11 trillion… Turkey’s cash coffer expanded the most during the period, increasing more than 6%. Thailand’s currency pile rose 5.5%, while Indonesia’s climbed 3.6%”

Leveraged Speculator Watch:

August 16 – Wall Street Journal (Laurence Fletcher and Gregory Zuckerman): “A growing exodus from hedge funds extended to two of the biggest names in the industry Tuesday, Tudor Investment Corp. and Brevan Howard, as disenchanted investors increasingly shun what was once the hottest place to put money. The funds’ problem is clear: They just aren’t performing. Hedge funds and actively managed mutual funds have been underperforming since financial markets began their rebound in early 2009. The average hedge fund is up 3% this year through the end of July, according to… HFR Inc., less than half the S&P 500’s rise… Funds in the $2.9 trillion hedge-fund sector have now experienced three consecutive quarters of withdrawals for the first time since 2009, according to HFR.”

August 16 – Bloomberg (Lu Wang): “The steady drumbeat of gains that has lifted the S&P 500 Index in six of the last seven weeks is making life difficult for bears. Hedge funds that aim to profit from long and short bets have raised net equity holdings in the past three months, with bullish positions now exceeding bearish ones by 22.7 percentage points. That’s higher than 97% of the time since Credit Suisse Group AG began tracking the data in 2009. Perhaps not coincidentally, marketwide readings of short interest just posted the biggest decline in four years, while shares of the most-hated companies led in the rally that just lifted the S&P 500 to another record Monday, its 10th since early July.”

August 15 – Wall Street Journal (Maria Armental): “Billionaire investor George Soros, who rose to fame and fortune by betting against the sterling in 1992, on Monday showed his latest hand: nearly doubling down on his bearish bet against the market. The 86-year-old’s fund disclosed in a regulatory filing it had increased its bet against the S&P 500…, reporting ‘put’ options on roughly 4 million shares as of June 30 in an exchange-traded fund that tracks the index. That’s up from ‘puts’ on 2.1 million shares as of March 31.”

August 16 – Bloomberg (Janet Lorin): “Following the lead of pensions, some U.S. endowments and foundations are souring on hedge funds. Hedge fund fees and lagging performance are cause for concern for nonprofit investors, who are reducing their allocation, according to a survey published Monday by NEPC, a Boston-based consulting firm with 118 endowment and foundation clients with assets of $57 billion… ‘The last several years have been difficult for the industry and investors are starting to look very closely at how hedge funds can work for them,’ Cathy Konicki, who oversees the company’s endowment and foundation business, said…”

Geopolitical Watch:

August 18 – Bloomberg (Daryna Krasnolutska Aliaksandr Kudrytski): “Ukraine isn’t ruling out a full-scale Russian invasion and may institute a military draft if the situation with its neighbor worsens, President Petro Poroshenko said… The confrontation between Ukrainian forces and the rebels in Ukraine’s eastern Donbas region has worsened, Poroshenko said… Putin vowed to respond with ‘serious measures.’ ‘The probability of escalation and conflict remains very significant,’ Poroshenko said… ‘We don’t rule out full-scale Russian invasion.’”

August 19 – Wall Street Journal (James Marson and Thomas Grove): “Russia is bolstering its military presence on its western border, sending tens of thousands of soldiers to newly built installations within easy striking distance of Ukraine. The moves, which come as Moscow ratchets up confrontation over the Black Sea peninsula of Crimea, are a centerpiece of a new military strategy the Kremlin says is meant to counter perceived threats from the North Atlantic Treaty Organization.”

August 13 – Bloomberg (Monami Yui): “The Japanese government has decided on a plan to develop land-to-sea missiles with a range of 300 kilometers (186 miles) to protect the nation’s isolated islands, including the Senkaku, the Yomiuri newspaper reported… China has been stepping up pressure on Japan over the disputed Senkaku Islands, which are called Diaoyu in Chinese. Hundreds of fishing boats and more than a dozen coastguard vessels have been spotted recently in the area, encroaching at times on what Japan sees as its territorial waters.”

August 17 – Bloomberg (Iain Marlow): “From the sandstone walls of the 17th-century Red Fort in India’s capital, Prime Minister Narendra Modi sent a warning shot this week to his counterparts in Islamabad and Beijing. Modi’s reference to disputed territories on Monday during his annual Independence Day speech — his most high-profile appearance of the year — signaled that India would become more aggressive in asserting its claims to Pakistan-controlled areas of Kashmir. The region is a key transit point in the $45 billion China-Pakistan Economic Corridor known as CPEC that will give Beijing access to the Arabian Sea through the port of Gwadar.”

Weekly Commentary: Updating Government Finance Quasi-Capitalism

I found my thoughts this week returning to Hyman Minsky, financial evolution and Capitalism. Updating my 2013 Government Finance Quasi-Capitalism thesis seemed overdue.

“Minsky saw the evolution Capitalist finance as having developed in four stages: Commercial Capitalism, Finance Capitalism, Managerial Capitalism and Money Manager Capitalism. ‘These stages are related to what is financed and who does the proximate financing – the structure of relations among businesses, households, the government and finance’…”

Money Manager Capitalism: “The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy… Unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits… A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market…”

Late in life (1993) Minsky wrote: “Today’s financial structure is more akin to Keynes’ characterization of the financial arrangements of advanced capitalism as a casino.” More and more concerned by the proclivity of “Money Manager Capitalism” to foment instability and crises prior to his death in 1996, Minsky would have been absolutely appalled by the late-nineties “Asian Tiger” collapse, the Russia implosion, LTCM and the “tech” Bubble fiasco. Minsky was no inflationist. His focus would have been to rectify the institutional and policy deficiencies that were responsible for progressively destructive mayhem.

Policymakers instead responded to instability and crisis with increasingly “activist” (inflationist) measures. In particular, the Fed (and global central bankers) moved aggressively to backstop marketplace liquidity. At the same time, the government-sponsored enterprises (GSEs) began guaranteeing a large percentage of new mortgage Credit, while employing their balance sheets (liabilities enjoying implied federal backing) in similar fashion to central banks, as so-called “buyer of last resort” during periods of market tumult and speculative deleveraging.

These government-related liquidity backstops and guarantees fundamentally altered finance. Back in 2001, I updated Minsky’s stages of Capitalistic Development with a new phase, “Financial Arbitrage Capitalism”. Evolving financial, institutional and policymaker frameworks had seemingly mitigated volatility and crisis. Then the 2008 debacle unmasked what had been an unprecedented buildup of risky Credit, problematic risk intermediation processes and the accumulation of leverage and speculative positions. Policymakers and the markets had been oblivious to catastrophic latent liquidity risk inherent to the new institutional structure.

“The worst crisis since the Great Depression” provoked extraordinary policy measures. In 2013, after witnessing previously unimaginable central bank interest-rate manipulation, monetization and the specific policy objective of inflating securities markets, I was compelled to again update Minsky’s stages: “Government Finance Quasi-Capitalism”.

As finance has a proclivity of doing, “Money Market Capitalism” evolved over time to become increasingly unstable. Policy responses then nurtured a freakish financial backstop that greatly incentivized leveraged speculation throughout the securities and derivatives markets. This process fundamentally loosened financial conditions and spurred risk-taking and spending. After attaining significant momentum in the nineties, the progressively riskier phase of “Financial Arbitrage Capitalism” reached its zenith with the issuance of $1.0 TN of subprime CDOs is 2006/07.

The policy response to the 2008/2009 crisis was nothing short of phenomenal. A Trillion of QE from the Fed, zero rates and massive bailouts. Still, the Fed at the time claimed to be committed to returning to the previous policy regime as soon as practical. The Fed devoted significant resources toward mapping out a return to normalcy, going so far as releasing in 2011 a detailed “exit strategy” for normalizing rates and returning its balance sheet to pre-crisis levels.

But with the European crisis at the brink of turning global back in 2012, it had become clear by that point that thoughts of returning to so-called “normalcy” were illusionary. It may have been the ECB’s Draghi talking “whatever it takes,” but he was speaking for global central bankers everywhere. QE was no longer just a crisis measure. It would effortlessly provide unlimited ammo for which to inflate securities markets and spur risk-taking and economic activity. If zero rates were not providing the expected market response, no reason not to go negative. If buying sovereign bonds wasn’t getting the job done, move on to corporates and equities.

Such a deviant policy backdrop coupled with an already deeply distorted and speculative market environment ensured descent into a truly freakish financial landscape. Most obvious, markets have come to largely disregard risk. Serious cracks in China and Europe have been largely ignored by global markets. The increasingly alarming geopolitical backdrop is completely disregarded. Brexit was regarded – for about a trading session. Global economic vulnerability is on full display, though massive QE and negative-yielding developed country sovereign debt ensures a “money” deluge into the corporate debt marketplace. Concern for risk has hurt performance. Recurring bouts of concern puts one’s career at risk – whether one is a portfolio manager, financial advisor, trader, independent investor, analyst or strategist.

The financial and institutional arrangements that I collectively refer to as “Government Finance Quasi-Capitalism” have over time had profound impacts on the securities markets. Policymakers have largely removed volatility from equities (VIX ends the week at 11.39) and fixed income. U.S. corporate debt issuance remains at near-record pace. Stock prices are at all-time highs in the U.S. and elevated around the world. Bond prices are near records almost everywhere. Risk premiums in general have collapsed. Why then is unease so prevalent throughout the securities markets?

For one, it’s impossible these days to gauge risk. How much are QE and rate policies impacting securities prices? Will global policymaker have the capacity to withdraw from unprecedented measures, or have they become trapped in disproportionate stimulus with no way out? How big is the downside? How will the future policy backdrop play out? The truth is that no one – certainly not the policymaker community – has any idea what the future holds for policy or the markets. A turn back in the direction of reasonableness and “normalcy” or a further spiral out of control?

There’s a strong argument that investing has been largely relegated to a thing of the past. If risk is completely unclear, it’s impossible to gauge risk versus reward. Furthermore, how are company fundamentals (i.e. earnings, cash-flow, etc.) impacted by massive monetary and fiscal stimulus? How about the macro economy? And if risk vs. reward is unknowable and valuation metrics so obscured, it’s delusional to refer to “investment”.

A defining feature of Government Finance Quasi-Capitalism is that speculation now completely dominates investment. An unintended consequence of policymakers suppressing volatility and masking risk is that active management has been severely disadvantaged relative to passive management. Traditional investment analysis and risk management have been a significant detriment to performance. Why bother, when fees are lower with passive anyway? So “money” has flooded into ETFs and other index products simply to speculate on “the market.” Passive management really couldn’t care less about China, European banks, Brexit, Japan, Bubbles or policymaking more generally.

The abnormal backdrop does a major disservice to those that appreciate the unstable backdrop and hence seek to proceed cautiously. Indeed, Government Finance Quasi-Capitalism has nurtured one of history’s great speculative Bubbles in perceived low-risk “investments.” Trillions of liquidity injections coupled with volatility suppression has ensured that Trillions have flooded into dividend-paying stocks, “low beta,” “smart beta” and other perceived low-risk equity market strategies.

Government Finance Quasi-Capitalism has transformed Trillions of risk assets into perceived “money-like” instruments, throughout the securities markets and surely in derivatives. These massive flows into perceived safety have been instrumental in fueling the entire market to record highs in the face of persistent and growing risks. Previously, Financial Arbitrage Capitalism fomented “money” risk misperceptions and resulting liquidity crisis vulnerability in the “repo” market. Similar risks continue to mount in the Government Finance Quasi-Capitalism period throughout perceived low-risk equities, fixed income, corporate debt more generally and higher-yielding assets throughout the overall economy (i.e. commercial real estate).

U.S. household Net Worth is at record highs, while the ratio of Net Worth to GDP is near all-time highs. It’s worth noting that U.S. unemployment at 4.9% is outdone by China’s 4.1% and Japan’s 3.1%. Why then is there such social tension and geopolitical unease?

The Financial Arbitrage Capitalism period was notable for a momentous misallocation of real and financial resources. The economic structure suffered mightily, clearly evidenced by deteriorating productivity associated with deep structural deficiencies, along with underlying economic fragility. I would strongly argue that the ongoing Government Finance Quasi-Capitalism phase, with a massive inflation of government debt and only more grotesquely distorted markets, is even more dysfunctional at creating and distributing real economic wealth. Thus far it has succeeded in inflating perceived financial wealth, although this has only exacerbated the social and political problems associated with blatant wealth inequities.

Government Finance Quasi-Capitalism creates essentially unlimited demand for perceived low-risk corporate Credit (think Apple, Microsoft, Verizon, etc.), creating myriad market, financial and economic distortions. For one, it feeds financial engineering, including stock-repurchases and M&A. This dynamic exacerbates the big firm advantage and monopoly power more generally, at the expense of economic efficiency. I would contend it also is an increasingly important aspect of wealth inequality: the few really big get bigger and more powerful at the expense of everyone else. Financial flows are siphoned away from the general economy to be flooded into the hot sectors. A handful of cities – think SF, Seattle, Portland, Austin, L.A., and New York – lavish in prosperity while small town America is left to rot.

I have asserted that Bubbles only redistribute and destroy wealth. I have further posited that geopolitical instability is a dangerous consequence of the global government finance Bubble. Both China and Japan are in the midst of respective precarious Bubble Dynamics. It’s no coincidence that animosities and geopolitical risks between the Chinese and Japanese are rapidly escalating. Tensions between Russia and the West have close ties to the global Bubble. Turkey’s problems are exacerbated by its bursting Bubble. The Middle East, Latin America and Asia are all suffering from Bubble consequences. Brexit was Bubble fallout.

I am most nervous because I see no dialing back Government Finance Quasi-Capitalism. Government intervention – in the U.S., Europe, Japan, China and EM – has been so egregious and overpowering that retreat has become unthinkable. Policymakers would have to admit to historic misjudgment – and then be willing to accept the consequences of reversing course. Global markets and economies are now fully dependent upon aggressive fiscal and monetary stimulus. Bubbles are in the process of “going to unimaginable extremes – and then doubling!” Bursting Bubbles will evoke finger-pointing and villainization. That’s when the geopolitical backdrop turns frightening.

This week, the Bank of England (BOE) surprised the markets with a move to even more aggressive monetary stimulus. Global central bankers these days all play from similar playbooks, although when presented with the opportunity each takes their whirl at experimentation. Bank of England Governor Mark Carney’s announcement that the BOE would commence corporate bond purchases solidified the market view that global central bankers will increasingly look to corporate debt for QE fodder. The BOE also announced a new lending facility, hoping to entice banks into lending more aggressively.

Minsky’s phases of capitalistic evolution were U.S.-focused. It’s disturbing that Government Finance Quasi-Capitalism has evolved into such powerful global phenomenon. This ensures market fragilities and economic maladjustment on a globalized and highly correlated basis. Thus far, global central bankers have maintained a rather consistent and concerted approach. Central banks seem to collectively recognize that they are together trapped in the same dynamic. This has encouraged cooperation and coordination. At some point, however, zero-sum game dynamics will prevail.

I’ve briefly touched upon the misallocation of real and financial resources, along with attendant social, political and geopolitical risks associated with economic stagnation and gross wealth inequalities. One can these days see the “third world” as increasingly chaotic. One can as well see EM regressing toward more “third world” tendencies. And in the developed U.S. and Europe, in particular, one can witness more EM-like tendencies of wealth inequality, polarized societies, corruption and political instability.

There’s another key facet of Government Finance Quasi-Capitalism: A troubled global banking sector. Sinking stock prices seem to confirm that banks are a big loser, as governments impose command over financial relationships and economic structure. This is a complex subject. I would argue that governments have placed banking institutions in a difficult – perhaps dire – predicament. In general, banks have become increasingly vulnerable to mounting financial and economic vulnerability. Highly leveraged banking systems from the UK to China will have no alternative than to lend, no matter the degree of policy-induced financial and economic instability. And the more government policies inflate asset prices (including U.S. housing), the more these assets Bubbles will depend on ongoing bank lending support.

Moreover, keep in mind that banking systems have been delegated the task of intermediating central bank Credit (largely) into bank deposits. Central bank issued Credit (IOUs) ends up chiefly on commercial bank balance sheets, banks having accepted central bank funds in exchange for new bank deposit “money”. So in this high-risk backdrop of government-induced market distortions, banks are building increasingly risky loan books (and “investment” portfolios) while sitting on specious (and inflating) holdings of central bank and government obligations. And this high-risk structure works only so long as Credit – central bank, government and financial sector – continues to expand.

Government Finance Quasi-Capitalism really amounts to a Hyman Minsky “Ponzi Finance” dynamic on an unprecedented global scale. Worse yet, the greatest impairment unfolds right in the heart of contemporary “money” and Credit.

It’s worth noting that despite Friday’s 4.9% surge Italian Bank Stocks sank 6.2% this week (down 51% y-t-d). Japan’s TOPIX Bank Index dropped 3.1% (down 32% y-t-d). Japanese 10-year JGB yields jumped 10 bps to a three-month high negative 10 bps. Ten-year Treasury yields rose 14 bps this week. There’s an increasingly unpredictable element to the U.S. Bubble Economy that should keep the Federal Reserve and the bond market uneasy. Currency market instability persists. The pound remains vulnerable, while the yen is curiously resilient. EM is a mystery wrapped inside an enigma. And if bond yields begin to surprise on the upside, a whole lot of “money” is going to be positioned on the wrong side of an extremely Crowded Trade.

For the Week:

The S&P500 added 0.4% to a new record high (up 6.8% y-t-d), and the Dow gained 0.6% (up 6.4%). The Utilities sank 2.6% (up 17.7%). The Banks jumped 2.0% (down 4.2%), and the Broker/Dealers rose 2.0% (down 6.5%). The Transports increased 0.3% (up 4.8%). The S&P 400 Midcaps added 0.2% (up 11.7%), and the small cap Russell 2000 gained 0.9% (up 8.4%). The Nasdaq100 advanced 1.3% (up 4.3%), and the Morgan Stanley High Tech index rose 1.4% (up 7.0%). The Semiconductors gained 0.9% (up 16.6%). The Biotechs jumped 2.0% (down 9.4%). Though bullion was down $15, the HUI gold index was little changed (up 147%).

Three-month Treasury bill rates ended the week at 26 bps. Two-year government yields rose six bps to 0.72% (down 33bps y-t-d). Five-year T-note yields jumped 12 bps to 1.14% (down 61bps). Ten-year Treasury yields surged 14 bps to a seven-week high 1.59% (down 66bps). Long bond yields jumped 14 bps to 2.32% (down 70bps).

Greek 10-year yields jumped 14 bps to 8.12% (up 80bps y-t-d). Ten-year Portuguese yields declined six bps to 2.84% (up 32bps). Italian 10-year yields slipped three bps to 1.13% (down 43bps). Spain’s 10-year yield were unchanged at 1.01% (down 76bps). German bund yields rose five bps to negative 0.07% (down 69bps). French yields gained five bps to 0.15% (down 84bps). The French to German 10-year bond spread was unchanged at 22 bps. U.K. 10-year gilt yields dipped one basis point to 0.67% (down 129bps). U.K.’s FTSE equities index advanced 1.0% (up 8.8%).

Japan’s Nikkei equities index dropped 1.9% (down 14.6% y-t-d). Japanese 10-year “JGB” yields surged 10 bps to negative 0.10% (down 36bps y-t-d). The German DAX equities index increased 0.3% (down 3.5%). Spain’s IBEX 35 equities index declined 0.6% (down 10.5%). Italy’s FTSE MIB index fell 1.3% (down 22.4%). EM equities were mixed. Brazil’s Bovespa index added 0.6% (up 33%). Mexico’s Bolsa dropped 1.1% (up 9.8%). South Korea’s Kospi index was little changed (up 2.9%). India’s Sensex equities was about unchanged (up 7.5%). China’s Shanghai Exchange slipped 0.1 (down 15.9%). Turkey’s Borsa Istanbul National 100 index gained 0.9% (up 6.0%). Russia’s MICEX equities index was unchanged (up 10.4%).

Junk bond mutual funds saw outflows jump to $2.464 billion (from Lipper).

Freddie Mac 30-year fixed mortgage rates fell five bps to a near-record low 3.43% (down 48bps y-o-y). Fifteen-year rates declined four bps to 2.74% (down 39bps). Bankrate’s survey of jumbo mortgage borrowing costs had 30-yr fixed rates down seven bps to 3.62% (down 48bps).

Federal Reserve Credit last week fell $8.9bn to $4.426 TN. Over the past year, Fed Credit declined $21.5bn. Fed Credit inflated $1.615 TN, or 58%, over the past 195 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt declined $1.3bn last week to $3.219 TN. “Custody holdings” were down $136bn y-o-y, or 4.1%.

M2 (narrow) “money” supply last week surged $49.7bn to a record $12.933 TN. “Narrow money” expanded $879bn, or 7.3%, over the past year. For the week, Currency increased $2.2bn. Total Checkable Deposits gained $3.5bn, and Savings Deposits surged $41.2bn. Small Time Deposits were unchanged, while Retail Money Funds rose $2.8bn.

Total money market fund assets jumped $24bn to $2.739 TN. Money Funds rose $69bn y-o-y (2.6%).

Total Commercial Paper declined $3.9bn to a 2016 low $1.022 TN. CP declined $45bn y-o-y, or 4.2%.

Currency Watch:

August 4 – Wall Street Journal (Saumya Vaishampayan and Takashi Nakamichi): “Investors largely ignored jawboning by Japanese currency officials aimed at stemming the yen’s rise, suggesting that Tokyo is losing its influence on the market. ‘My understanding is that there have been movements that are quite biased, one-sided and speculator-driven,’ Masatsugu Asakawa, vice finance minister for international affairs, told reporters following a meeting… with senior Bank of Japan officials. ‘We will pay the closest possible attention [to the yen] and watch it intensely to ensure that speculator-driven movements won’t accelerate, and if necessary, we will take firm action,’ Mr. Asakawa said.”

The U.S. dollar index gained 0.7% to 96.24 (down 2.5% y-t-d). For the week on the upside, the Brazilian real increased 1.2%, the Australian dollar 0.3% and the Japanese yen 0.2%. For the week on the downside, the British pound declined 1.2%, the Swiss franc 1.2%, the South African rand 1.1%, the Canadian dollar 1.1%, the euro 0.8%, the New Zealand dollar 0.8%, the Norwegian krone 0.7%, and the Swedish krona 0.1%. The Chinese yuan declined 0.4% versus the dollar (down 2.6% y-d-t).

Commodities Watch:

August 5 – Financial Times (Neil Hume and Henry Sanderson): “Investors have pumped more than $50bn into commodities this year, chasing a recovery in oil prices while falling interest rates have increased the attraction of haven assets like gold. The inflows mark the best start to a year since 2009… The new money, combined with rising prices, have pushed total commodity assets under management to $235bn, up from a low of $161bn reached at the end of 2015.”

The Goldman Sachs Commodities Index rallied 0.8% (up 9.7% y-t-d). Spot Gold declined 1.1% to $1,336 (up 26%). Silver fell 3.2% to $19.73 (up 43%). WTI Crude recovered 53 cents to $41.98 (up 13%). Gasoline rallied 4.1% (up 8%), while Natural Gas fell 3.5% (up 18%). Copper sank 3.2% (up 1%). Wheat gained 2.0% (down 12%). Corn fell 2.5% (down 7%).

Turkey Watch:

August 5 – Bloomberg (Constantine Courcoulas): “The fate of billions of dollars in investments in Turkish bonds hangs in the balance as Moody’s… prepares to reveal whether it’s handing the country a second junk rating on its debt. Moody’s, which put Turkey on review for a downgrade immediately after a failed military plot to oust the government last month, currently ranks the nation’s debt at Baa3, its lowest rung within investment grade. A rating review is scheduled for Friday and derivatives traders are already treating it as speculative, with the score implied by credit default swaps at Ba3, three steps into high-yield territory…”

Brexit Watch:

August 4 – Wall Street Journal (Jason Douglas and Paul Hannon): “The Bank of England cut its benchmark interest rate to the lowest in its 322-year history and revived a financial crisis-era bond-buying program to cushion the U.K. economy from the aftershocks of the vote to leave the European Union. Thursday’s unexpectedly large and diverse stimulus package—which included a torrent of cheap cash for banks—underscores the concern at the central bank following the June 23 referendum… The stimulus package contained four elements. The BOE cut its benchmark interest rate to 0.25% from 0.5% and said it expects to cut it further toward zero in the months ahead. It revived a program to buy U.K. government bonds that has been on pause since 2012, and announced it would begin buying corporate bonds, too. The final part was a new term-funding program for banks, offering lenders ultracheap four-year loans to finance lending to households and businesses.”

August 3 – Reuters (Costas Pitas): “House prices in London’s most expensive areas recorded their biggest fall in nearly seven years in July after the Brexit vote reinforced a downward trend caused by a rise in property taxes, a consultancy said… Knight Frank’s prime central London index fell 1.5% last month from a year earlier… ‘Since the vote, a number of buyers have requested discounts due to the climate of political and economic uncertainty,’ Head of London Residential Research Tom Bill said.”

Europe Watch:

August 4 – Bloomberg (Sofia Horta E Costa and Justin Villamil): “Europe’s banking shares are back in the limelight for all the wrong reasons. On Tuesday, the second day of trading since stress tests showed almost all euro-area lenders would have sufficient capital to cope with a crisis, Germany’s Commerzbank AG and Deutsche Bank AG tumbled to fresh record lows, dragging a Stoxx Europe 600 Index gauge of their peers towards its biggest two-day loss in almost four weeks. ‘I don’t want to say it, but it’s Armageddon for the banks,’ if the index drops any further, said Joe Tracy, head of continental European equities at Svenska Handelsbanken… As recently as July last year, shares of European banks were worth the most since 2008. They’ve lost about 40% of their value since then, or more than half a trillion euros ($560bn)…”

August 5 – Bloomberg (Stephen Morris): “European banks have pushed back profitability targets so many times, the dates are now more placeholders than deadlines. Eight years after the financial crisis hit its peak, several of the region’s lenders said they’ll probably need more time to reach the return on equity goals they set for the next few years… The commentary has been almost uniform across the industry and is bad news for a sector that’s already seen dramatic share-price declines. The European Stoxx 600 Banks Index has fallen 32% this year and the 30 firms it tracks trade on average at half their book value…”

August 1 – Bloomberg (Camila Russo): “While the stress tests showed most of the region’s banks would keep an adequate level of capital in a crisis, investors remained skeptical about the results. Lenders in the benchmark Stoxx Europe 600 Index slipped 1.8%, reversing a gain of as much as 1.3%. UniCredit SpA sank 9.4%, while Britain’s Barclays Plc dropped 2% as it fared worse than Deutsche Bank AG, down 1.8%… The stress-test results come at a time of growing pessimism about the industry, whose shares have already slumped the most among sectors this year.”

August 1 – Reuters (Robert Muller and Marcin Goclowski): “Factory activity in the Czech Republic unexpectedly shrank in July for the first time since April 2013 and barely grew in Poland, surveys showed on Monday, suggesting a decline in output ahead. Central Europe’s growth has outpaced most of the European Union’s, but it now faces a slowdown in EU development funds as a new funding period gets under way.”

Fixed-Income Bubble Watch:

August 1 – Bloomberg (Sally Bakewell): “Foreign buyers are poised to push their record 40% share of the U.S. corporate-bond market even higher as they seek to escape negative yields that have swept the globe. While Europe is the biggest overseas owner of the debt with 80% of the foreign holdings, investors from Asia were the fastest-growing buyers, according to Nathaniel Rosenbaum at Wells Fargo… Bond buyers are pouring into U.S. corporate securities as European Central Bank policies aimed at stimulating growth push yields on more and more sovereign and company debt below zero. The declines were extended in June after the ECB expanded asset purchasing to include corporate bonds, a move that helped drive yields on a record 496 billion euros ($554bn) of highly rated corporate bonds into negative territory…”

Global Bubble Watch:

August 5 – Wall Street Journal (Sam Goldfarb and Christopher Whittall): “Central banks have a new favorite tool for boosting lackluster growth: corporate-debt purchases. Two months after the European Central Bank started buying corporate bonds, the Bank of England said Thursday that it would adopt a similar strategy. It will buy as much as £10 billion ($13.33bn) of U.K. corporate debt starting in September as part of a larger package of stimulus measures, including £60 billion of additional government-bond purchases… But the decision again raises concerns about possible side effects of unconventional monetary policies, including excessive risk taking by investors… In the U.S., the average yield of investment-grade corporate bonds was 2.85% Wednesday, compared with 3.67% at the end of 2015… The average spread to Treasury yields also has shrunk, to 1.48 percentage points from 1.72. Companies have issued $519.2 billion of investment-grade corporate bonds this year, just below their pace at this time last year when issuance ultimately reached a record $794.6 billion…”

July 31 – Bloomberg (Thomas Black): “Corporate earnings are heading for a fifth straight quarter of declines, dragged down mostly by energy companies’ struggles with low oil prices and a tepid global economy that threatens to throttle sales growth in many industries… The global economy is forecast to expand 2.9% this year… That’s the lowest rate since 2009… With about two-thirds of Standard & Poor’s 500 Index members having reported, earnings have declined 3.3% from a year earlier and sales have slumped 0.5%… Asia and Europe have fared worse. With 294 companies on the MSCI AC Asia Pacific Index having announced results, earnings have plummeted 19%. In Europe, profits have dropped 14% with results in from almost two-thirds of companies on the Stoxx Europe 600 Index.”

August 4 – Bloomberg (Sid Verma): “A global fight for yield has boosted the appeal of dividend-juicy stocks around the world. What’s surprising is where developed-market investors are now staging this battle — in emerging market stocks — and the justification that’s involved: low bond yields in their usual domain. ‘Investors are switching into EM stocks for yield ‘income’ given a lack of bond income in developed markets,’ UBS AG analysts led by Geoff Dennis write… That turns on its head the traditional way that investors have viewed EM equities. The stocks are typically seen as a bet on rising global growth prospects and as such, are bought for capital gain rather than income.”

August 2 – Bloomberg (Katia Dmitrieva and Natalie Obiko Pearson): “The walls of Clarence Debelle’s Vancouver office on Canada’s west coast are lined with gifts from his real estate clients: jade and turtle dragon figurines; bottles of baijiu, a traditional Chinese alcohol; and enough special-edition Veuve Clicquot to fuel several high-end cocktail parties. They are the product of Vancouver’s decade-long real estate frenzy. The city… has long been one of the world’s most expensive places to live but price gains have reached a whole new level of intensity this year. Low interest rates, rising immigration, and a surge of foreign money—particularly from China—have all driven the increases. Consider the latest milestones: • The cost of a single-family home surged a record 39% to C$1.6 million ($1.2 million) in June from a year earlier. • More than 90% of those homes are now worth more than C$1 million, up from 65% a year earlier…”

August 4 – Bloomberg (Yuji Nakamura and Lulu Yilun Chen): “Bitcoin plunged, then erased losses Wednesday as one of the largest exchanges halted trading because hackers stole about $65 million of the digital currency…. Prices dropped 7.8% on Tuesday after declining 6.2% Monday.”

August 1 – Bloomberg (Marton Eder and Krystof Chamonikolas): “Some nations don’t even need a government for investors to snap up bonds and send their borrowing costs to record lows in the post-Brexit hunt for yield. That’s what’s happening in Croatia, whose Eurobonds are heading for their fifth straight quarterly gain even after the country’s government imploded in June, triggering early elections.”

U.S. Bubble Watch:

August 5 – Bloomberg (Michelle Jamrisko): “Employment jumped in July for a second month and wages climbed, pointing to renewed vigor in the U.S. labor market that will sustain consumer spending into the second half of the year. Payrolls climbed by 255,000 last month, exceeding all forecasts…, following a 292,000 gain in June… The jobless rate held at 4.9% as many of the people streaming into the labor force found jobs.”

August 5 – Reuters: “The U.S. trade deficit rose to a 10-month high in June as rising domestic demand and higher oil prices boosted the import bill while the lagging effects of a strong dollar continued to hamper export growth. The… trade gap increased 8.7% to $44.5 billion in June, the biggest deficit since August 2015.”

July 31 – Financial Times (Allistair Gray): “US banks have ramped up lending to consumers through credit cards and overdrafts at the fastest pace since 2007, triggering concerns that they are taking on too much risk in a slowing economy. The industry has piled on about $18bn of card loans and other types of revolving credit within just three months, as consumers borrow more and banks battle for customers with air miles, cashback deals and other offers.”

August 1 – Wall Street Journal (Josh Mitchell): “The U.S. government desperately wants Mr. Osborne and his wife to start repaying their combined $46,500 in federal student debt. But they are among the more than seven million Americans in default on their loans, many of them effectively in a standoff with the government. These borrowers have gone at least a year without making a payment—ignoring hundreds of phone calls, emails, text messages and letters from federally hired debt collectors. Borrowers in long-term default represent about 16% of the roughly 43 million Americans with student debt, now totaling $1.3 trillion across the U.S., and their numbers have continued to climb despite the expanding labor market. Their failure to repay… threatens to leave taxpayers on the hook for $125 billion, the total amount they owe.”

August 2 – Financial Times (James de Bunsen): “Investor positioning is as extreme as it has been since the dotcom bubble. In a neat bit of symmetry, it is some of the assets that were so detested at that time that now look most overinflated. Low volatility, high quality and defensive, with a yield, please — nothing else will do. Investors are continually having to convince themselves that these lofty valuations and record-low yields are merited because growth is anaemic, deflationary forces abound and rate rises are years away. Nevertheless, we believe that changing perceptions over monetary and fiscal policy could overwhelm these factors and cause a meaningful and painful rotation within markets.”

July 29 – CNBC (Jon Marino): “The market is showing signs that companies can’t keep issuing dividends to investors at the record pace they have developed, and the hunt for yield just got a little harder. Vanguard is shutting new investors out of its $30 billion Dividend Growth mutual fund, which has seen $3 billion in cash inflows over the last 6 months and nearly doubled in size in the last three years… ‘Vanguard is proactively taking steps to slow strong cash flows to help ensure that the advisor’s ability to produce competitive long-term results for investors is not compromised,’ Vanguard CEO Bill McNabb said…”

August 4 – Wall Street Journal (Austen Hufford): “Fannie Mae said it would send a $2.9 billion dividend payment to the U.S. Treasury in September as revenue and profit declined sharply in its latest quarter amid low interest rates. The… company posted net income of $2.95 billion for the second quarter, down from $4.64 billion a year prior and $1.14 billion in the first quarter. Revenue dropped 12% to $5.46 billion. The drop in profit was driven primarily by falling long-term interest rates, which hurt the value of derivatives Fannie uses to manage risk.”

China Bubble Watch:

August 3 – Reuters: “China will use multiple monetary policy tools and maintain ample liquidity and reasonable growth in lending and overall credit in the second half of the year, the central bank said… The People’s Bank of China (PBOC) will maintain a prudent monetary policy and fine-tune it as necessary, according to a summary of an internal meeting posted on the bank’s website.”

August 4 – Financial Times (Don Weinland): “China’s banking regulator has warned companies not to use the word ‘bank’ in their names following a series of scandals and multibillion-dollar investment scams. Several outfits posing as accredited financial institutions have been exposed by the regulator in the past year… An international trade union spotted a company whose name included the words ‘Goldman Sachs’ operating in Shenzhen… Misappropriation of the title touches a nerve with China’s financial regulators, which worry about social unrest stemming from plundered investments. Roger Ying, founder of Pandai, a peer-to-peer lending platform in Beijing, said: ‘Bank is a very sensitive word as it implies government ownership. Banks are there to instil confidence in the people. Thus authorities don’t want other financial services companies to be using the word ‘bank’ to raise funds illegitimately if they don’t have a banking licence.’”

August 1 – Bloomberg: “A Chinese shipbuilder said it may not be able to repay bonds due this week, highlighting rising default risks in the nation as the economy slumps. Wuhan Guoyu Logistics Industry Group Co. said there is uncertainty if it can repay the 400 million yuan ($60.2 million) of notes due Aug. 6 because of a capital shortage… Chinese companies are struggling with record debt payment in the second half as Premier Li Keqiang seeks to cut overcapacity even after the economy grew at the slowest pace in a quarter century. At least 17 bonds have defaulted this year, already exceeding the seven for all of 2015.”

Japan Watch:

August 3 – Reuters (Stanley White): “At least two members of the Bank of Japan’s board questioned its actions at their June meeting, minutes show, highlighting doubts about the sustainability of its policies. At the June meeting one board member called for the BOJ to reduce its bond buying while another said the BOJ had switched its focus to interest rates away from buying assets. At a subsequent meeting on July 29 the BOJ surprised investors by saying it would release a comprehensive review of its quantitative easing in September, further reinforcing the view that the BOJ’s current policy may be reaching its limit… The BOJ currently buys 80 trillion yen a year of Japanese government bonds to reach its 2% inflation target.”

July 31 – Reuters (Stanley White): “The Bank of Japan’s review of its monetary stimulus program promised for September has revived expectations it could adopt some form of ‘helicopter money’, printing money for government spending to spur inflation. The BOJ disappointed market hopes… that it might increase its heavy buying of government debt or lower already negative interest rates, cementing the view that it is running out of options within its existing policy framework to lift prices and end two decades of deflationary pressure. With little to show for three years of massive monetary easing, economists say BOJ governor Haruhiko Kuroda’s ‘comprehensive assessment’ of policy could push it into closer cooperation with Prime Minister Shinzo Abe, who announced a fiscal spending package worth more than 28 trillion yen ($275bn)…”

August 2 – Reuters (Tetsushi Kajimoto): “Japanese Prime Minister Shinzo Abe’s cabinet approved 13.5 trillion yen ($132bn) in fiscal measures… even as the central bank fought market speculation that it is preparing to put the brakes on monetary stimulus for the world’s third-biggest economy. The government’s package includes 7.5 trillion yen in spending by the national and local governments, and earmarks 6 trillion yen from the Fiscal Investment and Loan Program… But even before the announcement, Japanese government bonds saw their worst sell-off in more than three years as investors feared the Bank of Japan may ratchet back the pace of its aggressive government bond buying.”

Central Bank Watch:

August 4 – Reuters (Caroline Copley): “There are possibilities to adjust the European Central Bank’s quantitative easing (QE) programme, but it is important not to alter the design, Bundesbank President Jens Weidmann said… ‘With a view to the programme, there are adjustment possibilities. But from my point of view we must be very careful with the configuration,’ Weidmann told weekly Die Zeit. The ECB currently buys bonds weighted to each country’s contribution to the central bank’s capital… Weidmann said an increase in buying bonds from countries with particularly high indebtedness or bad credit ratings would distance the ECB further from its core mandate. ‘If we grant individual countries special conditions or concentrate increasingly on highly-indebted countries than we will blur the lines between monetary policy and fiscal policy somewhat further,’ he told the paper.”

EM Watch:

August 5 – CNBC (Fred Imbert): “Thousands of people from around the world will be flocking the streets of Rio de Janeiro during the 2016 Olympic Games, but the country’s political and economic state of affairs is anything but festive. ‘What was supposed to be an event to [showcase] Brazil to the rest of the world has now become a nightmare,’ Carlos Caicedo, senior principal analyst for Latin America at IHS Markit… told CNBC… ‘The Olympics no longer matter to anyone in Brazil now.’ What people care about is how the country’s huge political and economic crises will be solved, Caicedo said.”

August 4 – Bloomberg (Archana Narayanan): “Saudi Arabian interest-rate swaps climbed this week to levels last seen during the financial crisis, stoking speculation that the central bank needs to step up efforts to ease the country’s liquidity crisis. The five-year swap rate jumped as much as 30 bps this week to 3.70% on Wednesday, the highest close since January 2009, following a 22 bps increase in July. The central bank offered domestic lenders about 15 billion riyals ($4bn) in short-term loans at a discounted rate at the end of June, people familiar with the matter said last month.”

July 31 – Bloomberg (Archana Narayanan, Matthew Martin and Glen Carey): “Saudi Arabia’s central bank offered lenders short-term loans in late June to help ease liquidity constraints, according to five people familiar with the matter. The Saudi Arabian Monetary Agency, or SAMA, as the central bank is known, offered about 15 billion riyals ($4bn)…”

August 4 – Bloomberg (Y-Sing Liau): “The bad news just doesn’t stop for Asia’s worst-performing currency. Already reeling from a renewed slump in oil prices and a political scandal that just won’t go away, the Malaysian ringgit is now facing the prospect of another cut in interest rates. It’s the region’s biggest loser in the past month… The currency’s slide highlights all is not well as the nation’s economy heads for its worst performance this decade. Crude oil’s plunge to a four-month low this week undermines the finances of net oil exporter Malaysia, while the appeal of its relatively high bond yields is being tempered by the scandals surrounding a troubled state investment fund.”

Leveraged Speculator Watch:

August 3 – Financial Times (Mary Childs and Robin Wigglesworth): “Big hedge funds including Balyasny Asset Management and Tudor Investment Corporation are beefing up their computer-driven approach following seven straight years of investor inflows into the ‘quant’ sector. Some of the industry’s most successful so-called quantitative hedge funds… rely on fast computers, algorithms and data-crunching. They have stood out as the wider industry has struggled to make money and dissatisfied clients have withdrawn funds. The computer-powered hedge fund industry now has almost $880bn of assets under management — up from $408bn in 2009, according to Hedge Fund Research data — and is expected to continue growing.”

Geopolitical Watch:

July 31 – Reuters (Ben Blanchard and Benjamin Kang LIm): “China’s leadership is resisting pressure from elements within the military for a more forceful response to an international court ruling against Beijing’s claims in the South China Sea, sources said… The ruling has been followed in China by a wave of nationalist sentiment, scattered protests and strongly worded editorials in state media. So far, Beijing has not shown any sign of wanting to take stronger action… But some elements within China’s increasingly confident military are pushing for a stronger – potentially armed – response aimed at the United States and its regional allies, according to interviews with four sources with close military and leadership ties. ‘The People’s Liberation Army is ready,’ one source with ties to the military told Reuters. ‘We should go in and give them a bloody nose like Deng Xiaoping did to Vietnam in 1979,’ the source said…”

August 2 – Reuters (Tim Kelly): “Japan’s annual defense review on Tuesday expressed ‘deep concern’ over what it sees as China’s coercion, as a more assertive Beijing flouts international rules when dealing with other nations. Japan’s Defence White Paper comes amid heightened tension in Asia less than a month after an arbitration court in the Hague invalidated China’s sweeping claims in the disputed South China Sea… Japan called on China to adhere to the verdict, which it said was binding. Beijing retorted by warning Tokyo not to interfere. In the defense review approved by Prime Minister Shinzo Abe’s government, Japan warned that ‘unintended consequences’ could result from Beijing’s assertive disregard of international rules. China is poised to fulfill its unilateral demands without compromise…’”

August 2 – CNN (James Griffiths): “China has sent a clear warning to foreigners who enter contested areas of the South China Sea — stay away or you’ll be prosecuted. The warning came in a detailed explanation of last month’s Hague ruling, which found that China’s territorial claims in region have ‘no legal basis’ under the U.N. Convention on the Law of the Sea. China claims almost all of the South China Sea, including islands more than 800 miles (1,200 kilometers) from the Chinese mainland… On Tuesday, the Chinese Supreme People’s Court issued a regulation on judicial interpretation saying there was a ‘clear legal basis for China to safeguard maritime order, marine safety and interests, and to exercise integrated management over the country’s jurisdictional seas.’”

August 5 – Reuters (Michael Martina): “China… accused Japan’s new defense minister of recklessly misrepresenting history after she declined to say whether Japanese troops massacred civilians in China during World War Two. Tomomi Inada, a… lawmaker known for her revisionist views of Japan’s wartime actions, took up her post on Thursday and repeatedly sidestepped questions at a briefing on whether she condemned atrocities committed by Japan. China consistently reminds its people of the 1937 massacre in which it says Japanese troops killed 300,000 people in its then capital.”

August 3 – Reuters (Tim Kelly and Kiyoshi Takenaka): “Tomomi Inada will have precious little time to settle into her new job as Japan’s defense minister, as events on her first day in the office underlined. Hours before the hawkish lawyer was appointed to Prime Minister Shinzo Abe’s cabinet in a limited reshuffle, a North Korean missile landed in or near Japanese-controlled waters for the first time. The show of force, part of Pyongyang’s increasingly provocative arms testing, is a reminder of how strained relations between countries in northeast Asia have become, from North Korea’s nuclear program to China’s assertiveness in the disputed waters of the South and East China Seas. Into the mix steps Inada, a conservative ally of Abe whose support for his goal of revising Japan’s post-war, pacifist constitution risks exacerbating tensions.”

August 3 – Reuters (Ece Toksabay and Nick Tattersall): “President Tayyip Erdogan accused the West of supporting terrorism and standing by coups on Tuesday, questioning Turkey’s relationship with the United States and saying the ‘script’ for an abortive putsch last month was ‘written abroad’. In a combative speech at his palace in Ankara, Erdogan said charter schools in the United States were the main source of income for the network of U.S.-based cleric Fethullah Gulen, who he says masterminded the bloody July 15 putsch. ‘I’m calling on the United States: what kind of strategic partners are we, that you can still host someone whose extradition I have asked for?’ Erdogan said… ‘This coup attempt has actors inside Turkey, but its script was written outside. Unfortunately the West is supporting terrorism and stands by coup plotters,’ he said in comments which were met with applause, and broadcast live.”

August 1 – Financial Times (Guy Chazan): “Germany has said it will not be ‘blackmailed’ by Turkey after Ankara threatened to renounce its March migrant treaty with the EU unless the bloc granted visa-free travel to Turkish citizens. The row over the deal came as Berlin and Ankara clashed over a decision by the German authorities not to let Turkey’s president address a pro-democracy rally in Cologne at the weekend by video link… The two disputes highlight the strains that have emerged in the German-Turkish relationship since July 15, when Turkey was rocked by an attempted military coup.”

Weekly Commentary: Don’t Mess with Turkey

July 20 – Financial Times (Eric Platt): “The Turkish lira weakened a new record low against the greenback on Wednesday after the country was cut deeper into junk territory by Standard & Poor’s, with analysts warning Ankara faced unpredictable capital flows that could constrain its levered economy following last week’s failed coup attempt… The rating agency also lowered its opinion of Turkey’s local currency debt one notch to double-B plus, sweeping its lira obligations into junk as well. ‘In the aftermath of the failed coup, we believe that the risks to Turkey’s ability to roll over its external debt have increased,’ said Trevor Cullinan, an analyst with S&P. ‘We expect that given the political uncertainty, Turkey’s policymakers will likely stray from their commitment to enact reforms intended to wean the economy away from its dependence on foreign financing.’ Mr Cullinan said he expected Turkey would have to roll over more than two-fifths of its external debt over the next 12 months, worth roughly $177bn.”

July 20 – JNiMedia: “Erdogan blasted Standard & Poor’s downgrading of Turkey’s rating in the wake of the failed coup. ‘Why are you even interested in Turkey? We’re not part of you… Don’t ever try to mess with us,’ he said.”

Perhaps Standard & Poor’s and fellow rating agencies share keen interest because Turkey and Turkish corporations and financial institutions have over recent years been assertive borrowers in international markets. For the past decade, President Erdogan has championed Turkish economic renaissance, a powerful boom that has been fundamental to his popularity and ascending political power. Unfortunately, it morphed into a Credit-fueled Bubble, with all the associated financial, economic and social consequences. Turkish consumer debt has skyrocketed, fueled by aggressive bank lending. Meanwhile, Turkey’s financial institutions have borrowed aggressively in global inter-bank markets, with much of this debt short-term and denominated in foreign currencies.

The Turkish Credit Bubble gained important momentum as part of the post-2008 global EM funding boom. Estimates have as much as $300 billion having flowed into Turkey over recent years, inflows that accelerated with the 2013 sovereign rating upgrade to investment grade. As a NATO member, aspiring EU nation and key ally in the explosive Middle East, Turkey benefited greatly from the view that Europe, the U.S. and the world, more generally, would not tolerate crisis engulfing Turkey.

Erdogan and his AKP party have been huge beneficiaries of the global funding boom, both financially and politically. Now, with the tide having turned, previous bedfellows – the rating agencies and global finance – will be pilloried and villainized for political advantage. To be sure, they’re a precarious mix of C’s – coups, crackdowns, crackpots, Credit and confidence. It’s worth noting that the domestic purge has expanded past university deans to school teachers to bank regulators.

Turkish stocks dropped 13.4% this week, the “worst week since 2008.” Turkish bank stocks were down 5% on Thursday’s debt downgrade, as sovereign yields surged 26 bps (from Bloomberg). For the week, Turkish sovereign CDS jumped 66 bps to 336 bps (from Reuters). Turkey’s lira declined 1.7% to another record low. In any other environment, Turkey would be facing a crisis of confidence along with a major test for its currency and banking system.

July 21 – Bloomberg (Ercan Ersoy): “Turkey’s failed coup is dealing yet another blow to the nation’s banks, which are already under pressure from rising bad debts and a slump in tourism. Istanbul-based lenders Yapi ve Kredi Bankasi AS and Sekerbank TAS canceled about $800 million of debt sales this week after the attempt to unseat President Recep Tayyip Erdogan and the ensuing political unrest spooked investors… The renewed tension in Turkey, which imposed a three-month state of emergency last night, is hampering access to the funding banks need to cover their short-term debt, while a slumping lira is increasing the risks of lending in foreign currency. The political instability has made a difficult year worse for banks as they contend with a 33% surge in bad loans and soaring bankruptcy filings. ‘Funding for Turkish banks could become more expensive, or even more difficult to access, given their large dependence on market funds and their exposure to the foreign-exchange market in a context where the local currency could be under pressure,’ Moody’s… said…”

July 21 – Fitch Ratings: “Turkish banks’ dependence on foreign market access results from their high level of short-term external debt. We see the level of foreign-currency liquidity at Fitch-rated banks as generally adequate and broadly sufficient to cover short-term foreign-currency liabilities due within one year. However, any significant weakening in creditor sentiment, resulting in net capital outflows, would be likely to put banks’ FX liquidity under some pressure, and would also probably result in further depreciation of the lira. At end-1Q16, banks accounted for $170 billion of Turkey’s $416 billion external debt, with $100 billion of this (including both market funding and more stable sources) maturing within 12 months. The sharp drop in the lira following the attempted coup highlights the banking sector’s exposure to foreign-currency lending risks, with FX-denominated loans making up around a third of the total sector portfolio.”

More from Bloomberg (Ercan Ersoy): ‘Downside risks for Turkish banks’ credit profiles and ratings have increased as a result of the country’s attempted military coup,’ Fitch… said. ‘Turkish banks’ credit profiles are sensitive to country risks, access to foreign credit markets and the lira exchange rate.’ Banks accounted for $170 billion of Turkey’s $416 billion external debt in the first quarter, with $100 billion maturing within a year, according to Fitch.”

The unfolding EM debacle is one of the saddest consequences arising from the U.S. mortgage finance Bubble – turned reflationary QE before transforming into the global government finance Bubble. Throws Trillions of loose finance at the emerging markets and rest assured there will be epic corruption, economic maladjustment and destabilizing social and geopolitical stress. As for corruption and malfeasance, China, Brazil, Russia, Turkey and Malaysia come quickly to mind. Yet it’s systemic, the upshot from what has become a hopelessly dysfunctional global system. Indeed, EM these days has regressed into one big highly synchronized and vacillating Bubble. That EM could now somehow be experiencing record inflows in the face of such financial, economic and social instability is remarkable. There is precedent.

Apparently unappreciated by contemporary central bankers, over-liquefied and speculative markets are by their nature mystifying. They will confound – and seem to revel in doing the exact opposite of what is expected. Bubble markets will undoubtedly behave in a manner that guarantees that the most damage is inflicted upon the largest number of participants. I was in awe as “money” flooded into GSE debt and MBS following the subprime eruption in 2007. The Bubble had been pierced, with Trillions of securities and assets mispriced throughout the markets. Yet speculative impulses and confidence that aggressive monetary stimulus was in the offing ensured prices became only further detached from reality. MBS yields sank 100 bps in the six months preceding early-2008, extending “Terminal Phase” excesses and ensuring that risk markets turned highly correlated – and acutely vulnerable.

July 20 – Reuters (Karin Strohecker): “Developing countries have nearly tripled their external debt over the past decade, outpacing economic growth and increases in foreign exchange reserves – which could leave them open in the future to a ‘systemic crisis’, …Moody’s said… Emerging market governments and companies around the globe have rushed in recent years to take advantage of rock-bottom global borrowing costs and investor hunger for yield. As a result, external debt jumped to $8.2 trillion in 2015 from $3.0 trillion in 2005, the Moody’s report found, thanks largely to private-sector borrowing. The average ratio of external debt to gross domestic product jumped to 54% in 2015 from a decade-low of 40% in 2008. ‘External vulnerability has increased significantly in about 75% of emerging economies globally,’ the authors… wrote. The average ratio of external debt to reserves soared to more than 350% last year from just over 250% in 2007, the report added.”

July 22 – Bloomberg (Alastair Marsh and Siddharth Verma): “Investors are rushing into emerging-market debt so fast they’ve already beaten the record they set two weeks ago. Net inflows to funds that buy emerging-market bonds reached an all-time high in the week through July 20, according to Bank of America Corp. — $4.9 billion, to be precise. That’s over a billion more than the previous record registered only two weeks before, indicating that the “great migration” into the asset class heralded by BlackRock Inc. is rapidly picking up pace… Almost the same amount of money’s been poured into EM equity funds as into bonds. The $4.7 billion invested into EM stock markets over the same week amounts to the most in 12 months…”

A powerful short squeeze throughout EM has at this point morphed into self-reinforcing inflows. Recent outperformance has incited the mammoth – and fidgety – trend-following and performance-chasing Crowd. Of course, global QE and zero rates have been instrumental. Moreover, the policy-induced market dislocation that has created $12 Trillion of negative-yielding sovereign debt has unleashed another powerful round of global yield-chasing flows – right in the face of fundamental deterioration. Importantly, EM outperformance has worked to further synchronize global markets into one big highly-correlated speculative melee, a Bubble resting precariously on simple faith that central banks have it all under control.

Chairman Greenspan used to posit (rationalize) that since real estate markets were a local phenomenon a national real estate Bubble was implausible. I countered that the Bubble was in mortgage finance and that a centralized mortgage finance Bubble was exerting a powerful nationwide inflationary dynamic. “Terminal Phase” excess proved so powerful that a tidal wave of inflationary finance essentially lifted all boats.

These days, a similar dynamic has taken hold on a global basis, across asset classes. It’s a backdrop that continues to wreak havoc upon active fund managers – those more likely to incorporate micro and macro analysis along with risk control. It’s an atypical backdrop that continues to reward passive “management,” unencumbered by analysis and risk management. And as “money” floods in to play high-dividend payers, high-yield, low-beta, “defensive”, “smart-beta,” and EM, an inflating market forces short-covering, the unwinding of hedges and capitulation “gotta jump aboard ‘cause I can’t afford to miss the rally” flows. It boils down to one singular speculative bet on “the market.” All-time highs into an alarming, faltering fundamental backdrop? It happened in late-2007. What others label “bull market” I view as market dislocation.

For the Week:

The S&P500 increased 0.6% (up 6.4% y-t-d), and the Dow added 0.3% (up 6.6%). The Utilities gained 1.5% (up 22.3%). The Banks increased 0.4% (down 7.6%), and the Broker/Dealers advanced 1.3% (down 9.6%). The Transports slipped 0.2% (up 6.1%). The S&P 400 Midcaps increased 0.6% (up 11.0%), and the small cap Russell 2000 gained 0.6% (up 6.8%). The Nasdaq100 advanced 1.7% (up 1.6%), and the Morgan Stanley High Tech index jumped 2.6% (up 4.5%). The Semiconductors surged 2.6% (up 11.9%). The Biotechs rose 2.6% (down 14.9%). With bullion down $15, the HUI gold index dropped 3.2% (up 133%).

Three-month Treasury bill rates ended the week at 31 bps. Two-year government yields gained three bps to 0.70% (down 35bps y-t-d). Five-year T-note yields increased two bps to 1.12% (down 63bps). Ten-year Treasury yields rose two bps to 1.57% (down 68bps). Long bond yields added a basis point to 2.28% (down 74bps).

Greek 10-year yields jumped 18 bps to 7.82% (up 50bps y-t-d). Ten-year Portuguese yields fell eight bps to 3.02% (up 50bps). Italian 10-year yields dipped two bps to 1.23% (down 36bps). Spain’s 10-year yield sank 11 bps to 1.11% (down 66bps). German bund yields declined three bps to negative 0.03% (down 65bps). French yields fell two bps to 0.21% (down 78bps). The French to German 10-year bond spread increased a basis point to 24 bps. U.K. 10-year gilt yields declined four bps to 0.79% (down 117bps). U.K.’s FTSE equities index increased 0.9% (up 7.8%).

Japan’s Nikkei equities index rose 0.8% (down 12.6% y-t-d). Japanese 10-year “JGB” yields increased a basis point to negative 0.23% (down 49bps y-t-d). The German DAX equities index gained 0.8% (down 5.5%). Spain’s IBEX 35 equities index increased 0.8% (down 9.9%). Italy’s FTSE MIB index gained 0.2% (down 21.7%). EM equities were mixed. Brazil’s Bovespa index jumped 2.6% (up 32%). Mexico’s Bolsa advanced 1.8% (up 10.6%). South Korea’s Kospi index slipped 0.3% (up 2.5%). India’s Sensex equities was little changed (up 6.5%). China’s Shanghai Exchange fell 1.4% (down 14.9%). Turkey’s Borsa Istanbul National 100 index sank 13.4% (unchanged). Russia’s MICEX equities slipped 0.7% (up 9.4%).

Junk bond mutual funds saw inflows of $322 million (from Lipper).

Freddie Mac 30-year fixed mortgage rates added three bps to 3.45% (down 59bps y-o-y). Fifteen-year rates increased three bps to 2.75% (down 46bps). Bankrate’s survey of jumbo mortgage borrowing costs had 30-yr fixed rates up four bps to 3.71% (down 41bps).

Federal Reserve Credit last week expanded $7.7bn to $4.439 TN. Over the past year, Fed Credit declined $21.8bn. Fed Credit inflated $1.628 TN, or 58%, over the past 193 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt gained $6.0bn last week to $3.228 TN. “Custody holdings” were down $112bn y-o-y, or 3.4%.

M2 (narrow) “money” supply last week jumped $25bn to a record $12.847 TN. “Narrow money” expanded $822bn, or 6.8%, over the past year. For the week, Currency increased $0.2bn. Total Checkable Deposits jumped $21.4bn, and Savings Deposits gained $5.9bn. Small Time Deposits were little changed. Retail Money Funds slipped $2.5bn.

Total money market fund assets declined $5.6bn to $2.715 TN. Money Funds rose $66bn y-o-y (2.5%).

Total Commercial Paper expanded $5.3bn to $1.053 TN. CP expanded $6bn y-o-y, or 0.5%.

Currency Watch:

The U.S. dollar index gained 0.7% to 97.35 (down 1.4% y-t-d). For the week on the upside, the South African rand increased 1.9%, the Brazilian real 0.7% and the Mexican peso 0.3%. For the week on the downside, the New Zealand dollar declined 1.7%, the Australian dollar 1.5%, the Canadian dollar 1.2%, the Japanese yen 1.2%, the Norwegian krone 0.8%, the British pound 0.6%, the euro 0.5% and the Swiss franc 0.4%. The Chinese yuan increased 0.2% versus the dollar (down 2.9% y-d-t).

Commodities Watch:

The Goldman Sachs Commodities Index sank 3.3% (up 12% y-t-d). Spot Gold declined 1.1% to $1,323 (up 25%). Silver gave back 3.0% to $19.69 (up 43%). WTI Crude dropped $1.69 to $44.26 (up 20%). Gasoline sank 4.4% (up 7%), while Natural Gas added 0.7% (up 19%). Copper was little changed (up 5%). Wheat was about unchanged (down 10%). Corn lost 3.0% (down 5%).

Turkey Watch:

July 21 – Bloomberg (Constantine Courcoulas and Tugce Ozsoy): “Turkish stocks and bonds tumbled on concern further credit downgrades will spark an exodus of capital after President Recep Tayyip Erdogan imposed a three-month state of emergency on the nation following the failed weekend coup. The Borsa Istanbul 100 Index declined 4.4% Thursday, reversing this year’s gains and is headed for its worst week since 2008. The nation’s 10-year local currency government bonds fell for a fifth day.”

July 21 – Reuters (Samia Nakhoul, Nick Tattersall and Orhan Coskun): “Turkish President Tayyip Erdogan promised on Thursday to quickly restructure the armed forces in order to prevent another coup attempt, signaling a major overhaul in the military as emergency rule took hold across the country. Erdogan’s comments… come as Turkey seeks to assure its citizens and the outside world that the government was not turning its back on democracy and returning to the harsh repression of past regimes… Opposition parties which stood with the authorities against the coup expressed concern that the state of emergency could concentrate too much power in the hands of Erdogan, whose rivals have long accused him of suppressing free speech. About 60,000 soldiers, police, judges, civil servants and teachers have been suspended, detained or have been placed under investigation since the coup was put down.”

July 20 – Washington Post (Loveday Morris and Hugh Naylor): “Turkey declared a state of emergency on Wednesday, a move that President Recep Tayyip Erdogan said would enable the state to act faster against those who plotted a failed coup. In a late-night televised address, Erdogan, who has been carrying out a large-scale purge of the country’s institutions, sought to reassure the country that the measure — which would be in force for three months — will protect democratic freedoms. But the move consolidates more power in the president’s hands, allowing him to rule by decree. For the state of emergency to be implemented, the decision must be approved by parliament… Turkey’s countermeasures have affected more than 50,000 people — judges, civil servants, military, police and others — as the country’s leaders seek to root out opponents and perceived internal dissent… ‘The cleansing is continuing, and we remain very determined,’ Erdogan said. He described a ‘virus’ within the Turkish military and state institutions that had spread like ‘cancer.’”

July 21 – Bloomberg (Sujata Rao and Asli Kandemir): “Turkey’s botched coup and an apparent lurch toward authoritarianism is ratting investors and threatens to throw into reverse the hundreds of billions of dollars that have flowed to this once-booming emerging market. In the years after its 2001-2002 financial crisis, Turkey rode a wave of bullishness toward emerging markets, and while estimates vary, the Institute of International Finance reckons overseas investors poured more than $150 billion into Turkish stock and bond markets since end-2003. The IIF, one of the most authoritative trackers of capital to and from the developing world, also calculates bricks-and-mortar direct investment (FDI) into Turkish factories and property at $163 billion.”

July 19 – Financial Times (Thomas Hale, Katie Martin and Mehreen Khan): “Turkey’s fourth-largest lender pulled a US dollar-denominated bond deal that recently priced, a rare move that marks escalating investor aversion towards the country after a failed coup. Yapı ve Kredi Bankası said… it had cancelled the seven-year, $550m bond ‘due to the recent negative developments and the ensuing market volatility’. The bond priced on July 12, with a yield of 4.625%, was twice oversubscribed, and had been due to settle on Tuesday.”

July 22 – Bloomberg (Onur Ant, Isobel Finkel ad Ercan Ersoy): “Turkey is requesting that some banks with offices in the country share the market analysis they’ve written after Friday night’s failed coup attempt, according to three people familiar with the matter. The banking regulator contacted at least three international investment banks to formally request the macroeconomic reports they’ve sent to clients in recent days, the people said, asking not to be identified because of the subject’s sensitivity. A day after S&P Global Ratings downgraded Turkey’s credit rating to a further notch under investment grade, the head of the country’s banks regulator has also cautioned against talking down the economy. ‘We disapprove of our banks publishing reports that would turn expectations and the atmosphere negative, like the international credit rating agencies did,’ Mehmet Ali Akben, head of the banking regulator BDDK, was reported as saying by the state-run Anadolu Agency…”

July 16 – Reuters (David Brunnstrom and Jeff Mason): “Secretary of State John Kerry told Turkish Foreign Minister Mevlut Cavosoglu on Saturday that public claims suggesting the United States was involved in the failed coup in Turkey were harmful to relations between the two NATO allies. Kerry pressed Turkey to use restraint and respect the rule of law during its investigation into the plot, State Department spokesman John Kirby said…”

Europe Watch:

July 21 – Bloomberg (Alessandro Speciale): “As worries that the European Central Bank will soon run out of sovereign debt to buy for its quantitative-easing program persist, Europe’s over-leveraged governments are declining to lend a hand. According to a study by JPMorgan…, net issuance of new debt this year will fall well short of the ECB’s appetite, which runs at a monthly clip of 80 billion euros ($88bn). While that’s just a drop in the ocean compared with the total ‘eligible universe,’ the data illustrate the speed with which the central bank is eating up the market. The ECB’s demand for bonds this year was in fact about three times of what governments will put on the market.”

Brexit Watch:

July 22 – Reuters (Andy Bruce and Douglas Busvine): “Britain’s economy is shrinking, the broadest survey of business confidence since last month’s historic vote to quit the European Union showed on Friday, leading finance minister Philip Hammond to pledge a loosening of purse strings if the weakness endures. The Bank of England has also been clear that easing monetary policy may be necessary. The flash, or preliminary, Markit survey of purchasing managers… fell by the most in its 20-year history.”

Italy Watch:

July 21 – Financial Times (Claire Jones): “Mario Draghi backed a public bailout of Italy’s troubled banks ‘in exceptional circumstances’, even as he hailed the eurozone for its resilience in the aftermath of Britain’s decision to quit the EU and left interest rates on hold. The remarks by the president of the European Central Bank… helped alleviate concerns about Italian lenders, which have been weighed down by a heavy burden of bad debt and non-performing loans and whose shares have been depressed after the British referendum stoked fears about EU cohesion… European bank stocks, led by Italian lenders, rallied after he described a state backstop as a ‘very useful’ way to help banks rid their books of non-performing loans — a problem the ECB president said was making his central bank’s policies less effective.”

July 19 – Financial Times (Stephanie Bodoni): “The European Union’s top court backed EU guidelines designed to prevent taxpayers from footing the bill for bailing out stricken lenders, strengthening the hand of Brussels regulators as Italy fights to shield some bondholders caught up in the nation’s banking crisis. Tuesday’s decision is a show of support for the European Commission, which updated its crisis rules for banks in 2013 as part of a shift from taxpayer-funded bailouts to bail-in, the practice of imposing possible losses on investors before public money can flow. ‘Burden-sharing by shareholders and subordinated creditors as a prerequisite for the authorization, by the commission, of state aid to a bank with a shortfall is not contrary to EU law,’ according to the EU Court of Justice.”

Central Bank Watch:

July 19 – Bloomberg (Anooja Debnath): “The European Central Bank’s bond-buying program will be scrounging for German debt within months, according to two of the region’s banks. The securities that yield less than the ECB’s minus 0.4 deposit rate have grown to more than 60%, based on a $1.13 trillion Bloomberg German bond index. That means they’re ineligible for the purchases. Analysts from UBS Group AG and SEB AB are estimating the central bank may run out of German targets within six months, and as soon as August, unless the rules are broadened.

July 18 – Reuters (Francesco Canepa): “The European Central Bank snapped up debt of blue-chip names such as BMW, Sanofi and BASF as Germany and France accounted for the lion’s share of its first batch of corporate bond purchases. The ECB has bought 10 billion euros worth of corporate bonds since June 8… The purchases are part of its 80-billion-euros-a-month money-printing programme… Germany’s Bundesbank and the Banque de France, two of the six banks executing the purchases, bought hundreds of bonds between them, compared to a few tens apiece for the central banks of Italy and Spain.”

Fixed-Income Bubble Watch:

July 21 – CNBC (Jeff Cox): “Corporate debt is projected to swell over the next several years, thanks to cheap money from global central banks, according to a report Wednesday that warns of a potential crisis from all that new, borrowed cash floating around. By 2020, business debt likely will climb to $75 trillion from its current $51 trillion level, according to S&P Global Ratings. Under normal conditions, that wouldn’t be a major problem so long as credit quality stays high, interest rates and inflation remain low, and there are economic growth persists. However, the alternative is less pleasant should those conditions not persist.”

July 21 – Bloomberg (Sally Bakewell and Karl Lester M Yap): “It’s getting harder for corporate debt investors to avoid the volume of negative yielding bonds that are now pouring into credit markets. Investors are holding about 465 billion euros ($512bn) of investment-grade company bonds with yields below zero, an eleven-fold increase on the start of the year, according to Bank of America Merrill Lynch data.”

Global Bubble Watch:

July 20 – Financial Times (Roger Blitz): “Pill-popping financial markets are a patient who has swallowed enough central bank medicine to become numb to any shocks, perceived or real. Shocks that previously sent markets into spasms are still being watched closely, but it is not long before they are deemed to have no lasting effect… Consider three events of recent weeks, each with a potentially heart-stopping impact on markets — Brexit, China currency depreciation and Turkey. Brexit has caused barely a tremor beyond sterling, there has been no market seizure from the renminbi’s fall since the start of the year…, while the failed coup against Turkish president Recep Tayyip Erdogan and its repercussions left European stocks, 10-year Treasury yields and the currency market beyond the Turkish lira untroubled… Market commentators say the source for this market sang-froid comes from the doctors administering the pills, the central banks. Since the 2008 financial crisis, policymakers and their meetings, communications and subsequent actions (or inactions) have assumed huge importance to the market.”

July 18 – Financial Times (Rochelle Toplensky): “Yield-hungry investors buoyed by the prospects of further monetary easing have invested $73bn in bond exchange traded funds globally this year. Brexit has meant interest rates are expected to be lower for longer, forcing investors to search for safe assets with a non-negative yield, creating massive demand for bonds that has pushed sovereign debt yields to new lows. ‘EPFR Global-tracked Bond Funds took in over $9bn for the second week running as investors responded to predictions of a rate hike-free remainder of 2016 in the US and fresh monetary tailwinds for emerging markets,’ said EPFR. Flows into long-term US corporate debt set a new record last week and a net $52bn has been invested in US bond ETFs in the year to date.”

July 22 – Bloomberg (Wes Goodman and Anchalee Worrachate): “Japanese investors rushed into foreign debt for a second week, government figures showed… Fund managers in the Asian nation bought a net 1.72 trillion yen ($16.2bn) of medium- and long-term debt abroad in the seven days ended July 15, the Ministry of Finance said. They bought a record 2.55 trillion yen of debt the previous week…”

July 17 – Wall Street Journal (Kim Mackrael): “Low interest rates around the world are fueling a familiar threat of housing bubbles, and central bankers in a number of key economies feel powerless to stop them. The problem is being acutely felt in Canada, where home prices are soaring even as the country’s energy- and mining-dependent economy slows. Sweden and Australia are dealing with similar surges in the value of homes, leading officials in all three countries to worry about the risk of a destabilizing bust.”

July 19 – Wall Street Journal (Jenny Strasburg): “S&P Global Ratings on Tuesday lowered its credit outlook for Deutsche Bank AG to negative from stable, saying market conditions and the U.K.’s decision to leave the European Union are expected to complicate the German lender’s restructuring plans.”

July 19 – Financial Times (Rochelle Toplensky): “Fund managers are buying record amounts of protection against a sharp fall in equities over the next three months while a growing number expect a radical new chapter in monetary stimulus, according to the latest Bank of America Merrill Lynch survey. BAML’s July survey of fund managers said a record net 44% of investors ‘think global fiscal policy is currently too restrictive’ and 39% expect the introduction of so-called helicopter money… by a country in the next 12 months, a 12 percentage point jump from June. Ben Bernanke’s recent meeting with Japanese Prime Minister Shinzo Abe started chatter that the Bank of Japan may introduce some form of helicopter money.”

July 20 – Wall Street Journal (Kelly Crow): “The global art market has gone on a diet. After the recession, seasoned and newcomer collectors alike surged into the world’s chief auction houses to splurge on trophies carrying eye-popping asking prices. Now, art lovers are cutting back, plying fewer $20 million-plus pieces into auctions and increasingly contenting themselves with cheaper, overlooked pieces… On Wednesday, …Christie’s International offered further proof of a downturn when it said it sold $3 billion in art during the first half of the year, down a third from the same period last year. Christie’s latest total included $2.5 billion in auction sales, down 37.5% from a year ago.”

U.S. Bubble Watch:

July 17 – Wall Street Journal (Kate Linebaugh): “More than 90 of the biggest U.S. companies will report results this week, giving a clearer picture of what is expected to be the fourth straight quarter of declining profits. Based on analysts’ forecasts for companies in the S&P 500 index, Thomson Reuters predicted that adjusted earnings per share for the second quarter were down 4.7% from a year earlier. That follows a 5% drop in the first quarter and would be the fourth straight period of declines. Revenue, meanwhile, is expected to slip 0.8%, marking the sixth straight quarter of declines…”

July 18 – Financial Times (Stephen Foley): “The shift of assets from actively managed investment funds to low-cost index trackers accelerated last month, as US stockpicking funds suffered their worst outflows since the financial crisis… While $21.7bn flowed out of actively managed US equity funds in June, the worst monthly figure since October 2008, passive funds, including exchange traded funds, took in $8.7bn… Morningstar’s latest monthly figures show that American savers have now taken $236bn out of active equity funds in the past year, while $229bn has gone into passive equity funds.”

July 21 – Bloomberg (Lexi Nahl): “First-time buyers have returned, helping boost sales of previously owned homes in June to the highest level in more than nine years… Tight supply may impact future sales as inventories dropped 5.8% from a year earlier to 2.12 million units, the lowest for a June since 2001.”

July 21 – Bloomberg (Oshrat Carmiel): “It’s a good time to buy a home in New York’s Hamptons, especially for shoppers with more than $3 million to spend. Sales of luxury homes in the area, known as Wall Street’s beachside retreat, fell 20% in the second quarter from a year earlier to 57 deals, while the number of high-end listings climbed, according to… appraiser Miller Samuel Inc. and brokerage Douglas Elliman Real Estate.”

July 21 – CNBC (Robert Frank): “The number of real estate transactions in the Hamptons fell 21% during the second quarter, adding to evidence that the high end of the housing market is faltering… The average sale price also declined, slipping 0.3% to $1.68 million. The softness in the Hamptons mirrors declines in high-end real estate across the country, from Manhattan penthouses and Miami condos to L.A. mansions.”

China Bubble Watch:

July 22 – Bloomberg (Enda Curran): “China’s weakening currency has triggered an increase in the amount of cash leaving the country, according to… Goldman Sachs… The U.S. bank estimates $49 billion worth of foreign-exchange outflows in June, compared with $25 billion in May…. The yuan fell 1.1% against the dollar and 2.2% versus a trade-weighted index last month.”

July 18 – Reuters (Winni Zhou and Nick Heath): “China has room to increase its fiscal deficit ratio to between 4 and 5% to more effectively boost the economy, official media quoted a central bank official as saying. China’s current fiscal deficit target is 3% of gross domestic product (GDP), up from an actual 2.4% in 2015.”

Japan Watch:

July 21 – Bloomberg (James Mayger and Toru Fujioka): “Bank of Japan Governor Haruhiko Kuroda rejected the idea of helicopter money in comments made last month as investors seek hints on his next policy step as prices fall and growth wanes in the world’s third-largest economy. Given the current institutional setting, at this stage there is ‘no need and no possibility for helicopter money,’ Kuroda said in a BBC Radio 4 program that was aired Thursday and that the broadcaster said was recorded on June 17. ‘At this moment, the Bank of Japan has three options with quantitative and qualitative easing with negative interest rates.’ These current policies can be expanded if needed and there are no significant limitations to further monetary stimulus, he said.”

July 21 – Bloomberg (Toru Fujioka and Masahiro Hidaka): “An increasing number of officials at the Bank of Japan are concerned about the sustainability of the current framework for massive monetary stimulus, according to people familiar with the discussions. Some current and former BOJ officials, including dissenting board member Takahide Kiuchi, have for some time publicly said that the central bank’s unprecedented scale of bond purchases and time frame for achieving its 2% inflation goal is problematic. Now, there’s a broadening sense among some at the BOJ that the bank has to weigh the costs and benefits of policy measures more carefully, according to the people, who asked not to be named…”

EM Watch:

July 21 – Reuters (Karin Strohecker): “Developing countries have nearly tripled their external debt over the past decade, outpacing economic growth and increases in foreign exchange reserves – which could leave them open in the future to a ‘systemic crisis’, ratings agency Moody’s said… Emerging market governments and companies around the globe have rushed in recent years to take advantage of rock-bottom global borrowing costs and investor hunger for yield. As a result, external debt jumped to $8.2 trillion in 2015 from $3.0 trillion in 2005, the Moody’s report found, thanks largely to private-sector borrowing. The average ratio of external debt to gross domestic product jumped to 54% in 2015 from a decade-low of 40% in 2008. ‘External vulnerability has increased significantly in about 75% of emerging economies globally,’ the authors… wrote. The average ratio of external debt to reserves soared to more than 350% last year from just over 250% in 2007, the report added.”

July 21 – Wall Street Journal (Jon Sindreu): “The failed coup in Turkey is spotlighting a problem that threatens to sandbag emerging markets more broadly: burgeoning private debt. In the wake of Turkey’s political turmoil, credit-rating firms warned this week that heightened uncertainty threatens to undermine the country’s economy and the ability of companies to repay their debts. Standard & Poor’s… cut Turkey’s credit rating to double-B, deeper into junk territory. Moody’s… is weighing a downgrade. Economists often point to external debt as a key danger for emerging markets. In the case of Turkey and many other such nations, however, the growing debt pile is mostly home-based. Domestic credit to the Turkish nonfinancial sector has exploded to roughly 70% of gross domestic product, from around 20% in 2000…”

Leveraged Speculator Watch:

July 21 – Bloomberg (Oshrat Carmiel): “The amount of money leaving hedge funds slowed in the second quarter as firms that rely on computer algorithms made money in the selloff following the U.K.’s vote to exit the European Union. The industry saw $8.2 billion in net outflows in the second quarter, about 46% less than in the prior three months, Hedge Fund Research Inc. said… Global hedge fund assets rose by $42.1 billion in the second quarter to nearly $2.9 trillion… Asset growth was the strongest since the first quarter of 2015, boosted by a 2% return for the HFRI Fund Weighted Composite Index. The asset increase ‘was driven by strong quantitative CTA gains on Brexit Friday and broad-based industrywide gains across equity, commodity and currency markets pursuant to the Brexit dislocations,’ HFR President Kenneth Heinz said…”

Geopolitical Watch:

July 20 – Wall Street Journal (Michael Auslin): “In 1933, Japan walked out of the League of Nations after being condemned for invading Manchuria. This act of defiance dealt a blow to liberal internationalists’ hopes that global cooperation could lead to a peaceful resolution of the Asian crisis. It also ended decades of Japanese globalization during the Meiji and Taisho periods and set Tokyo on a path of confrontation with Western powers. The ultimate result was the Pacific War from 1937-45. Could the same thing happen today with China? Beijing’s reaction to last week’s ruling by the Hague-based Permanent Court of Arbitration recalls Tokyo’s rejection of the League’s attempt to rein in great-power competition 85 years ago.”

July 17 – Reuters (Ben Blanchard): “Freedom of navigation patrols carried out by foreign navies in the South China Sea could end ‘in disaster’, a senior Chinese admiral has said, a warning to the United States after last week’s ruling against Beijing’s claims in the area. China has refused to recognize the ruling by an arbitration court in The Hague that invalidated its vast territorial claims in the South China Sea, and did not take part in the proceedings brought by the Philippines.”

July 19 – Financial Times (Roman Olearchyk): “Ukraine’s top military commander promised an ‘adequate response’ after seven Ukrainian soldiers were killed and 14 injured in the past 24 hours in fighting with Russian-backed separatists… The battles mark one of the bloodiest days of fighting this year, as an uptick in the daily shelling and gunfire threatens to reignite full-scale fighting in a smouldering 26-month conflict that has claimed nearly 10,000 lives. The heightened hostilities are also a stark reminder that while last year’s internationally brokered peace accord succeeded in reducing the fighting from peak 2014 levels, the so-called Minsk agreements have failed to deliver a lasting ceasefire…”

July 20 – NBC: “North Korea said on Wednesday it had conducted a ballistic missile test that simulated pre-emptive strikes against South Korean ports and airfields used by the U.S. military… Leader Kim Jong Un guided the launches and expressed his satisfaction with them, the North’s official Korean Central News Agency reported, without saying when the tests happened.”

Doug Noland’s Credit Bubble Bulletin: Sovereign Market Dislocation and Derivatives Turmoil

When I criticized the Fed’s reflationary policies back in 2009 – and initially warned about the emergence of the “global government finance Bubble” – the focus of my concerns was not hyperinflation or a dollar collapse. My worry was the likelihood for massive global fiscal and monetary stimulus to foster a systemic mispricing of “finance” – securities prices and Credit more generally. From this global macro perspective, the outcome has been my worst-case-scenario.