How Do I Hate Thee?

By John Mauldin

Aug 31, 2013

How do I love thee? Let me count the ways.
I love thee to the depth and breadth and height
My soul can reach, when feeling out of sight
For the ends of Being and ideal Grace.
… I love thee with the breath,
Smiles, tears, of all my life! — and, if God choose,
I shall but love thee better after death.

– Elizabeth Barrett Browning (1806-1861)

When I was growing up, Labor Day always marked the official end of summer, since we started school the next day. These days everyone seems to start school sometime in August, but for those of us of a certain age, the natural annual rhythm is still to see the last few days of August as the end of a carefree summer. So with a nod to your need for a little more summer relaxation, I will try to keep this letter shorter than usual.

And with apologies to Elizabeth Barrett Browning, I will list a number of reasons why I hate this market and then suggest a few reasons why that should get you excited. We will look at some charts, and I'll briefly comment on them. No deep dives this week, just a survey of the general landscape.

How Do I Hate Thee? Let Me Count the Ways…

The market is down about 3½% since early August, with trading rooms short-staffed the last few weeks. Will the senior traders come back from vacation rested and looking for value? Or will they survey the gains they have banked so far this year and decide to lock them in to assure their year-end bonuses?

Finding value these days is tough. It won't be hard for them to find reasons to head for the sidelines.

1. There is a reason tapering is on everybody's radar screen. When the Fed ended its last two rounds of quantitative easing, the resulting sell-off was not pretty.

Some think that happened because the Fed was not really providing "juice" to the market. There is an element of truth to that analysis, but I think a more fundamental reason has to do with sentiment.

Fighting the Fed is very difficult. Or it might be more apt to say, fighting the narrative of the Fed that produces positive sentiment is very difficult. I remember more than a few commentators coming on CNBC in January of 2001, when Greenspan lowered interest rates by 1% in the span of 30 days, and telling us "Don't fight the Fed! You have to go long the stock market today!"

I was writing at the time that there was a recession coming, so I was saying pretty much the opposite. Perhaps the more appropriate lesson is to not fight the Fed unless there is a recession coming.

Here is a graph from a webinar (see below) that I will be doing in a few days. The last two times the Fed has ended a period of quantitative easing, the air has come out of the market balloon.

Has this coming move been so telegraphed that the reaction will be different than in the past, or will we see the same result? Want to bet your bonus on it? Or your retirement?

2. Global growth is in a funk (that's a technical economic term), and this market just doesn't seem to care. One of the first market aphorisms I learned was that copper is the metal with a PhD in economics. While you can get into a great deal of trouble regarding that as a short-term trading axiom, it is definitely a longer-term truth. Copper is a metal that is closely associated with construction, industrial development and production, and consumer spending. One can argue that the price of copper is falling today because of a fundamental increase in supply, but for those of us of a certain age, the following chart is nervous-making. Unless the long-term correlation has disappeared, the data would indicate that either the price of copper needs to rise or the market is likely to fall.

3. There is a full-blown crisis developing in the emerging markets that has more than one serious commentator thinking of 1998. On Thursday, the lead article in the business section of USA Today asked "Are we poised for a repeat of 1998 — or worse?" Yet as I highlighted in last week's Outside the Box, the US Federal Reserve has very clearly said that problems in the emerging markets are not the concern of US policy. One of my favorite thinkers, Ambrose Evans-Pritchard over at the London Telegraph, wrote this on Wednesday:

This has the makings of a grave policy error: a repeat of the dramatic events in the autumn of 1998 at best; a full-blown debacle and a slide into a second leg of the Long Slump at worst.

Emerging markets are now big enough to drag down the global economy. As Indonesia, India, Ukraine, Brazil, Turkey, Venezuela, South Africa, Russia, Thailand and Kazakhstan try to shore up their currencies, the effect is ricocheting back into the advanced world in higher borrowing costs. Even China felt compelled to sell $20bn of US Treasuries in July.

Back in 1998 the developed world was twice as big as the developing world. Today that ratio is about even. We all know what a crisis for the markets 1998 was. And now, more than a few emerging markets have clear debt problems denominated in currencies other than their own.

Evans-Pritchard goes on to say:

Yet all we heard from Jackson Hole this time were dismissive comments that the emerging market rout is not the Fed's problem. "Other countries simply have to take that as a reality and adjust to us," said Dennis Lockhart, the Atlanta Fed chief. Terrence Checki from the New York Fed said "there is no master stroke that will insulate countries from financial spillovers".

The price of oil in Indian rupees has gone from 1100 to 7800 in the space of 10 years. Think about what a move like that would do to the US economy. (Chart courtesy of Dennis Gartman)

The next chart shows the recent price spike in the Chinese SHIBOR (their short-term interbank rate, more or less equivalent to LIBOR). It is difficult to trust any of the economic data (positive or negative) coming out of China, so we really do not know whether China's growth story is simply moderating or whether we are seeing a hard landing in progress; but the sudden shock in interbank lending rates is an important sign that all is not well in the Middle Kingdom. The big question: is the recent SHIBOR spike a harbinger of a banking crisis, or does it presage an RMB devaluation?

Interbank rates do not spike from 3% to 13% (in about 2.5 weeks) in a healthy economy, and a big event along these lines in China would have enormous implications for global growth.

And while we are on the subject of emerging markets, I have to give you the lead paragraph of the latest note from my good friend and uber-bear Albert Edwards of Societe Generale. It is just too delicious.

The emerging markets "story" has once again been exposed as a pyramid of piffle. The EM edifice has come crashing down as their underlying balance of payments weaknesses have been exposed first by the yen's slide and then by the threat of Fed tightening. China has flip-flopped from berating Bernanke for too much QE in 2010 to warning about the negative impact of tapering on emerging markets! It is a mystery to me why anyone, apart from the activists that seem to inhabit Western central banks, thinks QE could be the solution to the problems of the global economy. But in temporarily papering over the cracks, they have allowed those cracks to become immeasurably deep crevasses. At the risk of being called a crackpot again, I repeat my forecast of 450 for the S&P, sub-1% US 10 year yields and gold above 10,000.

4. I have highlighted at length in recent letters, the significant rise in valuations in this latest stock market rally, which explains a significant portion of the run-up. Here is another chart, which shows that the rise in prices is not being accompanied by a rise in corporate earnings. This situation just screams for a correction.

Either corporate earnings have to rise above their already rather significant margins (at least in terms of overall profits to GDP), or the market needs to reflect the lack of earnings growth. That can happen by the market’s either going sideways for a long period of time or dropping in price. Choose your frustration wisely.

5. The Fed is telling us they're going to begin to reduce their purchases of bonds and mortgages. Three academic papers at Jackson Hole, plus the paper that I showed you a couple weeks ago from the San Francisco Federal Reserve, all suggest that QE has not been as helpful as was originally hoped. However, many other respected academics and the market itself disagree. If you are in the latter camp (and believe that QE has given a significant boost to the economy and not just the stock market), you should be very nervous.

The table below shows the revision of second-quarter GDP released Thursday. We should all be happy that growth was revised upward by 85 basis points2.5% annualized growth is about as good as we could expect. In fact, this result would argue that tapering should begin sooner rather than later and should proceed faster than most market observers expect. If the economy has recovered that much, it is time to take the foot off the gas pedal.

The problem I want to point out is highlighted in bold, and that is the implicit inflation deflator used by the Fed. Notice that it did not move at all with the revision, even though the economy was seen to grow almost 50% faster. That's a tad unusual though certainly within the realm of possibility. But if after the massive quantitative easing we have seen, all you can get is 0.7% inflation, that simply illustrates one of my main contentions: we are in an overall deflationary environment. What happens if you then suck the juice from the markets? Will we see a further fall in inflation?

                                      Q2 Advance (7/31)                Q2 Revision (8/29)

Real GDP                           1.67%                                      2.52%

Nominal GDP                    2.39%                                      3.25%

Deflator                             0.71%                                      0.71%

Just for fun, the next table gives us the numbers on CPI inflation for the last eight years. Notice that the number moves around a lot.

Date US Inflation Rate

Jul 1, 2013 1.96%
Jan 1, 2013 1.59%
Jan 1, 2012 2.93%

Jan 1, 2011 1.63%

Jan 1, 2010 2.63%

Jan 1, 2009 0.03%

Jan 1, 2008 4.28%

Jan 1, 2007 2.08%

Jan 1, 2006 3.99%

Jan 1, 2005 2.97%

The Fed prefers to use Personal Consumer Expenditures (PCE) as its measure of inflation. For the last 12 months, inflation has been only 1.2% as measured by PCE. Even if you use core CPI, inflation is still rather tame.

Couple tame inflation with the velocity of money’s continuing to fall and you get a deflationary environment. What will happen when the Fed removes QE?

6. Given the rise in interest rates of 30-year bonds, real interest rates (interest rates minus inflation) have increased to 2.6% if we use CPE. The long-term average for real interest rates is 2%, which suggests that rates need to come back down, or inflation should rise. You make the call as to which will happen when the Fed begins to reduce QE. This development suggests a rotation back into bonds, which is again another reason not to be thrilled with the equity markets.

7. And this is not something I can talk about in specifics, but I follow a number of money managers who use various systems to manage risk. The number of managers who have raised the cash portion of their portfolios to very high levels is significant. These are managers with long-term systematic models designed to keep their emotions out of investment decision-making. Talking with them, they all wish they could raise even more cash.

The Silver Lining

Yesterday after the markets closed I was invited to a local watering hole here in Dallas to meet with some younger but generally successful hedge fund managers (although younger for me is becoming a relative term). They were all interested in the macro environment, and they were all nervous. What interested me most, though, was not what they wanted to sell; it was what they wanted to buy. They were starting to find value in Saudi Arabia and Turkey and India and Indonesia stocks of serious companies in those countries had fallen to very low levels. Some were getting on planes to go check things out. And here and there some of the longer-term investors were teasing out opportunities in the US market. For these young Turks, market corrections were not a problem but simply an opportunity to find value.

And I picked up one other key thought from them. You would think, given their view of the world (which I generally share), that they were short a great deal of their book. That is not the case. Today's environment is a very, very difficult short, because the carry costs are so high. (Definition: Costs incurred as a result of an investment position. These costs can include financial costs, such as the interest costs on bonds, interest expenses on margin accounts, interest on loans used to purchase a security, and economic costs, such as the opportunity costs associated with taking the initial position.)

The Fed has distorted the interest-rate environments both in the US and internationally, and it is simply too costly to put on a short position for very long and be wrong. If you short something, you need to be right fairly quickly, or you will watch your portfolio begin to bleed. For young managers, their track record is critical, so they become quite sensitive to making longer-term macro calls that can go against them for a period of time. They have even more ways to hate the market than I do.

Investing in a Market to Hate

In my August 3rd newsletter ("Can It Get Any Better Than This?") I shared research supporting our forward-looking prospects for the markets. There was no way to sugar-coat our conclusions: if history is any indication, we are looking at the potential for a significant peak-to-trough drawdown and negative annual returns in equity markets for an extended period of time. We pointed out that where there is danger, there is also opportunity.

Investors have a lot to gain from diversifying as broadly as possible and reducing their reliance on equity risk. It therefore makes sense to embrace alternative strategies that are either less correlated or negatively correlated.

Have a great week.

Your getting ready to turn loose his inner geek analyst,

John Mauldin

Copyright 2013 John Mauldin. All Rights Reserved.

Autumn’s Known Unknowns

Nouriel Roubini

31 August 2013
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NEW YORKDuring the height of the Iraq war, then-US Secretary of Defense Donald Rumsfeld spoke of “known unknowns” – foreseeable risks whose realization is uncertain. Today, the global economy is facing many known unknowns, most of which stem from policy uncertainty.
In the United States, three sources of policy uncertainty will come to a head this autumn. For starters, it remains unclear whether the Federal Reserve will begin to “taper” its open-ended quantitative easing (QE) in September or later, how fast it will reduce its purchases of long-term assets, and when and how fast it will start to raise interest rates from their current zero level. There is also the question of who will succeed Ben Bernanke as Fed Chairman. Finally, yet another partisan struggle over America’s debt ceiling could increase the risk of a government shutdown if the Republican-controlled House of Representatives and President Barack Obama and his Democratic allies cannot agree on a budget.
The first two sources of uncertainty have already affected markets. The rise in US long-term interest rates – from a low of 1.6% in May to recent peaks above 2.9% – has been driven by market fears that the Fed will taper QE too soon and too fast, and by the uncertainty surrounding Bernanke’s successor.
So far, investors have been complacent about the risks posed by the looming budget fight. They believe thatas in the past – the fiscal showdown will end with a midnight compromise that avoids both default and a government shutdown. But investors seem to underestimate how dysfunctional US national politics has become. With a majority of the Republican Party on a jihad against government spending, fiscal explosions this autumn cannot be ruled out.
Uncertainties abound in other advanced economies as well. Germany’s general election appears likely to produce a repeat of the current government coalition of Chancellor Angela Merkel’s Christian Democratic Union and the Free Democrats, with opinion polls suggesting that a grand coalition between the CDU and the Social Democrats is less likely. In the former case, current German policies toward the eurozone crisis will not change, despite austerity fatigue in the eurozone’s periphery and bailout fatigue in its core.
Political risks in the eurozone’s periphery include the collapse of Italy’s government and a fresh election as a result of former Prime Minister Silvio Berlusconi’s criminal conviction. Greece’s ruling coalition could collapse as well, and political tensions may rise even higher in Spain and Portugal.
On monetary policy, the European Central Bank’s forward guidance – the commitment to keep interest rates at a low level for a long time – is too little too late and has not prevented a rise in short- and long-term borrowing costs, which could stifle the eurozone’s already-anemic economic recovery. Whether the ECB will ease policy more aggressively is also uncertain.
Outside of the eurozone, the strength of the United Kingdom’s recovery and the Bank of England’s soft forward guidance have led to similarunwarrantedincreases in interest rates, which the BoE, like the ECB, seems unable to prevent in the absence of more muscular action. In Japan, the policy uncertainty concerns whether the third arrow of Abenomicsstructural reforms and trade liberalization to boost potential growth – will be implemented, and whether the expected rise in the consumption tax in 2014 will choke economic recovery.
In China, November’s Third Plenum of the Communist Party Central Committee will show whether China is serious about reforms aimed at shifting from investment-led to consumption-led growth. Meanwhile, China’s slowdown has contributed to the end of the commodity super-cycle, which, together with the sharp rise in long-term interest rates (owing to the scare of an early Fed exit from QE), has led to economic and financial stresses in many emerging-market economies.
These economies – the BRICS (Brazil, Russia, India, China, and South Africa) and others – were overhyped for too long. Favorable external conditions – the effect of China’s strong growth on higher commodity prices and easy money from yield-hungry advanced-economy investors led to a partly artificial boom. Now that the party is over, the hangover is setting in.
This is especially true in India, Brazil, Turkey, South Africa, and Indonesia, all of which suffer from multiple macroeconomic and policy weaknesseslarge current-account deficits, wide fiscal deficits, slowing growth, and above-target inflation – as well as growing social protest and political uncertainty ahead of elections in the next 12-18 months. There are no easy choices: defending the currency by hiking interest rates would kill growth and harm banks and corporate firms; loosening monetary policy to boost growth might push their currencies into free-fall, causing a spike in inflation and jeopardizing their ability to attract capital to finance their external deficits.
There are two major geopolitical uncertainties as well. First, will the looming military strikes by the US and its allies against Syria be limited in scope and time, or will they trigger a wider military confrontation? The last thing that a fragile global economy needs now is another round of peak oil prices.
Second, a year ago the US convinced Israel to give its non-military approach to Iran’s nuclear-weapons ambitions time to bear fruit. But, after a year of economic sanctions and negotiations with no result, Israel’s patience on what it regards as an existential issue is wearing thin. Even short of an actual military conflict – which could double oil prices overnight – the resumption of saber-rattling by Israel and the war of words between the two sides could lead to a sharp rise in energy costs.
The looming known unknowns are plentiful. Some outcomes may be more positive, or at least less damaging, than expected. But the realization this autumn of even some of the risks described here could derail the global economy’s still-wobbly recovery. And the meta-risk of policy mistakes and accidents remains very high.
Nouriel Roubini, a professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.

Weak Links and Transmission Mechanisms

August 30, 2013

by Doug Noland

Global markets are turning more unsettled, and I suspect it has more to do with EM and the hedge funds than Syria.
It was another week of acutely unsettled emerging markets (EM). India’s rupee (down 3.6% for the week) and Turkey’s lira (down 2.5%) traded to record lows on Wednesday. Indonesia’s rupiah traded to the lowest level since April 2009 (down 1.1%). The Mexican peso fell 3.2% and Brazilian real declined 1.5%, while many Eastern European currencies played downside catch-up. The Polish zloty declined 2.2%, the Hungarian forint 2.2%, the Czech koruna 1.5% and the Romanian leu 1.3%
Especially early in the week, EM equities and bond markets were suffering the apparent effects of increasingly destabilizing outflows. Market tumult provoked a flurry of policy measures. Brazil raised rates. Indonesia boosted rates and extended a currency swap arrangement with the Bank of Japan (BOJ). India’s central bank implemented a currency swap arrangement with the country’s major energy companies, in a plan that would provide dollar liquidity to finance the rapidly escalating cost of energy imports. Policy effects seemed fleeting at best.

An unstable market backdrop compounded by desperate policy measures definitely made for some wild currency market volatility, notably for the Indian rupee and Indonesian rupiah. Meanwhile, the week provided added confirmation that the emerging market complex has commenced the self-reinforcing downside of an historic Credit cycle. Sinking currencies coupled with surging crude prices ensures that already rising inflationary pressures will intensify. This is especially an issue for India, Indonesia, Brazil, Turkey and Russia. And rising inflation and resulting bond market losses will only work to exacerbatehot money” and investment outflows.

Weak markets, robusthot moneyoutflows, rising inflation and higher policy rates all point to a consequential tightening of EM financial conditions. I have posited that major Bubble economies and financial systems are acutely vulnerable to any tightening of financial conditions. And while the marketplace is coming to better appreciate EM fragilities, the consensus view remains that the situation is quite manageable. Few expect EM to have much impact on U.S. markets or the American economic recovery.

EM instability has increased the relative appeal of U.S. securities markets, especially from the perspective of the hedge fund community and the greaterglobal pool of speculative financemore generally. U.S. equities have benefited from the rotation away from both EM and Treasuries. There is certainly no doubt that highly speculative, over-liquefied markets will chase outperforming asset classes. And a resilient equities market has both captured the imagination and worked to embolden the bullish mindset.

I would tend to view the popular consensus view as superficial and complacent. While U.S. stocks have been “resilient,” I would warn against disregarding prospects for a tightening of financial conditions. From the vantage point of my analytical framework, I have seen sufficient confirmation of the bursting EM Bubble thesis.

It’s now time to begin thinking forward to potential consequences. What are potential Transmission Mechanisms that could link the unfolding EM crisis to U.S. markets and our economy? Where are possible Weak Links?
Generally, I view the global economy and financialsystem” as anything but robust. Global economic maladjustment and imbalances are unprecedented. A multi-decade Credit boomculminated by post-’08 crisisterminal phase excess in China and EM – has left a legacy of acute fragility. Europe remains susceptible. For starters, analysts have been slow to recognize the direct impact the EM crisis will have upon global growth and corporate profits.

Unprecedented fiscal and monetary stimulusnow years of ultra-loosemoney” – have stoked renewed U.S. asset price inflation/Bubbles. Still, the structurally-challenged real economy refuses to gather a head of steam. Inflated global securities markets have become addicted to government guarantees and liquidity backstops, not to mention the Fed and BOJ’s $160bn monthly QE/“money printing.” From the “global government finance Bubble perspective, there have been a multitude of excesses with associated fragilities to less accommodative market environments. I see deeply systemic fragilities.
There would appear to be myriad Weak Links. I would argue that the global economy has never been as dependent upon the financial markets – as distorted markets have become hopelessly speculative and unsound. Fragile economic and financial systems have never been as vulnerable to a meaningful tightening of financial conditions. The bullish retort would be that central bankers remain on the case and have things well under control. That said, I believe the global leveraged speculating community is today a primary Weak Link and potential Transmission Mechanism for contagious EM disorder to afflict the developed world, including the U.S.

The hedge fund community has struggled for performance in recent years. Globally, there is way too much speculative finance chasing way too few attractive opportunities. So it’s degenerated into a rather barbarous high-stakes enterprise of speculation. Years of global imbalances coupled with Trillions of QE and central bank purchases have been instrumental in the ballooning pool of speculative finance and the dysfunctionalcrowded trademarket phenomenon. The collapse of interest rates has been instrumental in drivingmoney” to the hedge funds, especially from the pension fund complex requiring 8-9% annual returns. So, despite weak performance, the hedge fund industry has continued to enjoy inflows and record assets.

This year commenced with great hope that the hedge fund industry would finally turn the corner and put up some big numbers. Massive QE seemed to guarantee inflating global risk asset markets. The Draghi Plan appeared to ensure Europe would finally emerge from crisis. And surging stocks and home prices were seen finally propelling the U.S. economic recovery to launch speed. Global markets got off to a strong start – but it wasn’t too long before the global market instability wrecking ball started chipping away at hedge fund performance.
Gold and commodities weakness hurt performance, especially in the second quarter, as many funds were caught on the wrong side of a falteringglobal reflation trade.” EM currencies and equities also became minefields. Then (in spite of massive QE) global bond yields began to shoot higher, catching even the most adroit market operators flatfooted. June was a particularly painful month, as EM and bond selling fueled huge outflows from international and fixed-income funds. Latent liquidity issues surfaced in various ETF products, which induced a surprising tightening of market conditions in U.S. mortgage and municipal finance. At the same time, resilient U.S. equities ensured the performance-chasing speculators crowded deeper into our stock market.

A curious, perhaps quite important, dynamic developed. As the hedge funds and others increased exposure to outperforming U.S. stocks, the resulting resilience in our equities market bolstered the bullish view of the resiliency of the U.S. economy more generally. I would argue, however, that this dynamic makes certain that market participants will overlook significant mounting risks of a tightening of finance both globally and, believe it or not, even here in the U.S.

The overwhelming consensus view holds that the Fed (along with global central banks) controls financial conditions. Global markets have been keenly sensitive to taper talk, although most believe the Fed will continue to ensure ample liquiditythat the Fed, as Bernanke stated, would “push backagainst a tightening of market liquidity.

And while central banks clearly play an instrumental role, I view the leveraged speculating community as customarily the marginal player in determining financial conditions. When risk is being embraced and leveraged positions are being expanded, this is constructive for marketplace liquidity and a loosening of financial conditions more broadly. When, instead, risk aversion and de-leveraging are in play, market liquidity suffers and financial conditions tighten. This dynamic has been only somewhat mitigated by ongoing huge QE.

The markets’ fixation with tapering has distracted attention away from potentially far-reaching market developments. Has a multi-decade bond Bubble about run its course? Are global central banks finally losing control of market yields? After unprecedented inflows, does the abrupt reversal of flows away from EM (and resulting selling of international reserves by EM central banks) mark a major inflection point for Treasuries and global bonds more generallyWhat are market ramifications for an abrupt reversal of flows out of the "leveraged speculating community"?
I think I can make a decent case that over recent years the U.S. (and global) bond market succumbed to “terminal phaseexcess. Fed policies ensured Trillions of Treasury, municipal, MBS and corporate debt were issued at artificially depressed yields (highly inflated prices). This great mispricing is now coming back to trouble the system

Investors are being hit with losses and a self-reinforcing re-pricing dynamic is seeing flows begin to exit the sector. This reversal of flows coupled with EM central bank selling has significantly altered the risk profile of maintaining leveraged speculative positions in long-term fixed income instruments.
Fed QE notwithstanding, I believe the market backdrop today implies an important tightening of financial conditions going forward. Policy measures – including boosting QEdo (once again) have the potential to delay this tightening, although with the cost of only exacerbating the wide gulf that has developed between inflated global securities prices and deteriorating economic prospects.

If financial conditions are indeed tightening globally, I would expect the typicalperiphery to coredynamic to ensure a jump of EM stress to the more fragile peripheral developed markets. Europe and the euro initially benefited from the flight out of EM, although this week’s poor market performance was noteworthy.

The euro dropped 1.2% (1.75% vs. the yen), its worst performance in weeks. Germany’s DAX index was hit for 3.7%, France fell 3.3%, Spain sank 4.6% and Italian stocks dropped 3.8%. Perhaps indicating hedge fund de-risking/de-leveraging, European sovereign bond yield spreads (to bunds) widened this week. French yields widened 8 bps versus bunds yields to a one-month high 61 bps.

Italian and Spanish bond spreads to bunds widened a notable 15 and 16 bps. And at the troubled Eurozone periphery, Portugal saw its 10-yr yield jump 16 bps to 6.59% and Greece yields rose 24 bps to 10.02%. I suspect Draghi’s dramatic year ago move to backstop European bonds enticed the leveraged speculators back into higher-yielding Eurozone bonds.
Here at home, stocks were under some pressure while Treasuries generally held their own. Risk spreads widened somewhat. Interestingly, the VIX index jumped to the highest level since late-June. Benchmark MBS spreads were little changed. It is worth noting that, at 4.51%, benchmark 30-year mortgage borrowing rates have jumped 116 bps points from May lows. The mortgage Bankers Association weekly refi application index this week dropped to the lowest level since February (and near the weakest level since 2009). Higher borrowing costs will now throw some cold water on real estate markets. And there will be further economic ramifications for the end to a several-year period of homeowners improving their monthly cashflows by refinancing into low-cost mortgages.

Corporate debt issuance has slowed markedly, although issuance is expected to pick up in September. This week saw investment-grade and junk spreads widen 5 bps and 14 bps. Similar to equities, high-yield corporate debt has benefited at the expense of EM and Treasuries. I would expect junk bonds and leveraged finance more generally to be susceptible to equity market weakness and de-risking more generally.

According to Friday’s Bond Buyer, “The plunge in long-term municipal bond volume for 2013 continued as issuers in August floated 37.7% less than they did over the same period in 2012municipalities issued $20.9bn last month in 746 deals, against $33.5bn in 1,066 issues in August 2012.” An index of long-term bond yields ended the week at 4.07%, up about 150 bps from early May to the highest level since May 2011.

I am increasingly focused on municipal debt market developments. Muni funds suffered another week of significant redemptions (14 straight weekly outflows). Fed policies helped spur enormous inflows into municipal finance. I suspect, as well, that high-yielding tax-exempt muni bonds provided a too enticing venue for hedge fund, “structured products” and other derivative-related leveraging.

It’s also a big market where most underlying issues trade with little liquidity. And unlike Treasuries and MBS, muni debt doesn’t enjoy the benefits of the Fed’s QE backstop. So it has all the characteristics of a marketplace susceptible to risk aversion and a deteriorating general fixed income liquidity backdrop.
Benchmark Puerto Rico bond yields jumped another 8 bps this week to 6.24%, having increased 60 bps in three weeks. Andrew Bary’sTroubling Windsanalysis of “Puerto Rico’s huge debt load” was the cover story for last week’s Barron’s magazine. Reading Bary’s informative piece, I immediately recalled the Greek debt fiasco. 

Over-liquefied and complacent markets were content to continue lending to Greece despite increasingly obvious issues. In November 2009, Greece could tap the markets for two-year paper at just over 2% - and the marketplace could presume a Eurozone backstop and ignore fundamentals. Six months later, with market yields at 16%, Greece was hopelessly insolvent.
I don’t know enough to compare Puerto Rican fundamentals to those of Greece. But from a marketplace standpoint, I would expect Puerto Rico to play a similar role as the marginal borrower, first to lose access to cheap finance in a faltering Bubble environment. With muni yields shooting higher, with an abrupt reversal of finance out of the municipal debt complex, and with Detroit and other municipalities in trouble, the tightening of muni finance could evolve into an important Transmission Mechanism for an unfolding global crisis to the U.S. economy.