Doug Noland
Jun 2, 2009 - Asia Times
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Last week provided ample confirmation for the global reflation thesis. The dollar index dropped another 0.9%. Gold surged US$22 to $979. Crude oil jumped $4.67 to a six-month high, posting the largest one-month percentage gain since 1999 (according to Bloomberg). The Goldman Sachs Commodities index rallied 5.5% to an almost seven-month high (up 27% year-to-date). Emerging markets remain on fire. And the Baltic Dry Index rose again on Friday, increasing its streak of consecutive gains to 19.
Leading the "BRIC" sweepstakes, Russia's RTS equities index jumped 7.3% last week, while India's Sensex rose 5.3%. Russian stocks are now up 72% year-to-date, followed by India's 52%, China's 45%, and Brazil's 42%. Elsewhere, stocks in Taiwan are up 50%, South Korea 24%, Argentina 47%, and Hungary 22%. The "commodity" currencies led the charge again last week. The South African rand gained 4.1%, the New Zealand dollar 3.3%, the Brazilian real 3.0%, the Australian dollar 2.4%, and the Canadian dollar 2.7%.
It was quite a week in US interest rate markets. Ten-year Treasury yields jumped 29 basis points (bps) during the shortened week's first two trading sessions (to 3.74%), before backing off to end the week up only 2 bps to 3.47%. The mortgage marketplace turned rather tumultuous, with benchmark Fannie Mae mortgage-backed security (MBS) yields spiking 55 bps from last Friday's close before ending the week 19 bps higher at 4.33%.
Some interest-rate hedging markets seemed in disarray, with the dollar swaps market demonstrating price discontinuity. After closing last week at 14.4 bps, the 10-year dollar swap spread traded as high as 38.25 before ending the week at 19.50.
Importantly, at least for the week, mortgage-related market tumult didn't broaden to other risk markets. Corporate credit spreads were mostly narrower on the week, even as the company debt issuance boom ran unabated. The junk-bond market enjoyed another week of strong fund inflows more than matched by huge issuance.
It is also worth noting the resilience of the "emerging" debt markets. Brazilian benchmark dollar bond yields were down 14 bps to 5.86%. Mexican dollar bond yields fell 14 bps to 5.74%. Brazil's credit default swap (CDS) prices declined to the lowest level since early October (197 bps, down from the October high of 600 bps). It is no longer the case that when the Treasury market catches a cold others get really sick.
At this point, the markets' sanguine attitude toward US dollar and Treasury/MBS weakness is understandable. From a global perspective, a weaker dollar bolsters the inflationary bias that had prior to the credit meltdown been driving robust economic performance throughout the energy and commodities-based economies. Dollar devaluation also works to reinforce already heady financial flows to "emerging" markets and non-dollar assets more generally. There are facets of inflation that seductively salve recovery.
The dramatic loosening of financial conditions globally is supporting an improvement in economic conditions. The optimists are looking for Asia and the developing world to lead a global recovery, and a sinking dollar on a short-term basis would seem to support such a scenario. Our weak currency also empowers the global government finance bubble. Amazingly, most countries today have unprecedented flexibility to issue debt without fear of negative market reaction or a run against their currencies.
I again want to emphasize the dramatic change in circumstances that is increasingly in view throughout global markets and economies. During the 1990s - and stretching through the "King Dollar" period earlier this decade - there was an overarching inflationary bias that worked to direct flows to the "core" (the US credit system and securities markets). Whether it was a crisis that initially erupted in Mexico, Southeast Asia, Russia, Argentine or Brazil, the immediate market response was an abrupt reversal of financial flows from the developing countries to US dollar securities. While there was an ongoing acceleration in speculative flows meandering about the globe in search of big returns, the first sign of trouble would incite a panic straight to the dollar.
The "core" absolutely dominated the system, providing our policymakers (especially the US Federal Reserve) extraordinary latitude. The periphery-to-core bias fostered financial crises, along with general periphery financial and economic instability. This dynamic worked to keep global inflationary pressures in check. Or, better said, the nature of the inflationary flow of finance kept inflation pressures directed to US dollar securities markets - as opposed to energy, commodities and more traditional inflation.
The global financial and economic backdrop has changed profoundly. Today, there exists a powerful inflationary bias working to direct flows away from the core out to the periphery. This dynamic helps to explain the dramatic change in the cost and availability of finance for the developed world over the past several years - the virtually unlimited cheap finance that funded historic booms in China and Asia.
Granted, this flow was abruptly interrupted by last year's global credit crisis. It is, however, my view that the dynamic of powerful core-to-periphery flows has resumed. Moreover, it is the nature of this type of dynamic that if such a trend recovers it will likely resume stronger-than-ever (think tech stock reflation post the Long Term Capital Management collapse or mortgages reflation post the tech bubble). This analysis is supported by the periphery's recent dramatic economic and market outperformance relative to the core.
So, is this bullish or bearish? Well, I believe the core-to-periphery dynamic is supportive of a more rapid than expected global economic recovery. I definitely expect global inflation to surprise on the upside. Adherents to the global deflationary spiral thesis may be left wondering what the heck happened. The backdrop seems to be set for surprising revival in energy and commodities markets. And I would not be surprised if the global equities rally has some legs.
Yet I view the core-to-periphery dynamic as profoundly bearish for the US. At its core, this historic redirection of global flows and inflationary pressures is the consequence of a breakdown in the dollar standard. Failed policies, a resulting deeply impaired economic structure, and massive ongoing devaluation have ended the dollar's reign as the globe's premier reserve currency and perceived stable store of value. There is today no sound currency to replace the dollar, so the global financial system operates rudderless and with great uncertainties.
It is more certain, however, that the great benefits commanded to our economy and markets over the decades from governing the world's reserve currency are drawing to an end. Our policymakers still believe they can inflate credit and manipulate interest rates - and not have to pay a price for it. But the new global reality may be that currency markets will protest against massive US fiscal deficits and activist monetary policy, while global markets come to dictate US market yields. Over the past two weeks, we have seen the dollar and US Treasuries/MBS come under significant pressure. Is this the beginning of global markets disciplining Washington?
A robust core-to-periphery dynamic and the re-emergence of dollar vulnerability are a potent combination. US markets to this point remain sanguine with the prospect of an expanding Federal Reserve balance sheet rectifying any spike in interest rates. But currency markets are no doubt increasingly fixated on our propensity to monetize current and prospective stimulus.
At some point, increasingly unwieldy flows out of our currency may force the Fed's hand. The scenario where the Fed is forced to choose between loose monetary policy and currency crisis sits out there as a potential big negative surprise for US markets.
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