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Doug Noland: “There Is No Concern For Short-Term Funding Issues”

Prudent Bear’s Doug Noland was a must-read in the years leading up to the bursting of the housing bubble. Almost alone out there, he got not just the fact that we were heading off a cliff, but the exact mechanism of our demise: “Wall Street alchemy” was creating unlimited amounts of artificial securities that the marketplace was treating like money, which sent the effective global money supply through the roof and fueled a series of ever-bigger bubbles.

Once the crash came, Noland reined it in a bit and his articles fell off my automatic “Best of the Web” list. But now the bubble is back and so is Noland. His latest post dissects the current “recovery” and explains why we’re headed back into interesting times:

Deficits and Private Sector Credit

The bullish contingent is these days increasingly confident that there is much more to the recovery than a mere stimulus-induced “sugar high.” The marketplace now comfortably disregards bearish developments – and becomes further emboldened by “market resiliency”. The market this week brushed aside issues with Greece, China, Goldman and financial reform.

Complacency abounds, in true Bubble fashion. The U.S. stock market dismisses that there could be meaningful ramifications from the unfolding Greek debt crisis. Chinese authorities’ recent determination to restrict mortgage Credit barely garners a headline. And while the Goldman allegations generate great interest and discussion, few believe they will have much general market impact. Financial reform, well, it’s an afterthought when the market is open. Market participants are enamored with the notion that the securities markets and real economy are now conjoined in the initial phase of a big bull cycle.

Count me a subscriber of the “sugar high” thesis. The combination of double-digit (to GDP) deficits, protracted near-zero rates, and the Fed’s unprecedented Trillion-plus monetization has worked wonders. Government stimulus stabilized the Credit system, asset prices, system incomes and economic output. The bulls today believe that a new expansionary cycle has commenced, and fundamentals and prospects couldn’t be much more encouraging from their point of view. Surging stock prices have the optimists disregarding the possibility of a systemic addiction to massive government spending, ultra-low rates, and overabundant marketplace liquidity. Potential issues in the area of risk intermediation are not on the radar screen.

Yet, the sustainability of this recovery will be determined by private sector Credit – eventually.  The markets assume private Credit growth will snap back after its long recuperation – as it always has in the past.  But, mostly, analysts expend little energy pondering this issue.  Deficits of about 10% of GDP, rapid expansion of government-backed Credit (MBS, “build America bonds,” student loans, bank deposits, etc.), and near-zero rates have created a recovery backdrop where minimal private-sector growth has sufficed.  This won’t always be the case.

Greek Credit default protection began December at 176 bps. Not many months ago there was little fear of a debt Crisis and no worry of default. Yet here we are today with Greece 2-year debt yielding 11% and annual default protection priced at about 600 bps. Markets fear insolvency and debt restructuring.

The U.S. Treasury borrows these days for three months at 15 bps and for two years at 1.02%.  No one dares contemplate how dramatically the world would change if fear injected itself into the equation. While there is certainly more recognition of the structural debt issues confronting our government borrowers (local, state and federal), there is no concern for short-term funding issues. There was an important aspect of the Wall Street/mortgage finance Bubble that receives little attention: The explosion of Credit provided an enormous boost to governmental receipts.  Especially in the case of federal debt ratios, boom-related revenues reduced borrowing requirements and distorted debt-to-GDP ratios.

At about 70% of GDP, outstanding Treasury debt is not on the surface overly alarming.  Obviously, if one throws in GSE liabilities and the massive future spending obligations related to social security, healthcare, pensions, etc., things are much worse. Yet it is conventional wisdom that the U.S. has the luxury of several years to get its fiscal house in order. And there is today great faith that economic recovery will, as it always does, lead a revival of government receipts and ensure rapidly declining deficits. Count me skeptical. The previous Bubble helped disguise underlying structural debt issues at the state, local and federal levels. Going forward it’s payback time.

…The unfolding Greek debt crisis, China Bubble vulnerability, and more intense scrutiny of Wall Street risk intermediation now work in confluence to increase the probability for a negative surprise in our risk markets. Sure, the equities bulls have become intoxicated by some incredible stock and sector performance. But equity market reflation must be approaching the point of unnerving the bond market. And it can’t help sentiment that, as reported today by CNBC’s Steve Liesman, a rising number of FOMC members support a timely sale of assets and a removal of the Fed’s extraordinary liquidity measures. More bearish fundamentals for the private-sector Credit mechanism gladly ignored by a stock market Bubble.

Some thoughts:

  • Exactly. We’ve replaced the housing bubble with a government debt bubble, and there’s no way to transition back to private sector-led growth. The amount of debt needed to fuel an economy this unbalanced is simply too great.
  • Some kind of serious negative event is virtually a lock in the coming year. It might be the spread of Wall Street lawsuits or a PIGS country default. Or the bond market might simply decide it’s eaten enough and get up from the table. No way to know what it will be, but we’ve created the conditions for another nasty “surprise”.

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