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As everyone is engrossed by assorted groundless Christmas (and other ongoing bear market) rallies, and oblivious to the debt monsters hiding in both the closet and under the bed, Zero Hedge has decided it is about time to present the ugliest truth faced by our ‘intellectual superiors’ and their Wall Street henchman who succeeded in pulling off Goal #1 for 2009 – the biggest ever bonus season (forget record bonuses in 2010… in fact, scratch any bonuses next year if what is likely to transpire in the upcoming 12 months does in fact occur).

If someone asks you what happened in 2009, the answer is simple – two things. There was a huge credit and liquidity crunch, and then there was Quantitative Easing. The last is the Fed’s equivalent of band-aiding a zombied and ponzied corpse, better known as the US economy. It worked for a while, but now the zombie is about to go back into critical, followed by comatose, and lastly, undead (and 401(k)-depleting) condition.

In 2009, total supply of all USD denominated fixed income, net of maturities, declined by $300 billion from $2.05 trillion to $1.75 trillion. This makes sense: the abovementioned crunches stopped the flow of credit from January until well into April, and generally firms were unwilling to demonstrate to the market how clothless they are by hitting the capital markets until well into Q2 if not Q3. What happened was a move so drastic by the Fed, that into November, the worst of the worst High Yield names were freely upsizing dividend recap deals (see CCU) – the very same greed and stupidity that brought us here. Luckily, so far securitization and CDOs have not made a dramatic entrance. They likely will, at which point it will be time to buy a one-way ticket for either our southern or northern neighbor, both of which, in the supremest of ironies, transact in a currency that will survive long after the dollar is dead and buried.

Back to the math… And here is the kicker. Accounting for securities purchased by the Fed, which effectively made the market in the Treasury, the agency and MBS arenas, but also served to “drain duration” from the broader US$ fixed income market, the stunning result is that net issuance in 2009 was only $200 billion. Take a second to digest that.

And while you are lamenting the death of private debt markets, here is precisely what the Fed, the Treasury, and all bank CEOs are doing all their best to keep hidden until they are safely on their private jets heading toward warmer climes: in 2010, the total estimated net issuance across all US$ denominated fixed income classes is expected to increase by 27%, from $1.75 trillion to $2.22 trillion. The culprit: Treasury issuance to keep funding an impossible budget. And, yes, we use the term impossible in its most technical sense. As everyone who has taken First Grade math knows, there is no way that the ludicrous deficit spending the US has embarked on makes any sense at all… none. But the administration can sure pretend it does, until everything falls apart and blaming everyone else for its fiscal imprudence is no longer an option.

Out of the $2.22 trillion in expected 2010 issuance, $200 billion will be absorbed by the Fed while QE continues through March. Then the US is on its own: $2.06 trillion will have to find non-Fed originating  demand. To sum up: $200 billion in 2009; $2.1 trillion in 2010. Good luck.

As we pointed, the number one reason why 2010 is set to be a truly “interesting” year is a result of the upcoming explosion in US Treasury issuance. Fiscal 2010 gross coupon issuance is expected to hit $2.55 trillion, a $700 billion increase from 2009, which in turn was  $1.1 trillion increase from 2008. For those of you needing a primer on the exponential function, click here. But wait, there is a light in the tunnel: in 2011, gross issuance is expected to decline… to $1.9 trillion.

And while things are hair-raising in “gross” country (not Bill…at least not yet), they are not much better in netville either. Net of maturities, 2010 coupon issuance will be about $1.8 trillion, a 45% increase from the $1.3 trillion in FY 2009 (and the paltry $255 billion in 2008).

Now everyone knows that the average maturity of the UST curve has become a big problem for Tim Geithner: nearly 40% of all marketable debt matures within a year (a percentage that has kept on growing). In fact, the Treasury provided guidance in its November 2009 refunding, in which it stated that it intends “to focus on increasing the average maturity” of its debt after relying heavily on Bill issuance in H2. Once again, we wish Tim the best of luck.

Why our generous best intentions to the US Treasury? Because unless the US consumer decides to forgo the purchase of the 4th sequential Kindle and buy some Treasuries (and not just any: 30 Year Bonds or bust), the presumption that the Bond printer will have the option of finding vast foreign appetite for its spewage is a very myopic one. We already know that China is a major question mark, and will aggressively be looking at pumping capital into its own economy instead of that of Uncle Sam’s – at some point the return on investment in its own middle class will surpass that of funding the rapidly disappearing US middle class. That tipping point could be as soon as 2010.

As for Japan – the country has plunged into its n^th consecutive deflationary period. Whether or not the finance minister announces yet another affair with the Quantitative Easing whore on any given day, depends merely on what side of the bed he wakes up on. The country will have its hands full monetizing its own sovereign issuance, let alone ours.

Lastly, the UK – well, with the country set to have zero bankers left in a few months, we don’t think the traditionally third largest purchaser of US debt will be doing much purchasing any time soon.

None of this is merely speculation: October TIC data confirmed these preliminary observations. It will only become more pronounced in upcoming months.

How about that great globalization dynamo: emerging markets? Alas, they have their hands full with issuing their own record amounts of both sovereign and corporate debt as well: in 2009 gross EM debt issuance reached an astounding $217 billion, $29 billion higher than the previous record in 2007. Gross EM issuance was particularly high in the last quarter at $73 billion, with October breaking the record for the largest ever monthly gross issuance of emerging market global bonds at $38 billion (January is traditionally the busiest month of the year.) With $81 billion, 2009 was notably a record year for sovereign bonds, while gross issuance of corporate bonds amounted to $136 billion, the second highest level after that of 2007 with $155 billion.

Bottom line: everyone has major problems at home, and is more focused on the supply than the demand side of the equation.

What options does this leave for the administration? Very few, and all of them are ugly. As we stated earlier on, the options for the Fed are threefold:

1. Announce a new iteration of Quantitative Easing. This will be met with major disapproval across all voting classes (at least those whose residential zip codes do not start with 10xxx or 068xx), creating major headaches for Obama and the democrats which are already struggling with collapsing polls.
2. Prepare for a major increase in interest rates. While on the surface this would be very welcome for a Fed that keeps hinting that deflation is the biggest concern for the economy, Bernanke’s complete lack of preparation from a monetary standpoint (we are surprised the Fed’s $200 million reverse repos have not made the late night comedy circuit yet) to a forced interest rate increase, would likely result in runaway inflation almost overnight. The result would be a huge blow to a still deteriorating economy.
3. Engineer a stock market collapse. Recently investors have, rightfully, realized there is no more risk in equities, not because the assets backing the stockholder equity are actually creating greater cash flow (as we demonstrated recently, that is not the case), but simply because taxpayers have involuntarily become safekeepers for the entire stock market, due to Bernanke’s forced intervention in bond and equity markets. Yet the President’s Working Group is fully aware that when the time comes to hitting the “reverse” button, it will do so. Will the resultant rush into safe assets be sufficient to generate the needed endogenous demand for Treasuries is unknown. It will likely be correlated to the size of the equity market drop.

If the Fed decides on option three, we fully believe a 30% drop (or greater) in equities is very probable as the new supply/demand regime in fixed income becomes apparent. We hope mainstream media takes the ideas presented here and processes them for broader consumption as indeed the Fed is caught in a very fragile dilemma, and the sooner its hand is pushed, the less disastrous the final outcome for investors. Then again, as Eric Sprott has been pointing out for quite some time, it could very well be that the US economy has become merely one huge Ponzi, and as such, its expansion or reduction on the margin is uncontrollable. We very well may have passed into the stage where blind growth is the only alternative to a complete collapse. We hope that is not the case.

Merry Christmas and Happy Holidays to all readers.

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Henny Sender of the FT reports that top hedge funds bet on big rise in yields:

The
recent rise in long-term US interest rates comes as good news for
several leading hedge fund managers, including John Paulson, who have
positioned their trading books to benefit from higher yields on US
Treasury securities.

 

Mr Paulson, who
made big gains earlier this decade by betting against the subprime
mortgage market and whose firm, Paulson & Co, manages $33bn, has
said he believes that government stimulus efforts would inevitably lead
to higher inflation and a corresponding rise in rates.

 

“It will
be difficult for the government to withdraw the economic stimulus,” Mr
Paulson said in a speech. “An increase in the monetary base leads to an
increase in the money supply, which leads to inflation.”

Bond
prices fall as yields rise, and Mr Paulson told the Financial Times
last week that he has been hoping to benefit in the Treasury market by
buying options that would become profitable if rates headed higher.
TPG-Axon’s Dinakar Singh has been making similar options trades,
according to a person familiar with the matter.

Julian Robertson,
the hedge fund manager, has pursued a related strategy, hoping to
benefit from a bigger difference between short-term and long-term
interest rates, known as a steeper yield curve, a person familiar with
his trades said.

The yield on the 10-year Treasury, which hit a
crisis low of 2.055 per cent last year, has moved from 3.2 per cent
last month to 3.75 per cent on Tuesday.

Hedge fund managers,
however, have been hesitant to engage in short sales of Treasury bonds
to profit from the rising yields – and falling prices – because of the
Federal Reserve’s heavy involvement in the market. This has led some to
buy options – dubbed “high strike receivers” – that would enable them
to profit from sharply higher Treasury yields, hedge fund managers say.
These trades, which are relatively cheap to execute because they are so
out of the money, are based on the thesis that yields could hit 7 or 8
per cent.

“If they are right, and the world ends, they will make
a fortune,” said one fund manager who is sceptical of the idea. “If
they are wrong, they haven’t lost much.”

Some traders are
cautious because many peers lost large sums betting that rates would
rise in Japan in the 1990s – as yields fell to less than half a
percentage point. The trade was termed the “black widow” because it left so many victims.

“Nobody
understood the extent of deflation and economic weakness in Japan,”
said Dino Kos of Portales Partners, a research consultancy, who was
then a Fed official. “More money was lost on that trade than on any
other single trade. Everyone piled in when rates were at 3 per cent and
then at 2.5 per cent and then at 2 per cent.”

So
is it time to place big bets on rising yields? I could easily see a
backup in yields in the near term as economic reports surprise to the
upside, but I don’t believe that bonds have entered a long-term secular
bear market. I think the hedgies are right, best to play interest rate
directional calls though options.

Also, given the increase in
liability-driven investing by pension funds worried about their funding
status, there is an upper cap on bond yields. I don’t know what the
exact magic number is, but at a certain level (say 7%), you’ll have
pensions scambling to lock in rates. Bond bears tend to ignore this
when predicting doom and gloom on bonds. All they do is focus on the
“pending collapse” of the US dollar, which won’t happen .

The economy is so hot, that democrats in Congress are now moving with yet another stimulus package, this one for $170 billion, targeting bankrupt states and formerly surging unemployment (Obama has some TV appearances today; the BLS will be back to its previously scheduled job collapse next month). In other news, Japan did approximately 10 such small scale bailouts even as its market proceeded to keep probing new lows over the last two decades, and as reinvested 3x its annual GDP in comparable such one-time boosts to the economy without doing anything to prevent its current deflationary collapse.

From Dow Jones:

Congressional Democrats are moving ahead with a roughly $170 billion package to spur jobs growth and boost emergency  assistance to the unemployed, Democratic congressional aides say.

The two separate bills are taking shape amid an improving jobs picture, but with unemployment still at 10%. U.S. President Barack Obama will deliver a speech Tuesday at the Brookings Institution where he intends to lay out his own ideas for a narrowly targeted jobs bill, which will overlap with  Congress’s intentions but won’t be identical.

Both the administration and Congress will almost certainly pay for part of their program with some of the $115 billion that bailed out banks have repaid to the Treasury Department.

Some more details on Krugman’s wet dream:

The legislation will likely be split in two. The first part, at around $110 billion, would be considered emergency spending. It would again extend unemployment insurance, food stamp increases and a provision in the stimulus bill that subsidizes private-health insurance for the unemployed. This portion will likely be attached to a giant spending bill this month to fund the federal government, and will be added to the already huge U.S. budget deficit.

A second “jobs” bill would cost up to $70 billion, funded by the bank bailout. It would include more money for highway and bridge building, school construction and repair, and water and sewer projects. A second component would be direct aid to state governments cutting back services and raising taxes, moves that are hurting the economic recovery.

Finally, some repaid bailout funds will be lent back to small businesses directly from the Treasury.

Of course, nobody will have the brilliant idea of actually using TARP repayments (before they are needed to bail out the banking system again some time in late 2010) to actually pay back some of the debt which as of a few months ago has been classified as “unmanageable” by everyone including Mr. Bernanke. But why care about the sovereign default in 4-6 years when there are mid-term elections to be worried about. At least in the meantime, the abovementioned Fed Chairman can teach us all we need to know about Fiscal responsibility, courtesy of a completely “apolitical” and transparent Federal Reserve.

As Zero Hedge presented previously, the sharp divergence between the Nikkei and the S&P indexed in gold continues. The two reindexed indexes, which have correlated 0.91 since March, have diverged sharply in the past three weeks, and now stand at an over 11% divergence in performance since the year lows. Whether this is due to the “shocking” recent realization that Japan is caught in an ever increasing deflationary vortex (which the US likely will not avoid, at least not in the near term), or simply due to momo quants deciding that the Nikkei is no longer fun to chase, a convergence trade on the two broad indexes (long Nikkei, short S&P) seems like a rather painless way to pick 10%. Then again, ask Boaz Weinstein about “surething” convergence trades.

Albert Edwards and Dylan Grice’s latest must read slideshow:

We have just had the worst decade’s performance for equity investors on record. Relative to government bonds, equities have been an even bigger disaster. Surely after such a terrible decade for equity investors things can only get better?

On a ten year view, equities may indeed prove to be a good investment. On a 1-2 year view, however, we still see much pain to come. After what we have been though so far, where the bulls? optimism has been crushed in 2001/2 and in 2007/8 surely there must be a heavy weight of self-doubt yoked onto the shoulders of the bulls ? but apparently not!

The lesson from Japan is that while de-leveraging plays itself out, the global economy will remain extremely vulnerable. The Great Moderation is dead. It was built on a super-cycle of private sector debt. We know from Japan, we now return to what was before, i.e. highly volatile and unpredictable cycles. Recession will quickly follow recovery.

US equity valuations did not reach revulsion levels in March this year. After some 15 years of gross overvaluation do we really believe that this valuation bear market that has been in place since 2000 will finish with equities looking cheap for only three months? Long term-valuation measures suggest equities will fall substantially below March lows.

Government bonds are now an extremely poor investment. On a 10-year view, the insolvency of government finances will surely end in substantially higher inflation. Yet on a 1-2 year view, we believe the key threat remains deflation. Markets will react aggressively to this as the cycle stalls in 2010. Expect sub-2% bond yields to accompany new lows on the equity market next year. Thinking the unthinkable has paid off over the last decade and should continue to do so.

Edwards Slideshow –

By Economic Forecasts & Opinions

Stock markets around the world cracked on Friday with the Dow Jones industrial average down more than 150 points (Fig. 1), and commodities plunging as Dubai debt woes unnerved investors, and sent tremors of uncertainty throughout all markets.

The crisis flared after Dubai, a part of the United Arab Emirates (UAE) federation, asked to delay interest payment for six months on $60 billion of debt issued by the state-run conglomerate Dubai World and its main property unit Nakheel.

Concerns that a government-backed investment company risked default ripped through world markets. Investors read it as a sign of yet another sovereign implosion after Iceland and Ireland, and recoiled from risk and piled into dollars.

Las Vegas on Steroids

Dubai World has served as Dubai’s main driver of growth, operating ports, transportation groups, spearheading real-estate & infrastructure projects both at home and abroad. Its real-estate subsidiary Nakheel built Dubai’s iconic palm-tree-shaped island, packed with luxury villas and hotels, many still under construction. Real estate and construction accounts for about 23% of Dubai’s GDP.

With little oil, Dubai financed much of this rapid real estate development with debt. After incurring its estimated $80-$90 billion of debt in a four-year construction boom to transform its economy into a regional financial and tourism hub, Dubai suffered the world’s steepest property slump in the first global recession since World War II.

Deutsche Bank estimates that Dubai’s property prices, both commercial and residential, have halved since August last year, and could fall a further 15-20% this year.

U.S. Banks Less Exposed

Most analysts believe U.S. banks are probably less exposed than European rivals to a potential debt default by Dubai World, but a lack of transparency and the interconnection of the modern financial system make it difficult to know which institutions are ultimately exposed.

Dubai World’s largest creditors are reportedly domestic banks in Dubai and Abu Dhabi. MarketWatch noted data from the Bank for International Settlements which put cross-border banking exposure for the UAE as a whole at $123 billion at the end of June. Of that total, European banks hold 72%, with the United States and Japan only holding 9% and 7% of the exposure, respectively. The United Kingdom is by far the biggest creditor with a share of 41%.

Reminder of Other Risks

On a global scale, Dubai World’s debt problem seems relatively minor, but it illustrates the impact from one tiny country in an increasingly interconnected world. The Dubai news also cast doubt over the strength of the U.S. economic recovery, and the prospects for a bottoming of property prices.

Commercial Real Estate

As pointed out in my previous article that the commercial real estate sector posed a much greater threat than the over-hyped “mother of all carry trades.”  The Dubai debt crisis further reinforces this viewpoint.

The potential for contagion from Dubai’s debt woes could further unhinge an already fragile U.S. commercial real estate sector, whose values have already fallen 42.9% from their 2007 peak, close to the lowest since 2002, according to Moody’s. (Fig. 2) The latest Moody’s projection is for prices to bottom at 45-55% below their peak, but could drop as much as 65% from their peak in a “stress case”.

As commercial property values fall, debt defaults rise. The $3.4 trillion outstanding in debt backed by commercial real estate poses a real threat to the recovery. Trepp LLC reported that last month, delinquencies on U.S. commercial real estate loans that were packaged into commercial mortgage-backed securities reached 4.8%, more than six times the year earlier level. Hotel loans, at 8.7% distressed, have begun falling into delinquency faster than any other kind of commercial real estate debt.

Write-downs and losses at banks around the world have risen to more than $1.7 trillion since 2007 as the credit crisis undermined the value of assets owned by financial institutions, according to data compiled by Bloomberg. Any further deleveraging and the resulting credit tightening from commercial real estate would impede the financial sector and probably derail the U.S. economy sending it into another recession. 

Housing Market Mortgage Crisis

So far, the appearance of recovery in the housing sector is being driven primarily by reduced prices combined with federal programs to lower mortgage rates with the goal of bringing more buyers into the market.

Based on a study released by Zillow.com, the foreclosure crisis has moved beyond subprime mortgages and into the prime mortgage market. (Fig. 3) While subprime borrowers are still a factor in the current foreclosure epidemic, it’s becoming increasingly apparent that the weak labor market is the driving force behind the mortgage crisis we face today.

According to the Mortgage Bankers Association, one in seven U.S. home loans was past due or in foreclosure as of Sept. 30, putting that quarterly delinquency measure at its highest level since t

he report’s inception, 1972, and up from one in ten at the beginning of the year.

The continued surge in delinquencies suggests that a recovery in the housing market could be hindered by the weak job market as well as by further fallout from the easy money and loose lending practices of the past. The foreclosures and delinquencies are expected to keep rising well into 2010, not leveling off until the unemployment rate starts to moderate.

In a study by First American CoreLogic found that one in four of all U.S. mortgage-borrowers owe more than the value of their properties in the 3rd quarter. And many experts didn’t expect U.S. home prices to hit bottom until early 2011, perhaps falling another 5-10%, as more foreclosures get pushed onto the market.

Negative equity is another outstanding risk hanging over the mortgage market.

Dubai Is No Lehman

The circumstances behind Dubai’s moves are murky, making it hard to gauge the exact risk to the pertaining bonds and Dubai’s own general creditworthiness. UBS cautioned that Dubai’s overall debt “might be higher than the generally assumed $80 billion to $90 billion, due to potential off-balance sheet liabilities. These could include unlimited and unquantifiable amount of credit default swaps (CDS) and other derivatives against the underlying assets, and once unraveled, could potentially erupt into a subprime-like crisis.

The current expectation; however, is that there’s a good chance that Dubai’s problems will probably prove a local issue. Most likely, Dubai, or its neighboring emirate, Abu Dhabi, won’t risk tarnishing their images and reputation further, and will come up with a reasonable resolution.

Even if Dubai goes into sovereign default, the amount is probably not enough on its own to threaten the financial system since any actual losses would be a fraction of the total. So, the problems in Dubai are unlikely to be as serious as last year’s Lehman Brothers collapse, nor is it a reflection on the ability of emerging markets to lead a global economic recovery.

Rational Expectations?

But Dubai could well spur a broader crisis of investor confidence in overly leveraged economies as market confidence world-wide is still fragile from the severity of the financial crisis.  The debts of many emerging markets have risen even further as the countries governments have fought the ravages of the global recession by issuing more stimulus debt to fill the gap voided by private investment.

The spread of credit-default swaps on developing-nation’s bonds jumped 14 basis points after the Dubai news broke, the most in a month, to 3.24 percentage points, according to JPMorgan Chase & Co.’s EMBI+ Index. There is also a clear sign of potential contagion effects of global risk aversion on basically all risky assets, with the dollar and yen being the prime beneficiaries.

Rational expectations or not, for now, the Dubai crisis is simply a reminder that the severe global recession has relegated much debt to near junk status, and there still remains a high degree of uncertainty as to the percentage recoverable on all outstanding debt which is going to be coming due over the next 5 years.

Despite some seminal signs of green shoots in the news headlines during this 9 month liquidity driven rally in many asset classes around the globe, we should be reminded that all that glitters is not gold, and that the global economic recovery is still on shaky ground.

#  “I know the odds are against me, but if there’s a win I’m gonna find it!”  ~Goku  #

Economic Forecasts & Opinions