Diverging Like It's 1929

As regional and global economic downturns gain momentum, the ECB significantly lowered its forecasts for Eurozone growth this week. The ECB staff is now predicting 2012 economic activity to contract in the range of between 0.2% and 0.6%. The German economy is now also projected to slip into a recession.

by Doug Noland
September 07, 2012

Spanish 10-year yields dropped 123 bps this week to 5.57%. Yields are now down 194 bps from July 24 highs (7.51%). Italian 10-year bond yields sank 80 bps this week to 5.02%, and are down 153 bps from July highs (6.55%). Spanish stocks (IBEX) have rallied 34% off July lows, slashing its 2012 loss to only 8%. And after its 32% rally from July lows, Italian stocks (MIB) now sport a 6.8% y-t-d gain. The German DAX has gained 14% from July lows, increasing its 2012 gain to 22.3%.

Here in the U.S., tens of Trillions of (government, corporate, and mortgage-related) bonds are priced at or near record high levels (low yields). The S&P 400 Mid-Cap equities index, up 14.3% y-t-d, is only 0.4% below its all-time high. The small cap Russell 2000 (up 13.7% y-t-d) is 0.6% below its record high. The S&P 500 traded this week to the highest level since May 2008. The Nasdaq (“NDX”) 100 now enjoys a 2012 gain of 24.0% - and traded this week to its highest level going all the way back to 2000. Junk bond spreads traded this week to a 13-month low.

As regional and global economic downturns gain momentum, the ECB this week significantly lowered its forecasts for Eurozone growth. ECB staff now project 2012 economic activity to contract in the range of between 0.2% and 0.6%. Thursday the Organization for Economic Cooperation and Development (OECD) revised downward its estimates for G7 economic growth. The German economy is now projected to slip into recession, with Q3 GDP forecast at an annualized negative 0.5%. Economic activity is expected to weaken further to negative 0.8% in Q4. The French economy is expected to contract 0.4% in Q3, before recovering for 0.2% growth in Q4. The Italian economy is forecast to contract 2.9% during Q3 and 1.4% in Q4. The British economy is seen contracting 0.7% in Q3, before recovering for 0.2% growth in Q4. Japan’s economy is now expected to contract 2.3% (annualized) in Q3. U.S. growth is expected to improve mildly to a 2.0% rate during Q3 and 2.4% in Q4. Outside of the G7, the Greek and Spanish economies are unmitigated disasters.

With the financial world fixated on Draghi, Bernanke and endless QE, global markets now wildly diverge from economic fundamentals. Many are content to celebrate, holding firm to the view that financial conditions tend to lead economic activity. Markets discount the future, of course. And, traditionally, an easing of monetary policy would loosen Credit and financial conditions - spurring lending, spending, investing and stronger economic activity.

Importantly, traditional rules and analysis no longer apply. Monetary policy has been locked in super ultra-loose mode now entering an unprecedented fifth year. Here in the U.S., financial conditions can’t get meaningfully looser. The Federal Reserve has pushed corporate and household borrowing costs to record lows. Liquidity abundance will ensure near-record 2012 corporate debt issuance. “Loose money” has already had too long a period to impact decision making throughout the economy – with decidedly unimpressive results. Arguably, previous unfathomable monetary measures some time ago created dependencies and addictions that are increasingly difficult to satisfy.

Clearly, monetary policy is exerting a much greater impact on the financial markets than it is on real economic activity. In the U.S. and globally, market gains are in the double-digits, while economic growth is measured in dinky decimals. The vulnerability associated with elevated securities markets has tended to only compound the issue of systemic fragility, and policymakers have responded to heightened stress with only more extraordinary policy measures. Recent weeks have provided important confirmation of the Bubble Thesis.

Amazingly, in the face of exceptionally buoyant securities markets and an expanding economy, the Federal Reserve is apparently about to embark on yet another round of quantitative easing (“money printing”). Few expect this to have much impact on the real economy, but it is clearly having a major impact on already speculative financial markets.

I’ve always feared such a scenario: Severely maladjusted Bubble Economies responding poorly to aggressive monetary stimulus, spurring policymakers into only more aggressive stimulus measures. Meanwhile, financial fragility mounts, as Credit systems continue to rapidly expand non-productive debt. Securities markets become dangerously speculative and detached from underlying fundamentals.

Students of the late-1920s appreciate how late-cycle policy-induced market and economic distortions laid the groundwork for financial collapse and depression. Especially in 1928 and early-1929, highly speculative financial markets diverged from faltering global economic fundamentals. Our nation’s business came to be precariously dominated by “money changers,” financial leveraging and market speculation.

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