I have posited that the policy response to the bursting of the Wall Street/mortgage finance Bubble unleashed the Global Government Finance Bubble.  It now appears that the Greek debt crisis will mark a key Bubble inflection point. 

From a market perceptions point of view, it’s a changed world.  Faith in government policymaking has been badly shaken.  Confidence that fiscal and monetary stimulus ensures ongoing global reflationary forces has waned.  Markets now appreciate that massive stimulus can’t assure market stability.  Indeed, further deterioration in government finances is now recognized as creating instability, uncertainty, and heightened systemic risk throughout the markets.  The world will now look at structural debt issues in a much less positive light.

From a flow of funds perspective, one can identify four key sources of finance that propelled the recent 18-month reflationary period.  First, recall that federal liabilities increased about $340bn in 2007.  This debt growth ballooned to $1.63 TN annualized during the first quarter and averaged about $1.60 TN annualized over the past six quarters.  Second, reflation was fueled by Federal Reserve monetization - especially the $1.2 TN increase in agency debt/MBS holdings over the past five quarters.  Third, zero rates encouraged a massive flow out of relative safety in search of higher returns.  Fourth, there was the critical - if not transparent - re-risking and leveraging for the hedge funds, sovereign wealth funds and other global speculators.

All four of these critical sources of reflationary finance now have issues.  Alan Greenspan’s op-ed piece in today’s Wall Street Journal – “U.S. Debt and the Greece Analogy” - highlights the newfound attention to our nation’s structural debt predicament.  Though I’ll somewhat reserve judgment until the next crisis or economic downturn, the political pendulum appears to have swung decisively against additional bailouts, stimulus measures or other programs that would worsen our dismal fiscal situation.  Staggering amounts of government spending stabilized the system, while it increasingly appears we will garner few additional “benefits” from double-digit percentage-to-GDP deficits.

Similarly, caution is the watchword when it comes to anticipating additional benefits from monetary policy.  Granted, the Fed is likely stuck in the vicinity of zero indefinitely.  I am nonetheless skeptical that this necessarily equates to ongoing ultra-loose financial conditions.  I would argue that the Trillion-plus purchases of MBS had a momentous impact on marketplace liquidity, especially when it came to unfreezing the private-label MBS marketplace.  I expect a divided Fed to approach any additional monetization of MBS cautiously. 

Slashing rates certainly has a powerful impact when it comes to inciting Risk Embracement and asset inflation.  I don’t, however, anticipate that zero rates will have a great expansionary influence in a period of renewed risk aversion and faltering markets.  Looking at this issue from the Household sector perspective, zero rates can have varying benefits as well as costs.  On the back of surging securities prices, Household net worth jumped $6.30 TN over the past year (ended 3/31).  Previous low rate environments saw households enjoy huge housing wealth effects, including the free-flowing extraction of (inflating) home equity.  Near zero returns on household savings may not be a big issue when assets markets are rapidly inflating and households are tapping cheap sources of borrowings.  But that’s not the likely backdrop going forward.  Instead, zero rates may prove an impediment to consumption after this cycle’s atypical (especially in regard to housing and private-sector Credit expansion) reflationary dynamics have run their course.

I’ll be surprised if the wall of liquidity fleeing low returns isn’t in the process of slowing toward a trickle – or perhaps even reversing.  Especially with the continued drag from weak housing and jobs markets, the household sector is not favorably positioned to take on additional market risk.

I would find it very surprising if the European debt crisis did not mark a key inflection point for the global leveraged speculating community.  Painful (and highly correlated) losses in debt, currency, equities and commodities markets would seem to ensure heightened risk aversion going forward.  Clearly, sovereign debt has a greater degree of risk than was perceived in the marketplace prior to the Greek eruption.  A more cautious approach to “carry trades” (i.e. borrowing in yen or dollars to purchase higher-yielding instruments in other currencies) and leverage more generally seems certain.  This equates to more challenging marketplace liquidity and tighter financial conditions.