It was another unusual week in the stock market, with extraordinary divergences between stocks and groups. For example, the AMEX Biotech index gained 15%, while the S&P Bank index dropped 9%. Many stocks with short positions made significant moves higher, propelling the Russell 2000 and the NASDAQ Composite to about 2% gains for the week. The Semiconductors advanced 1%, increasing year-to-date gains to 66%, while the NASDAQ Telecommunications index also added 1%. The Dow posted a slight decline, while the S&P500 dropped about 1%. The Morgan Stanley Cyclical index sank 3%, the Transports edged 1% lower, and the Morgan Stanley Consumer index was unchanged. The Utilities rose 1%. The NASDAQ100 and The Street.com Internet index were slightly positive, and the Morgan Stanley High Tech index marginally negative. After last week’s huge rally, the Bloomberg Wall Street index declined about 4%.
Action in the credit market remains quite unsettled. Treasuries were mixed with 2-year yields rising 3 basis points, and 10-year yields declining 2 basis points. Credit spreads were volatile. After ending Monday at 119, the key 10-year dollar swap spread ended the week at 128. Mortgage-back securities performed poorly this week, with spreads widening almost 5 basis points to 189. Agency spreads generally widened about 2 basis points, while corporate spreads narrowed slightly. The dollar index ended the week on stronger footing, but still dropped about 1% for the week. Gold ended the week with a gain of about $2.
It is fascinating to juxtapose the current new-paradigm focus of American economic research to the cautious and introspective post-bubble analysis from Japan. As such, we strongly recommend a recently released paper from the Bank of Japan’s Institute For Monetary And Economic Studies - The Asset Price Bubble and Monetary Policy:
Japan’s Experience in the Late 1980s and the Lessons (http://www.boj.or.jp/en/ronbun/dps00.htm) written by Kunio Okina, Masaaki Shirakawa, and Shigenori Shiratsuka. While the Federal Reserve has chosen to stick with the notion that one can only identify a bubble in hindsight, the BOJ has provided a succinct and commonsense definition of a “bubble economy”: “While the term ‘bubble’ is used differently among people, based on the experience of Japan’s economy in the late 1980’s, let us characterize the bubble economy in this paper by three factors: a rapid rise in asset prices, the overheating of economic activity, and a sizable increase in money supply and credit.” Seems simple enough to us. And although the Fed, most unfortunately failed to garner what should have been valuable lessons from the Japanese experience, this excellent report provides many insights quite pertinent to the present U.S. bubble. From the section discussing increases in money supply and credit: “The growth of credit was more conspicuous than that of money supply. During the bubble period, not only bank borrowing but also financing from capital markets substantially increased against the backdrop of the progress of financial deregulation and increases in stock prices.”
Under the heading “Mechanisms behind the Emergence and Expansion of the Bubble,” the report identified the following factors: Aggressive behavior of financial institutions; Progress of financial deregulation; Inadequate risk management on the part of financial institutions; Introduction of the capital accord; Protracted monetary easing; Taxation and regulations biased toward accelerating the rise in land prices; Overconfidence and euphoria; Over-concentration of economic function on Tokyo. The authors concluded, “No single factor was responsible for generating the bubble. Rather we believe that when several initial factors changed, there existed certain factors amplifying such changes, which led to the emergence and expansion of the bubble. The bubble was generated by complex interaction of various factors in a similar way as in a chemical reaction. The process of such a chemical reaction could be termed the process of ‘intensified bullish expectations.” Furthermore, at some point “bullish expectations became dominant among many economic agents such as firms, households, financial institutions, and the government.”
Expanding on the factor, “weak mechanism to impose discipline,” the reports states, “while the behavior of many economic agents including financial institutions, firms, individuals, and the government became gradually aggressive during the bubble period, a mechanism to impose discipline on these agents was not functioning effectively. In Japan, the main bank system had been playing an important role in imposing discipline on firms, i.e. corporate governance. However, it’s functioning gradually weakened as major firms increased their funding through capital markets. In addition, the mechanism whereby discipline is imposed by shareholders and creditors did not function sufficiently due to such factors as cross-shareholdings, the application of the acquisition cost method of accounting and insufficient disclosure.”
Under the factor, “expansion of money supply and credit,” the BOJ writes, “…during the bubble period, it was the large increase in money supply and credit that signaled the need for an early rise in interest rates. In fact…while the BOJ expressed concern over this increase from a relatively early stage, it turned out that such concern was not sufficiently taken into account. The major reason for this was lack of a common understanding, including on the part of the BOJ, as to what kind of problems might be occasioned by the massive expansion of money supply and credit.”
The report also has an excellent section – Recognizing the Adverse Effects of the Bubble. “…We conclude that we had insufficient recognition about the magnitude of damage caused by the bursting of the bubble which was disproportionately larger than the gains obtained in the emergence and expansion of the bubble.” Interestingly, this passage was footnoted with the following quote: “IMF’s Annual Reports in 1989 and 1990 expressed an optimistic view of the future course of economic developments in Japan saying that both high economic growth and price stability could be achieved through appropriate economic policy management.” The authors identified three post-bubble mechanisms that have prolonged economic recession. First, “…The correction of bullish expectations. For example, we can point out the reversed wealth effects on expenditure and classical stock adjustment as a result of excessive investment during the bubble period.” Second, “…a reduction in the economic value of capital equipment and reduced supply capacity. During the bubble period, capital expenditures dramatically increase on the premise of a future rise in asset prices and the underlying pattern of demand. The economic value of such physical assets fell sharply because they were unlikely to be utilized in the future and it would have been costly to convert them to different use…In this context, we should recognize that the serious dynamic resource misallocation caused by misguided prices during the bubble period was a mechanism inducing economic stagnation. “The third and the most important mechanism is a so-called balance sheet adjustment which a fall in asset prices eroded the asset quality of both lenders and borrowers, and reduced credit availability through the erosion of capital base, leading to a decline in economic activity.” Furthermore, “ a change in asset prices may have a huge impact on financial system stability and, in due course, on economic activity as a whole.”
Directing our attention now to the current U.S. bubble, it is precisely “financial system stability” that is our analytical focal point. In fact, we believe the fragility of the U.S. financial system is certainly greater than that of the Japanese system at the peak of their bubble. For one, the Japanese household sector was a large saver. And second, the Japanese economy ran enormous trade surpluses. And while such issues are conveniently ignored by the bullish “new era” contingent – blathering away with mindless talk of an effortless “soft landing” – the critical point is ignored: The U.S. financial sector is in the grip of a hopeless credit trap.
To clarify our analysis, we thought it helpful to share a bit of “Credit Trap” economic theory pulled from Lars Tvede’s excellent book - Business Cycles – From John Law to Chaos Theory: “(Henry) Thornton (1760-1815) explained that if you increased money supply by, say, lowering interest rates below expected profit rates, this would lead to a higher level of borrowing and, subsequently, of business activity (Thornton mentioned the early phases of John Law’s scheme in France as an example). But then he added a very important observation: Given increased activity, society would be able to absorb more money. Every increase in money supply would afterwards seem justified, as long as ensuring growth in activity could follow suit – until you reached full employment. This was crucial as it could lead the central banker to expand the money supply much too far without seeing the danger before it was too late. The system was in other words unstable – more credit seemed (deceptively) to justify more credit, and less credit seemed to justify less. The concept of such inherent instability was of course very different from Adam Smith’s invisible hand concept and indicated that the economy might have the ability to lead itself off track (because of positive feed-back)…”
Thornton, a successful banker and early monetary theorist (described as the “father of central banking”), understood (as did several early economic thinkers) that increases in the quantity of money and credit would, in fact, lead to heightened economic growth with little initial impact on general prices. This apparent advantageous position would exist as long as there were unemployed labor and general slack in factors of production. However, there came a point - when resources become more fully employed - when additional money and credit creation would manifest almost directly into destabilizing higher prices. Thornton was also one of the first to recognize that interest rates were influenced by inflation expectations, and that public confidence, while very volatile, was critical for the stability of a financial system.
The phenomena of central banker complacency to building inflationary pressures was also addressed in the BOJ report: “While the most orthodox rationale for a shift to monetary tightening is the existence of inflationary pressure, extremely stable price developments at the time considerably weakened the recognition of the need to raise interest rates...prices eventually rose substantially toward the end of the bubble period. CPI had been stable until around 1987, started to rise gradually in 1988, and the year-on-year increase was 1.1% in March 1989…The year-on-year increase in CPI…continued to rise after April 1989, and it reached 2% in April 1990 and 3% in November 1990. In addition, the month-to-month annualized increase on a seasonally-adjusted basis momentarily exceeded 4% in the latter half of 1990.”
It is certainly our view that U.S. labor markets are in a period of extreme tightness and that a strong inflationary bias continues to develop for wage earners. This week, Market News International ran some interesting quotes from John Challenger of the major placement firm Challenger, Grey and Christmas: “The labor shortage has reached a point where the President should call a labor summit to review all the possibilities to solve what some industries see as a crisis situation. There may be a slowdown in certain sectors, but the contrary exists for most industries…a number of companies had to curtail expansion plans and we have already seen the unthinkable – a major company being forced to shutter a facility because there was not enough skilled labor…” We hear lots of bullish expectations of a slowing economy; we see nothing of the kind that would rectify what has developed in the labor market.
Such burgeoning inflationary pressures should not be surprising, considering the long period of inflationary money and credit creation. The fact that they did not arrive earlier was likely more to do with the weak position of the international economy, and the fact we have gutted our industrial base in favor of massive imports. Today, however, the global economy has recovered strongly and a booming service sector is aggressively bidding up the price of labor. Importantly, the resultant inflationary bias poses a significant risk for our “credit trapped” financial sector.
After probably too much “background,” let’s try to go directly to the heart of the issue today for the U.S. financial and economic bubble. Since our economy has such inconsequential savings, the financial sector must take on additional leverage as it provides the necessary money and credit “fuel” to perpetuate the bubble. Accordingly, the financial sector should be viewed as much less an “intermediary” than a direct creator of money and credit. And while economic textbooks would hold that market interest rates are the “price of money” where supply (savings) meets demand (borrowings), this concept is simply not applicable today. Instead, our analysis leads us to believe that market interest rates are specifically determined by the supply of credit provided not by savers, but by the leveraging financial sector. Demand for credit is virtually insatiable, with bubble-induced borrowings emanating both from the overheated economy and asset markets. The credit creation process is furthermore emboldened by increasing price pressures – as inflation increases demand for additional credit. But as long as the financial sector is aggressively lending and adding to securities holdings – taking on additional leverage/borrowings in the process – market interest rates will remain low despite extraordinary borrowing demands. In the process, however, the overheated economy only runs hotter, overpriced assets become only dearer, and distortions and imbalances grow to only greater and more dangerous extremes.
But wouldn’t one expect that there would be some hesitancy by the financial sector in regard to accumulating additional leverage, especially in a rising rate environment? Well, there certainly should be, but here we see the proliferation of derivatives as an important factor. You see, many major U.S. financial institutions use derivatives to “shift” to other parties interest rate and other risk associated with $100’s of billions of loans and securities, hence supposedly mitigating the risk of taking on unprecedented leverage/borrowings. It is the proliferation of derivatives that allows unprecedented financial sector leveraging. At the same time, it is the financial sector that dominates the derivatives marketplace, both as the major buyers and sellers of derivative “insurance.” In fact, Chase Manhattan is the largest player in providing interest rate “insurance.” During just the past seven quarters, Chase’s notional amount of swaps has more than doubled to $8 trillion. During this year’s first quarter, Chase increased swap positions by 10%, while total notional amount of commercial banks derivative positions increased 9% to a staggering $30 trillion. Especially considering the inhospitable derivatives market for much of the quarter, the continued expansion of derivative positions is not comforting. Yet, amazingly, perception holds that this market is functioning well and that all the major players are “hedged.” Well, this is one of financial history’s great myths, as it is simply impossible for the financial sector to “hedge” itself from the great risk created through reckless lending and leveraging.
Admittedly, as long as rates do not move significantly higher, the perception can be maintained that this unfathomable amount of interest rate derivative “insurance” is valid. Or said another way, as long as there are no major “claims” on this “insurance” there is no problem. So, the precarious situation has developed that as long as the financial sector continues to lend and purchase securities aggressively – perpetuating credit creation excess through continued financial sector leveraging – the supply of credit will work to engender continued artificially low interest rates and general system liquidity. And as long as credit excess fuels rising asset prices, additional collateral “value” will foster additional borrowings. But this is a major TRAP, as any slowdown in financial sector credit creation will immediately cause a problematic imbalance between the supply and overheated demand for credit. Such an outcome, as we got an inkling of during the first quarter when financial sector borrowings slowed to a rate of less than 8%, is sharply wider spreads, heightened illiquidity, and rising interest rates for private sector borrowings (mortgages, agencies, corporates, junk, etc.). Above all, the resultant higher rates dramatically increase the probabilities that derivative “insurance” claims may actually be made, forcing players that have written the “insurance” to attempt to dynamically “hedge” their exposure by selling/shorting securities. This, obviously, leads only to less liquidity, higher rates, and heightened systemic risk in a dangerous feedback mechanism.
Presently, this TRAP has become particularly precarious as the degree of financial sector credit creation necessary to keep the U.S. financial system liquid and derivatives market viable is highly inflationary for the overheated economy. Despite the clear necessity to temper increasingly destabilizing credit growth, the consequences are dire. As we have seen repeatedly, faltering markets quickly elicit financial sector “reliquefication.” Over the past week or so such efforts led to narrowing spreads and declining rates and a semblance of normalcy and return of liquidity to credit market – much to the delight of a very long list of eager corporate borrowers. There is also the euphoric and debt-crazy household sector, extraordinarily rich with inflating home equity gains, that is hypersensitive to any reduction in mortgage rates. So, despite the financial sectors urgency to “reliquefy,” such efforts are this time self-defeating. It should be obvious that the last thing our system needs is additional household sector liquidity stoking already overheated demand and surging real estate prices. And there is no doubt that the consequences of continued credit excess will be inflation and larger trade deficits. As such, we continue to believe that the U.S. credit bubble has hit the wall and that the financial simply cannot lend its way out of trouble.
It is also our view that foreign creditors will become increasingly aware of U.S. credit trap dynamics. Certainly, we believe global central bankers understand clearly that the U.S. is in a dangerous bubble, and they furthermore recognize that inflationary pressures are rapidly building globally. From the BOJ’s report, we will surmise that Japanese authorities have a clear understanding of the U.S. bubble and a keen appreciation for its painful consequences. We also see yesterday’s aggressive move by the ECB and talk of the Bank of Japan ending the protracted period of extreme accommodation consistent with the recognition of heightened risk. Despite the perception that the U.S. taps the world’s savers for our financial boom – at least to some degree (possibly significantly), our bubble has been fed internationally by extraordinary "easy money" central bank accommodation - particularly from Japan and Europe. Today, however, we see this coming to an end. And with already enormous foreign liabilities expanding rapidly with massive current account deficits, we see the highly leveraged U.S. financial sector vulnerable to any change in dollar sentiment. Indeed, it is likely aggressive international borrowings by the U.S. financial sector that has been primarily responsible for maintaining dollar strength. Now, however, it is certainly our belief that the credit trap dynamics are in full force for the U.S. financial sector creating an acutely fragile financial structure and liabilities that will be much less attractive to foreign investors. There is vulnerability all along the chain of aggressive financial sector leveraging, unprecedented derivative positions, an overheated economy, perilous asset inflation and enormous dollar liabilities. Today, not even continued aggressive financial sector leveraging could mask a financial system that becomes increasingly unstable by the week.