Two-year government yields declined 6 bps to 4.76%. Five-year yields declined 4.5 bps to 4.65%, and 10-year Treasury yields fell 5 bps to 4.65%. Long-bond yields dropped 6.5 bps to 4.75%. The 2yr/10yr spread ended the week inverted 11 bps. The implied yield on 3-month December ’07 Eurodollars fell 8 bps to 4.87%. Benchmark Fannie Mae MBS yields sank 10 bps to 5.69%, this week nicely outperforming Treasuries. The spread on Fannie’s 5 1/4% 2016 note narrowed one to 27, and the spread on Freddie’s 5 1/2% 2016 note narrowed one to 25. The 10-year dollar swap spread declined 2 to 47.80. Corporate bonds performed well, with junk spreads narrowing as much as 15 bps.
January 4 – The Wall Street Journal (Serena Ng): “Junk has never been so fashionable. The ranks of companies whose debt is rated below investment grade, known as junk, are swelling, a sign of increased borrowing and a growing appetite for risk by investors seeking high returns. Back in 1980, the debt of slightly less than a third of U.S. industrial corporations tracked by Standard & Poor’s was rated junk. By the late 1980s, more than half were, and now 71% of the pie fits into that category… ‘Junk bonds used to be a bad word on Wall Street,’ says Joe Bencivenga, who used to be a bond analyst at Wall Street’s junk-bond house Drexel Burnham Lambert in the 1980s. ‘They have since gained a lot more respectability…’ The rising tide of junk points to glacial changes in the nation’s financial markets, and to more explosive short-term trends.”
Investment grade issuers included Morgan Stanley $4.5 billion, Goldman Sachs $2.25 billion, Donnelley & Sons $1.25 billion, and MBIA $100 million.
International issuers included North Rock Building Society $2.0 billion.
Japanese 10-year “JGB” yields increased 3 bps this week to 1.71%. The Nikkei 225 began the New Year by declining 0.8%. German 10-year bund yields rose 4 bps to 3.98%. Emerging markets started 2007 trading mixed. Brazil’s benchmark dollar bond yields dipped 1.5 bps this week to 5.99%. Brazil’s Bovespa equities index sank 5.0% (one-yr gain 20.9%). The Mexican Bolsa declined 1.2% (one-yr gain 40.5%). Mexico’s 10-year $ yields were little changed at 5.58%. Russia’s 10-year Eurodollar yields dipped one basis point to 6.62%. India’s Sensex equities index was little changed (one-yr gain 44%). China’s Shanghai Composite index declined 1.3% (one-yr gain of 121%).
Freddie Mac posted 30-year fixed mortgage rates were unchanged last week at 6.18%, down 3 bps from a year earlier. Fifteen-year fixed mortgage rates added one basis point to 5.94% (up 18bps y-o-y). And one-year adjustable rates dropped 5 bps to 5.42% (up 26bps y-o-y), the lowest rate since the week of March 24. The Mortgage Bankers Association Purchase Applications Index increased 4.3% this week. Purchase Applications were down 3% from one year ago, while dollar volume was up 0.5%. Refi applications rose 2.2%. The average new Purchase mortgage declined to $219,300 (up 3.5% y-o-y), and the average ARM dropped to $364,000 (up 13.4% y-o-y).
Bank Credit gained $7.0 billion during the week (of 12/27) to $8.297 TN. For the year, Bank Credit expanded $809 billion, or 10.8% annualized. During the week, Securities Credit declined $5.3 billion. Loans & Leases increased $12.3 billion to a record $6.076 TN, with a 2006 gain of $621 billion (11.4%). Commercial & Industrial (C&I) Loans expanded 12.6% during the year. For the week, C&I loans fell $10.8 billion, and Real Estate loans dipped $1.4 billion. Bank Real Estate loans expanded 14.1% during 2006. For the week, Consumer loans were about unchanged, while Securities loans jumped $17.9 billion. Other loans increased $6.5 billion. On the liability side, (previous M3) Large Time Deposits dropped $15 billion.
M2 (narrow) “money” surged $30.8 billion to a record $7.042 TN (week of 12/25). Narrow “money” expanded $356 billion, or 5.3%, over the past year. M2 has expanded at a 7.8% pace during the past 20 weeks. For the week, Currency increased $0.6 billion, and Demand & Checkable Deposits jumped $27.2 billion. Savings Deposits declined $3.0 billion, while Small Denominated Deposits increased $1.3 billion. Retail Money Fund assets rose $4.3 billion.
Total Money Market Fund Assets, as reported by the Investment Company Institute, rose $9.9 billion last week to $2.392 Trillion. Money Fund Assets increased $331 billion over 52 weeks, or 16.1%. Money Fund Assets have expanded at a 24.6% rate over the past 20 weeks.
Total Commercial Paper jumped $17.6 billion last week to a record $1.992 Trillion. Total CP has increased $344 billion, or 20.9%, over the past 52 weeks. Total CP has expanded at a 27% rate over the past 20 weeks.
Fed Foreign Holdings of Treasury, Agency Debt increased $10.9 billion last week (ended 1/2) to a record $1.763 Trillion. “Custody” holdings were up $239 billion y-o-y, or 15.7%. Federal Reserve Credit expanded $7.3 billion to $859 billion. Fed Credit was up $26.7 billion y-o-y, or 3.2% annualized.
International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $760 billion y-o-y (18.8%) to $4.806 Trillion.
Currency Watch:
The dollar this week gained 1.2% to 84.40. On the upside, the Indonesian rupiah increased 0.5%, the Canadian dollar 0.4%, the Japanese yen 0.4%, and the Malaysian ringgit 0.3%. On the downside, the South Korean won declined 2.4%, the New Zealand dollar 1.8%, the Turkish lira 1.7%, and the Hungarian forint 1.0%.
Commodities Watch:
January 2 – Financial Times (Kevin Morrison): “China is scouring the world to secure supplies of key raw materials to feed its fast-growing economy and - apart from oil - the greatest need is for iron ore for steelmaking. China imports more iron ore in weight terms than any other commodity to feed the demand for steel to build more roads, bridges, tunnels, industrial complexes, housing and office buildings to underpin the country’s surging economic growth. Iron ore imports for 2006 are expected to have totalled 330m tonnes, up from 275m tonnes a year earlier. The figure is expected to increase to 370m tonnes in 2007.”
January 2 – Bloomberg (Eduard Gismatullin): “Russia, the world’s second-largest oil supplier, raised output 2.2 percent in 2006, the smallest annual increase since 1999, after companies cut investment because the state is increasing controls on the industry.”
For the week, Gold dropped 4.6% to $607.40, and Silver declined 4.9% to $12.295. Copper sank 11.3% to a 9-month low. February crude dropped $4.81 to end the week at $56.24, an 18-month low. March Gasoline sank 7.5%, and January Natural Gas declined 1.0%. For the week, the CRB index dropped 5.3%, and The Goldman Sachs Commodities Index (GSCI) sank 6.0%.
Japan Watch:
January 2 – Bloomberg (Issei Morita): “Japan’s economy will grow about 2.2 percent a year through March 2016, the country’s biggest business lobby projects. That compares with the government’s estimate of 1.9 percent growth for this fiscal year and 2 percent for next.”
China Watch:
January 2 – Bloomberg (Dune Lawrence): “China’s tax revenue climbed 22 percent to 3.76 trillion yuan ($482 billion) in 2006, buoyed by its expanding economy.”
January 5 – Bloomberg (Nipa Piboontanasawat): “China told banks to set aside more money as reserves for the fourth time in seven months to prevent a rebound in lending and investment in the world’s fastest-growing major economy. Banks must put aside 9.5 percent of deposits starting Jan. 15, up from 9 percent…”
January 2 – Bloomberg (Nipa Piboontanasawat): “Hong Kong economic activity rose to the highest in more than six years in December as companies received more orders and production increased, a survey of purchasing managers showed.”
India Watch:
January 5 – Financial Times (Joe Leahy): “Forget “Incredible India”, the government advertising campaign that uses images of sari-wearing princesses and trumpeting elephants to attract tourists to the sub-continent. India has a new kind of visitor – the real estate investment tourist, or “reit”, as Ravi Raheja, group president of K Raheja Corp, the Mumbai-based developer, likes to call the foreign private equity investors, bankers and others looking to buy into its property market. In fact, so hot has Indian property become, domestic developers no longer have to wait for foreign investors to come to them – they are increasingly able to sell their paper overseas, particularly on Aim, London’s junior market. The trend is prompting some to question whether it really is wise for foreign investors to be buying into a distant, chronically under-developed real estate sector that even on the domestic market is only just emerging as a credible asset class.”
Asia Boom Watch:
January 1 – Bloomberg (Kevin Cho and Seyoon Kim): “South Korea’s exports rose in December as companies sold more goods including cars, chips and other goods. Exports increased 13.8 percent to $29.2 billion from a year earlier…”
January 3 – Bloomberg (Seyoon Kim): “South Korea is planning ‘aggressive’ measures to stem the won’s gains to protect the economy, President Roh Moo Hyun said. ‘We will put together aggressive measures and manage so that the currency issue does’t burden the economy…We need to set longer-term management strategy so that the currency situation doesn’t deteriorate.’”
December 31 – Bloomberg (Shamim Adam): “Singapore’s economic growth accelerated to 7.7 percent this year due to ‘robust’ performances in manufacturing and services, Prime Minister Lee Hsien Loong said… The $118 billion economy expanded 6.4 percent in 2005.”
January 5 – Bloomberg (Clarissa Batino): “Philippine money-supply growth quickened for a third month in November on higher remittances, investment and lending, the central bank said… Domestic liquidity expanded 18.5 percent in November…from a year earlier…”
Unbalanced Global Economy Watch:
January 5 – Bloomberg (Alexandre Deslongchamps): “Canadian employers added 61,600 jobs in December, more than four times what economists expected and the fourth-straight gain… The unemployment rate dropped to 6.1 percent from November’s 6.3 percent, matching a 31-year low…”
January 4 – Market News International: “Bank of England November personal lending data highlighted the continuing strength of the housing market, with mortgage approvals climbing to a near 3-year high.”
January 2 – Bloomberg (Brian Swint): “U.K. house-price inflation accelerated to the fastest pace in 18 months in November, led by gains in London and the east of England… Home values rose 6.8 percent from a year earlier…”
January 3 – Bloomberg (Andreas Cremer): “German unemployment in December fell the most since reunification in 1990 as accelerating economic growth encouraged companies to hire and the construction industry retained workers amid unseasonably warm weather. The number of people out of work…fell 108,000 to 4.12 million… The jobless rate fell to 9.8 percent from 10.1 percent.”
January 4 – Bloomberg (Tasneem Brogger): “Denmark’s jobless rate dropped to 4 percent in November, raising the prospect of increased wage demands when about 600,000 workers start pay talks this quarter, and threatening to push up inflation.”
January 2 – Bloomberg (Ben Holland): “Turkish exports rose 19 percent in December from a year earlier…Exports increased to a record $8.72 billion…”
Latin American Boom Watch:
January 2 – Bloomberg (Bill Faries): “Argentina’s tax revenue rose 25 percent in December from a year earlier, the country’s tax-collection agency reported.”
January 4 – Bloomberg (Eliana Raszewski): “Buenos Aires is putting the brakes on construction after a four-year boom overstretched water, electricity and sewage services -- and prompted residents to protest the destruction of their barrios. City Hall has a moratorium on new building permits for six neighborhoods to prevent developers, spurred by surging residential real estate prices, from ripping down two-story houses to build apartment buildings.”
January 3 – Bloomberg (Alex Kennedy): “Venezuelan government spending soared 94 percent in October to its highest in at least eight years as President Hugo Chavez boosted outlays on health, education and food programs ahead of last month's presidential election.”
Central Banker Watch:
January 5 – Bloomberg (Ye Xie): “China’s central bank may have earned $29 billion last year on investment of its foreign reserves, according to Standard Chartered Plc. …China’s foreign reserves, the world’s largest, exceeded $1 trillion in November. Analysts estimate that about 70 percent of the holdings are invested in U.S. Treasuries and other dollar-denominated assets.”
Bubble Economy Watch:
January 2 – Financial Times (Brooke Masters): “Corporate legal bills soared nearly 20 per cent this year and could increase by a further 9 per cent in 2007, according to a survey of leading companies in the US. The survey of Fortune 1000 companies by the BTI Consulting Group found that total spending on outside counsel reached $56.4bn in 2006, driven by large increases in spending by the biggest US and multinational firms. A typical company in the BTI survey spent $19.5m on outside lawyers, nearly double the $10.5m average only five years ago.”
January 5 – Bloomberg (Kristy McKeaney): “U.S. same store sales rose 3.1 percent in Dec. from a year earlier, according to the International Council of Shopping Centers. Total store sales rose 8.3 percent from a year earlier.”
Financial Sphere Bubble Watch:
January 4 – Financial Times (Richard Beales): “Investment banks pulled in 18 per cent more revenue from US debt capital markets deals last year than in 2005, with fee growth on Wall Street outpacing the increase in revenues earned in Europe, according to…Dealogic.
Mortgage Finance Bubble Watch:
January 5 – Bloomberg (James Tyson): “Freddie Mac, the second-largest source of money for U.S. home loans, reported a $550 million net loss for the third quarter and had an undetermined loss in the fourth quarter as lower bond yields reduced investment returns… Freddie Mac's third-quarter performance stemmed from $1.5 billion in pretax losses on derivatives and other assets and obligations, the company said… The results ‘reflect the volatility we see quarter-to-quarter in response to movements in interest rates,’ Freddie Mac Chief Executive Richard Syron said in the statement. ‘We face a challenging market environment…’ Freddie Mac spent $1.2 billion in the first nine months of last year fixing accounting and other administrative expenses, compared with $1.1 billion during the same period of 2005.”
Real Estate Bubble Watch:
January 3 – Bloomberg (Sharon L. Crenson and Kathleen M. Howley): “Manhattan apartment prices rose 3.2 percent in the fourth quarter from a year earlier, the smallest annual gain in a decade… The average sales price was $1.22 million in the three months ending Dec. 31, compared with $1.19 million in 2005, according to Miller Samuel Inc…broker Prudential Douglas Elliman Real Estate. Sales volume rose 15.5 percent from the third quarter to 2,441 units in the fourth.”
January 4 – The Wall Street Journal (Jennifer S. Forsyth): “Office landlords had a heyday in 2006 as rents rose at the fastest pace in six years. Yet there are signs that conditions could be turning a little more in the favor of tenants. Newly released data by Reis Inc., a New York real-estate research firm, show that office rents rose 9% nationally last year, the heftiest increase since the height of the technology boom in 2000. However, the report also found that demand for new office space slowed sharply near the end of last year, a sign that large rent increases may not continue.”
M&A and Private-Equity Bubble Watch:
January 4 – Bloomberg (Edward Evans): “Kohlberg Kravis Roberts & Co. will pay at least $837 million in fees to investment banks for deals in 2006, more than any other private equity firm, in an unprecedented year for leveraged buyouts. Henry Kravis and George Roberts’ firm spent three times more in the first 11 months of 2006 on fees to securities firms than in the whole of 2005…A record amount of LBOs last year will generate $11 billion in fees for banks…”
Financial Sphere Bubble Watch:
January 3 – The Wall Street Journal (Alan Murray): “The New Year’s forecasts are so unrelentingly sanguine that you have to wonder whether a tanker of strong, black coffee is in order. The U.S. economy will keep growing. The housing market will recover. The Federal Reserve will cut interest rates. And financial markets will soar. The world, it seems, has become intoxicated by the steady flow of what my fellow financial writers call ‘liquidity.’ Money flows freely, like the vodka from Dennis Kozlowski’s infamous ice-hewn David, filling every dark and desolate crevice of the financial world. There is a steady stream of resources to the most perilous of emerging markets, the most hopeless of troubled companies and the most overextended of home buyers. That’s great fun while it lasts. But does anyone seriously think it will last forever?”
Energy Boom and Crude Liquidity Watch:
January 3 – Financial Times (Ed Crooks and Javier Blasin): “US dependence on the Or-ganisation of Petroleum Exporting Countries for its oil imports has risen to its highest level in 15 years, following Angola’s arrival this week as the 12th member of the oil producers’ group… The move comes at a time when Opec is trying to exert more influence, as seen in its decision at the December meeting to cut 500,000 barrels a day from its output from February. Including Angola, Opec now supplies more than 54 per cent of the oil imports of the developed countries, its highest level for five years. For the US, the increase is even sharper: at more than 52 per cent, Opec’s share of US oil imports is at its highest since 1992.”
Climate Watch:
January 3 – Financial Times (Michael Mackenzie): “Summer has come to Argentina with a vengeance, bringing temperatures soaring above 40 degrees Celsius this week and almost unbearable loads on the power system. The national grid is groaning under the strain of soaring demand for price-capped electricity and as sticky residents in Buenos Aires flip on their air conditioning en masse, consumption has hit a new peak, surpassing last summer’s high and plunging parts of the capital into sporadic blackouts.
Power cuts are one of the most tangible signs of trouble in Argentina’s energy industry…”
Speculator Watch:
January 3 – Financial Times (Michael Mackenzie): “When it comes to easy money, it is hard to overlook a dramatic distortion in the credit market that has generated virtually risk-free returns for some investors in recent months. Thanks to surging demand for credit exposure in the derivatives market, the cost of offloading credit risk through credit default swaps (CDSs) - which provide an insurance against corporate default - has dropped. For some companies, the annual cost of buying credit protection has fallen below the risk premium, or spread, a bond investor receives on the same company’s bonds over and above benchmark risk-free interest rates. This situation is known as ‘negative basis’. Investors can buy both bonds and CDS protection, leaving them with net credit risk of almost zero but still able to pocket a spread above risk-free rates.”
Issues 2007:
I simply have a difficult time getting on board with the view that our housing markets will be this year’s major Issue. And, actually, I’ll be surprised if the U.S., Chinese or the global economy takes center stage. When it comes to Issues 2007, I fully expect developments in and around finance and the financial markets to overshadow economic issues, concerns and risks. I’ll even go out on the analytical limb and predict it will be one captivating, historic and, likely, fateful year – and very much All About Finance.
The concurrent Credit Boom and Economic Transformation are these days quite comfortably entrenched. Contemporary unchecked “Wall Street” finance can now so easily adapt to changes in the quantity and composition of demand for borrowings from both the real economy and the securities markets. And today’s energized Credit apparatus has no problem adjusting to well-telegraphed marginal changes in short-term interest-rates. A quasi-pegged cost of funds suits the markets just fine.
The “resilient” U.S. services-based economy efficiently adapts to (finance-driven) changes in demand - effortlessly expanding the volume, type and price of “services” rendered, while imports freely satisfy whatever quantity of foreign-produced goods is desired. Traditional measures of inflation are now far removed - and capture little of the effects – from Prevailing Inflationary Manifestations. Meanwhile, manufacturing and inventory cycles these days engender only a secondary impact on the overall economy. As we witnessed in 2006, even major downturns in housing and auto manufacturing leave much of the Bubble Economy unscathed and even (through exacerbating loose financial conditions) stimulate key sectors such as financial services.
Don’t, however, even during a moment of weakness allow this feel-good backdrop to seduce you into the complacency that has enveloped the vast majority. The Financial Sphere’s Miraculous Adaptability and the Economic Sphere’s Trumpeted Resiliency owe everything to an Unprecedented and Continuous Flow of New Credit and Liquidity. This predicament is both the secret of recent success and the magic elixir offering the possibility for the inordinate stretching of this venerable boom – one person’s so-called “bullish” 2007 and another’s disastrous extension of “blow-off” excesses. Today’s acute dependency on massive Credit creation and superabundant liquidity is the system’s fatal flaw, playing guilefully into ingrained optimism and for the duration of the boom toying with calamity.
The bottom line is that the U.S. Credit and Economic Bubbles have no alternative than to expand (“failure is not an option”). But with risk intermediation and speculation having already been pushed to risk-taking extremes, sustaining this boom will be no small feat. Indeed, it will require another Herculean pushing of the Finance envelope. We did witness as much last year with developments in global Credit derivatives, high-risk lending, financial leveraging, and M&A. One can at this point safely assume the U.S. financial sector is up to 2007’s challenge, which leaves me pondering the ramifications for only greater Monetary Disorder.
There are these days commanding institutional enrichment and preservation “biases”. Wall Street investment bankers, traders, derivatives specialists, and brokers have every intention of earning even fatter bonuses in 2007. “Bank” executives appreciate that last year’s double-digit Bank Credit expansion was welcomed and well-rewarded. They surely expect to do more of the same this year to satisfy Wall Street’s (inflating) earnings expectations. Corporations (led by the financials) were remunerated handsomely for buying back stock and will plan on only larger repurchases in 2007. Coming off a decent year, the leveraged speculating community will enjoy additional robust inflows, while incorporating only greater leverage in the corporate debt and “Credit arbitrage” speculations that served them so well in 2006.
Admittedly, it is too easy to extrapolate current liquidity conditions and perhaps even the four-year liquidity-driven “bull market.” And, let’s face it, Credit Bubble inertia is a force to be reckoned with. The continued rapid increase in total system Credit and liquidity in the face of rapidly decelerating U.S. nominal GDP was the prevailing dynamic of 2006. And while we’ll know more come the March arrival of 4th quarter data, there is already ample evidence to indicate that the extended discord between system Credit creation and economic “output” took a decided turn for the worst during the closing months of 2006. The Economic Sphere’s moderate expansion has been perfect for immoderate Financial Sphere Ballooning.
Apparently focused on housing sector vulnerabilities, the Fed halted rate increases mid-year. Whether one believes this was appropriate policy or not, inarguably our energized Financial Sphere - feasting in Ultra-Loose Financial Conditions - was waiting keenly to take full advantage. Bubble Economy Fragility set the stage for a record year in M&A, corporate debt issuance, junk issuance, “leverage lending,” and global financial (trade, investment, and speculative) flows and imbalances. The Credit derivatives marketplace went nuts; global liquidity excess went bonkers; and global equities went crazy. U.S. and global finance completely lost their moorings. As I have written previously, the degree of Credit, speculative, and asset inflations experienced over the past year (or the past four or 14) does not unfold without the impetus of some underlying Credit System Disorder.
For Issues 2007, we’ll contemplate some key marketplace assumptions – Today’s Defining Tenets of Contemporary Finance – that are suspect and increasingly susceptible to miscalculation and eventual repudiation.
- Marketplace Liquidity: The long boom has participants convinced that liquidity is a permanent fixture of contemporary financial markets. This is especially problematic in an age where marketable instruments and securities markets have become such an instrumental force in the Credit creation process - and where speculative endeavors play such a profound role in Credit Availability and Marketplace Liquidity. The perception of unlimited liquidity, especially with Fed “tightening” having been removed from the equation, has fueled an extraordinary expansion in securities leveraging – a self-feeding liquidity-creating dynamic that only further reinforces the pretense of endless marketplace liquidity. Market dynamics are also increasing the likelihood that a problematic reversal of leveraged positions could at any time abruptly degrade the liquidity backdrop.
- Derivatives are a Boon to Finance and Economics: Despite some notable setbacks over the years, markets have nonetheless come to believe derivatives reduce market volatility and overall systemic risk. To be sure, finance evolves and adapts in its constant pursuit of profit opportunities. With prospective returns having been largely wrung from the investment-grade securities markets, the leveraged speculators last year shifted decisively into “Credit arbitrage” – leveraged positions to profit from Credit spreads, as well as booking gains from writing Credit insurance. This powerful dynamic feeds risk-taking and general liquidity excesses, fueling self-reinforcing global asset inflation. The upshot is dramatically heightened systemic fragility, including vulnerability to unpredictable speculative trading dynamics and asset market susceptibility to any waning of liquidity excess. The perception that market insurance will always be available at a reasonable cost is a major factor championing late-cycle financial excess.
- Liquid and Continuous Markets: Markets, especially the derivatives marketplace, operate under the assumption that the Federal Reserve and global central banks guarantee that markets will always remain abundantly liquid. This is an essential premise for computer and model-based “dynamic” hedging strategies (market-dictated buying or selling/shorting of instruments to offset changing derivative exposures) that these days dominate the market landscape. Unprecedented foreign central bank buying of U.S. dollar securities (“backstop bid”) has fed the misperception of endless marketplace liquidity. In particular, potential liquidity issues related to the reversal of the Credit Insurance Bubble, including the unwind and hedging of (corporate) Credit derivative positions in an unfavorable market environment, could emerge as a major Issue 2007.
- Credit Insurance: As much as the markets are determined to reckon otherwise, Credit losses are not insurable risks. Losses are categorically non-random and non-independent (as opposed to auto and fire accidents). By their very nature, they come and go in waves, and that infrequent Tidal Wave of Destruction can be expected to come precisely when it is least expected. Boom-time exuberance, with its intoxicating run of inflated financial profits and minimal Credit problems, propagates the crescendo, reversal and dismal downside of the Credit Cycle. The current Credit Derivatives Mania is putting the finishing touches on a Credit system and economy distorted to the point where there is no applicable history that might offer guidance as to downside cycle risks and expected Credit losses. Certainly, forecasting future losses based upon recent (cycle “blow-off”) Credit performance – as derivative models do – lays the foundation for some very ugly surprises when the cycle reverses (recall the lesson not learned: CDO losses from telecom debt defaults).
- Overvaluing Risk Intermediation: The markets today perceive that the more aggressive the risk intermediation, the higher the value of the enterprise. The more rapid a financial institution issues (perceived safe) liabilities and expands its holdings of risky loans, securities, and instruments - the better. The more rapidly Goldman Sachs balloons its balance sheet, the greater the value of its stock. The more rapidly the financial guarantors (“Credit insurers”) grow earnings the happier are shareholders. This bullish market mindset continues to play a major role in promoting Credit expansion and excess. Still, at this stage of the cycle, the perception of grossly inflated intermediation profits and unrecognized risks creates the backdrop for some rather abrupt and consequential market reassessments.
- “Moneyness of Credit”: The markets vigorously advocate the fallacious notion that Wall Street “structured finance” (alchemy) can interminably transform risky Credits into top-quality and highly liquid marketable instruments (that are blessed with virtually insatiable domestic and global demand). Subprime mortgages will certainly not be the only 2006 vintage recognized as the residual of a banner year of atrocious lending. Booms are traditionally at some point restrained by the hesitancy of participants to expand holdings of increasingly risky market securities and/or Credit instruments. The evolution of contemporary finance (certainly encompassing the GSEs, MBS, ABS, derivatives, Credit guarantees, “repos,” CDOs, mutual funds, hedge funds, Wall Street, “structured finance,” and ballooning global central banks) has revolutionize the intermediation of risky Credits into perceived “money”-like instruments. To be sure, this revolution has radically altered the efficacy of efforts to sustain the Credit cycle. It would, however, be a huge analytical blunder to surmise that these dynamics have mitigated cycle risks. Quite the contrary. At this point, we are left to ponder to what extent The Illusion of “Moneyness” with respect to ($Trillions of) U.S. Credit instruments has buttressed our currency and prolonged a precarious boom.
- Orderly Currency Markets: It is today lunatic-fringe market blasphemy to suggest that currency markets could dislocate, with unmanageable dollar selling instigating a full-fledged global financial crisis. But the confluence of acutely vulnerable U.S. debt, risk intermediation, and economic structures make such an eventual outcome a high probability event. Sustaining the U.S. Credit Bubble is dependent upon the markets’ adherence to a confluence of (interdependent) specious assumptions with respect to marketplace liquidity, the Fed and global central bankers’ capacities, derivatives, risk intermediation, and the “Moneyness” of Credit.
It is impossible to predict when markets might begin to seriously question some of contemporary finance’s more suspect premises. It is reasonable to assume that some unexpected geopolitical event, development or crisis could prove the catalyst for a radical market reassessment. Much more knowable, however, is that last year’s Acute Monetary Disorder (especially the four quarter’s) has set the stage for speculative dynamics to dominate global financial markets. After recent serial melt-ups, one would expect Monetary Disorder to more regularly give rise to some hair-raising market reversals and downdrafts. Coming out of the 2007 starting blocks, the marketplace has turned mercilessly against the energy and commodities bulls.
With no apparent end in sight to U.S. Credit Bubble excess, along with resulting Current Account Deficits and a world awash in dollar liquidity, the already massive global pool of speculative finance is poised to continue its ever increasing rate of expansion. Therefore, trend-following and leveraging dynamics can be expected to remain powerful instigators of destabilizing speculative runs on the upside, while also dictating that market retreats will be especially dramatic and ruthless (“Dog Eat Dog”). When global asset prices are rising in concert, a certain gentlemanly order seems to prevail. But when things turn erratic – the natural tendency following periods of wild speculative excess – the hunt for gains turns more desperate. This dictates increasingly cutthroat markets where the easiest trading gains are often achieved by pounding those caught on the wrong side trades gone sour (i.e. copper).
To what extent the cumulative effect of these speculative frenzies turned nasty tumbles (i.e. natural gas and crude) finally instills sufficient speculative consternation for contagious declines in major markets is a key Issue 2007. I will add that the ongoing energy sector downdraft is not an especially illuminating indicator of contagion vulnerability, as falling energy prices are a clear positive for much of the system. Similarly, I don’t want to overstate the impact of escalating problems in the subprime mortgage market because they are today counterbalanced by gains in the much larger investment-grade market in anticipation of housing-related problems forcing the Fed to cut rates.
A significant reversal and speculator bludgeoning in, say, the interest-rate, Credit default swap, yen-carry trade, or global equities markets would provide much more challenging (for the system) and telling (for analysts) dynamics. As such, a top analytical focus for 2007 has to be discerning at what point speculator-driven market volatility begins to evolve into liquidity-reducing position unwinding. The challenge will be distinguishing the elevated noise of volatile and scheming trading dynamics from important liquidity-impacting market developments. At this point, I will give benefit of the doubt to ongoing liquidity excess and don’t believe we’ve witnessed the demise of the anti-dollar bull market in energy, metals and commodities.
The flaw of the fateful late-twenties period was that vulnerabilities and fragilities, certainly including obvious and mounting U.S. and global economic risks, had monetary authorities acquiescing to increasingly egregious Credit and speculative excesses. And the more encompassing, commanding, and towering the Financial Sphere Bubble became, the more intimidating the process of reigning in excess appeared to a shrinking Federal Reserve. It is the nature of Credit and Economic Bubble imbalances, disparities and asset price inflation to keep policymakers confused, unassured, hesitant, and, in the end, accommodative.
I find it rather astounding that some are today calling for the Fed to soon initiate an easing cycle. This would be an enormous mistake, one I don’t expect the Fed to be in any hurry to make. Unrelenting Financial Sphere excesses today pose by far the greatest systemic risk. To what extent the Fed and global central bankers recognize this reality may very well be The Key Issue for 2007. The Fed and the markets are in an especially tenuous position if the Bernanke Fed actually attempts to wrest some control of “money,” Credit and the entire financial system back from Wall Street and the speculator community. Ditto if foreign central bankers dare enter the fray.
Power cuts are one of the most tangible signs of trouble in Argentina’s energy industry…”
Speculator Watch:
January 3 – Financial Times (Michael Mackenzie): “When it comes to easy money, it is hard to overlook a dramatic distortion in the credit market that has generated virtually risk-free returns for some investors in recent months. Thanks to surging demand for credit exposure in the derivatives market, the cost of offloading credit risk through credit default swaps (CDSs) - which provide an insurance against corporate default - has dropped. For some companies, the annual cost of buying credit protection has fallen below the risk premium, or spread, a bond investor receives on the same company’s bonds over and above benchmark risk-free interest rates. This situation is known as ‘negative basis’. Investors can buy both bonds and CDS protection, leaving them with net credit risk of almost zero but still able to pocket a spread above risk-free rates.”
Issues 2007:
I simply have a difficult time getting on board with the view that our housing markets will be this year’s major Issue. And, actually, I’ll be surprised if the U.S., Chinese or the global economy takes center stage. When it comes to Issues 2007, I fully expect developments in and around finance and the financial markets to overshadow economic issues, concerns and risks. I’ll even go out on the analytical limb and predict it will be one captivating, historic and, likely, fateful year – and very much All About Finance.
The concurrent Credit Boom and Economic Transformation are these days quite comfortably entrenched. Contemporary unchecked “Wall Street” finance can now so easily adapt to changes in the quantity and composition of demand for borrowings from both the real economy and the securities markets. And today’s energized Credit apparatus has no problem adjusting to well-telegraphed marginal changes in short-term interest-rates. A quasi-pegged cost of funds suits the markets just fine.
The “resilient” U.S. services-based economy efficiently adapts to (finance-driven) changes in demand - effortlessly expanding the volume, type and price of “services” rendered, while imports freely satisfy whatever quantity of foreign-produced goods is desired. Traditional measures of inflation are now far removed - and capture little of the effects – from Prevailing Inflationary Manifestations. Meanwhile, manufacturing and inventory cycles these days engender only a secondary impact on the overall economy. As we witnessed in 2006, even major downturns in housing and auto manufacturing leave much of the Bubble Economy unscathed and even (through exacerbating loose financial conditions) stimulate key sectors such as financial services.
Don’t, however, even during a moment of weakness allow this feel-good backdrop to seduce you into the complacency that has enveloped the vast majority. The Financial Sphere’s Miraculous Adaptability and the Economic Sphere’s Trumpeted Resiliency owe everything to an Unprecedented and Continuous Flow of New Credit and Liquidity. This predicament is both the secret of recent success and the magic elixir offering the possibility for the inordinate stretching of this venerable boom – one person’s so-called “bullish” 2007 and another’s disastrous extension of “blow-off” excesses. Today’s acute dependency on massive Credit creation and superabundant liquidity is the system’s fatal flaw, playing guilefully into ingrained optimism and for the duration of the boom toying with calamity.
The bottom line is that the U.S. Credit and Economic Bubbles have no alternative than to expand (“failure is not an option”). But with risk intermediation and speculation having already been pushed to risk-taking extremes, sustaining this boom will be no small feat. Indeed, it will require another Herculean pushing of the Finance envelope. We did witness as much last year with developments in global Credit derivatives, high-risk lending, financial leveraging, and M&A. One can at this point safely assume the U.S. financial sector is up to 2007’s challenge, which leaves me pondering the ramifications for only greater Monetary Disorder.
There are these days commanding institutional enrichment and preservation “biases”. Wall Street investment bankers, traders, derivatives specialists, and brokers have every intention of earning even fatter bonuses in 2007. “Bank” executives appreciate that last year’s double-digit Bank Credit expansion was welcomed and well-rewarded. They surely expect to do more of the same this year to satisfy Wall Street’s (inflating) earnings expectations. Corporations (led by the financials) were remunerated handsomely for buying back stock and will plan on only larger repurchases in 2007. Coming off a decent year, the leveraged speculating community will enjoy additional robust inflows, while incorporating only greater leverage in the corporate debt and “Credit arbitrage” speculations that served them so well in 2006.
Admittedly, it is too easy to extrapolate current liquidity conditions and perhaps even the four-year liquidity-driven “bull market.” And, let’s face it, Credit Bubble inertia is a force to be reckoned with. The continued rapid increase in total system Credit and liquidity in the face of rapidly decelerating U.S. nominal GDP was the prevailing dynamic of 2006. And while we’ll know more come the March arrival of 4th quarter data, there is already ample evidence to indicate that the extended discord between system Credit creation and economic “output” took a decided turn for the worst during the closing months of 2006. The Economic Sphere’s moderate expansion has been perfect for immoderate Financial Sphere Ballooning.
Apparently focused on housing sector vulnerabilities, the Fed halted rate increases mid-year. Whether one believes this was appropriate policy or not, inarguably our energized Financial Sphere - feasting in Ultra-Loose Financial Conditions - was waiting keenly to take full advantage. Bubble Economy Fragility set the stage for a record year in M&A, corporate debt issuance, junk issuance, “leverage lending,” and global financial (trade, investment, and speculative) flows and imbalances. The Credit derivatives marketplace went nuts; global liquidity excess went bonkers; and global equities went crazy. U.S. and global finance completely lost their moorings. As I have written previously, the degree of Credit, speculative, and asset inflations experienced over the past year (or the past four or 14) does not unfold without the impetus of some underlying Credit System Disorder.
For Issues 2007, we’ll contemplate some key marketplace assumptions – Today’s Defining Tenets of Contemporary Finance – that are suspect and increasingly susceptible to miscalculation and eventual repudiation.
- Marketplace Liquidity: The long boom has participants convinced that liquidity is a permanent fixture of contemporary financial markets. This is especially problematic in an age where marketable instruments and securities markets have become such an instrumental force in the Credit creation process - and where speculative endeavors play such a profound role in Credit Availability and Marketplace Liquidity. The perception of unlimited liquidity, especially with Fed “tightening” having been removed from the equation, has fueled an extraordinary expansion in securities leveraging – a self-feeding liquidity-creating dynamic that only further reinforces the pretense of endless marketplace liquidity. Market dynamics are also increasing the likelihood that a problematic reversal of leveraged positions could at any time abruptly degrade the liquidity backdrop.
- Derivatives are a Boon to Finance and Economics: Despite some notable setbacks over the years, markets have nonetheless come to believe derivatives reduce market volatility and overall systemic risk. To be sure, finance evolves and adapts in its constant pursuit of profit opportunities. With prospective returns having been largely wrung from the investment-grade securities markets, the leveraged speculators last year shifted decisively into “Credit arbitrage” – leveraged positions to profit from Credit spreads, as well as booking gains from writing Credit insurance. This powerful dynamic feeds risk-taking and general liquidity excesses, fueling self-reinforcing global asset inflation. The upshot is dramatically heightened systemic fragility, including vulnerability to unpredictable speculative trading dynamics and asset market susceptibility to any waning of liquidity excess. The perception that market insurance will always be available at a reasonable cost is a major factor championing late-cycle financial excess.
- Liquid and Continuous Markets: Markets, especially the derivatives marketplace, operate under the assumption that the Federal Reserve and global central banks guarantee that markets will always remain abundantly liquid. This is an essential premise for computer and model-based “dynamic” hedging strategies (market-dictated buying or selling/shorting of instruments to offset changing derivative exposures) that these days dominate the market landscape. Unprecedented foreign central bank buying of U.S. dollar securities (“backstop bid”) has fed the misperception of endless marketplace liquidity. In particular, potential liquidity issues related to the reversal of the Credit Insurance Bubble, including the unwind and hedging of (corporate) Credit derivative positions in an unfavorable market environment, could emerge as a major Issue 2007.
- Credit Insurance: As much as the markets are determined to reckon otherwise, Credit losses are not insurable risks. Losses are categorically non-random and non-independent (as opposed to auto and fire accidents). By their very nature, they come and go in waves, and that infrequent Tidal Wave of Destruction can be expected to come precisely when it is least expected. Boom-time exuberance, with its intoxicating run of inflated financial profits and minimal Credit problems, propagates the crescendo, reversal and dismal downside of the Credit Cycle. The current Credit Derivatives Mania is putting the finishing touches on a Credit system and economy distorted to the point where there is no applicable history that might offer guidance as to downside cycle risks and expected Credit losses. Certainly, forecasting future losses based upon recent (cycle “blow-off”) Credit performance – as derivative models do – lays the foundation for some very ugly surprises when the cycle reverses (recall the lesson not learned: CDO losses from telecom debt defaults).
- Overvaluing Risk Intermediation: The markets today perceive that the more aggressive the risk intermediation, the higher the value of the enterprise. The more rapid a financial institution issues (perceived safe) liabilities and expands its holdings of risky loans, securities, and instruments - the better. The more rapidly Goldman Sachs balloons its balance sheet, the greater the value of its stock. The more rapidly the financial guarantors (“Credit insurers”) grow earnings the happier are shareholders. This bullish market mindset continues to play a major role in promoting Credit expansion and excess. Still, at this stage of the cycle, the perception of grossly inflated intermediation profits and unrecognized risks creates the backdrop for some rather abrupt and consequential market reassessments.
- “Moneyness of Credit”: The markets vigorously advocate the fallacious notion that Wall Street “structured finance” (alchemy) can interminably transform risky Credits into top-quality and highly liquid marketable instruments (that are blessed with virtually insatiable domestic and global demand). Subprime mortgages will certainly not be the only 2006 vintage recognized as the residual of a banner year of atrocious lending. Booms are traditionally at some point restrained by the hesitancy of participants to expand holdings of increasingly risky market securities and/or Credit instruments. The evolution of contemporary finance (certainly encompassing the GSEs, MBS, ABS, derivatives, Credit guarantees, “repos,” CDOs, mutual funds, hedge funds, Wall Street, “structured finance,” and ballooning global central banks) has revolutionize the intermediation of risky Credits into perceived “money”-like instruments. To be sure, this revolution has radically altered the efficacy of efforts to sustain the Credit cycle. It would, however, be a huge analytical blunder to surmise that these dynamics have mitigated cycle risks. Quite the contrary. At this point, we are left to ponder to what extent The Illusion of “Moneyness” with respect to ($Trillions of) U.S. Credit instruments has buttressed our currency and prolonged a precarious boom.
- Orderly Currency Markets: It is today lunatic-fringe market blasphemy to suggest that currency markets could dislocate, with unmanageable dollar selling instigating a full-fledged global financial crisis. But the confluence of acutely vulnerable U.S. debt, risk intermediation, and economic structures make such an eventual outcome a high probability event. Sustaining the U.S. Credit Bubble is dependent upon the markets’ adherence to a confluence of (interdependent) specious assumptions with respect to marketplace liquidity, the Fed and global central bankers’ capacities, derivatives, risk intermediation, and the “Moneyness” of Credit.
It is impossible to predict when markets might begin to seriously question some of contemporary finance’s more suspect premises. It is reasonable to assume that some unexpected geopolitical event, development or crisis could prove the catalyst for a radical market reassessment. Much more knowable, however, is that last year’s Acute Monetary Disorder (especially the four quarter’s) has set the stage for speculative dynamics to dominate global financial markets. After recent serial melt-ups, one would expect Monetary Disorder to more regularly give rise to some hair-raising market reversals and downdrafts. Coming out of the 2007 starting blocks, the marketplace has turned mercilessly against the energy and commodities bulls.
With no apparent end in sight to U.S. Credit Bubble excess, along with resulting Current Account Deficits and a world awash in dollar liquidity, the already massive global pool of speculative finance is poised to continue its ever increasing rate of expansion. Therefore, trend-following and leveraging dynamics can be expected to remain powerful instigators of destabilizing speculative runs on the upside, while also dictating that market retreats will be especially dramatic and ruthless (“Dog Eat Dog”). When global asset prices are rising in concert, a certain gentlemanly order seems to prevail. But when things turn erratic – the natural tendency following periods of wild speculative excess – the hunt for gains turns more desperate. This dictates increasingly cutthroat markets where the easiest trading gains are often achieved by pounding those caught on the wrong side trades gone sour (i.e. copper).
To what extent the cumulative effect of these speculative frenzies turned nasty tumbles (i.e. natural gas and crude) finally instills sufficient speculative consternation for contagious declines in major markets is a key Issue 2007. I will add that the ongoing energy sector downdraft is not an especially illuminating indicator of contagion vulnerability, as falling energy prices are a clear positive for much of the system. Similarly, I don’t want to overstate the impact of escalating problems in the subprime mortgage market because they are today counterbalanced by gains in the much larger investment-grade market in anticipation of housing-related problems forcing the Fed to cut rates.
A significant reversal and speculator bludgeoning in, say, the interest-rate, Credit default swap, yen-carry trade, or global equities markets would provide much more challenging (for the system) and telling (for analysts) dynamics. As such, a top analytical focus for 2007 has to be discerning at what point speculator-driven market volatility begins to evolve into liquidity-reducing position unwinding. The challenge will be distinguishing the elevated noise of volatile and scheming trading dynamics from important liquidity-impacting market developments. At this point, I will give benefit of the doubt to ongoing liquidity excess and don’t believe we’ve witnessed the demise of the anti-dollar bull market in energy, metals and commodities.
The flaw of the fateful late-twenties period was that vulnerabilities and fragilities, certainly including obvious and mounting U.S. and global economic risks, had monetary authorities acquiescing to increasingly egregious Credit and speculative excesses. And the more encompassing, commanding, and towering the Financial Sphere Bubble became, the more intimidating the process of reigning in excess appeared to a shrinking Federal Reserve. It is the nature of Credit and Economic Bubble imbalances, disparities and asset price inflation to keep policymakers confused, unassured, hesitant, and, in the end, accommodative.
I find it rather astounding that some are today calling for the Fed to soon initiate an easing cycle. This would be an enormous mistake, one I don’t expect the Fed to be in any hurry to make. Unrelenting Financial Sphere excesses today pose by far the greatest systemic risk. To what extent the Fed and global central bankers recognize this reality may very well be The Key Issue for 2007. The Fed and the markets are in an especially tenuous position if the Bernanke Fed actually attempts to wrest some control of “money,” Credit and the entire financial system back from Wall Street and the speculator community. Ditto if foreign central bankers dare enter the fray.
