It didn’t take long for some of last year’s air to come out of the balloon. For the week, the Dow and S&P500 declined about 2%. The Morgan Stanley Consumer index dipped 1%. Losses were more dramatic for stocks and groups marked up during the fourth quarter. The Transports dropped 4% for the week, and the Utilities and Morgan Stanley Cyclical index declined 3%. The highflying small cap Russell 2000 index was clipped for 6%, and the S&P400 Mid Cap index dropped 4%. Technology stocks were under heavy selling pressure. The NASDAQ100 declined 3.5%, and the Morgan Stanley High Tech index sank 4%. The Semiconductors lost 6% and The Street.com Internet index sank 7%. The NASDAQ telecommunications index declined 3%. The Biotechs dropped 2%. The Broker/Dealers fell 3%, and the Banks declined 2%. With bullion sinking $19.40, the HUI gold index fell 6%.
Treasuries also began the year under pressure. For the week, two-year Treasury yields jumped 11 basis points to 3.185%. Five-year Treasury yields rose 10 basis points to 3.715%. The ten-year added 5 basis points to 4.27%. Long-bond yields ended the week at 4.84%, up one basis point for the week. Benchmark Fannie Mae MBS yields added one basis point. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note declined 2 basis points to 37, and the spread on Freddie’s 5% 2014 note narrowed one basis point to 34. The 10-year dollar swap spread declined 1.25 basis points to 40.25. Corporate bonds lagged, with junk bonds underperforming during the first week of the year. The implied yield on 3-month March Eurodollars rose 4 basis points to 2.945%.
The corporate bond market came out of the blocks strong with $21 billion of issuance. This week’s investment grade issuers included Berkshire Hathaway $3.75 billion (raised from $3.0bn) Morgan Stanley $3.25 billion, Ford Motor $1.0 billion, Goldman Sachs $3.37 billion, Northern Rock $1.75 billion, ING $625 million, PepsiAmericas $300 million, National City $275 million, HBOS $250 million, John Deere Capital $250 million, Ryland Group $250 million, Central American Bank $200 million, and Moog $150 million.
Junk bond funds reported inflows of $129 million during the week ended Wednesday. Junk issuers included Rite Aid $200 million, Six Flags $195 million, and Axtel SA $75 million.
Convert issuers included Bearingpoint $450 million and Atherogenics $175 million.
Foreign dollar debt issuers included European Investment Bank $3.0 billion and Mexican United States $2.0 billion.
Japanese 10-year JGB yields declined 3 basis points this week to 1.40%. Brazilian benchmark bond yields jumped 50 basis points to 8.19%. Mexican govt. yields ended the week at 5.24%, up 4 basis points for the week. Russian 10-year dollar Eurobond yields were up 12 basis points to 5.94%.
Freddie Mac posted 30-year fixed mortgage rates dipped 4 basis points this week to 5.77%. Fifteen-year fixed mortgage rates declined 2 basis points to 5.21%, while one-year adjustable-rate mortgages dropped 9 basis points for the week to 4.10% (9-week low). To begin 2004, 30-year fixed rates were at 5.87%, 15-year at 5.17%, and adjustable-rate at 3.76%. The Mortgage Bankers Association Purchase applications index slumped 13.7% for the week. Purchase applications were up 3.6% from one year ago, with dollar volume up 13.7%. Refi applications dropped 5.7% during the week. The average new Purchase mortgage slipped to $222,700, while the average ARM declined to $298,600. ARMs dipped marginally to 32.6% of total applications.
Broad money supply (M3) surged $56.6 billion (week of December 27) to finish 2004 at $9.45 Trillion. For 2004, broad money increased $630.4 billion, or 7.1%. For the week, Currency dipped $0.8 billion. Demand & Checkable Deposits jumped $21.6 billion. Savings Deposits declined $18.7 billion (2004 gain of $336.8bn, or 10.7%). Small Denominated Deposits added $1.4 billion. Retail Money Fund deposits gained $3.3 billion, and Institutional Money Fund deposits rose $20.9 billion. Total Money Market deposits declined $117.4 billion during the year, or 6.2%. Large Denominated Deposits jumped $19.4 billion (up 26.7% for the year). Repurchase Agreements and Eurodollar deposits each increased $2.5 billion.
Bank Credit dipped $1.5 billion for the week of December 29 to $6.756 Trillion. Bank Credit expanded $481.1 billion during the year, or 7.7% annualized, with bank Loans and Leases up $423.2 billion, or 9.6%. For the week, Securities holdings declined $10.1 billion, while Loans & Leases expanded $8.6 billion. Commercial & Industrial loans gained $3.9 billion, while Real Estate loans dipped $2.1 billion. Real Estate loans rose $312.3 billion during 2004, or 14.0%. For the week, consumer loans increased $13.3 billion, while Securities loans declined $5.7 billion. Other loans dipped $0.8 billion. Elsewhere, Total Commercial Paper dropped $16.1 billion to $1.397 Trillion. Financial CP declined $20.4 billion to $1.264 Trillion. Non-financial CP increased $4.2 billion to $133.7 billion.
Fed Foreign Holdings of Treasury, Agency Debt began the new year right where they left off. “Custody” holding jumped $8.43 billion to $1.344Trillion for the week ended January 5 (up $271.5bn, or 25% from a year earlier). Federal Reserve Credit added $1.0 billion for the week to $791.7 billion, with a 52-week gain of 6.5%.
A total of $8.0 billion of ABS was issued this week (from JPMorgan).
The dollar index surged 3.35%. The euro, Swiss frank, Australian dollar and New Zealand dollar declined about 3%. The South African rand sank 7% and the Hungarian forint 4%.
January crude oil rose $1.98 this week to $45.43. The Goldman Sachs Commodities index rose 2%, while the CRB index declined 2%.
January 4 – Bloomberg (Janet Ong): “China’s foreign trade last year is estimated to reach $1.1 trillion, making it the world's third largest trading nation, the official Communist Party newspaper, People’s Daily, said… Exports may account for 30 percent of the nation’s gross domestic product, boosting growth by two percentage points…”
January 7 – XFN: “China’s gross domestic products (GDP) rose some 15% in nominal terms and by about 9.2% in real terms in 2004, said Xie Xuren, director of the State Administration of Taxation. Xie told state television that China’s value-added industrial output rose some 23% in nominal terms last year… He said fixed asset investment rose 25%, while profits of all enterprises were approximately 40% higher in 2004. China’s imports last year rose 34% from 2003, Xie said. He gave no figures for exports.”
January 7 – UPI: “Guangzhou, capital of China’s economic powerhouse Guangdong province, has imposed power cuts after three grid overloads this week, local media said Friday. According to the Shenzhen Daily, the city has faced a shortfall in electrical power supplies of between 500,000 to 600,000 kilowatts per day thus far in the new year. The newspaper said shortages were occurring because power generators in the province are being overhauled and hydropower output has decreased due to a prolonged drought in southern China.”
January 4 – XFN: “The main sources of inflation pressure in China this year will be rising raw materials prices and the weakening US dollar, the China Securities Journal reported, citing a senior government official (Xu Lianzhong). In a research report… (Xu) said past increases in the price of production materials would flow through to inflation in 2005. The price of steel rose by 38.3% over the past two years, while the price of non-ferrous metal rose 44.1%, coal rose 28.5%, and crude oil increased 23.9%. Xu said he expects the cost of production materials will rise again in 2005 and push up the price of goods. He said the price of coal and electricity will also increase.”
January 5 – Bloomberg (Allen T. Cheng): “Chinese broadband subscribers more than doubled in number to 26.3 million in 2004… Broadband subscribers rose from 12.5 million at the end of 2003, BDA China said… The number is forecast to rise to 42.1 million by the end of 2005 and to 86.3 million by 2008, the Beijing-based research company said.”
January 1 – Bloomberg (Zhang Shidong): “China hosted 20 percent more overseas tourists in the first 11 months of 2004 from a year earlier, the official Xinhua News Agency reported…”
Asia Inflationary Boom Watch:
January 7 – Bloomberg (Sumit Sharma): “India’s Prime Minister Manmohan Singh called on people of Indian origin to help raise $150 billion of investment in the next 10 years, saying the economy needs to grow as much as 8 percent annually to reduce poverty. ‘India needs 7 percent to 8 percent growth to create more jobs. We need to absorb $150 billion over the decade to achieve this. We need your investments. We will make the environment conducive to invest in India.’”
January 5 – Bloomberg (Francisco Alcuaz Jr.): “Rising food and fuel prices helped drive Philippine inflation to a six-year high in December, giving the central bank less room to keep interest rates at 12-year lows. The consumer price index rose 7.9 percent from a year earlier, its biggest gain since April 1999…”
January 4 – Bloomberg (Yunsuk Lim): “South Korea attracted twice as much investment from overseas in 2004, the first increase in five years… Foreign direct investment rose 97.4 percent to $12.8 billion…”
January 7 – Bloomberg (Stephanie Phan): “Malaysia’s industrial production rose at a faster-than-expected pace in November as growing domestic demand countered a slowdown in electronics exports. Output at factories, mines and utilities rose 9.9 percent from a year earlier, accelerating from a revised 7.2 percent pace in October…”
January 3 – Bloomberg (Shanthy Nambiar): “Indonesia’s consumer price index rose
6.4 percent in December from a year earlier, accelerating from a gain of 6.2 percent in November…”
January 4 – Bloomberg (Jason Folkmanis): “Vietnam’s economy expanded last year at its fastest pace since 1997, the government said, bolstered by accelerated growth in service industries. Gross domestic product grew 7.7 percent in 2004…”
Global Reflation Watch:
January 7 – Bloomberg (Theophilos Argitis and Kevin Carmichael): “Canadian employers hired 33,500 workers in December, more than twice what economists expected, helping the jobless rate fall to its lowest in almost four years. The unemployment rate declined to 7.0 percent last month from 7.3 percent in November, for the lowest since May 2001…”
January 4 – Bloomberg (Victoria Batchelor): “An index that measures Australian manufacturing production rose in December to the highest in more than 2 1/2 years spurred by increased consumer demand for food and beverages and a gain in coal, chemical, and metal exports.”
January 5 – Bloomberg (Monika Rozlal): “The Polish economy expanded 5.7 percent in 2004 after growing 3.8 percent a year earlier, daily Parkiet reported, citing the Economy Ministry. Last year’s growth rate was the most robust in seven years…”
January 6 – Bloomberg (Vernon Wessels): “South African house-price inflation may slow to between 15 and 20 percent this year after surging 32.1 percent in 2004 as the lowest interest rates in two decades boosted demand, said Absa Group Ltd., the country’s biggest home-loan provider. House prices rose 32.6 percent in December…”
January 6 – Bloomberg (Vernon Wessels): “South African vehicle sales in December rose 38 percent to the highest for that month since 1981, as low interest rates boosted consumer and business spending, an industry group said.”
Latin America Reflation Watch:
January 3 – Bloomberg (Guillermo Parra-Bernal): “Brazil’s trade surplus widened to a record $33.7 billion last year as the world's biggest producer of sugar, iron ore and coffee boosted exports to expanding economies in China, the Netherlands and other countries. The surplus, or the excess of exports over imports, grew to $3.51 billion in December from $2.08 billion in November…”
January 6 – Brazil Wire: “Agribusiness exports in 2004 closed at US$ 39.015 billion, representing an increase of 27.3% in relation to 2003. According to data published today by the Ministry of Agriculture sector foreign sales correspond to 40.4% of total Brazilian exports, which closed last year at US$ 96.475 billion.”
January 3 – Bloomberg (Daniel Helft): “Argentina’s tax revenue rose 19 percent in December from a year earlier as the economy expanded more than 8 percent this year, the government said.”
January 5 – Bloomberg (Alex Emery): “Peru’s tax collection reached its highest level in six years in 2004 as an economic expansion bolstered consumer spending and corporate earnings.”
January 5 – Bloomberg (Igor Munoz): “Chile’s economy expanded faster than economists forecast in November as exports rose. The economy grew 7.5 percent from a year earlier, the Chilean central bank said…”
January 4 – Bloomberg (Alex Kennedy): “Venezuelan imports surged by more than
half in October as the government boosted the sale of dollars to importers amid an economic recovery. Imports of products such as cars, automotive parts and electronics increased 57 percent to $1.4 billion in October from the same month a year earlier…”
January 3 – Bloomberg (Alex Kennedy): “Venezuelan industrial production rose for an eleventh month in October, led by a surge in the output of metals, cars and chemicals. Industrial production, which excludes oil output, jumped 15 percent from October 2003…”
Bubble Economy Watch:
January 5 – The Wall Street Journal (Thaddeus Herrick): “High oil prices are causing economic pain in most of the country, but they’re proving a bonanza for oil-producing states. The windfall has been greatest in the sparsely populated states of Alaska, Wyoming and New Mexico, where revenue from oil and natural gas has yielded large budget surpluses at a time when most states are recovering from deficits. Together, the three states are on track to pull in $4.5 billion from royalties and taxes on energy for fiscal 2004, up $900 million, or nearly 25%, from fiscal 2003 and from a mere $2.9 billion as recently as 2002.”
January 4 – Bloomberg (Kristy McKeaney): “U.S. spending on Visa brand cards rose last week compared with the same week last year, according to VISA. In the week ending Jan. 2 purchases with Visa debit and credit cards rose 20 percent to $21.193 billion compared with the same week last year.”
January 6 – Bloomberg (Jeff Green): “Toyota Motor Corp.’s Lexus, Bayerische
Motoren Werke AG and General Motors Corp.’s Cadillac benefited from a U.S. luxury-vehicle market than expanded four times faster than total auto sales last year. Sales of luxury vehicles, which typically cost at least $30,000, rose 6.1 percent to 1.97 million, according to forecasting firm Global Insight Inc. The total U.S. market grew 1.4 percent to 16.9 million cars and light trucks. Lexus, BMW and Cadillac, the largest luxury-vehicle brands in the U.S., each increased sales at least 8 percent last year... ‘Luxury is booming and any talk about people being more pragmatic with their spending is nonsense,’ said auto analyst Wes Brown at Los Angeles-based Iceology, which studies consumer trends. ‘These people are worried about their image and don’t want to be embarrassed by the car in their driveway.’ Toyota’s Lexus led U.S. luxury vehicles sales in 2004 for the fifth straight year, with an 11 percent rise to 287,927.”
January 5 – Market News (Mark Pender): “U.S. non-manufacturers are reporting firming business conditions, pointing to new strength for the group into the new year, according to Institute for Supply Management survey head Ralph Kauffman. The ISM’s business activity index rose for a third straight month… The best news in December was centered in orders with new orders edging back over 60 to 60.3 from 59.9 in November and backlog orders also higher at 56.5 vs. 54.0… Prices paid, despite a drop-off in fuel costs, edged higher to 71.4 from 71.0 in November. The index has now held over 70 in seven of the last eight months, its most severe run in the seven-year history of the report. Kauffman said emerging cost passthrough in the manufacturing sector may be at least be partly responsible for the continued pressure on the price index. ‘Some suppliers to the non-manufacturing sector are now successfully increasing prices. One of the big complaints from our members over the last couple of months is that they cannot get what they need when they want it and in the quantities they want. Perhaps some suppliers are taking advantage of that situation to raise prices.’”
The December ISM Non-Manufacturing index jumped almost two points to 63.1, the highest level since July. For comparison, this index ended 2001 at 49.5, 2002 at 53.7, and 2003 at 58.
Mortgage Finance Bubble Watch:
January 3 – Bloomberg (Kathleen M. Howley): “Manhattan apartment prices gained 16 percent in the fourth quarter as the city’s economy accelerated and income rose at the fastest pace in six years, according to a report by residential appraiser Miller Samuel Inc. and real estate broker Prudential Douglas Elliman. The median price for a condominium and a cooperatively owned apartment rose to $670,000 from $580,000 a year earlier, the report said. The price was the highest on record after the second quarter’s $674,000, according to the report.”
January 4 – Dow Jones (John Conner): “The Federal Housing Administration has increased its single-family home mortgage limits… Effective Jan. 1, 2005, FHA will insure single-family home mortgages up to $172,632 in low-cost areas and up to $312,895 in high-cost areas, HUD said. Last year, the FHA loan limits were $160,176 in low-cost areas and $290,319 in high-cost areas. HUD said the loan limits for two-, three, and four-unit dwellings also increased. ‘These higher loan limits will help the FHA mortgage insurance program keep pace with the strong housing market while contributing to the Bush Administration’s commitment to create 5.5 million new minority homeowners by the end of the decade,’ said HUD Secretary Alphonso Jackson.”
January 6 – The Wall Street Journal (Ryan Chittum): “Companies snapped up more U.S. office space in the fourth quarter than they have in any quarter in the past four years, pushing vacancies down sharply, stabilizing rents and confirming that the sector is finally in recovery after several weak years, according to a new survey. The findings suggest that firms are continuing to hire or are preparing to create more jobs. The vacancy rate fell to 16.2% in the fourth quarter from 16.6% in the third Quarter… Absorption, the net change in total occupied space, was 20 million square feet in the fourth quarter, the most in four years… For the year, absorption totaled 40.8 million square feet, compared with negative 8.5 million square feet in 2003 and negative 35.9 million square feet in 2002. The vacancy rate has fallen 0.7 percentage point from its peak of 16.9% in the fourth quarter of 2003.”
Liquidity Excess Watch:
January 5 – Bloomberg (Sun Yu-huay and James Peng): “Taiwan’s foreign-currency reserves, the third-highest in the world, rose in December to a record $242 billion boosted by net foreign capital inflows… The reserves, which trail those of Japan and China, rose for a 42nd month from $239 billion in November…”
January 3 – Bloomberg (Meeyoung Song): “South Korea’s foreign-exchange reserves rose to a record $199.1 billion at the end of December… The reserves, the world’s fourth largest, rose to a record $199.1 billion at the end of December, the Bank of Korea said… The reserves rose 28 percent from a year earlier and 3.4 percent from November…”
January 6 – Bloomberg (Miles Weiss): “D.E. Shaw & Co., a hedge fund group with a reputation for secrecy, lost the right to keep its stock investments confidential, forcing the firm to reveal holdings valued at $21 billion. Shaw, which ranks among the 20 largest hedge fund managers in the country, has relied on a securities law loophole to keep all its positions secret for at least the last five years… According to the SEC documents, Shaw’s stock holdings ranged between $6 billion and $7.5 billion from December 2001 through March 2003. The holdings climbed to $14.9 billion during the remainder of 2003 and rose another $6.4 billion to $21.3 billion during the first nine months of this year.”
January 6 – Market News: “The Federal Home Loan Bank priced a 3-year global bond Wednesday… Size: $4 billion… Spread: 28.5 basis points…Yield: 3.654%... Preliminary distribution data: US 41%, Asia 51%, Europe 4%, Other 4%... This deal was well oversold prior to pricing. There was considerable Central Bank, money manager, and corporate interest.”
I have never met Stephen Roach, but I sure admire him. On Bloomberg television the other day he made a simple comment that really resonated: “…It’s important, number one, just to go back and really do a personal inventory of how your view, how your lens, how your prism worked.” Over the years he has been an impressive role model characterized by independent thinking, humility, diligent analysis, and a disciplined approach to adopting and refining his analytical framework.
Yet to better understand from where we have come and to where we might be going, I do want to contrast his “prism” from my own Macro Credit (including Bubble and speculative finance dynamics) analytical framework. Extracting sentences from Mr. Roach’s latest article, he writes, “For me, many of last year’s lessons are interrelated — part and parcel of the general framework of global rebalancing that has guided my macro view over the past few years… Suffice it to say, the resolution of global imbalances has hardly had a major impact on share prices… I viewed the dollar’s renewed decline in late 2004 as an encouraging development on the road to rebalancing… Up until now, currency realignments have borne the brunt of global rebalancing.”
I share a great deal of common ground with Mr. Roach, but our distinct “prisms” lead us to some divergent views of what 2004 was all about. While I subscribe to the view that a major global rebalancing is as imperative as it is inevitable, I can find little evidence that this arduous process has commenced. I don’t see encouraging signs that the dollar’s three-year decline has yet to incite global rebalancing, and there certainly isn’t any “resolution” in the works. Global financial and economic imbalances have grown only more acute and unwieldy. But I do expect markets to (much belatedly) force the onset of this “rebalancing” process at some point during 2005.
The U.S. Credit system and asset markets are the focal point of my analysis. Only restraint in Credit creation and the termination of asset Bubbles will initiate the required “rebalancing” – domestic as well as global. Until asset and speculative Bubbles burst, the dysfunctional U.S. financial sector will maintain its dangerous fixation on asset-based lending and interest-rate arbitrage. At this point, only a crisis will force the curtailment of over-consumption and the misallocation of resources. And rather than viewing the dollar’s fall as an encouraging development, from a Credit Bubble perspective, it is exactly what one would expect to coincide with the “blow off” period of Credit and liquidity excess.
When I reflect back upon 2004 through my analytical framework, I see Reflation dangerously transformed into Gross Over-liquefication, on a global scale never before experienced. What do I mean by this? Ultra-accommodative Fed policies that reached a crescendo in late 2002 nurtured blow-off excesses throughout U.S. mortgage and securities finance – Bubble at The Core. This dynamic set in motion an all-encompassing liquidity free-for-all domestically and globally, creating Myriad Bubbles all along The Periphery. From subprime, junk bonds and virtually all securities; to hedge funds, REITs and M&A; to energy, commodities and essentially all hard assets; to emerging debt and equity markets, cheap finance was abundant in virtually every nook and cranny across the globe.
I believe this is very pertinent analysis with respect to contemplating where and how we proceed from 2004. While some may view the weaker dollar and stronger global growth as factors reducing systemic imbalances and risk, I fear the exact opposite: An historic Bubble has gone to only more dangerous and endemic extremes. Indeed, Macro Credit/Bubble analysis leads me to place the potential for financial crisis at the very top of Issues 2005. Last year it was incumbent upon the Fed to demonstrate resolve by tightening financial conditions and repressing burgeoning excess – retraining reflation from its proclivity to run out of control. Once again, the Fed has erred on the side of upholding excess, which reinforced already strong inflationary biases throughout the U.S. and global securities markets. Systems have become only more dependent on abundant Credit and liquidity.
There are many that view easy Credit and teeming liquidity as part and parcel to the New Paradigm, engendered by contemporary finance coupled with a technology-induced productivity revolution. And there is these days more talk of a secular decline in financial market volatility. Such a view has been emboldened by 2004’s collapse in Credit and risk spreads, as well as the bond market’s (and general financial markets’) resiliency in the face of a sinking dollar. This is a hook – an analytical trap.
From my analytical perspective, the notion of a secular decline in financial volatility is the ultimate in Analytical Irrational Exuberance. It is “secular” only so long as Credit Bubble and liquidity excesses are sustained; as long as inflated asset prices continue inflating. Indeed, the collapse in risk spreads is one critical manifestation of Gross Systemic Over-Liquefication. And this liquidity emanates directly from profligate lending throughout mortgage finance, unprecedented securities leveraging, and unparalleled expansion of central bank holdings of U.S. securities. Indeed, The Great Analytical Paradox of 2004 was the collapse in risk premiums concurrent with heightened Monetary Disorder. This aberration is not sustainable.
Importantly, I would strongly argue that Credit Market Dislocation was The Untold Story of 2004. Clearly, the massive U.S. securities purchases by foreign central banks distorted bond prices and general marketplace liquidity. And with the U.S. current account destined to be even larger during 2005, it is reasonable to presume another year of enormous central bank buying and continued low bond yields. I would be very cautious with such extrapolations.
There are important but ambiguous facets to last year’s dislocation. To what extent did massive and unending foreign central bank purchases distort the marketplace? Somewhat more specifically, to what degree did these operations entice the leveraged players to maintain or, even, sharply increase their speculations? I would strongly argue that with the Fed raising rates, with oil and commodity prices spiking, and general consumer inflation on the rise, the speculators would have typically been defensively reducing leverage rather than offensively increasing it. On the margin, this had a profound impact on marketplace liquidity and interest rates. Moreover, with both central banks and speculators increasing positions, the resulting decline in yields caught the bears, those hedged, and the derivative players all on the wrong side of the market. The resulting unwind and related leveraging – an important facet of the Monetary Disorder created by Credit excess, the falling dollar, and massive global central bank support operations – was a powerful force behind collapsing spreads, system Over-Liquefication, heightened asset inflation, and self-reinforcing Credit and liquidity creation.
A year ago the marketplace and general financial backdrop appeared conducive to a period of surprisingly low interest rates. Many had positioned for a jump in yields (and ended up paying for their caution). Today, I see much the opposite. Market perceptions have ongoing global central bank purchases sustaining low market rates and profuse liquidity for as far as the eye can see. Some even see the Fed as having almost completed their “tightening.” Last year’s worry is gone, which is reflected in the depressed price of interest rate derivative protection (and risk premiums generally). The fundamental backdrop is one of notably easier financial conditions and heightened inflationary pressures when compared to 12 months ago. It will be fascinating to watch players talk low rates and weak economy as they work to reduce their bond exposure.
Pondering the current economic and financial landscape, I sense an unusually high probability that the leveraged speculators and hedgers/derivative players will again prove this year’s price setters – but for 2005 as sellers instead of buyers. The risk of an upward surprise in inflationary pressures; a resilient Mortgage Finance Bubble “blow-off;” and a global backdrop of aroused animal spirits and rampant liquidity -- all increase the possibility that the Fed may be forced to move aggressively to avoid falling even further behind the curve. And with the extreme amount of leveraging and the potential for massive derivative hedging-related selling (trend-following “dynamic” trading), the possibility for a major and abrupt spike in market rates and risk premiums should not be dismissed.
We certainly begin 2005 with many of the necessary conditions for a surprising spike in yields and spreads that could easily lead to marketplace dislocation. Perceptions are bullish and complacent, while last year’s dislocation induced many to remove hedges. The derivative "dynamic traders/hedgers" are exposed and positioned leveraged on the long side, but poised to sell when rates move higher and/or spreads widen. And as much as 2003 recalled the bond market mania of 1993, 2004 brought back memories of the SE Asia/emerging market excesses of 1996. By promising little bitty Baby Steps (“Tightening Lite”) that would never ever dishearten the precious markets, the Fed last year avoided a 1994-style interest rate speculator boom turned bust. But the cost of sustaining the U.S. Credit Bubble was inflating myriad Bubbles around the globe. Not only does this increase global risk to a bursting of U.S. Bubbles, it also creates a risk that faltering Bubbles anywhere at The Periphery could now spark speculator losses, risk aversion, de-leveraging and contagion effects that could easily jeopardize The Vulnerable Core (recall the trail of Thailand to all of SE Asia to Russia to LTCM to the U.S. Credit market “seizing up”).
From my “prism,” I cannot overstate the degree that 2004’s Monetary Disorder translated into liquidity excess and Bubble dynamics taking hold at The Periphery. These Bubbles include subprime mortgage, home equity lending, the REITS, Credit default swaps, junk bonds, and “emerging” debt and equity markets, to name only a few. The nature of excess and Bubbles at The Periphery is that they are always sensitive and vulnerable to developments at The Core. And one can think in terms of Reflation having degenerated into problematic Gross Over-liquefication at the point when liquidity and speculative excess inundated The Periphery. This 2004 development sets the stage for Trouble at the Periphery during 2005.
And there is also the issue of the hedge fund community. Last year marked another year of huge inflows to the leveraged speculators. This was despite lacklustre performance that was made respectable by the big year-end rally in U.S. and global markets. Never had so many managing so much wanted so badly to have markets rally into year end. Well, what do you know… And it is an interesting facet of Speculative Dynamics that a popular investment theme or asset class receives keenest attention – and largest financial flows! – after returns have peaked and often when they are declining rapidly. This year certainly holds significant potential for disappointing performance and a reversal of fortunes from the leveraged speculating community. At the minimum, crowds of anxious (and leveraged) hedge fund managers chasing limited opportunities are not conducive to stable markets. This is an Issue for 2005.
Macro Credit and Bubble analyses are as fascinating as they are challenging. As much as we analyze and gain understanding from studying the intricacies of Bubbles, there should be an axiom that warns to absolutely avoid predicting when they are going to burst. What’s more, the bigger and more conspicuous the Bubble – and the more confident we are in our analysis - the more likely that forecasts of its demise will prove as much as years premature. This was the case with the NASDAQ Bubble and now with the Mortgage Finance, Leveraged Speculation, and U.S. bond market Bubbles. Excesses go to unbelievable extremes – and then “double.” Almost by definition, those of us that partake in Bubble analysis will, from the consensus’s point of view, be discredited and our analysis in disrepute at the pinnacle of the Bubble; it just goes with the territory. A sound analytical framework, along with perseverance, becomes an absolute prerequisite.
With that caveat out of the way, I believe there is a reasonably high (much greater than 2004) probability that we will experience a major Bubble burst during 2005. The nature of current blow-off excesses will not run indefinitely, and Inflationary Manifestations will only turn more destabilizing. As we appreciate, it is the very nature of Credit, asset and economic Bubbles that they are sustained only by greater amounts of Credit. Contemporary finance, these days dominated by marketable securities, leveraging, and speculation, is hooked on cheap, abundant liquidity. And we have reached a stage in the cycle where heightened and broadening inflationary pressures dictate that a continuation of Credit Bubble excess will manifest into traditional inflationary pressures. Rising inflation is an Issue for 2005, as is the stability of the $3.2 Trillion “repo” market.
The U.S. economy is in the midst of a distorted boom, with an increasingly ingrained inflationary bias. Asset Bubbles are heavily influencing spending and investing patterns, hence the underlying structure of the economy. The nature of the U.S. Bubble economy – where gross financial excess is required to fuel minimally acceptable employment gains – will be an Issue for 2005. Current market rates and liquidity conditions appear poised to initially foster stronger-than-expected demand domestically and globally, although the unstable and unbalanced nature of the current global expansion will continue to provide fodder for those arguing for an imminent slowdown. I expect the Chinese and Asian inflationary booms to become increasingly problematic. I forecast that Latin America and other "developing" economies surprise on the upside as long as liquidity conditions remain so accommodative. Energy and commodities will remain in tight supply, with prices extraordinarily volatile but with a continued upward bias. The current minority Fed view that inflation and marketplace speculation pose increasing risks has potential to become consensus. And I can certainly envisage a scenario of increasingly anxious central bankers eyeing inflationary pressures and unstable markets across the globe.
I wrote last week that 2004 was “The Year It Didn’t Matter.” The markets were content to disregard accounting irregularities and capital inadequacy at the GSEs in the bountiful liquidity environment of 2004. There will, however, come a time when the GSE’s role as Buyers of First and Last Resort for the Leveraged Speculators will be a major issue. When interest rates spike higher and the marketplace falters toward dislocation, the degree to which the GSEs can balloon their balance sheets will be of immediate critical importance. If, as one would today presume, the GSEs have lost their capacity for unlimited balance sheet expansion, this could prove a major Issue for 2005. In the past I have argued that the GSE’s capacity to “reliquefy” the Credit market was, in several instances, a critical factor in containing interest rate spikes/dislocations.
For some time there has been circularity at work. The highly leveraged and exposed GSEs were, on the one hand, major buyers of derivative protection against higher rates. One the other hand, their aggressive balance sheet expansion at critical junctures ensured that the writers of this “insurance” would not be exposed to loss. The GSE played a vital role in the viability, hence the mushrooming, of the interest-rate derivatives marketplace. If the GSE’s have lost their quasi-central bank status, there are momentous ramifications that will become inopportunely relevant during the next unfolding liquidity/financial crisis.
There is a much riding on the continuation of Credit and liquidity excess. The Great Credit Bubble has spawned a long and lengthening list of Bubbles. The Bubble of leveraged interest rate speculation and the closely related Mortgage Finance Bubble are historic. And the sibling California Housing Mania, along with Bubbles in scores of housing markets along the coasts and across the country, has inflated to quite dangerous extremes. The California Housing Mania, in particular, is vulnerable to any meaningful increase in adjustable mortgage rates. I will go out on a limb with the view that the vulnerable California market is in the process of topping and will be in trouble by year end. Other overheated markets will follow the Golden State, and evidence of the massive amount of mortgage-related fraud that has transpired - as the Fed has nurtured and watched this Bubble unfold - will begin to surface.
And while the dollar is currently mustering its strongest rally in some time, I do not expect 2005 to be any kinder or gentler to our currency. The very serious issues of bursting Bubbles and financial system integrity remain to be resolved. In the meantime, there will be another year of massive current account deficits and, quite likely, a continuation of speculative flows to commodities and non-dollar assets and markets that will weigh on our currency. I have been surprised that the dollar has been incapable of mounting even a respectable bear market rally – especially considering the amount of currency speculation and derivative hedging that would be expected to make for some dramatic price swings.
From my analytical vantage point, 2005 appears poised for only greater Monetary Disorder. And I do sense in the marketplace an unusually high degree of uncertainty and indecision. This is as one would expect considering the confluence of over-liquidity, gross speculative excess, and acutely fragile Bubble underpinnings. Uncertainty and indecision would appear to guarantee wild volatility and unpredictability in various markets. Indeed, I expect increasingly treacherous market conditions as the year progresses. Cash is anything but trash, and currently inflated prices and depressed risk premiums across virtually all asset classes create a very unfavourable risk vs. return outlook for most markets. I expect the confluence of the Chinese/Asian/emerging market booms and uncontrollable dollar liquidity excess to support energy and commodity prices. The flight out of dollar balances into perceived better stores of value is in its infancy.
The Critical Issue for 2005 is the commanding role speculative leveraging has come to play in creating liquidity for both the financial markets and economy, including inflated corporate cash flows and profits. Following 2004’s massive central bank securities purchases, speculative leveraging, unwinding of hedges, and marketplace dislocation-induced Over-liquefication -- market players and economic agents throughout are taking liquidity excess for granted. This is a mistake. The speculative liquidity-creating mechanism is vulnerable, and problematic whether the Bubble continues or bursts in 2005.