For the week, the Dow was down slightly and the S&P500 closed about unchanged. The Transports dropped 2%, while the Utilities gained 2%. The Morgan Stanley Cyclical and Morgan Stanley Consumer indices were about unchanged. The broader market was somewhat stronger this week. The small cap Russell 2000 and the S&P400 Mid-cap indices were up about 1%. Technology stocks were generally little changed. The NASDAQ100 and Morgan Stanley High Tech indices were flat. The Semiconductors declined 1%, while The Street.com and NASDAQ Telecom indices were about unchanged. The Biotechs dipped 1%. The financial stocks were unimpressive. The Broker/Dealers declined 1%, and the Banks slipped 2%. Although bullion gained $4.10, the HUI gold index was little changed for the week.
For the week, two-year Treasury yields rose 4 basis points to 3.22% (high since May 2002). Yet five-year Treasury rates dipped 1 basis point to 3.71%. Ten-year Treasury yields declined 5 basis points to 4.22%. Long-bond yields sank 10 basis points to 4.73%. The spread between 2 and 30-year government yields dropped to 151 basis points, down from 254 basis points as recently as September 2. Benchmark Fannie Mae MBS yields dropped 8 basis points. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note narrowed 3 basis points to 34, and the spread on Freddie’s 5% 2014 note narrowed 3 basis points to 31. The 10-year dollar swap spread declined 1 to 39.25, the lowest in about one month. Corporate bond spreads generally widened slightly but remain extraordinarily tight, with junk spreads widening moderately. GM bonds widened 15 basis points on the back of the company’s poor outlook. The implied yield on 3-month March Eurodollars rose 3 basis points to 2.97%.
Corporate bond issuance declined to $16.8 billion. This week’s investment grade issuers included Morgan Stanley $2.2 billion, Wal-Mart $1.0 billion, American General $750 million, Energy Transfer Partners $750 million, Southern Cal Edison $650 million, International Lease Finance $500 million, Caterpillar Finance $400 million, Albermarle $325 million, TGT Pipeline $300 million, Gulf South Pipeline $275 million, HBOS $250 million, Westar Energy $250 million, Consumer Energy $250 million, Entergy Arkansas $175 million, CMS Energy $150 million, Mack-Cali Realty $150 million, Ames True Temper $150 million, New Plan Excel Realty $100 million, and Alabama Gas $40 million.
January 14 – Bloomberg (David Russell): “Kohlberg Kravis Roberts & Co. and Clayton, Dubilier & Rice Inc. are among buyout firms taking advantage of a hot junk bond market by selling investors high-yield, high-risk debt that pay no interest for several years. At least 12 borrowers, including KKR-controlled PanAmSat Corp. and Clayton Dubilier’s VWR International Inc., have raised more than $2 billion from investors since September through so-called discount bond sales. The number and face value of the offerings exceed the totals for every year since at least 1999. Proceeds are being used to pay a dividend to the buyout firms.”
Junk bond funds reported outflows of $265 million for the week ended Wednesday. Junk issuers included Warner Chilcott $600 million, RH Donnelley $300 million, Lin Television $175 million, General Nutrition $150 million, and City Telecom $125 million.
Convert issuers included Atherogenics $200 million.
Foreign dollar debt issuers included Italy $4.0 billion, KFW $1.0 billion, and Republic of Turkey $2.0 billion.
Japanese 10-year JGB yields were unchanged this week at 1.40%. Brazilian benchmark bond yields jumped 13 basis points to 8.32%. Mexican govt. yields ended the week at 5.21%, down 3 basis points for the week. Russian 10-year dollar Eurobond yields were down 2 basis points to 5.92%.
Freddie Mac posted 30-year fixed mortgage rates declined 3 basis points this week to 5.74%. Fifteen-year fixed mortgage rates dipped 2 basis points to 5.19%, while one-year adjustable-rate mortgages were unchanged at 4.10%. The Mortgage Bankers Association Purchase applications index declined 5.8% for the week. Purchase applications were down almost 13% from one year ago, with dollar volume slipping 3%. Refi applications increased 1.1% during the week. The average new Purchase mortgage jumped to $230,300, and the average ARM increased to $309,700. ARMs increased slightly to 32.7% of total applications.
Broad money supply (M3) added $1.5 billion (week of January 3) to$9.455 Trillion. For the week, Currency increased $0.9 billion. Demand & Checkable Deposits declined $0.3 billion. Savings Deposits sank $28.1 billion. Small Denominated Deposits fell $1.2 billion. Retail Money Fund deposits added $0.7 billion, and Institutional Money Fund deposits jumped $22.1 billion. Large Denominated Deposits rose $14.0 billion. Repurchase Agreements declined $16.4 billion, while Eurodollar deposits rose $7.3 billion.
Bank Credit jumped $28.4 billion for the week of January 5 to $6.773 Trillion. For the week, Securities holdings gained $10.4 billion, and Loans & Leases surged $18.0 billion. Commercial & Industrial loans increased $2.9 billion, while Real Estate loans expanded $13.3 billion. Real Estate loans are up $319 billion, or 14.3%, over the past 52 weeks. For the week, consumer loans dipped $0.6 billion, while Securities loans gained $1.6 billion. Other loans declined $0.7 billion. Elsewhere, Total Commercial Paper declined $3.7 billion to $1.394 Trillion. Financial CP declined $4.5 billion to $1.26 Trillion. Non-financial CP added $0.7 billion to $134.4 billion.
Fed Foreign Holdings of Treasury, Agency Debt added $6.8 billion to $1.351 Trillion for the week ended January 12(up $268bn, or 24.8% from a year earlier). Federal Reserve Credit dropped $11.0 billion for the week to $780.7 billion.
This week’s ABS issuance totaled a strong $11 billion (from JPMorgan), with $7 billion of home equity ABS sold.
The dollar index declined slightly, but held most of last week’s rally. The Japanese yen gained 2%, as Asian currencies generally performed well. The Uruguay peso dropped 4% and the Chilean peso declined 1%, as Latin American currencies generally underperformed.
January 13 – XFN: “China’s 2004 crude oil imports rose 34.8% to 120 million metric tons on the back of strong energy demand, the Customs General Administration of China said. …iron ore powder imports rose 40.5% to 210 million metric tons, as China’s steel makers increased production…Imports of home appliances and electronic products rose 36.7% to $142.07 billion, and machinery imports rose 28.2% to $91.62 billion last year.”
February Crude Oil jumped $2.95 this week to $48.38. The Goldman Sachs Commodities index rose 4%, with two-week gains of 6.4%. The CRB index added 1.6%, largely recovering last week’s decline.
January 11 – XFN: “China’s exports rose 35.4% year-on-year to $593.4 billion in 2004 and imports were up 36% to $561.4 billion, the Ministry of Commerce said. Exports for December rose 32.7% year-on-year to $63.8 billion and imports for the month were up 24.6% on a yearly basis to $52.7 billion.”
January 13 – Bloomberg (Nerys Avery): “China’s foreign exchange reserves rose 51 percent last year to a record $609.9 billion, the People's Bank of China said…”
January 13 – Bloomberg (Nerys Avery): “China’s money supply growth in December stayed within the government's target for a seventh straight month after banks were told to limit lending to industries including steel, autos and real estate. M2, which includes cash and all deposits, expanded 14.6 percent from a year earlier to 25.3 trillion yuan ($3.06 trillion)…”
January 13 – Bloomberg (Nerys Avery and Philip Lagerkranser): “Foreign direct investment in China rose about 14 percent to a record last year as companies such as Wal-Mart Stores Inc. and Coca-Cola Co. expanded to tap rising demand in the world's fastest-expanding major economy. Investment increased to $60.6 billion, the Ministry of Commerce said…”
January 13 – XFN: “China is beginning to have an impact on US technology industries formerly thought to have been insulated from low-wage overseas competition, according to a report prepared by a US Congress-mandated commission. China’s exports of electronics, computers, and communications equipment…are growing much faster than its exports of low-value, labor-intensive items…”
January 11 – XFN: “China has not been able to moderate its rapid economic growth despite taking a series of steps to achieve a soft landing for its economy, the IMF said. Last year, the Chinese authorities took a number of steps, largely in the form of administrative controls, to moderate the pace of economic growth, which had been averaging 9.7% a year from 1990 to 2003. The controls included bank lending, but in late October Beijing also announced a modest rise in interest rates. ‘There have not been clear signs of growth moderating to a level that can safely be viewed as sustainable,’ IMF first deputy managing director Anne Krueger said…”
Asia Inflationary Boom Watch:
January 12 – Bloomberg (Cherian Thomas and Bharat Ahluwalia): “Indian industrial production rose 7.9 percent in November as the cheapest credit in 31 years and rising incomes spurred demand for cars, motorcycles and homes. The increase in output at factories, utilities and mines from a year earlier was driven by demand for consumer goods, boosting manufacturing by 8.8 percent…”
January 14 – Bloomberg (Anand Krishnamoorthy): “Indian automobile sales rose 42 percent in December after Maruti Udyog Ltd., Ford Motor Co. and other automakers boosted discounts and customers borrowed to buy cars and motorcycles. Sales of cars, trucks and motorcycles rose to 688,072 in December from 504,557 a year earlier…”
January 13 – Bloomberg (Cherian Thomas): “Indian exports rose 15 percent in December from a year earlier, boosted by shipments of textiles, gems and jewelry to the U.S., the country’s biggest overseas market.”
January 11 – Bloomberg (Francisco Alcuaz Jr.): “Philippine exports rose in November at their fastest pace in more than two years as electronics makers shipped more computer chips and disk drives to Japan and China. The peso climbed to a one-month high. Shipments jumped 19.5 percent from a year earlier…”
January 10 – Bloomberg (Yoolim Lee): “Singapore said investment commitments from local and overseas manufacturers rose 11 percent to S$8.3 billion ($5 billion) last year from S$7.51 billion in 2003.”
January 14 – Bloomberg (Naila Firdausi): “Auto sales in Indonesia rose 36 percent last year as peaceful elections and lower interest rates boosted car purchases…”
January 12 – Bloomberg (Claire Leow): “Indonesia’s government will offer 91 infrastructure projects valued at $22 billion to local and overseas investors over the next five years, the Jakarta Post said, citing the Coordinating Minister for Economics Affairs… That’s double the original proposal of 37 infrastructure projects valued at about 100 trillion rupiah…”
January 13 – Bloomberg (Jason Folkmanis): “Vietnam wants to cut inflation to less than 6.5 percent this year, the central bank said, after consumer prices rose at their fastest pace in nine years in 2004. Inflation last year was 9.5 percent…”
Global Reflation Watch:
January 10 – The Wall Street Journal (Gregory Yuka Hayashi): “A proliferation of real-estate investment funds, both foreign and home-grown, is fueling intensive bidding for choice properties in Tokyo and beyond, setting off a small revival in top end of Japan’s real-estate market. The rebound, which comes after the epic 1990s slide in land prices that helped trigger Japan’s long economic slump, is a classic case of too much money chasing too few properties…. Buyers are popping up with armfuls of cash raised through private investment funds and publicly traded real-estate investment trusts, as well as with Japanese bank loans available at rock-bottom interest rates.”
January 13 – Bloomberg (Nerys Kathleen Chu): “Tokyo office vacancies dropped in December to their lowest in 28 months… The vacancy rate declined for a fifth straight month to 6.1 percent from 6.44 percent in November…”
January 13 – Bloomberg (Keiko Ujikane): “Japan’s 10-year bond yield may rise to 2.5 percent in 2005, the highest since 1997, as a six-year bout of deflation the world's second-biggest economy comes to an end, according to Merrill Lynch Japan Securities Co.”
January 10 – Bloomberg (Maher Chmaytelli): “Egypt’s Suez Canal, the waterway linking the Red and Mediterranean seas, reported record revenue for 2004, in part as rising energy demand led to increased shipments on oil tankers. Revenue rose 18 percent to $3.09 billion, the most since its opening in 1869…”
January 10 – Bloomberg (Theophilos Argitis and Kevin Carmichael): “Canadian building permits jumped 9.3 percent to C$5 billion ($4 billion) in November, more than expected, to the second highest level on record.”
January 14 – Bloomberg (Jeremy van Loon): “Western European car sales rose 7.7 percent in December, leading to the first annual gain in three years as Toyota Motor Corp. and Asian competitors introduced new products and Volkswagen AG offered incentives to boost demand…”
January 13 – Bloomberg (Brian Swint): “The German economy, Europe’s largest, returned to growth in 2004 after the longest period of stagnation since World War II as an increase in exports overcame a slump in consumer spending. Gross domestic product rose 1.7 percent after failing to grow more than 0.8 percent in the previous three years… The fastest global expansion in nearly three decades fueled Germany’s recovery from the contraction in 2003.”
January 10 – Bloomberg (Ben Holland): “Turkey’s industrial production rose 9.6 percent in November from the same month of 2003, as rising exports helped drive economic growth.”
January 13 – Bloomberg (Victoria Batchelor): “Australian consumer confidence in January surged to its highest in almost 11 years, spurred by rising share prices, cheaper gasoline and increased employment. The consumer confidence index rose 4.2 percent from December to 123.5, the highest since June 1994…”
January 13 – Bloomberg (Maria Ermakova): “Russia’s foreign currency and gold reserves rose to a record of $124.6 billion, gaining for the second-straight week, the central bank said.”
January 11 – Market News: “Industrial output in Mexico rebounded from a disappointing October, to jump 5.4% in November compared to the same month of 2003, as manufacturing output increased 5.8%... It was the 12th consecutive increase for the headline number…”
Latin America Reflation Watch:
January 11 – Bloomberg (Guillermo Parra-Bernal): “Brazil’s industrial output rose for a 15th month in November, led by increased production of vehicles, machinery and processed foods, the government said in a report. Industrial output, which includes manufacturing, mining and electricity generation, jumped 8.1 percent, compared with 2.7 percent in October…”
January 14 – Bloomberg (Alex Kennedy): “Venezuela boosted spending in November to at least a six-year high as record oil prices fueled income. The government raised spending 60 percent in the month from November 2003 to 6.6 trillion bolivars ($3.4 billion), the central bank said…”
January 14 – Bloomberg (Alex Emery): “Peru’s economy grew at the fastest pace in 32 months in November as copper, fishmeal and natural gas output expanded. Gross domestic product expanded 8.4 percent in November from a year earlier…”
Dollar Consternation Watch:
Market News International: “Senior Deputy Governor Paul Jenkins suggested international investors could cool off lending to the United States if its ‘massive current account deficit with the rest of the world’ continues... “The United States is running a large fiscal deficit, which is reflected in a massive current account deficit with the rest of the world,’ … The United States had to borrow an amount equivalent to 5.5% of its GDP each year to support U.S. consumption. ‘So far, international investors have been willing to continue to lend to the United States. But this situation is simply not sustainable: no economy can continue to pile up current account deficits of that size forever, especially if these deficits represent current consumption rather than investment which would increase the economy’s production capacity.’”
January 11 – Bloomberg (Chan Tien Hin): “Malaysia is seeking ways to reduce its reliance on the dollar for trade because of its volatility and may turn to other currencies, the Star newspaper reported, citing Prime Minister Abdullah Ahmad Badawi.”
January 4 – Bloomberg (Jeff Green): “Japanese automakers Toyota Motor Corp., Nissan Motor Co. and Honda Motor Co. said December U.S. auto sales rose more than 20 percent. Ford Motor Co. and DaimlerChrysler AG’s Chrysler unit had smaller increases, and General Motors Corp.’s sales fell. Toyota’s 23 percent December gain lifted Japan’s biggest automaker to 2.1 million U.S. sales for 2004, the first time a non-U.S. company sold more than 2 million vehicles in a single year. Japan’s No. 2 automaker, Nissan, rose 38 percent for the month, and No. 3 Honda increased 35 percent.”
January 6 – Bloomberg (Andrea Rothman): “Airbus SAS, the world’s biggest planemaker, delivered 320 aircraft last year, beating Boeing Co. for a second year in a row, a person familiar with Airbus said… Airbus surpassed Chicago-based Boeing for the first time in 2003 with 305 planes to 281. Boeing delivered 285 planes in 2004…”
Bubble Economy Watch:
From Bloomberg: “The 8.9 percent gain in sales excluding automobiles in 2004 was the biggest in 12 years of comparable record-keeping. Retail sales account for almost half of all consumer spending, which in turn accounts for about two-thirds of the economy.”
Total December Retail Sales were up 8.7% compared to December 2003. To put this number into perspective, December 2003 y-o-y Retail Sales were up 6.1%, Dec. ’02 up 3.7%, Dec. ’01 up 3.1%, and Dec. ’00 up 2.4%. One has to return to go-go December 1999 (up 9.6%) to beat last month’s performance.
December Industrial Production was up 4.4% from comparable 2003. For the year, Industrial Production rose 4.1%, the strongest showing since 2000. For comparison, Industrial Production was flat during 2003, down 0.3% for 2002, down 3.6% for 2001, and up 4.3% during 2000. Capacity Utilization jumped to 79.2% during December, the highest level since January 2001.
January 11 – Market News (Gary Rosenberger): “Imports continued to jam the nation’s ports and other transportation facilities long after the normal end of the peak holiday shipping season during November and December, suggesting a further widening of the trade gap from current record highs, say port and cargo officials. There was a modest improvement on exports due in part to a weaker dollar, but the nation’s busiest ports saw outbound traffic at about the third the levels of what was coming in -- and there are no realistic prospects for more balanced trade in 2005, they say.”
January 13 – UPI: “A Tampa, Fla., development company and Donald Trump are building the city’s tallest building… The Trump Tower Tampa will be a 52-story, 190-unit condominium building… The $220 million project will include condos from 1,991 square feet to 6,150 square feet. Most units will cost $1 million to $2 million.”
Mortgage Finance Bubble Watch:
January 14 – Market News International (Steven K. Beckner): “St. Louis Federal Reserve Bank President William Poole warned Thursday night that mortgage financing leviathans Fannie Mae and Freddie Mac are vulnerable to ‘very large’ losses, the shock waves of which could cause a ‘tsunami’-like impact on financial markets and cause ‘substantial risk’ to the U.S. economy. Poole warned that the Fed would be unable to contain the ‘solvency crisis’ that could ensue if markets lose confidence in the giant government-sponsored enterprises’ debt obligations, and if the GSEs exhaust their slim capital.”
Countrywide Financial posted a strong December. Total fundings were up 11% for the month to $34.7 billion (strongest since April). Purchase fundings were up 36% from December 2003 to $16.5 billion, and “non-purchase”/refi fundings were up 40% to $18.2 billion. Home equity fundings were up 74% from last December to $3.15 billion. Subprime fundings jumped 24% from November (up 91% from December 2003) to a record $4.3 billion. Total Bank Assets were up $2.3 billion for the month to $41 billion, having more than doubled over the past year.
Liquidity Excess Watch:
January 10 – The Wall Street Journal (Gregory Zuckerman and Henny Sender): “Last spring, investors gathered in a hotel in Garden City, Long Island…to meet hedge-fund managers looking to raise money. A throng of more than 200 people piled into one conference room and spilled into the corridor. Inside sat Eric Mindich, a 37-year-old former Goldman Sachs hotshot with no hedge-fund experience. According to two people who were there, Mr. Mindich didn’t divulge details about his trading strategy and acknowledged he hadn’t managed money for several years. In a low monotone, he said those permitted to invest would have to pony up at least $5 million, pay stiff management fees, hand over 20% of investment profits and tie up their money for as long as 4 1/2 years or pay a big penalty. The response: Where do I sign? Two months ago, Mr. Mindich launched his fund, Eton Park Capital Management, with more than $3 billion in assets committed by investors. People in the clubby world of hedge funds think that’s the largest launch on record.”
The Fed Again Falls Flat on Bubble Analysis
January 13 – Bloomberg (Alison Fitzgerald and Vivien Lou Chen): “Identifying asset price bubbles as they occur is ‘arguably impossible’ and there’s no appropriate way for central bankers to respond by altering monetary policy, Federal Reserve Vice Chairman Roger Ferguson said. ‘Current statistical methods are simply not up to the task of ‘detecting’ asset-price bubbles, especially not in real time, when it matters most,’ Ferguson said in the text of a speech to the Stanford Institute for Economic Policy Research… Therefore, ‘a clear-cut policy response to suspected waves of exuberance cannot be suggested.’ Recessions preceded or accompanied by a bust in asset prices are not necessarily more costly or longer than ones in which securities or real estate retain their value… ‘Each recession and recovery episode would seem to call for its own tailor-made policy response.’”
The Greenspan Fed undertook the study of asset Bubbles nearly a decade ago. There is no doubt that this effort has been a disappointing failure. And the pathetic state of understanding with regard to the nature of asset inflation and Bubble dynamics is an indictment of our central bank as much as it is of contemporary economics. I found Mr. Ferguson’s paper and discussion especially discouraging. Not only does the Federal Reserve today possess a dismal appreciation for the underlying dynamics that fueled the telecom/tech Bubble, they are seemingly oblivious to the reality that Credit and asset Bubbles have taken full command of global asset markets and economies. Somehow the Fed insists – and is intent on celebratory self-congratulations – that we are in a healthy post-Bubble environment. How can this be?
I will begin with an interesting exchange from Mr. Ferguson’s Q&A session:
Question: “During the asset Bubble the extension of debt – whether it was margin debt, corporate debt and so forth - my anecdotal experience was that the amount of debt that was being raised based on the inflated asset values versus cash flow generating ability expanded very erratically. Margin debt being an example of that. So the question is: what effect does that have on accelerating the Bubble effect? And, secondly, is there a way that policymakers – even if they are not going to make a call that we are in a Bubble – if there’s a certain rate of asset value accretion in certain time periods (when the Fed would) institute some type of Credit controls which (would) dampen the acceleration.”
Vice Chairman Ferguson: “First thing, during some of this period there was some call on the Federal Reserve to move margin requirements, for example. And the literature and the research that we’ve managed to do – and there have been a few episodes in history when margin requirements were moved – does not show that it has any impact on that kind of extension of Credit. The second thing to observe is that the source of this Credit may matter. And one of the things that made the U.S.’s situation different from the Japanese in this study, was the point that I made (in the paper), was that risk management was much better in the U.S., so that the extension of Credit that was going into some of these activities was not purely from banks. There were some venture capitalists and others… Undoubtedly some people in this room (at Stanford University) will understand that the Credit was not coming from banks it was coming from venture capitalists, who are obviously extraordinarily important in this part of the country. But what you don’t find is the propagation of weak financial systems, which is one of the reasons why – why I say one of the important conclusions here – is at least with respect to the banks that play a unique risk-taking and risk conversion role – it’s extremely important when we are not in these periods for us as regulators to enforce or to encourage the best kinds of risk management practices. Because you can avoid the kind of propagation that seems to have occurred with the Japanese.”
“The other thing I think that happened is – the theoreticians in the room would do this better than I will – but one of the points I was trying to make in the talk was that it’s fair to say the academic literature has had a difficult time identifying Bubbles retrospectively. I think it’s impossible to identify – almost impossible to identify them in real time. Just as the academic literature doesn’t do that very well, I would argue that many of the individuals involved don’t necessarily do that very well either. And so what you end up, yes some stories, and yes is in hindsight you can say “well, gee why would one have extended Credit on that kind of story versus a real income statement.” But the reality was, at the time, the expectations which turned out in hindsight to have been faulty, weren’t necessarily viewed as being faulty at the moment. There were very smart, very credible people, who had had a great deal of success, say, in the world of venture capital who continued to buy into some of these stories. Some of them true, some of them not true. And so I think the same problem that the academic literature has in terms of defining a real Bubble – where fundamentals and prices are dramatically disconnected – I think the reality is that the individuals involved at the time have the same problem. All the more reason to think about having, if you will, a strong, resilient and successful economy and good policy to offset some of the changes that might occur.”
My comment: The Fed should not mistake “a strong, resilient and successful economy” for the perpetuation of a Bubble economy. And to focus on “venture capitalists” as the commanding source of Credit for the telecom/tech Bubble is poor analysis. What about the late-nineties’ surge in junk bond issuance, rapid corporate debt growth, unprecedented syndicated bank lending (fodder for collateralized debt obligations and other “structured products”) - all part of the estimated Trillion dollar global telecom debt debacle? Let’s also not forget the underlying speculative leveraging in tech/telecom related instruments – stocks, junk debt, CDOs, “special purpose vehicles,” etc. – that played an instrumental role in the tech sector liquidity onslaught. What about the hedge funds and proprietary trading operations that placed big speculative tech bets? The derivatives markets were directly instrumental in fostering leveraging – hence liquidity creation – that inundated the marketplace. And, importantly, there were indirect sources of Credit creation – mortgage debt in particular and MBS/agency securities leveraging – that were the underlying source of liquidity for the purchase of equities and mutual fund shares that also directed liquidity straight to the Bubbling technology sector.
And I do not believe that superior “risk management,” per se, has spared the U.S. financial sector from a Japanese-style bust. Rather, a significant portion of tech Bubble Credit exposure had been shifted to non-traditional, market-based non-bank entities (CDOs, derivatives, hedge funds, off-balance sheet entities, etc.). And while some huge losses were suffered, the Fed-orchestrated collapse in yields (spike in fixed-income prices) and ultra-low borrowing costs mitigated the impact of these (largely isolated) losses for most players. The tech/telecom Bubble had burst, but the progenitor Credit Bubble was empowered to nurture the bond, mortgage finance, and leveraged speculating Bubbles to blow-off extremes. Contemporary finance provided the Fed with the extraordinary capacity to perpetuate asset Bubbles – hence Credit and liquidity excess - and the greater the securities and real estate Bubbles expanded, the more inconsequential became tech and telecom. The tech bust was “monetized,” a process that will work only for as long as a new larger Bubble can inflate sufficiently to supplant the one deflating.
From Dow Jones: “The groundwork of prudent bank regulation, price-restraining monetary policy and fiscal health was essential to the U.S. economy’s quick recovery from the 2001 recession, a top Federal Reserve policymaker said… ‘Relative to other recessions, this recession was shallow and did not appear to impart an unusual drag on investment, despite the sharp asset-price correction’ in the stock market, Fed Vice Chairman Roger Ferguson said… The Fed vice chairman said the advance measures of U.S. banking regulation, anti-inflationary monetary policy and balanced government budgets insulated the economy from the effects of a recession preceded by a severe equity-market correction. By comparison Japan still hasn’t recovered fully from three recessions beginning in 1992, when the country went through an asset-price correction following a sharp climb in equity and real estate prices in the 1980s. The Japanese recoveries have been incomplete largely because of insufficient monetary policy measures and inadequate regulation of the country’s troubled banks, Ferguson said. In the U.S., the savings and loan crisis, the international debt crisis and the Basel I capital standards agreement during the 1980s put banking regulation on a solid footing by the mid-1990s, he said. ‘Prudential regulation coupled with good risk management meant that financial firms limited their exposure to risk during the boom years of the 1990s,’ he said. ‘Despite the recession, banks remained well capitalized, and their strength eliminated the threat of a vicious credit crunch or the risk of fragility in the system.’”
My comment: In an effort to garner asset Bubble insights from historical experience, Mr. Ferguson’s paper compares three post-asset boom economic downturns: the 1974 recession in the U.K., Japan in 1992, and the U.S.’s 2002 recession. While I don’t profess expertise with respect to the U.K. economy during the seventies, I find comparing 1992 Japan to 2002 United States essentially Fruitless Apples vs. Oranges. Collapsing real estate values were forcing the entire Japanese Credit system to its knees, while Japanese consumers were retrenching and increasing their already sizable pool of savings. The U.S. in 2002? Well, it is worth recalling that Total (financial and non-financial) Credit market borrowings increased by $2.16 Trillion (21% of GDP) during 2002. This was record Total Credit Growth, and up 7.4% for the year (an increase from 2001’s 7.2% and 2000’s 6.7% growth). Non-financial sector debt expanded a record $1.32 Trillion (up from 2001’s $1.12TN, 2000’s $850bn, and 1999’s $1.07TN). The year’s 6.8% increase in non-financial borrowings was the strongest since 1999’s 6.9%. Financial sector borrowings expanded a robust 9.0%, down only somewhat from 2001’s 10.8%. GSE assets increased 10% during the year to $2.55 Trillion. Residential mortgage debt increased 12% during 2002, with total mortgage debt growth of $678 billion, up 32% from 2001’s record (annual mortgage debt growth averaged $286 billion during the preceding 10 years). U.S. Retail Sales were up 3.7% during 2002. And examining the household balance sheet, Tangible Assets actually increased $1.4 Trillion (8.5%) during the year to $18.2 Trillion, offsetting much of the decline in stock prices. That the U.S. corporate bond market was faltering in the autumn of 2002 - in the face of robust (albeit unbalanced) system Credit expansion - is indicative of underlying acute financial fragility.
The fact of the matter is that 2002 was not a post-Bubble environment at all. Indeed, the bursting of the tech/telecom Bubble proved an instrumental development for the blow-off stage of myriad Bubbles – most notably the Mortgage Finance Bubble and the Bubble of Leveraged Speculation - a process that is still very much in play. And to credit prudent regulation, anti-inflationary monetary policy and balanced government budgets is dangerously inaccurate analysis. Ironically, Bubbles are today perpetuated only by imprudent regulation, inflationary monetary policy, and unprecedented fiscal and current account deficits.
Excerpts from Mr. Ferguson’s “Recessions and Recoveries Associated with
“The word bubble is sometimes employed to describe any quick and large increase in asset prices, but a more precise definition would associate bubbles with only those increases in asset prices that are not due to economic fundamentals. Under such a definition, a bubble is present when investors buy assets at prices above their fundamental values in the expectation of being able to sell them at even higher prices in the future. To be sure, such departures from fundamentals may start small, but over time they could grow explosively. The fundamental price of an asset typically is defined in terms of the discounted present value of the income stream or equivalent services that the asset is expected to provide over time. For stock prices, for example, this is the present discounted value of dividends; for real estate, it is the discounted value of the rents or services that are expected to accrue to the owner over time. In theory, the existence of bubbles, defined in this way, is possible in standard asset-pricing models and may even be consistent with rational, profit-maximizing behavior.”
My comment: Any definition of a Bubble that relies on “economic fundamentals” or “fundamental values” will prove worthless in practice and worse for developing a sound analytical framework. The focus must be on underlying Credit growth and speculation. What are the monetary sources for the price gains, and are they sustainable? What are the broader influences from price inflation on the nature of spending, investing, speculating? To what extent is price inflation inciting Credit and speculative excess? And to what degree is this Credit expansion impacting/distorting “fundamentals” (i.e. industry cash flow and profits, personal income growth, Credit Availability, Credit losses, lending margins, trading profits, government revenues, liquidity, etc.), thereby fostering self-reinforcing lending, asset inflation, spending and speculation?
Ferguson: “Ascertaining the existence of bubbles in practice is a very different matter. An immediate difficulty is that the theoretical notion of the fundamental price does not have an easily measured empirical counterpart. In part as a result of this measurement problem, statistical tests using historical data cannot easily distinguish bubbles from failures of the standard asset-pricing model in some other dimensions, or no failure of the model at all. Indeed, for every study of historical data that finds evidence of a bubble, often another shows that the findings could be explained by an alternative specification of the fundamentals in the absence of bubbles. That is, even with the benefit of hindsight, statistical tests attempting to confirm the existence of bubbles in historical episodes can remain inconclusive.”
“Of greater relevance for policy discussions, however, is not whether economists can identify a bubble long after it occurs, but whether the presence of a bubble could be detected in real time, when the information might be useful for policy decisions. Unfortunately, detection of a bubble, which is problematic even ex-post, is an even more formidable task and arguably becomes virtually impossible in real time. Indeed, in real time, it is not uncommon for economists and market participants to fail to recognize important shifts in underlying trends that may subsequently be viewed as the source of significant changes in market fundamentals. Current statistical methods are simply not up to the task of ‘detecting’ asset-price bubbles, especially not in real time, when it matters most. ‘Detecting’ a bubble appears to require judgment based on scant evidence. It entails asserting knowledge of the fundamental value of the assets in question. Unsurprisingly, central bankers are not comfortable making such a judgment call. Inevitably, a central bank claiming to detect a bubble would be asked to explain why it was willing to trust its own judgment over that of investors with perhaps many billions of dollars on the line.”
My comment: The notion that it becomes virtually impossible to identify a Bubble in real time is Fed Fallacy. While it may be virtually impossible to forecast the scope and life of a Bubble, it is possible to identify evidence and characteristics of Bubble development. “Scant evidence”? The tech/telecom Bubble was conspicuous at the time, and today’s Mortgage Finance and Leveraged Speculation Bubbles are even more so. As for mortgage finance, total Mortgage Debt has almost doubled in only 7 years. Home equity lending has exploded, as has subprime. Bank real estate lending increased 14% during the past 12 months, with three-year gains of 44%. Prudent regulation in real estate lending? There are now spectacular housing Bubbles in California, along the East Coast (including our nation’s capital!) and elsewhere, while national average prices are surging.
We are witnessing a proliferation of no down-payment, interest only, adjustable-rate, no-documentation, and teaser-rate loans. There are tens of thousands of mortgage brokers extending Credit with little concern for the long-term soundness of the mortgage. Credit standards have never been easier. Many are borrowing against 401k plans to make down payments. More borrow against inflated home equity for consumption and to acquire financial assets. Housing sales and construction are easily at all-time records. Speculative buying is unparalleled – second homes, rentals, vacation condos and time-share units. On the financial side, there are highly leveraged holdings of mortgage-backed and agency securities. There is a huge boom in related derivative positions. Various types of institutions have become enamored with lending, investing, and speculating in mortgage securities and instruments. REITs are booming. And, importantly, the Wall Street structured finance machine is working overtime to transform risky mortgage loans into enticing high-yield structured products, just as it did with tech/telecom debt in the late nineties. Identifying Bubbles “requires judgment based on scant evidence”? That is simply not accurate.
“The Japanese economy saw rapidly increasing equity and real estate prices during the 1980s, a remarkably long period of stability and prosperity.”
My comment: The Fed must be able to distinguish an unsound Bubble environment from “a remarkably long period of stability and prosperity,” at least in hindsight.
“The bursting of the bubble importantly shaped subsequent developments in this case. The asset-price collapse hit the Japanese banking system hard, eroding bank capital. The ensuing disintermediation subsequently proved an important impediment to the economy's recovery. However, the extent of the problem was not fully appreciated at the time by policymakers. Despite steps toward an expansionary policy, the monetary easing of the early 1990s was insufficient to mitigate the underlying weakness during the expansion from 1994 to 1996. The continued fragility of the financial system arguably left the Japanese economy especially vulnerable to additional disturbances that could have otherwise been easily weathered. An economic crisis in Southeast Asia, coupled with a previously planned increase in consumption taxes, resulted in a larger-than-anticipated drag on domestic demand and set the stage for the recession that started in 1997. Following a brief recovery, monetary policy was tightened in 2000, and the third recession in a decade followed soon after.”
“The Japanese experience offers a reminder of the importance of monitoring the health of the financial system and the need to be especially wary of signs of fragility following a period of sharp asset-price declines. It also serves to highlight how the behavior of the banking system during the asset-price run-up may influence subsequent outcomes. Lastly, it points to the potentially crucial role played by fiscal and monetary policies in recoveries following asset-price-bust recessions.”
“Why was the 2001 recession relatively short and shallow even though the preceding swing in asset prices was so severe? In my opinion, two reasons stand out. The first regards the health of the financial sector. During the 1980s and early 1990s, the U.S. banking sector faced a succession of challenges: the savings and loan crisis of the early 1980s, the international debt crisis of the mid-1980s, waves of bank failures and consolidation, and the need to build capital in response to the adoption of the Basel I standards in 1988. But by the mid-1990s the banking sector had regained a solid footing, and regulators were careful to keep it that way. Prudential regulation coupled with good risk management meant that financial firms limited their exposure to risk during the boom years of the late 1990s. This approach paid off handsomely when the asset-price break occurred. Despite the recession, banks remained well capitalized, and their strength eliminated the threat of a vicious credit crunch or the risk of fragility in the system.”
“As a result, the elements that appear to have been so detrimental for the recovery of the Japanese economy during the 1990s were absent during this episode. Following the ‘bursting of the bubble’ in Japan, the banking system found itself holding a substantial amount of bad loans. And, as already seen, the woes of the banking system turned into a recessionary force in itself, curtailing the recovery. This comparison points to a useful policy lesson: A healthy financial sector and strong prudential regulation during an asset-price boom offer valuable insurance in case the boom turns to bust with an asset-price break.”
“The second, and perhaps equally important, reason that the recent U.S. episode was unusually benign was, in my view, the quick response of policy. Both fiscal and monetary policy were eased quickly and effectively in this episode. The Federal Reserve cut the federal funds rate rapidly to create monetary accommodation and maintained conditions of substantial monetary policy ease for a considerable period well into the expansion. As well, the Administration and the Congress took quick steps early in the recession to provide fiscal stimulus that helped to prop up aggregate demand.”
Placing the policy response in its proper historical context may be critical for drawing the appropriate policy lessons for the future. Countercyclical fiscal and monetary policies are unlikely to have been as swift and strong during 2001 had earlier policies not set the stage for such action. On the fiscal side, the budgetary prudence of the 1990s yielded comfortable surpluses at the onset of the 2001 recession that facilitated the large fiscal policy easing. And on the monetary side, the successful completion of the last stage on the long path to price stability during the 1990s allowed substantial easing in response to the downturn. As policymakers stressed repeatedly, the prevalence of low- and well-anchored inflation expectations ultimately facilitates pursuit of such countercyclical policy. A clear lesson emerges from this experience for policy over the long haul. By pursuing fiscal prudence and price stability during booms, policymakers greatly enhance their ability to take swift, effective countercyclical action when it is needed most.”
My concluding comments: The nature of contemporary finance dictates that central banks must be especially on guard and ready to ward off Credit excess, non-traditional inflation and Bubbles. The backdrop beckons for central banker diligence and caution. Free-wheeling Credit systems are unconstrained in their capacity to create inexpensive and abundant liquidity, while financial systems have a strong predilection toward asset-based lending. A massive global pool of vacillating speculative finance has evolved. Meanwhile, central bankers have relegated themselves to the only line of defense against asset inflation, destabilizing speculation, and Bubbles. Yet they have no sound analytical framework for discharging this most important responsibility.
Amazingly, the Fed has learned exactly the wrong lessons from the Japanese experience. Rather than moving early to quell lending and speculating impulses before Bubbles become unwieldy and a great risk to the financial system and economy, the Fed has convinced itself to move immediately and aggressively to ensure the avoidance of post-Bubble fallout. No good will come from Bubble Perpetuation, Evolution and Dispersion. Today’s paramount issue for monetary policymaking is to be able to differentiate stimulation/stabilization in a post-Bubble environment from nurturing and supporting unsustainable/destabilizing asset inflation and Bubble dynamics. This is a most challenging endeavor, one made insurmountable by the Fed’s misguided analytical framework.