The Dow and S&P500 both closed at three-year highs today. The Dow Transports closed at an all-time high. The S&P400 Mid-cap average closed at a record high. The S&P Homebuilding index closed at a record high, up 18% y-t-d. For the week, the Dow and S&P500 gained about 1%. The Transports jumped 3%, and the Utilities added 1.5%. The Morgan Stanley Cyclical index gained 1%, with the Morgan Stanley Consumer index up slightly less. The broader market traded in line with the major averages. The small cap Russell 2000 added 1%, and the S&P400 Mid-cap index was up 1.3%. Technology stocks were mixed. The NASDAQ100 was down fractionally, and the Morgan Stanley High Tech index was about unchanged. The Semiconductors dropped 2%. The Street.com Internet index rose 2% and the NASDAQ Telecommunications index added 1.5%. The troubled Biotechs were hit for 6%. Financial stocks were strong, with the Broker/Dealers up 2.5% and the Banks up 1.3%. With Bullion down 95 cents, the HUI gold index was little changed.
Two-year Treasury yields rose for a seventh straight week, adding 4 basis points to 3.56%. Two-year government yields are up about 50 basis points so far this year. Five-year Treasury yields were up 7 basis points this week to 3.96%. Ten-year Treasury yields rose 5 basis points to 4.32%. Long-bond yields added 2 basis points to 4.65%. The spread between 2 and 30-year government yields narrowed 3 basis points to 109. Benchmark Fannie Mae MBS yields increased 4 basis points. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note widened 1 basis point to 34, while the spread on Freddie’s 5% 2014 note narrowed 1 basis point to 28. The 10-year dollar swap spread rose 1.75 to 40.75, a 2005 high. Corporate bonds continue to benefit from abundant liquidity. The implied yield on 3-month June Eurodollars was unchanged at 3.43%.
Corporate bond issuance surged to $23 billion, led by aggressive borrowing from the financial sector. Investment grade issuers included Wells Fargo $5.0 billion, GE Capital $4.0 billion, WestLB $1.75 billion, DaimlerChrysler $1.5 billion, Toyota Motor Credit $1.0 billion, Nissan Acceptance $750 million, PNC Funding $700 million, World Savings $700 million, US Bank $700 million, Host Marriot $650 million, National City Bank $500 million, United Healthcare $500 million, Textron Financial $400 million, John Deere Capital $300 million, Caterpillar Finance $250 million, Ryder $225 million, Colorado Interstate Gas $200 million, Range Resources $150 million, South Carolina E&G $100 million, and AvalonBay $100 million.
Junk bond funds saw outflows decline to $96 million. Junk issuers included Allied Waste $600 million and WCI Communities $200 million.
Convert issuers included Open Solutions $270 million.
Foreign dollar debt issuers included Brazil $1.0 billion, Oester Kontrollbank $1.0 billion and Delek & Avner $275 million.
March 3 – Bloomberg (Telma Marotto): “Brazil’s stock exchange in February had a record inflow of foreign capital on optimism that high commodities prices and an expanding economy will keep profits growing… A total of 3.7 billion reais ($1.4 billion) of overseas funds flowed into the market…”
Japanese 10-year JGB yields increased 6 basis points to 1.49%. Emerging market debt again traded well. Brazilian benchmark dollar bond yields dipped 3 basis points to 7.73%. Mexican govt. yields ended the week down 6 basis points to 5.13%. Russian 10-year dollar Eurobond yields rose 3 basis points to 5.93%.
Freddie Mac posted 30-year fixed mortgage rates jumped 10 basis points to 5.79% (up 22 bps in 3 weeks). Fifteen-year fixed mortgage rates increased 11 basis points to 5.33%. Yet one-year adjustable rates dipped 2 basis points to 4.14%. The Mortgage Bankers Association Purchase Applications Index jumped 5.3% this past week. At the same time, refi applications dropped 9.9%. The average new Purchase mortgage declined somewhat to $235,400. The average ARM declined to $326,400. The percentage of ARMs was unchanged at 30.7% of total applications.
Broad money supply (M3) surged $43.5 billion to $9.50 Trillion (week of February 21). M3 is up $538 billion, or 6.0%, over the past year. It is worth noting that M3 Less Money Market Funds has expanded at a 9.4% rate over the past year, and is growing at an 8.7% pace so far during 2005. For the week, Currency added $1.9 billion. Demand & Checkable Deposits jumped $21.9 billion, while Savings Deposits declined $6.3 billion. Small Denominated Deposits rose $3.6 billion, while Retail Money Fund deposits dipped $1.0 billion. Institutional Money Fund deposits gained $6.3 billion. Large Denominated Deposits fell $1.7 billion. Repurchase Agreements jumped $19.9 billion (up $31.1 billion in 2 weeks), while Eurodollar deposits declined $1.2 billion.
Bank Credit has expanded an alarming $226.5 billion over the past 8 weeks (21.8% annualized). For the week ended February 23, Bank Credit surged $41.8 billion to a record $6.971 Trillion. Securities Holdings rose $13.6 billion, with gains of $42.1 billion over the past four weeks. Loans & Leases jumped a notable $28.2 billion, with 5-week gains of $87.3 billion. Commercial & Industrial (C&I) loans added $1.9 billion. Real Estate loans jumped $27.2 billion. Real Estate loans are up $335.8 billion, or 14.8%, over the past 52 weeks. For the week, consumer loans increased $0.8 billion, and Securities loans added $3.7 billion. Other loans dipped $5.3 billion.
Total Commercial Paper declined $6.2 billion last week to $1.434 Trillion, having expanded at an 8.4% rate y-t-d. Financial CP dropped $7.7 billion to $1.290 Trillion. Non-financial CP increased $1.6 billion to $144 billion, the highest level since May 2003. Non-financial Commercial Paper is up 19.4% over the past year.
March 3 – Bloomberg (Al Yoon): “U.S. commercial paper outstanding increased for a fourth month in five in February as a growing economy led companies to raise short-term funds for acquisitions and expansions, according to Federal Reserve data. Commercial paper, or debt maturing in nine months or less, rose 2.1 percent to $1.44 trillion in February, the most since January 2002…”
Fed Foreign Holdings of Treasury, Agency Debt jumped $14.0 billion to $1.379 Trillion for the week ended March 2 (up $36.4 billion in 2 weeks). “Custody” holdings are up $42.9 billion, or 18.6% annualized, year-to-date (up $227bn, or 20%, over 52 weeks). Federal Reserve Credit gained $4.1 billion for the week to $785 billion (up $48.3bn, or 6.6%, over 52 weeks).
ABS issuance declined to $9 billion (from JPMorgan). Year-to-date issuance of $106 billion is running 6% ahead of comparable 2004. At $65.7 billion, Home equity ABS issuance is running 22% above year ago levels.
Currency Watch:
Today’s bludgeoning put the dollar index slightly in the red for the week. The New Zealand dollar gained 1.3%, the Taiwan dollar 0.7%, the Canadian dollar 0.6%, and the Australian dollar 0.5%. On the downside, the Venezuelan Bolivar was devalued 10% this week, while the Chilean peso declined 1.6%, the Brazilian real 1.4%, and the Uruguay peso 1.2%.
Commodities Watch:
March 2 – Financial Times (Geoff Dyer): “China’s steel industry yesterday accepted the 71.5 per cent increase in iron ore prices proposed by two of the biggest suppliers just a week after it warned of the damage from such a price rise… Guy Dolle, Arcelor chief executive, told the FT…”I don’t understand why for the first time the Asians have taken the lead in the negotiations, because the biggest clients for the iron ore producers are in Europe.”
April crude jumped $2.29 to $53.78. The Goldman Sachs Commodities index jumped 3.4%, increasing year-to-date gains to 17.6%. The CRB index rose 3.0%, closing today at the highest level since January 1981. The CRB is sporting 2005 gains of 8.9%.
China Watch:
March 2 – Bloomberg (Samuel Shen): “China’s inflation may accelerate to 2.5 percent in the first quarter, driven by increases in energy and transport prices, the nation’s top economic planning agency forecast. Bottlenecks in raw materials such as coal are worsening while a cold spring will increase storage and transport costs for vegetables, the National Development and Reform Commission said in a report published in the China Securities Journal.”
February 28 – Bloomberg (Yanping Li): “China’s fixed-asset investment may rebound this year, and the nation faces further shortages of electricity and transport bottlenecks, the National Bureau of Statistics said. ‘There is still a fairly large number of new projects being started and projects under construction, and the impulse for investment to expand blindly is still strong,’ the bureau said in a statement…”
February 28 – XFN: “China’s electricity demand is forecast to rise 13%...in 2005… the official Xinhua news agency reported. China faces growing power shortages due to a combination of planning mistakes, strong economic growth, decreasing water supplies for hydroelectric power generators and disruption of coal supplies.”
February 27 – Bloomberg (Zhang Shidong): “China’s electricity consumption rose 15 percent last year, the official Xinhua news agency reported, citing the China Electricity Council.”
February 28 – XFN: “China’s breakneck economic growth is causing a dangerous shortage of its most important energy source -- coal -- with potential consequences for the entire world, the China Business Weekly reported… The scarcity is so severe that officials even worry aloud that it could cause social instability among the 1.3 billion Chinese, the state-run newspaper said. ‘The imbalance between coal demand and supply will become more acute this year,’ the newspaper quoted the National Development and Reform Commission as saying.”
February 28 – Bloomberg (Philip Lagerkranser): “Hong Kong’s exports rose in January as the city’s ports shipped more Chinese-made electronics and clothes to the U.S., Europe and Japan. Overseas sales gained 34.8 percent from a year earlier…($23.4 billion) after climbing 12.9 percent in December…”
Asia Inflationary Boom Watch:
March 2 – Bloomberg (Subramaniam Sharma): “India’s faster-than-expected economic growth is helping increase tax revenue, allowing the government to spend more money on health and education, Finance Minister P. Chidambaram said. ‘Growth alone will give me room to spend,’ Chidambaram said… The government ‘will ensure the growth engine does not sputter, falter, or fail.’”
March 1 – Bloomberg (Subramaniam Sharma): “India’s Finance Minister P. Chidambaram will ensure that banks ‘deliver on credit’ pledges made in the budget for the fiscal year starting April 1. The minister said loans to farmers will be increased by 30 percent next fiscal year…”
March 4 – Bloomberg (Theresa Tang): “Taiwan’s foreign-currency reserves, the third-highest in the world, rose in February to a record $247 billion, boosted by ‘substantial’ foreign inflows and investment returns…”
March 3 – Bloomberg (Meeyoung Song): “South Korea’s foreign-exchange reserves rose to a record $202.2 billion at the end of February as U.S. dollar weakness boosted the value of assets denominated in euros and other currencies, the central bank said. The reserves, the world’s fourth largest, rose $2.46 billion from January and were 24 percent higher than a year earlier…”
March 2 – Bloomberg (Meeyoung Song): “South Korea should consider lending some of its foreign exchange reserves, the world’s fourth-largest, to domestic industries, said Rhee Gwang Ju, head of the Bank of Korea’s international department. ‘If our reserves become as large as China and Japan, (lending to local companies) is something to consider in the long-term,’ Rhee said…”
February 28 – Bloomberg (Meeyoung Song): “South Korea’s industrial production rose 3.1 percent in January from the previous month, the biggest gain in more than a year, as exporters such as Hyundai Motor Co. boosted overseas sales.”
March 3 – Bloomberg (Yunsuk Lim): “South Korean business confidence had its biggest jump in more than a decade last month, surging to a three-year high amid signs consumer spending will pick up after a two-year slump.”
March 1 – Bloomberg (David Yong): “Overseas investors bought a record amount of Malaysian ringgit-denominated government bonds in the fourth quarter, according to the Web site of Bank Negara Malaysia, the central bank. Net purchases of local bonds rose to 4.78 billion ringgit ($1.26 billion) from 2.22 billion ringgit in the third quarter. The figure is the most since the central bank started keeping records of the purchases in 1991.”
February 28 – Bloomberg (Stephanie Phang): “Malaysia’s economy expanded 5.6 percent in the fourth quarter, the slowest in more than a year, amid a slump in overseas demand for the semiconductors and electronics parts…”
February 28 – Bloomberg (Stephanie Phang): “Malaysia’s broadest measure of money in circulation expanded at a faster pace in January, as exporters brought back earnings and foreign investors put more money into Malaysia, the central bank said… M3, the most closely watched measure of money supply, rose 12.5 percent in January from a year earlier…”
March 2 – Bloomberg (Anuchit Nguyen): “Thailand’s unemployment rate in January fell from the same month a year earlier as manufacturers increased hiring to meet rising sales of new cars, cement and other products, the government said. The jobless rate in the country of 65.2 million was 3.3 percent, compared with 3.7 percent in January 2004…”
March 3 – Bloomberg (Laurent Malespine): “Thailand’s tax revenue rose 14.8 percent in February from a year earlier, boosted by a continued increase in sales and corporate tax receipts, the Finance Ministry said.”
March 2 – Bloomberg (Jun Ebias): “Philippine tax revenue rose 15 percent in January, beating the government’s goal, as officials stepped up efforts to catch tax cheats."
Global Reflation Watch:
March 1 – Bloomberg (Kenzo Taniai and Keiichi Yamamura): “Japan’s economic recovery is starting to show signs of spreading to households, Prime Minister Junichiro Koizumi said. ‘The labor market continues to improve, and employees’ compensation also rose in the fourth quarter,’ Koizumi said… ‘The economic recovery is starting to show signs of spreading to households.’ Spending by Japanese households headed by a salaried worker rose a seasonally adjusted 8.2 percent in January from December…”
March 1 – Bloomberg (Harumi Ichikura): “Japan’s tax revenue rose 14.8 percent in January from a year earlier to 3.322 trillion yen, the Ministry of Finance…said. Income tax revenue rose 14 percent in January from a year earlier…”
February 28 – Bloomberg (Harumi Ichikura): “Construction orders at Japan’s 50 largest contractors rose 15.8 percent in January from a year earlier, the Ministry of Land, Infrastructure and Transport in Tokyo said. In December, orders rose 1.4 percent.”
March 2 – Financial Times (Ivar Simensen): “The European corporate bond market rallied more in the first two months of this year than all last year, despite increased payments to shareholders and expectations of higher default rates. The yield spread…tightened by 17 percent in January and February… Companies can now borrow for less than half a percentage point more than governments – the narrowest since the creation of the euro in 1999. Suki Mann, a credit strategist at SG CIB, the investment bank, said: “We are rubbing our eyes. The pace of spread tightening has been incredible.’”
March 3 – Bloomberg (Laura Humble): “Property prices in France, Spain and Ireland grew the most of 15 countries in Western Europe in both halves of last year, a report by the Royal Institution of Chartered Surveyors said. Prices of homes in France, Spain and Ireland were the only to post growth of more than 10 percent in both halves… ‘2004 was another strong year for most EU housing markets,’ said the report. ‘By the second half only one country -- the U.K. -- seemed to be heading in an altogether different direction.’”
February 28 – Bloomberg (Andrea Rothman and Susanna Ray): “European airlines’ passenger traffic rose 9.3 percent in January, continuing last year’s growth, on higher demand for flights to Asia. Traffic to North America increased 3.5 percent in the month, more than the group’s initial estimate. Traffic on Asian routes climbed 13.2 percent…”
March 1 – Bloomberg (Gonzalo Vina): “U.K. mortgage lending accelerated for a second month, rising at the fastest pace since September and adding to evidence of a pickup in the housing market after a drop in prices at the end of last year.”
March 1 – Bloomberg (Sam Fleming): “U.K. house prices rose in February at the fastest monthly pace since November, suggesting six months of unchanged interest rates are supporting property values in Europe’s second-biggest economy.”
March 1 – Market News: “Home construction in France remained buoyant in January, as three-month housing starts posted a 13.5% rise on the year, while permits were up 17.6% on the year… For the month of January alone, starts were up 17.9% on the year…”
March 1 – Bloomberg (Kristian Rix): “Spanish wholesale power prices soared 97 percent in February to their highest level since the start of market opening in 1998, as soaring power demand added to low hydroelectric reserve levels.”
March 2 – Bloomberg (Trygve Meyer): “Norwegian consumer confidence rose to the highest in more than seven years this quarter on expectations of faster economic growth and increased employment levels.”
March 3 – Bloomberg (Maria Ermakova): “Russia’s foreign currency and gold reserves rose to a record $132.4 billion in the seven days to Feb. 25… The reserves rose from $129.2 billion a week before…”
March 2 – Bloomberg (Dylan Griffiths): “South African vehicle sales surged 32 percent in February from the same month last year as the lowest interest rates in 24 years boosted consumer and business spending, an industry group said.”
Latin America Reflation Watch:
March 1 – Bloomberg (Michael Smith and Guillermo Parra-Bernal): “Brazil’s economy grew 5.2 percent last year, the fastest pace in a decade as lower borrowing costs boosted spending and exports of iron ore, soybeans and other commodities jumped to a record… ‘Credit grew very intensely throughout 2004,’ Jorge Mattoso, president of Caixa Economica Federal, Brazil’s state-owned savings and loan bank, said… The bank boosted lending to companies by 46 percent in 2004 and expects loans to grow at a faster pace in 2005.”
March 1 – Bloomberg (Romina Nicaretta): “Brazil’s trade surplus widened to $2.79 billion in February from the previous month as imports fell. The surplus rose 28 percent from January and 42 percent from February last year…”
March 2 – Bloomberg (Guillermo Parra-Bernal and Marilia Paiotti): “Brazil’s central bank bought $3.5 billion in February to bolster international reserves, the most in at least four years, after the currency rose to a 2 1/2 year-high. The central bank had purchased $2.55 billion in January and $2.65 billion in December…”
Dollar Consternation Watch:
March 2 – Financial Times (Steve Johnson): “The scale of the upward pressure on the renminbi was highlighted yesterday when the People’s bank of China revealed it spent $195bn on buying foreign currency last year. The figure was 40 per cent greater than in 2003 as hot money flows poured into China, with speculators gambling on a renminbi revaluation in spite of the country’s strict capital controls…the People’s Bank needed to counterbalance not only this hot money but booming foreign direct investment inflows.”
Bubble Economy Watch:
March 4 – Dow Jones: “The U.S. government ran a budget deficit of about $225 billion in the first five months of fiscal year 2005, about $4 billion less than for the same period last year, the Congressional Budget Office estimated. In a new monthly budget review report Friday, CBO said outlays were about $68 billion higher than they were for the same period last year, while receipts were about $72 billion higher. ‘Receipts in the first five months of this fiscal year were about 10% higher than those in the comparable period in fiscal year 2004,’ CBO said… Outlays through February were 7% higher than they were in the same period last year…”
March 2 – Los Angeles Times (Ronald D. White): “This could be another record cargo year at Southern California’s twin ports, where ambitious plans to avoid a repeat of 2004’s floating traffic jam are encountering rough waters. A total of 13.1 million shipping containers moved through the ports of Los Angeles and Long Beach last year, helping create the harbors’ worst pre-holiday shipping logjam ever. This year, international trade has set such a brisk pace that shipping lines are wondering whether predictions for 12% to 14% growth in 2005 might be too low. At Long Beach’s port, for example, January container traffic was up 35% compared with the same month last year.”
March 3 – Bloomberg (Brian K. Sullivan and Liz Willen): “Harvard and Stanford universities led U.S. colleges and universities in raising $24.4 billion in fiscal 2004, 3.4 percent more than the previous year, according to a study by Rand Corp.”
March 1 – Bloomberg (Jianguo Victor Epstein): “U.S. construction spending rose 0.7 percent in January to a record $1.047 trillion at an annual rate, as residential, commercial and public building increased, a government report showed… ‘This is going to be another record year for construction spending,' said James Smith, chief economist at the Society of Industrial and Office Realtors in Washington. ‘It’s almost pre-ordained by the literally off-the-charts housing starts number in January, which was the strongest since February 1984.’”
March 1 – Bloomberg (Tony Capaccio): “The U.S. Department of Defense will reach its goal of boosting annual spending on new weapons by 52 percent over the next six years, as at least 13 programs move into production, Pentagon Comptroller Tina Jonas said. The increase would take annual spending for new weapons to $118 billion in fiscal 2011 from $78 billion this year.”
Mortgage Finance Bubble Watch:
March 2 – Chicago Tribune (Mary Umberger): “Real estate speculators are buying at a pace that far exceeds previous estimates of their influence on the housing market, according to a first-of-its kind report released Tuesday by the National Association of Realtors. Collectively, investors and second-home buyers bought more than one of every three homes sold in last year’s record market… ‘I am astonished,’ said David Lereah, the association’s chief economist, who said that the data suggest a sea change in the role of real estate in the nation’s economy. ‘What we’re seeing is that real estate is no longer just a place to live. It’s a viable alternative to stocks and bonds,’ Lereah said. ‘Sept. 11 changed real estate forever, the way people look at it. They’re nervous about stocks and bonds and they’re placing money in real estate, which has proven to be a stable and wealth-building asset.’”
Financial Sector Bubble Watch:
March 4 – American Banker (David Boraks): “Rapid growth in the number of hedge funds continues to stoke competition among prime brokers, who do everything from clearing the funds’ trades and lending them money to introducing them to investors and giving them office space. Hedge funds – which may number more than 8,000 – are more active traders than other institutional investors. The funds generate 30% of Wall Street’s equity commissions, or an estimated $7.5 billion this year alone…”
A Liquidity-creating Juggernaut:
There is, especially following comments last week from chairman Greenspan, considerable attention directed to the happenings of GSE balance sheets. Fannie’s Retained Portfolio actually contracted by $13.7 billion during January, 18% annualized. Freddie’s Retained Portfolio declined $6.0 billion, or 11% annualized. There has been less mention of the growth of their guarantee business. Fannie’s Outstanding MBS (not retained on its balance sheet) expanded $13.3 billion during January (12% annualized), the largest increase in 11 months. Freddie’s growth was even stronger at $15.9 billion (22% annualized), the strongest in a year. Combined Outstanding MBS expanded $29.1 billion in one month (16% annualized) to $2.28 Trillion, the strongest growth since January 2004. Furthermore, combined non-retained MBS was up $92.8 billion, or 10% annualized, over the past five months.
Throughout the marketplace, agency and non-agency MBS issuance remains quite strong, while home equity and other asset-backed securitizations are running above last year’s record pace. Spectacular derivatives growth runs unabated. “Structured finance” is on course for a historic year, right along with bank Credit.
At this stage of the Credit Bubble, GSE mortgage-backed guarantees and the booming ABS marketplace are more critical to the sustainability of Credit expansion than the increase of GSE balance sheets. There is more than ample financial asset expansion from the booming banking, REIT, hedge fund, and Wall Street sectors.
I would like to refresh readers’ memories with respect to Mr. Greenspan’s recent comments on the GSEs and market distortions.
“…What concerns me is not what Fannie and Freddie have been doing in the securitization area, which they’ve been exceptionally effective – as indeed their competitors as well -- have created a very important element within the total financial system. And so let me just stipulate that that’s important, and that has got to be maintained and essentially to expand, if at all possible… they have, granted by the marketplace, a significant subsidy which enables them to sell debentures significantly -- at a significantly lower interest rate than their competition.”
I am, of course, quite sympathetic to Mr. Greenspan’s (tardy) appreciation for market distortions throughout the agency debt market. I will, however, part company with respect to his wholesome view of the securitization marketplace. Inarguably, the market’s perception of implicit government backing of GSE securitizations has and continues to play a momentous role in fostering insatiable marketplace demand. This has had a profound impact on both Credit Availability and the pricing of mortgage finance. I would argue as well that the entire arena of “structured finance” rests on the capacity for transforming pools of risky loans – especially real estate borrowings - into perceived safe and liquid securities. This incomparable championing of The Moneyness of Credit has nurtured history’s greatest marketplace distortion. Mr. Greenspan has no intention whatsoever of addressing this issue.
It has become a crowd-pleasing exercise to trumpet the economy’s hitherto resiliency to a litany of hurdles and setbacks. Flawed analysis has borne dogged complacency. And one cannot too often repeat that recognizing the commanding role played by contemporary finance and Credit system exuberance is critical to sound economic analysis. Yes, the structure of the economy has been radically altered by intense Monetary Processes. But this is much more a case of a strange service sector/finance/asset inflation economy, and certainly not some wonderful New Economy or New Paradigm. What is new is the economy’s dependency to rampant Credit growth, abundant liquidity and endemic speculation.
It is tempting, in the current revisit with boom-time euphoria, to extrapolate the past decade’s extraordinary U.S. economic growth and asset price gains far into the future. As bullish thinking goes, with a weaker dollar buttressing U.S. competitiveness and the global economy demonstrating the strongest underpinnings in decades, economic growth (and stock prices!) can now really get humming. In this precarious period of rational over-exuberance (things do, indeed, look enticing to the “naked” analysis), it is more important than ever to have and apply a sound analytical framework.
First of all, 10-year Treasury yields have been in a steady (albeit squiggly) 20-year downward trajectory from 1985’s 11.5% to the recent 4% or so. Yields are about half of where they were 10 years ago, while benchmark 30-year mortgage rates are down from 8.6%. Credit Availability – fostered by the evolution and historic expansion of both the securitization marketplace and speculative finance – has never been as robust across the board - for households, corporations, governments, the emerging markets, or speculators. This gives pause to students of financial and economic history.
It is also important to recognize that for more than a decade the global economy faced disinflationary headwinds emanating from the aftermath of the Japanese Bubble and the downfall of the Soviet Union and Eastern block economies. There were, as well, the recurring global financial dislocations (Mexico, SE Asia, Russia, Argentina, Latin America, etc.) that severely impaired domestic (and regional) Credit systems and fanned general disinflationary pressures. The U.S. economy was the great beneficiary of abundant supplies of cheap manufactured goods, commodities, and, most importantly, crude oil. This unusual backdrop provided the U.S. Credit system a blank checkbook to inflate at will and at whim, with little risk of heightened traditional price pressures.
For the U.S. financial markets, well, it became virtual nirvana; they were the only game in town; they relished a global monopoly on speculative finance. The American Credit system created liquidity in gross excess, only for ballooning Current Account Deficits to be recycled right back into U.S. securities markets. With unlimited access to finance, the GSEs ignited one of history’s spectacular Credit inflations. Concurrently, the mushrooming global leveraged speculating community pledged full faith and Credit in the power and guardianship of Alan Greenspan. It was a most deleterious combination of Credit excess, liquidity recycling and central bank accommodation. Why would speculators have played any other market?
When the technology/telecom Bubble burst, the Fed had the great advantage of strong inflationary biases throughout mortgage finance, structured finance, and leveraged speculation. Somewhat later (2002), when the U.S. corporate bond market was on the threshold of dislocation, the Fed dug deeper in the realm of marketplace subversion, further reducing rates and offering unparalleled assurances of central bank support and limitless marketplace liquidity. It is with the Mortgage Finance Bubble, the Bubble of Leveraged Speculation, booming structured finance and extraordinary market insurance that one can isolate the source of U.S. economic “resiliency.”
Underwriting market subversion is not without great cost. Unrelenting Credit inflation has spawned myriad Bubbles and distortions, while severely devaluing our currency. Still, this type of inflationary Bubble has scores of powerful friends and but a few (ineffectual) detractors. As we continue to witness, the danger is that, left to its own devices, this strain of inflation has a proclivity to strengthen and broaden (while expanding its fanatical patrons).
Only a determined Federal Reserve could have extinguished the California housing Bubble before it succumbed to dangerous blow-off extremes. Only a determined Fed could have thrown some cold water on the kindling hedge fund fire before it raged uncontrollably. Only determined central bankers could have suppressed the mushrooming pool of global leveraged finance before it commanded so many markets and economies. Only a determined Federal Reserve could have reined in "structured finance" before it became much too big and powerful. Instead, the Greenspan Fed was determined to sustain both artificially low U.S. rates and excess marketplace liquidity, while pandering to Wall Street, the leveraged players and other speculators. The costs of the Fed’s mistaken determination continue to expand exponentially.
The current market environment could not be more challenging and fascinating. Yesterday afternoon’s data had the NY Fed’s foreign official “custody” holdings up $36 billion in two weeks. This suggests recent large central bank dollar support operations and significant underlying dollar vulnerability, subsequent to another alarmingly brief dollar “rally.” Foreign central banks surely recognize that an abrupt dollar drop at this point could precipitate a full-fledged currency crisis. Such a dilemma does not go unrecognized by the bevy of “macro” speculators. So when the dollar reversed lower immediately following today's jobs report, there was a mad dash to buy bonds and sell more dollars. Not only do these bond purchases “front run” the central banks, it also catches the bond shorts and derivative players exposed. Bond market speculative dynamics, having sustained artificially low yields and excess liquidity for some time, resurfaced again today.
For those extrapolating quiescent financial and economic conditions far into the future, I would like to raise a few issues. First, the massive pool of global speculative finance – of which the Fed nurtured and used as a key “reflating” mechanism - has today vastly different interests than those of our central bank. Before, when the Fed wished to force market rates lower and stimulate, leveraged speculators were happy to oblige all the way to the bank. This symbiotic relationship created the semblance of tight Federal Reserve control. But the environment is now altogether different. The need today is for lower bond prices, greater risk premiums, less Credit Availability and reduced marketplace liquidity. But outside of risking financial crisis, the Fed has limited control of over the environment. Speculative finance is running the show and is increasingly willing to play chicken with the diffident Fed.
In the past, the Fed enjoyed monopoly power over the speculators, inciting them to purchase/leverage dollar securities almost on demand. Now, the massive pool of global speculative finance has its sights on myriad markets and asset classes. Over the past decade, the Fed and U.S. economy benefited handsomely from Credit inflation’s propensity to finance speculative buying of U.S. bonds, equities, and real estate prices. These days, Credit excess increasingly stokes global oil, energy, and commodity prices. For some time, the U.S. enjoyed an extraordinary liquidity advantage over the rest of the global economy. Today, in The Global Credit Bubble and Wildcat Finance World, we must bid for energy, commodities and things against a bevy of highly liquid competitors.
I would argue that the previous decade’s seemingly placid U.S. inflationary environment was an aberration borne of the disinflationary/asset inflation-centric/outperforming U.S. currency and markets world. Only asset inflation remains from the previous favorable backdrop, although this inflation is increasingly destablizing. Acute energy inflation (and looming shortages) and dollar fragility ensure that the era of seemingly riskless liquidity excesses has ended. And, importantly, the Fed awhile back relinquished its control over the liquidity spigot. This returns us to the securitization market, speculative finance and the issue of fragile “resiliency.”
Whether the Fed recognized it clearly at the time or not, in those peculiar days back in autumn 2002 - with talk of printing presses, helicopter money, and non-conventional measures – they implicitly promised to bankroll “structured finance” and endemic speculation. The securitization and derivative markets have never looked back. And as much as it believes the GSEs are too big to fail, the marketplace is absolutely certain that "structured finance" is much, much too big. At the same time, the emboldened speculating community plays confidently knowing the timid Fed will not risk wresting back power. These forces have created momentous marketplace distortions that have manifested in fervent global asset inflation. Here at home, there is virtually unlimited capacity to transform risky loans into enticing securities and no bounds whatsoever on liquidity creation. What we are dealing with is a Liquidity-creating Juggernaut.
I look at the market environment with great concern. The dollar liquidity-creating mechanism (most notably bank Credit, structured finance, and speculative leveraging) has dislocated. Excess dollar liquidity is dangerously inflating U.S. asset markets, while at the same time inundating global markets. Foreign central bank dollar purchases only exacerbate marketplace and liquidity distortions. Never have global boom/bust dynamics been as synchronized, from the California housing Bubble, to U.S. bonds and equities, to global markets and economies.
The U.S. bond market is right in the thick of liquidity-induced distortions. First of all, the inflationary backdrop is conducive to much higher market rates. I would argue that inflation expectations are being distorted by today’s artificially low yields (“Inflation must not be a problem or else bond prices wouldn’t be this high.”). This creates the potential for an abrupt change in marketplace perceptions to manifest into a self-reinforcing spike in yields. Second, I believe that the “structured finance”/speculator Liquidity-creating Juggernaut will continue to be impervious to Federal Reserve baby-steps. It is my view that we are witnessing blow-off dynamics in the Mortgage Finance Bubble, the Structured Finance Bubble, and the Bubble of Leveraged Speculation. If this is the case, it will require the Fed to take short-term rates significantly higher to temper Bubbling Credit and liquidity excess. The defining contrast between 2004 and 1994 was the differing perceptions as to how far the Fed might be forced raise rates. Fears that short-term rates might be forced back to the levels of the late-eighties tightening cycle (Fed funds were at 9% in late 1989) precipitated the self-reinforcing 1994 bond rout. Last year’s fearlessness that Fed funds would stay below 2.5 to 3.0% kept bond yields exceptionally low, while emboldening “animal spirits.”
One of the problems with today’s inspirited animal spirits is that they only exacerbate already malignant liquidity excesses and distortions. It is a central tenet of Credit Bubble analysis that inflating asset markets create their own liquidity, and the greater the speculative component the more excessive the liquidity creation. And as I examine the financial landscape this evening, I see every indication that the mortgage finance and global securities Bubbles are in a dangerous state of self-reinforcing liquidity excess. There is the intermediate issue of myriad liquidity-induced booms eventually succumbing to faltering liquidity and busts. That asset markets across the globe are concurrently in liquidity Bubbles suggests that massive ongoing Credit creation and liquidity will be required to sustain the global boom. This may be possible in the short-run, but at the same time it raises a few key issues: First, how high can the Global Liquidity and Speculation Bubbles inflate oil and commodity prices? Second, how long can global markets and policymakers thwart a dollar and global currency crisis? Third, how much longer will the effects of rampant liquidity and speculative dynamics overwhelm deteriorating U.S. bond market fundamentals?
