03/08/2002 Market Dislocations *

Markets turned chaotic this week. We certainly see this as the beginning of what could be a very problematic dislocation throughout the financial markets, although how it plays out is very much an open question. Bullish pundits and media commentators are quick to credit news of a strengthening economy for fueling this week’s broad-based stock market rally. And while the strength of the data is not in doubt, it sure looked to us like a major short-squeeze and likely derivative-related “melt-up” in key sectors were the key market dynamics this week. For the week, the Dow added 2% and the S&P500 gained 5%. The Transports added 4%, increasing year-to-date gains to 14%, while the Morgan Stanley Cyclical index gained 3%, bringing y-t-d gains to 11%. The Utilities gained 4%, while the Morgan Stanley Consumer index was unchanged. The broader market was quite strong, with the small cap Russell 2000 and S&P400 Mid-Cap indices rising 4%. The wild action, however, was most conspicuous with stocks and within sectors that have the most questionable fundamentals. For the week, the NASDAQ100 gained 8% and the Morgan Stanley High Tech index jumped 10%. The Semiconductors surged 12%, increasing y-t-d gains to 22%. The Street.com Internet index jumped 15% and the NASDAQ Telecommunications index gained 12%. The Biotechs added 7%. A major squeeze also developed throughout the financials, especially in the subprime, consumer lending, and brokerage sectors. For the week, the S&P Bank index gained 6% and the AMEX Securities Broker/Dealer index surged 12%. With bullion down $8.10, the HUI Gold index dropped 8%.

This week’s economic data was finally too much for the bond market to ignore. For the week, two-year Treasury yields spiked 38 basis points to 3.56%. Five-year yields surged 29 basis points to 4.70%, while 10-year Treasury yields jumped 34 basis points to 5.32%. The long-bond saw its yield rise 21 basis points to 5.71%. Over two weeks, implied yields on 2-year, 5-year, 10-year and bond Treasury futures increased 57, 54, 43, and 39 basis points, respectively. Mortgage-backs generally outperformed, with benchmark yields increasing 21 basis points. Agency securities were hammered, with the implied yield on agency futures surging 36 basis points this week and 44 basis points over two weeks. Fannie Mae 5 3/8 2011 bond saw its yield jump 35 basis points to 5.99%, with its spread to Treasuries adding 1 to 66. It was a bloodbath in the euro pits, with the implied yield on December Eurodollar futures surging 47 basis points to 3.89%.

Bonds were hammered globally, with strong economic data in Australia (and faltering U.S. bonds) fueling a 37 basis point rise in 10-year yields to 6.38% (the highest yield in 22 months!). New Zealand bond yields jumped to 6.90%. UK bond yields rose 17 basis points to 5.21%, with similar jumps throughout Europe. Foreign markets will have some catching up to do after today’s U.S. bond sell-off. Even commodity prices are moving, with the CRB index gaining better than 2% this week. Currency markets have, not surprisingly, also turned tumultuous, with the dollar suffering its most abrupt decline against the yen since the crisis of October 1998. With today’s dollar rally, however, the dollar index ended the week down less than 2%.

This will be an abbreviated, sloppy “vacation edition” of the Credit Bubble Bulletin. Today’s employment report leaves little room for argument that demand is now recovering throughout much of the maladjusted U.S. economy. Considering the importance of data to the acutely leveraged U.S. Credit market, I think it worthwhile to go through some of the key data released over the past two weeks.

Last Friday’s stronger than expected January construction spending report was further evidence that faltering industrial and private non-residential building has been easily offset by a booming public sector and continued strong residential building. Total construction spending was up 2% over very strong year ago levels. Residential spending was up 4.2%, led by a 23% increase in multifamily construction (GSE financed?). Non-residential spending was down 14%, with “industrial” dropping 51%, “office” 33%, and “hotels/motels” 19%. The public sector construction boom continues, with spending up 17.5% y-o-y. Of the largest categories, “education” was up 18% and “roads” up 22%. Last Friday we also had stronger than expected gains in personal income and spending. The three-month gain in personal income is the strongest in 40 months. Also last Friday, the ISI (formerly NAPM) manufacturing index jumped above 50 for the first time in 19 months. The composite index increased almost 5 points for the month to 54.7, and is up sharply from October’s 39.5. The key “production” component jumped from 52 to 61.2 (low in October of 40.4), while “backlog” surged from 44.5 to 53 (Oct. low of 36). Even the Detroit Purchasing Managers index climbed above 50 in February, up from 42.7 in December and 35 in October.

This week’s ISI Non-Manufacturing report was even more dramatic. The composite index surged from the previous month’s 49.6 to 58.7. “New orders” increased to 57.3, up from January’s 49.3 (October’s 40.3!) and the highest level in 15 months. It is also worth noting that the “prices paid” component is back to 50 after sinking to 38.5 in October. We would not be surprised to see an inflationary bias return to key areas of the “service sector” that accounts for a major portion of the U.S. economy. Elsewhere, the Mortgage Bankers Association’s weekly application index was up strongly over last week. With purchase applications jumping 16% over the past two weeks, volume is running 4.2% above strong year ago levels.

February auto sales were also reported stronger than expected. Despite a sharp decline in fleet sales, total unit sales came in at a strong seasonally adjusted rate 16.7 million units (vs. expectations of 15.9 million). This is only marginally below last year’s 17.3 million unit pace, the second strongest ever. Interestingly, the upper-end continues to demonstrate resiliency. BMW enjoyed record February sales, up 14% y-o-y, while sales at Lexus were up 9.4%. Mercedes Benz y-t-d sales are running up 7.5%. Toyota sales were 1.7% above very tough year ago comparisons, while sales were up 10.4% at Nissan, 4.1% at Audi, 2.4% at Volvo, and 14.9% at SAAB. The Korean manufacturers continue to excel, with Kia sales up 35% and Hyundai up 15%. The U.S. nameplates continue to struggle, with passenger car sales a virtual disaster. Passenger sales were down 20% at GM and 25% at Ford and Chrysler. The “Big Three” better hope truck and SUV sales continue to boom.

Consumers are buying cars and lots of stuff, and they are doing much of it on Credit. February consumer debt growth of $12.9 billion made estimates of a $3.3 billion increase look silly. Consumer debt has increased at a 9% rate over the past four months. Most retailers reported better than expected sales during February, with some key players reporting sales well ahead of plan. Behemoth Wal-Mart reported February sales up 15.6% year-over year to $17.2 billion. Same-store comparable sales were up an eye-opening 10.3%. It wasn’t just Wal-Mart, however, as Target reported same store sales up 10%, J.C. Penney 12.5%, Kohl’s 14.4%, and Costco 8%. Overall, discount stores enjoyed comparable sales up 10.8%, warehouse clubs up 7.1%, and department stores up 0.7%. Overall same-store sales were up 6.2%, with Bloomberg’s index of retail sales marking its biggest gain since April 2000. This week’s Bank of Tokyo-Mitsubishi UBSW weekly sales report had same-stores sales running up 4.7% y-o-y.

And then there is today’s stronger than expected jobs report. For the month, 66,000 jobs were added, the first gain in seven months. “Goods producing” job losses of 31,000 were a notable decline from the average 156,000 monthly declines over the past three months. Construction jobs increased 25,000, the first gain since September. The service sector added 97,000 jobs (largest gain since August!), with “retail” adding 58,000 (99,000 in two months), and “health services” 34,000 (151,000 in five months). The government sector added 20,000 jobs in February (102,000 in 5 months).

Bullish analysts and members of the Fed have begun discussing the “shallow nature” of the now concluded downturn, with some even questioning if we even experienced a recession. And while they can make a valid argument and we very much appreciate the data, our overall analysis could not be further from the consensus. We will let others indulge in “recession” semantics, while we stick with our focus on an historic Credit Bubble that, while acutely vulnerable, has not yet been pierced. The Federal Reserve released its fourth quarter Credit data yesterday and this release confirmed that Credit excess ran unabated through year-end. Looking at these numbers, one is certainly hard pressed to identify recessionary conditions. Moreover, we continue to believe traditional analysis is disadvantageous, preferring instead to recognize that we are in the midst of an extraordinary financial and economic Bubble environment – NOT a traditional business cycle. During the fourth quarter, total outstanding Credit market debt increased at a 6% annualized rate, compared to the fourth quarter 2000’s 4.2%. Businesses borrowed at a 5.5% rate, down from fourth quarter 2000’s 8.4%. The household sector continues to accumulate enormous amounts of debt, borrowing at an 8.1% rate (vs. 7.5%).

For 2001, total Credit market borrowings increased $1.975 trillion, or 7%, to $29.496 trillion. This was actually an increase from year-2000’s $1.785 trillion, or 6.9%. “Non-Financial Business” borrowings did slow sharply to $321.9 billion, or 3.4%, from 2000’s $677.3 billion, or 7.6%. However, the explosion of financial Credit – the key to the U.S. Credit Bubble – runs unchecked. Financial sector Credit market borrowings increased at a 10.4% rate during the fourth quarter and increased $913.3 billion, or 10.8%, for the year (compared to 2000’s $827.5 billion increase). Financial sector Credit market borrowings increased $3.9 trillion, or 72%, to $9.37 trillion during the past four years.

“Structured finance” again dominated the financial sector’s Credit creation, with the GSEs (government-sponsored enterprises) leading the charge. GSE increased their holdings of financial assets (Credit creation!) by a record $332 billion (vs. 2000’s $249 billion) during the year, a 17% growth rate. Over the past four years, GSE assets have more than doubled to $2.3 trillion. Outstanding “Federal-related mortgage pools” (GSE mortgage-backs) increased a record $337 billion last year, compared to 2000’s increase of $199 billion. Total outstanding agency securities (company debt and guaranteed mortgage securities, with some double-counting of mortgage-backs held in GSE portfolios) surged an amazing $625 billion, or 14.4% to almost $5 trillion. This compares to 2000’s increase of $433 billion. With the fourth quarter’s eye-opening annualized rate at $366 billion, outstanding asset-backed securities increased $282 billion, or 16% during 2001 (vs. 2000’s $211 billion). Outstanding asset-backed securities have almost doubled in four years to $2.1 trillion. Securities Broker/Dealer assets continue to mushroom, increasing $216 billion, or 18% for the year. During the past four years, Broker/Dealer assets have jumped 84% to $1.44 trillion.

Mortgage finance continues to be the greatest source of Credit excess, with total mortgage debt increasing $723.2 billion, or 10.4%. New mortgage debt was up 25% from last year and was easily a record. Total mortgage debt has surged 47% to almost $7.7 trillion over the past four years.

With domestic Credit excess fueling endemic over consumption and resulting trade deficits, foreigners have thus far been willing to increase holdings of U.S. dollar denominated financial assets. The “Rest of World” holdings of U.S. assets increased $823 billion last year to $8.2 trillion. During the past four years “Rest of World” holdings of U.S. financial assets has increased $3.3 trillion, or 66%. Surely, Mr. Greenspan knows much better than to fall into the analytical hole that has trapped others – believing that it is foreign investment flows that are driving unrelenting trade deficits. This badly confuses cause and effect.

Bloomberg quoting Greenspan from yesterday’s Q&A: “The cause of the strength of the value of the dollar is largely the presumed perception on the part of foreign investors that the rate of return in the U.S. is higher than in their home countries,” Greenspan said. “They are moving capital increasingly into the U.S. and that’s pressing the exchange rate higher. I guess we could dissuade foreigners from investing here; I'm not sure that's to our advantage,” he said. “We do have the obverse of this huge flow of funds into the economy, which is our current account deficit -- which is increasingly widening -- and the trade deficit, which is the major part of that,” he said, “which means that there are ever-increasing claims on the American economy by foreign investors. That can’t go on indefinitely without some difficulty, history tells us. So as I've argued many times in the past that the current account deficit, meaning the capital surplus, cannot continue to increase, but it is the capital surplus which is driving the exchange rate at this particular point,” Greenspan said. “This process will end as some point. But I’ve been forecasting this for five years, and I guess I'll be forecasting it for another five.”

Well, it’s been five years of unprecedented Credit market speculation. It should have been clear to Greenspan and others that much of the massive foreign flows into the U.S. have been to play for speculative financial “profits” instead of business profits. Yes, this works like magic - that is until the speculative gains disappear and players head for the exits.

To be succinct, it is now obvious that short-term U.S. interest rates at 1.75% are inappropriate. Credit market players have been slow to react to strengthening data, although this is surely due to the reasonable expectation that Greenspan would be overly cautious in raising rates. The sophisticated leveraged players have been conditioned to expect an extended period of forewarning from the Fed before rates are increased. It appears these early alerts commenced this week, so the game has changed. Economic data will now be monitored closely instead of being disregarded. It certainly appears that a liquidation of speculative positions began in earnest this week, which could prove a seminal inflection point in financial history. Importantly, there will be pressure on central bankers globally to move to a more appropriate monetary stance, which only makes it more conspicuous that the Fed erred in its overly aggressive cuts and is rapidly falling way behind the curve. Remembering 1994 and 1998 in particular, we get very nervous whenever the leveraged speculators are forced to reduce exposure. Liquidation begets losses, which begets more selling and faltering liquidity. Believing the amount of leverage and speculation has grown significantly since 1998 and exponentially since 1994, we could today not be more concerned.

There is no doubt that leveraged speculation has come to dominate the U.S. markets and Credit system, as it has also in the U.K. and likely increasingly throughout Europe and elsewhere. How much money has been borrowed cheap in Japan, Switzerland, or elsewhere to play spreads in the U.S. only time will tell. How much derivative “insurance” has been purchased (or planned to be acquired) to protect against a decline in the dollar is anyone’s guess, although it must be huge. How much derivative “insurance” has been purchased to protect against rising U.S. rates is similarly unknown, but clearly enormous. Who are the GSE counterparities and how will they protect themselves? Clearly, we are sitting on top of a massive pile of dry derivative tinder, with dynamic hedging strategies in both the interest rate and currencies markets an accident waiting to happen. There is also the issue of the 6,000 or so hedge funds, with myriad of “sophisticated” strategies and unknown leverage. Once one strategy fails, the risk of a domino collapse of forced liquidations is a distinct possibility. The leveraged Credit market players were bludgeoned this week. It also sure looked as if the “market neutral’ equity strategies – where speculators’ long equity positions are hedged with short positions and/or derivatives – ran amuck. And, yes, panic short covering does do wonders for the prices of many stocks and the market as a whole. However, such dynamics and this week’s dislocation should be a cause for serious concern and not celebration. In such an environment, today’s short covering can abruptly change to tomorrow’s panicked long liquidation.

This week brought back memories of how technology and financial stocks (in particular) rallied strongly back in June and July of 1998, as the system was headed straight into what proved near financial collapse by late September/early August. We are the first to admit that after this week’s stock market dislocation, anything could happen in the short-term. And perhaps the dollar Bubble will be sustained over the coming weeks. But the bulls should not kid themselves. There’s one hell of a problem unfolding, a crisis that has been building for years. It should also be obvious that a stock market melt-up will only put further pressure on the Fed and the Credit market, a circumstance that has significant potential to develop into U.S. systemic liquidity crisis and potential dollar dislocation.