Global markets are under somewhat elevated stress with a mini flight from risk assets. For the week, the Dow and S&P500 declined about 1%. The Transports dropped 2%, while the Utilities added almost 1%. The Morgan Stanley Cyclical and Morgan Stanley Consumer indices declined 1%. The broader market slightly outperformed the major averages. The small cap Russell 2000 lost 0.7%, and the S&P400 Mid-cap index declined 0.8%. The NASDAQ100 fell more than 1%, and the Morgan Stanley High Tech index dropped 2%. The Semiconductors were hit for 3%. The Street.com Internet Index declined 1%, and the NASDAQ Telecommunications index dipped 0.6%. The Biotechs were up 3%. The Broker/Dealers were unchanged, while the Banks lost 1%. With bullion down $5.60, the HUI index fell 2%.
Two-year Treasury yields declined 3 basis points to 3.69%, ending eight straight weeks of rises. Five-year Treasury yields dropped 5 basis points this week to 4.16%. Ten-year Treasury yields declined 3 basis points to 4.51%. Long-bond yields were unchanged at 4.81%. The spread between 2 and 30-year government yields widened 2 basis points to 112. Benchmark Fannie Mae MBS were unimpressive, with yields unchanged for the week. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note widened 3 basis points to 33, while the spread on Freddie’s 5% 2014 note widened 3 basis points to 30. The 10-year dollar swap spread added 0.75 to 43.25. Dismal earnings news from GM throttled their bonds and rattled much of the corporate bond market. Yet junk bonds continue to hold up relatively well. The implied yield on 3-month December Eurodollars rose 0.5 basis points to 4.14%.
Corporate issuance increased to about $16 billion. Led again by the financial sector, investment grade issuers included JPMorgan Chase $2.0 billion, Washington Mutual $1.0 billion, National Capital Trust $800 million, Ford Motor Credit $750 million, Newmont Mining $600 million, Carolina P&L $500 million, Liberty Mutual $500 million, New York Times $500 million, Pitney Bowes $400 million, Amsouth Bancorp $350 million, Compass Bank $300 million, Bemis $300 million, Suntrust Bank $500 million, and GATX $135 million.
Junk bond fund outflows surged to $681 million. Junk issuers included Davita $1.35 billion, Exide Tech $350 million, Trustreet Properties $250 million, US Oncology $250 million, Progress Rail $200 million, CHC Helicopter $150 million, and M/I Homes $150 million.
Convert issuers included Connetics $150 million and M-systems $75 million.
Foreign dollar debt issuers included Scottish Power $1.5 billion, Rentenbank $1.25 billion, Skandinav bank $600 million, Grupo Televisa $400 million and Argentine Beverage $150 million.
Japanese 10-year JGB yields declined 6 basis points to 1.42%. Emerging debt markets were volatile and generally under pressure. Brazilian benchmark dollar bond yields jumped 7 basis points this week to 8.32%. Mexican govt. yields ended the week up 10 basis points to 5.52%. Russian 10-year dollar Eurobond yields rose 15 basis points to 6.01%.
Freddie Mac posted 30-year fixed mortgage rates jumped 10 basis points to 5.95% (up 38 bps in 5 weeks) to the highest level in 32 weeks. Fifteen-year fixed mortgage rates rose 7 basis points to 5.47%. At the same time, one-year adjustable rates declined 4 basis points to 4.20%. The Mortgage Bankers Association Purchase Applications Index rose 2.5% the past week. Purchase applications were up 2% from one year ago, with dollar volume up 10%. Refi applications gained 4.2%. The average new Purchase mortgage jumped to $240,500. The average ARM increased to $327,400. The percentage of ARMs jumped to 32.4% of total applications.
Broad money supply (M3) declined $23.7 billion to $9.025 Trillion (week of March 7). Year-to-date, M3 has expanded at a 2.0% rate, with M3-less Money Funds growing at a 5.7% pace (up 9.3% over 52 weeks). For the week, Currency dipped $0.8 billion. Demand & Checkable Deposits sank $25.0 billion, while Savings Deposits gained $20.5 billion. Small Denominated Deposits added $3.2 billion, while Retail Money Fund deposits were down $4.6 billion. Institutional Money Fund deposits declined $1.5 billion. Large Denominated Deposits added $0.5 billion. Repurchase Agreements declined $16.1 billion, while Eurodollar deposits were unchanged.
Bank Credit has expanded $252.2 billion during the first 10 weeks of the year (19.4% annualized), more than it expanded during the entire year of 2001. Bank Credit jumped $23.2 billion for the week of March 9 to a record $7.0 Trillion.
Securities Holdings rose $7.0 billion. Loans & Leases jumped $16.3 billion, with six-week gains of $85 billion. Commercial & Industrial (C&I) loans added $2.8 billion. Real Estate loans rose $14.7 billion, with a three-week gain of a noteworthy $60.4 billion. Real Estate loans have expanded at a 19% rate during the first ten weeks of 2005. Real Estate loans are up $344 billion, or 15%, over the past 52 weeks. For the week, consumer loans dipped $0.8 billion, while Securities loans added $0.7 billion. Other loans declined $1.1 billion.
Total Commercial Paper expanded $6.4 billion last week to $1.451 Trillion. Total CP has expanded at a 12.4% rate y-t-d, and has increased 10.0% over the past 52 weeks. Financial CP rose $2.1 billion last week to $1.385 Trillion. Non-financial CP jumped $4.2 billion to $145.1 billion.
Fed Foreign Holdings of Treasury, Agency Debt rose $4.6 billion to $1.385 Trillion for the week ended March 16. “Custody” holdings are up $49.2 billion, or 17.4% annualized, year-to-date (up $217bn, or 19%, over 52 weeks). Federal Reserve Credit rose $7.7 billion for the week to $785.4 billion (up $48.4bn, or 6.6%, over 52 weeks).
ABS issuance jumped to $13 billion (from JPMorgan). Year-to-date issuance of $132 billion is running 7% ahead of comparable 2004. At $82 billion, y-t-d home equity ABS issuance is running 21% above year ago levels.
Rising U.S. yields supported the dollar this week, as the dollar index gained about 1%. The New Zealand dollar gained 0.7%, the Canadian dollar 0.3%, and Australian dollar 0.2%. On the downside, the Polish Zloty, Slovakia koruna, and South African rand declined 3%, while the Hungarian forint, Czech koruna, and Romania leu declined 2%.
March 13 – Bloomberg (Wing-Gar Cheng): “China may use its foreign reserves to buy crude oil that it will stockpile to meet the country’s need for energy, China Business Post said, citing a member of the parliament’s top advisory body. The nation may use about $30 billion of its foreign reserves to buy 100 million metric tons of crude oil, the newspaper said…”
March 15 – Bloomberg (Bruce Blythe): “Crude-oil prices may have to rise to $80 a barrel or higher before U.S. demand for gasoline, diesel and other fuels begins to slow, said Arjun Murti, an analyst with Goldman Sachs Group Inc. U.S. motorists show few signs of curtailing their driving habits even with retail gasoline above $2 a gallon across much of the country, Murti said…”
March 14 – Bloomberg (Gonzalo Vina): “The cost of raw materials used by British factories in February rose at the fastest pace in almost a decade, boosted by increases in crude oil and homegrown foods. Non-seasonally adjusted raw material costs rose 10.7 percent in the year, the biggest increase since April 1995…”
March 16 – Bloomberg (Koh Chin Ling): “Natural-rubber prices in China rose 4.5 percent, the biggest fluctuation of any commodity market today, as rising industrial output fueled expectations that demand will grow for vehicle tires and power-cable casings… Rubber has risen 17 percent this year.”
This week crude oil traded to an all-time high, copper to a 16-year high, and hogs to a 7-year high. April Crude Oil jumped $2.29 to close at a record $56.72. The Goldman Sachs Commodities index gained 3%, increasing year-to-date gains to 24.1%. The CRB index was slightly positive this week. The CRB is up 12.4% so far this year.
March 17 – Bloomberg (Nerys Avery): “Goldman Sachs Group, Inc. and rival banks have raised their 2005 economic growth forecasts for China after reports showed exports and industrial production rose faster than expected in the first two months of the year. Goldman lifted its forecast to 8.8 percent from 8.1 percent, Credit Suisse First Boston raised its projection to 8.6 percent from 7.3 percent and UBS AG upgraded its estimate to 9.6 percent from 8.8 percent…”
March 16 – Bloomberg (Nerys Avery): “Investment in China’s factories, roads and other fixed assets rose at a faster pace in the first two months of the year, adding to evidence that growth is accelerating in Asia’s second-largest economy. Fixed-asset investment in urban areas increased 24.5 percent from a year earlier to 422 billion yuan ($51 billion) after climbing 21.3 percent in December…”
March 15 – Bloomberg (Nerys Avery): “China’s industrial production rose more than economists forecast in the first two months of 2005 as makers of clothing, cell phones and computers expanded to meet growing consumer and export demand. Production in the world’s seventh-largest economy rose 17 percent from a year earlier…”
March 16 – Bloomberg (Rob Delaney): “China’s wholesale crude oil price rose in February by 43 percent from a year earlier and gained 14 percent from January, according to the People’s Bank of China… China’s wholesale copper price rose
26 percent in February from a year earlier… The country’s zinc price rose 17 percent from a year earlier and 4.6 percent month on month…”
March 16 – Bloomberg (Yanping Li): “China’s outstanding foreign debt rose 18 percent last year, driven by economic growth and expectations of a yuan appreciation, the foreign-exchange regulator said. Overseas debt rose $35 billion to $228.6 billion at the end of 2004, the State Administration of Foreign Exchange said…”
March 14 – Bloomberg (Nerys Avery): “China’s retail sales climbed 13.6 percent in the first two months of 2005 as rising incomes spurred spending in the world's most-populous nation.”
March 16 – Bloomberg (Jianguo Jiang): “China’s restaurant sales may rise 18 percent this year, the commerce ministry forecast, as rising incomes in the world’s fastest-growing major economy encourage more people to eat out. Restaurant sales may reach 880 billion yuan ($106 billion)…”
March 16 – Bloomberg (Koh Chin Ling): “China’s agricultural product prices rose 7.9 percent in February from a year earlier, led by gains in prices of livestock and grains, the People’s Bank of China said…”
March 14 – Bloomberg (Rob Delaney): “China’s crude oil imports by rail from Russia may rise 50 percent to 15 million metric tons next year because of higher demand. China will get ‘preference’ for shipments through a proposed pipeline, Chinese Premier Wen Jiabao told reporters in Beijing…”
March 16 – Bloomberg (Yanping Li): “China’s central bank tightened restrictions on housing loans, seeking to rein in property price gains and prevent financial risks. Individual home buyers in some areas will have to put up 30 percent of a property’s value as a down payment, raised from 20 percent…”
Asia Inflationary Boom Watch:
March 14 – Bloomberg (Cherian Thomas and Kartik Goyal): “Indian exports rose 8 percent in February from a year earlier boosted by shipments of textiles, gems and jewelry to the U.S., the country’s biggest overseas market.”
March 17 – Bloomberg (Yunsuk Lim): “South Korea’s foreign-exchange reserves rose to a record $206.8 billion as of March 15 as U.S. dollar weakness increased the value of assets denominated in euros and other currencies, the central bank said. The reserves, the world’s fourth largest, rose $4.7 billion from the end of February…”
March 17 – Bloomberg (Yunsuk Lim): “South Korea’s central bank, holder of the world’s fourth-largest foreign currency reserves, said it will focus on finding ways and products to boost returns on its holdings…”
March 18 – Bloomberg (Young-Sam Cho): “South Korea’s foreign debt rose 10 percent last year to $177.6 billion on increased overseas borrowings by lenders, the Ministry of Finance and Economy said.”
March 15 – Bloomberg (Amit Prakash): “Singapore’s retail sales rose 12.5 percent in January from a year earlier, more than expected, as consumers bought more cars, computers and furniture ahead of the Lunar New Year holidays.”
March 16 – Bloomberg (Soraya Permatasari): “Automobile sales in Indonesia rose 35 percent in February from a year ago, PT Astra International said today, citing figures from the Indonesian Automakers’ Association, or Gaikindo.”
March 16 – Bloomberg (Jun Ebias): “Philippine commercial bank loans rose 4 percent in January, the biggest increase in six months, as manufacturers borrowed more, the central bank said today… Demand for credit has been rising since last March, helping boost economic growth to a 15-year high in 2004.”
March 15 – Bloomberg (Jason Folkmanis): “Vietnam’s exports to the U.S., the Southeast Asian country’s largest overseas market, surged 42 percent in January, boosted by sales of apparel, furniture and crude oil.”
Global Reflation Watch:
March 16 – Bloomberg (Lindsay Whipp): “The Japanese government became more pessimistic about the outlook for corporate profits for the first time since June 2003 because of concern about rising costs of oil, steel and other raw materials.”
March 18 – AFX: “M4 money supply was up a provisional 0.8 pct in Feb from the previous month on a seasonally adjusted basis…the Bank of England said. On a year-on-year basis, M4 increased by 9.3 pct, up on Jan's 9.0 pct rise.”
March 18 – Bloomberg (Matthew Brockett): “German producer prices rose more than expected in February, gaining for the seventh month in eight… The prices for goods ranging from toys to trucks gained 0.4 percent from January, when they rose 0.8 percent… From a year earlier, prices climbed 4.2 percent, their fastest rate of increase since June 2001.”
March 15 – Bloomberg (Tracy Withers): “New Zealand companies advertised a record number of jobs last month, stoking concern a shortage of workers in a nation where the unemployment rate is at a 19-year low will fan wage inflation.”
March 17 – Bloomberg (Tracy Withers): “New Zealanders bought the most homes in 11 months in February as a 19-year-low jobless rate and rising wages encouraged borrowing and new investment.”
Latin America Reflation Watch:
March 16 – Bloomberg (Heather Walsh): “Latin America and Caribbean economies had their first increase in foreign investment in five years in 2004, bolstered by spending on services and manufacturing, the United Nations said. Foreign direct investment rose 44 percent to $56.4 billion from $39.1 billion in 2003…”
March 17 – Bloomberg (Eliana Raszewski): “Argentina’s economic expansion accelerated in the fourth quarter as companies boosted investment to tap rising demand for cars, mobile telephones and other goods. Gross domestic product expanded 9.1 percent in the fourth quarter from a year earlier after growing 8.3 percent in the third quarter. GDP grew 9 percent last year, the fastest since 1992…”
March 15 – Bloomberg (Alex Kennedy): “Venezuela boosted government spending by 40 percent in January on bigger outlays for social programs such as food and medical care, paid for by surging revenue from record oil prices.”
Bubble Economy Watch:
The Current Account Deficit is out of control. The fourth quarter’s record $187.9 billion deficit (up 48% from Q4 ’03) puts 2004 at $665.95 billion. This was up 25% from 2004’s record deficit and is more than double 1999’s deficit.
March 15 - PRNewswire: “A collection of one-of-a-kind and personal memorabilia belonging to baseball legend Mickey Mantle has been purchased by All American Collectibles, with the help of $1.2 million from Kennedy Funding, a direct private lender based in Hackensack, New Jersey… Kennedy Funding has a standard policy of careful evaluation based on the quality of the collateral and inherent value of the project or business. Their quick, precise appraisals result in loan commitments in as little as 24 hours, and quick closings, often in just 2 weeks. Their speed and expertise has meant that an increasingly wide range of borrowers, from land-use developers to resort builders, entrepreneurs, and major businessmen, have turned to Kennedy Funding to arrange for financing from $1 million to $100 million. While specializing in commercial real estate loans, Kennedy Funding has expanded its scope of lending to include a wide range of enterprises, including amusement parks, high-profile golf courses, TVand radio stations, airlines, and sports complexes, among others.”
Mortgage Finance Bubble Watch:
February Housing Starts were reported at a stronger-than-expected annualized 2.195 million units, the highest level since February 1984. For comparison, Starts averaged 1.371 million annually during the nineties and 1.735 million during the past five years. February Starts were up almost 16% from one year ago. Homes Under Construction were up 9% from one year ago, with Single-family Starts up 11.4%. Building Permits were up 6%.
March 17 – San Francisco Examiner: “Home prices in the San Francisco Bay Area moved up to a new peak in February, and sales remained at near-record levels. The median price paid for a home in the nine-county Bay Area was $549,000, a record. That was up 2.8 percent from $534,000 in January, and up 20.1 percent from $457,000 in February 2004. Prices are going up at their fastest pace in four years, DataQuick… reported.”
Financial Bubble Watch:
March 16 – Bank for International Settlements: “The 2004 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity shows a substantial increase in turnover in the foreign exchange market and in the growth of activity in the derivatives market. In traditional foreign exchange markets, average daily turnover in April 2004 was $1.9 trillion, a 57% increase...compared to April 2001. This more than reversed the fall in global trading volumes between 1998 and 2001. Turnover rose across instruments but particularly in the spot and forward markets. In the derivatives market, global daily turnover in foreign exchange and interest rate related products, including outright forwards and foreign exchange swaps, increased by an estimated 74% between April 2001 and April 2004…, to $2.4 trillion. Activity grew for both interest rate related and currency-related products. Business was strong especially between reporting banks and main financial institutions, mostly hedge funds and insurance companies, but also between reporting banks and firms. Notional amounts rose by 121% to $221 trillion as of end-June 2004, with a peak in credit-linked contracts, up 568%. Gross market values more than doubled, from $3.0 trillion to $6.4 trillion, in the three years to end-June 2004.”
March 17 – Bloomberg (Hamish Risk): “The global credit-derivatives market more than doubled last year to $8.42 trillion on demand for contracts to bet on company creditworthiness or insure against default, the International Swaps and Derivatives Association said. The $200-trillion market for derivatives -- contracts based on underlying assets -- grew in 2004, led by credit-default swaps, which pay compensation in the event of borrowers defaulting on their debt. Default swaps, the most common credit derivative, grew by 123 percent, ISDA said…”
Booming Broker Finance and Market Tops:
Four of the major Wall Street securities firms reported blockbuster earnings this week.
Morgan Stanley reported Net Income of $1.468 billion, up 20% from the comparable year ago period. “Net revenues of $6.8 billion were 10 percent higher than last year’s first quarter and 26 percent ahead of last year’s fourth quarter.” “The Individual Investor Group had its highest revenues since the second quarter of 2001.” “Fixed income sales and trading net revenues were a record $2.0 billion, a 21 percent increase over a strong first quarter of 2004. The increase was broad-based, with strong performances across the interest-rate & currency products, credit products and commodities group. Interest Rate & currency products benefited from strong new deal activity with clients and successful interest rate, foreign exchange and volatility positioning.” “Fixed income underwriting revenues rose 48 percent from a year ago… The increase in fixed income underwriting revenues reflected higher non-investment grade activity.” “Equity sales and trading revenues were $1.2 billion, a 10 percent increase from a year ago and the highest since the second quarter of 2001. Record revenues in the company’s Prime Brokerage business were a substantial contributor to the increase. Higher revenues were also achieved in the derivatives business…” Total Assets expanded at a 13.8% rate to $802.2 billion and were up a noteworthy $145.3 billion, or 22%, from one year ago. Total Assets are up 43% over two years. “In the first quarter of 2005, the company repurchased 24 million shares of its common stock.”
Lehman Brothers reported Net Income of $875 million, up 34% from the year earlier period (fiscal 2004 Q1). Highlights included: “Achieved record revenues in Investment Banking, Capital Markets, Europe and Asia.” “Investment Banking revenues increased 34% to a record $683 million…reflecting improved performance across all products, including record results in debt origination and continued strength in M&A activity. Record Capital Markets net revenues, which increased 21% to $2.7 billion…were driven by record results in Fixed Income Capital Markets and strong results in Equities Capital Markets. The record results in Fixed Income Capital Markets reflect a strong performance across all major businesses, and in particular mortgages and interest rate products.” Total Assets expanded at a 12.8% rate to $370 billion and were up 15% y-o-y. “Secured financing arrangements (reverse repo and securities borrowed)” was up 18% for the year to $169 billion. Total Assets are up 38% from two years ago. The company repurchased 8.6 million shares of stock during the quarter, up from the previous quarter’s 6.0 million.
Goldman Sachs reported record Net Earnings of $1.51 billion during the first quarter, up 17% from the year earlier period. CEO Henry Paulson stated, “The strength of our performance comes from the breadth of our global franchise.” “Fixed Income, Currency and Commodities (FICC) generated record quarterly net revenues of $2.49 billion, 18% higher than the previous record set in the first quarter of 2004.” “Net revenues in Trading and Principal Investments were $4.38 billion, 6% higher than the first quarter of 2004 and 52% higher than the fourth quarter of 2004.” “Net revenues in Investment Banking were $893 million, 17% higher than the first quarter of 2004…” “Compensation and benefits expenses were $4.26 billion, 7% higher than the first quarter of 2004 and 49% higher than the fourth quarter of 2004.” The company repurchased 11.5 million shares of stock during the quarter.
Bear Stearns reported first quarter Net Income of a record $379 million, up 5% from the year ago quarter. “Once again the diversity of our franchise is demonstrated in this quarter’s strong performance,” said CEO James Cayne. “Fixed Income net revenues were $824 million, up slightly from $819 million in the year-ago quarter. The Credit business produced record revenues led by the credit derivatives, high yield, distressed debt and leveraged finance areas. Record revenues from interest-rate businesses were driven by increased customer flow in interest-rate derivatives and foreign exchange. Mortgage-related revenues remained robust…”
Not only are all the securities firms doing exceptionally well, virtually all businesses of each of the brokers are doing exceptionally. This is true by product type as much as it is by region globally. I would argue that there are today no better indicators of broad-based Liquidity Excess and Credit Availability than those provided by the operating success of Wall Street. It is worth digging a little deeper.
Combined Bear Stearns, Lehman, Goldman, and Morgan Stanley first quarter revenues were up 29% from the year ago period to a remarkable $31.6 billion. By major category, Principal Transactions were up 11% to $9.3 billion. Investment Banking increased 13% to $ 2.6 billion. Commissions were down 2% to $1.5 billion. Most notably, Interest & Dividends surged an amazing 63% from one year ago to $14.9 billion. And as Interest Expense rose 74% to $12.5 billion, Net Revenues increased 10% to $19.0 billion. How large must positions be (by the brokers and their clients) to generate approximately $60 billion of annual interest and dividends?
The degree of recent Wall Street ballooning is demonstrated more clearly by comparing combined first quarter 2005 results back two years to comparable 2003. Combined Total Revenues were up 54%. By major category, Principal Transactions were up 84%, Investment Banking 51%, Commissions 31% and Asset Management 4%. With Interest & Dividends up 56%, Total Combined Net Revenues were up 44% over two years. And, more specifically, Principal Transactions combined with Interest & Dividends increased 66% in two years to $24.2 billion. How much have positions mushroomed over the past two years to generate such incredible growth?
Combining the most recent data available from Bear, Lehman, Goldman, Morgan Stanley, and Merrill, I come up with combined Total Assets of approximately $2.60 Trillion. This is up 24% from comparable year-ago Total Assets, with a two-year gain of 44%. Fellow data hounds might question why the Fed’s “flow of funds” data has total Securities Broker Assets at $1.84 Trillion, significantly below my total of assets for just the five largest firms. Well, the Fed does not report “Security RPs” (repos) assets, but instead nets repo assets against liabilities. A “Security RP (net)” of $528 billion shows up as Security Brokers and Dealers liability, thus understating actual total assets and liabilities. It is worth noting that the Fed also nets Banking sector repos, also underreporting total bank assets and liabilities. With outstanding repos now approaching $3.2 Trillion, the netting of repo assets and liabilities significantly understates the financial sector balance sheet.
Listening to this week's Wall Street earnings conference calls, I clearly sensed a newfound degree of confidence – the type that develops over time after making more money than one could ever have imagined; making it in so many ways in so many diverse markets; and after overcoming myriad setbacks and a few near panics. After all, if things go wrong in one market, there are all these other hot markets. Today’s Exuberance is rational but misguided. These diverse markets couldn’t all falter concurrently, could they?
As always, overly abundant liquidity and acute asset inflation create genius and fearlessness, and there’s more of all of the above today than ever. Everything is working for Wall Street – Absolutely Everything. Opportunities seem endless and everyone is energized. Sure, rising rates would marginally hurt the value of bond positions, but this would supposedly be offset by a jump in trading and derivative volumes as hedge funds and other clients move aggressively to hedge and reposition. Similarly, a further decline in the dollar or gain in crude would present additional opportunities. Both would incite only greater trading and hedging volume. And just look at the huge (limitless?) opportunities available in the emerging markets!
We have reached The Pinnacle of Wall Street Finance. Endless Credit and liquidity has fueled booms in virtually all asset classes everywhere – 24/7 around the globe. Indeed, Wall Street “structured finance” has mastered the powerful capacity to generate its own liquidity – to create buying power for securities and instruments it fashions and sells. And these skills, technologies and structures have been aggressively implemented across the globe. It is natural for Wall Street and market participants to extrapolate current boom-time conditions – The Heyday of Financial Engineering - far into the future. It is too easy today to forget that there are critical market dynamics at play; that market tops sow the seeds of their own demise.
We all have learned that a market top is established when “everyone” has finally bought in – literally and figuratively. When The Crowd is secure with the bullish story and enthusiastically owns the asset (classic mania), there is no one else left to buy. Prices are left to go nowhere but lower and often abruptly. Well, that’s an important aspect of market dynamics. Not as straightforward or commonly appreciated are the commanding liquidity dynamics that fuel unsustainable asset inflation and resulting distortions. This is true for individual markets tops and can be true as well for entire financial systems.
When a Credit system as a whole succumbs to speculative market dynamics, liquidity effects and distortions become dangerously systemic. Such dynamics played crucial roles during historic boom and bust periods such as the “Roaring Twenties,” and to a lesser extent late-eighties Japan.
The ballooning of the broker call loan market in the late-twenties evolved into the mechanism providing the marginal source of liquidity for the asset markets and the increasingly finance and asset-based economy. In a definitive demonstration of the power of late-cycle market dynamics, the 1928/29 “blow-off” of margin lending and resulting asset price spikes assured imminent systemic crisis. Price gains had, at that point, become unsustainable, while liquidity and perceived wealth effects were severely distorting the Bubble Economy. Highly speculative and inflated asset markets, along with an increasingly maladjusted economy, required uninterrupted and ever increasing amounts of Credit and liquidity. There was no way out.
The inevitable (if not easily predictable) market reversal set in motion a liquidation of positions and a self-feeding collapse in speculative leverage. Not only had the boom created its own source of finance, the resulting asset inflation and liquidity effects fostered profound distortions to the nature of spending and investing, hence the underlying structure of the real economy. When the marginal source of liquidity – stock market leveraging – reversed, the financial and economic spheres’ underlying vulnerability quickly manifested. Perceptions and spending patterns changed overnight.
To this day, there are many (notably, Dr. Bernanke and the “Friedmanites”) who believe the underlying economic fundamentals of the 1920s were sound. The twenties were The Golden Age – The New Paradigm - for American ingenuity, productivity, free markets and, not to be underappreciated, central banking. If only the (post-Benjamin Strong) Fed had not “popped the Bubble” and then compounded the crisis by failing to create sufficient “money” after the market break, then that great period would have been sustained. What they fail to grasp about late-twenties systemic fragility, they fail to appreciate today: Speculative Leveraging Having Evolved into the Marginal Source of Systemic Liquidity.
Today, Wall Street “structured finance” is The Speculative Bubble – the marginal source of liquidity for both the financial and economic spheres. It has evolved to commandeer our entire Credit system and others’. And never has the structure of a Credit system been more conducive to Bubble dynamics. Financial engineering provides the capability to craft any type of security or any instrument to satisfy the demand of would be speculators or investors. At the same time, virtually any type of loan can be devised for the convenience of the borrower, and then easily found a home as collateral for a structured product. Moreover, Wall Street, especially through the “repo” market, essentially provides unlimited low-cost finance for securities leveraging (financing spread trades). The resulting liquidity excess then stokes inflation across a broadening array of asset classes, only inciting greater and more diverse speculative leveraging. It is really a case of the harder Wall Street works the greater the demand for their services and products.
The problem today – too similar to 1929 – is that the larger the number and the greater degree that markets domestically and internationally succumb to Asset Inflation Dynamics, the greater the amount of Credit and liquidity required for sustaining the Bubble. How much additional Mortgage Credit will be required this year to sustain housing inflation throughout California, Florida, the East Coast and nationally? How much additional Credit market leveraging will be required to supply the cheap finance necessary to sustain The Great Mortgage Credit Bubble? How much U.S. Mortgage Credit will be necessary to sustain U.S. consumption, the key source of global demand? How much financial Credit will be necessary to sustain the enormous flow of speculative finance to emerging equity and bond markets? How much additional Credit will be required to finance the rising cost of energy and commodities? Investment in global energy research, exploration, extraction and transport?
Well, let’s just answer each of the above questions with “a lot.” The point is that to now sustain myriad asset Bubbles and broadening inflation will require enormous quantities of additional Credit and liquidity. Ask Wall Street and they would enthusiastically avouch that they are quite up to the task – more than able and willing. And, for now, that may indeed be the case. Importantly, however, we have now reached the point – with spiking crude, California home values, and the Current Account Deficit – that the system has developed a powerful inflationary bias. Sustaining the Wall Street Bubble has become immediately destabilizing and problematic.
Today a familiar pundit asserted on CNBC – supporting his view that the market has discounted too many Fed rate hikes - that the rise in fuel costs is similar to a tax increase. He contends that the Fed is nearing “neutral” territory and will soon back off. Well, I disagree. If crude and energy prices were rising in isolation, I would say he makes a valid point. Energy inflation, instead, is only one dimension of what is now endemic asset inflation, commodities being only one facet. While losing a bit at the pump, more consumers than ever perceive they are profiting from asset inflation and the resulting investment boom (especially housing and energy). Moreover, this type of inflation, by its very nature, will incite only greater speculative leveraging. The system, at this point, demonstrates a strong proclivity to monetize rising prices - inflation begeting higher inflation. This highly unstable environment will not make it easy on the Fed.
While Wall Street is a huge beneficiary of the inflationary boom, a few of the early losers (to inflation's wealth transfer) are beginning to surface. The airlines and American auto manufactures come to mind. And this week we saw some financial turbulence erupt at the periphery. Yet I don’t want to make too much of potential problems in the corporate or emerging bond market arenas at this point. I still have the sense that the key developments will manifest initially at The Core – Mortgage and “Repo” Finance. And this is precisely where Bubble and asset inflation dynamics turn most fascinating.
Wall Street is making (“printing”) incredible amount of “money” these days in both leveraged speculation and aiding and abetting the other leveraged speculators. Finance is easier than ever; excess easily everywhere. There is as yet no sign of faltering systemic liquidity - anything but.
I do think we have reached the “pinnacle.” In the past, flight from riskier assets and a bout of safe-haven buying were just what the doctor ordered for The Core. Credit and speculative excess would be restrained at the fringe, while Treasury yields were pressured lower. The backdrop would support increased (repo?) leveraging in government, agency, and MBS, while stoking liquidity at The Core. Today, however, with the all-encompassing securities boom and endemic leveraging having become so persuasive, there is unappreciated heightened vulnerability at The Core. Things have become so hot at the expanding and prospering periphery that this old faithful mechanism to help cool The Molten Core no longer functions.
Inflationary forces – most powerfully manifesting in global asset and commodities markets - are reaching the point that risks a significant rise in market yields. The wheels of global Credit are spinning much too fast. And this dynamic appears poised to risk havoc upon the highly leveraged and those exposed to interest rate derivatives. Sophisticated models, used in exuberant excess, were not developed to anticipate the historic Credit Bubble Blow-off they have worked to incite. Indeed, there are now the initial rumblings of problems in mortgage-related derivatives instruments.
I am this evening reminded of 1994 and the dynamics of deleveraging, derivative unwind and contagion. There are, as well, aspects of today’s acute systemic vulnerability that recall the “Asian contagion” and the LTCM fiasco. But there are also key aspects of the current environment unlike anything during these previous crisis periods. On the one hand, the global economy and domestic Credit systems, in most cases, are more robust. The Periphery does not appear as fragile, and the general liquidity backdrop and inflationary bias are much stronger. On the other hand, The Core – U.S. Mortgage and Repo Finance – appears more assailable than ever. And the GSEs’ market support has been basically taken out of the equation, while the Fed is hamstrung by a fragile dollar, already too low interest rates and heightened inflationary pressures. The unfolding environment will surely provide the utmost challenge for our analytical capacities.