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Interest-rate markets were also unsettled and volatile. Two-year Treasury yields ended the week up 5 basis points to 3.65%. At the same time, five-year government yields dipped 2 basis points to 3.90%, and 10-year Treasury yields declined 5 basis points to 4.20%. Long-bond yields dropped 6 basis points to 4.51%. The spread between 2 and 30-year government yields sank to a multi-year low of 86. Benchmark Fannie Mae MBS were notably unimpressive, with yields declining only 1 basis point. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note widened 1 basis point to 38, while the spread on Freddie’s 5% 2014 note widened 1 basis points to 36. The 10-year dollar swap spread added 0.25 to 44.75. The corporate bond market remains defensive, although junk spreads generally narrowed slightly during the week. The implied yield on 3-month December Eurodollars was unchanged at 3.935%.
It was another slow week of corporate debt issuance. Investment grade issuers included United Technologies $2.4 billion, Bear Stearns $1.25 billion, MBNA $750 million, Met Life $400 million, Developers Textron Finance $400 million, Diversified Realty $400 million, and Health Care REIT $250 million.
April 28 – Financial Times (James Politi): “ Investment banks financing the purchase of US data storage group SunGard, the largest leveraged buy-out since the 1980s, are struggling to find buyers for the debt, raising fears that the downturn in high-yield markets threatens a new class of large private equity deals. Deutsche Bank, JPMorgan and Citigroup recently began syndicating a $4bn bank loan, part of the financing of the $11.3bn deal, to hedge funds and other preferred investors before moving on to a formal roadshow. But early indications of interest in the bank loan and a $3bn bridge loan that will also soon be marketed, have been lukewarm… “The SunGard deal is signed, but the financing is not done by any means. Fingers crossed,” said one. The deal, in which seven private equity groups joined forces for the largest buy-out since Kohlberg Kravis Roberts bought RJR Nabisco in 1989, was seen as a model for future deals…”
Junk bond fund outflows slowed to $228.4 million. Issuers included Hawaiian Telecom $500 million, Movie Gallery $325 million, Triad Acquisition $150 million, Gardner Denver $125 million and North American Energy $60 million.
Foreign dollar debt issuers included Italy $3.0 billion, International Finance $1.0 billion, Diageo $750 million, Tenaga Nasional $350 million, and Vestel Electric $225 million.
April 25 – Kyodo: “Toyota Motor Corp. Chairman Hiroshi Okuda said Monday his company may hike the prices of its vehicles in the U.S. market in an effort to avert a row with U.S. automakers… Noting the auto industry is the symbol of the U.S. economy, Okuda said he is worried about GM’s situation…”
Japanese 10-year JGB yields sank 5.5 basis points to 1.235%. Emerging debt markets continue to prove resilient. For the week, Brazilian benchmark dollar bond yields rose 2 basis points to 8.32%. Mexican govt. yields ended the week up 6 basis points to 5.83%. Russian 10-year dollar Eurobond yields sank 18 basis points to 5.96%.
Freddie Mac posted 30-year fixed mortgage rates dipped 2 basis points to 5.78%, a low since late February and down 23 basis points from one year ago. Fifteen-year fixed mortgage rates declined 3 basis points to 5.33%. One-year adjustable rates declined 5 basis points to 4.21%, a six-week low. The Mortgage Bankers Association Purchase Applications Index gained 3.3% this past week. Purchase applications were up 4% from one year ago, with dollar volume up 14%. Refi applications jumped 9.8% to the highest level in six weeks. The average new Purchase mortgage jumped to $244,100. The average ARM surged to $340,000. For perspective, one year ago the average Purchase mortgage was $222,000 and the average ARM was $295,000. The percentage of ARMs this week slipped to 34.7% of total applications.
Broad money supply (M3) surged $53.6 billion to a record $9.597 Trillion (week of April 18). Year-to-date, M3 has expanded at a 4.3% rate, with M3-less Money Funds growing at a respectable 6.8% pace. For the week, Currency added $1.2 billion. Demand & Checkable Deposits gained $8.9 billion. Savings Deposits jumped $16.2 billion. Small Denominated Deposits increased $4.1 billion. Retail Money Fund deposits dipped $0.2 billion, while Institutional Money Fund deposits added $4.4 billion. Large Denominated Deposits jumped another $16.0 billion, with a four-week gain of $64.8 billion and y-t-d rise of a notable $141 billion. For the week, Repurchase Agreements rose $5.8 billion, while Eurodollar deposits declined $3.2 billion.
Bank Credit jumped $26.8 billion, increasing the year-to-date expansion to $310 billion, or 14.9% annualized. Securities Credit is up $106 billion, or 18% annualized, year-to-date. Loans & Leases have expanded at a 13.5% pace so far during 2005. For the week, Securities surged $25.2 billion. Commercial & Industrial (C&I) loans added $1.6 billion. Real Estate loans rose $5.5 billion. Real Estate loans have expanded at a 16.3% rate during the first 16 weeks of 2005 to $2.67 Trillion. Real Estate loans are up $321 billion, or 13.7%, over the past 52 weeks. For the week, consumer loans gained $4.1 billion, while Securities loans dropped $14.0 billion. Other loans increased $4.4 billion.
Total Commercial Paper gained $2.9 billion last week ($51.4bn in 4 wks) to $1.480 Trillion. Total CP has expanded at a 14.5% rate y-t-d (up 10.7% over the past 52 weeks). Financial CP rose $2.5 billion last week to $1.33 Trillion (up 11.1% ann. y-t-d). Non-financial CP added $0.4 billion to $150.1 billion (up 27% in 52 wks). Fed Foreign Holdings of Treasury, Agency Debt gained $1.8 billion to $1.390 Trillion for the week ended April 27. “Custody” holdings are up $55.0 billion, or 12.6% annualized, year-to-date (up $206.5bn, or 17.4%, over 52 weeks). Federal Reserve Credit expanded $1.1 billion for the week to $786.7 billion. Fed Credit has declined 1.5% annualized y-t-d (up $42bn, or 5.6%, over 52 weeks).
ABS issuance slowed to $12 billion (from JPMorgan). Year-to-date issuance of $210 billion is now 12% ahead of comparable 2004. At $133 billion, y-t-d home equity ABS issuance is 17% above the year ago level.
Currency Watch:
The dollar index added better than 1%. Talk of Chinese revaluation supported the Asian currencies. For the week, the Indonesian rupiah and Japanese yen gained more than 1%. The Taiwan dollar, South Korean won, Singapore dollar, and Australian dollar all gained about 0.7%. On the downside, the Polish zloty sank 4%, the Hungarian forint 2.6%, the Turkish lira 2.5%, and Czech koruna 2.3%.
Commodities Watch:
April 27 – Bloomberg (Koh Chin Ling and Jason Gale): “China, the world’s biggest cotton user, may boost imports of the fiber by 83 percent in the year starting Aug. 1 because of rising demand from textile mills and a smaller harvest, a U.S. agricultural attache said. China may import 3.3 million metric tons of cotton (15.2 million bales) in the next marketing year…”
June crude oil sank $5.67 in wild trading to $49.72. For the week, the CRB dropped 1.2%, lowering y-t-d gains to 7.0%. The Goldman Sachs Commodities index fell 6.8%, with 2005 gains declining to 13.8%.
China Watch:
April 27 – Bloomberg (Rob Delaney): “China’s banking regulator warned lenders to curb loans used to buy luxury real estate because occupancy rates are low and supply is too high, creating more default risks. The China Banking Regulatory Commission has ordered its local branches to conduct investigations into the loan books of the country’s four biggest state-owned banks including Bank of China, the country’s second-largest lender, and into 12 smaller shareholding banks to determine the extent of loans to risky real estate projects…”
April 26 – AFX: “China will experience a worsening coal shortage as a result of increasing demand and falling supply, the National Development and Reform Commission (NDRC) has warned. The NDRC, the country's economic development planner, also warned that profits will fall in the cement and aluminum industries as a result of capacity expansion.”
April 25 – XFN: “China’s residential house prices increased 13.5% in the first three months from a year earlier, compared with a 6.5% growth rate recorded in the same period of last year, the National Bureau of Statistics said.”
April 28 – AFX: “The recapitalization of the Industrial and Commercial Bank of China and the Agricultural Bank of China will cost the government at least $110 bln, Standard & Poor’s Ratings Services said…”
Asia Boom Watch:
April 27 – Bloomberg (Nerys Avery): “The World Bank raised its 2005 economic growth forecast for East Asia to 6 percent from a November estimate of 5.9 percent, citing stronger-than-expected expansion in China. ‘China has confounded all of our expectations,’ Homi Kharas, the Washington-based lender’s chief economist for East Asia and the Pacific, said… ‘China continues to be the driver of growth.’”
April 28 – Bloomberg (Subramaniam Sharma): “India’s economy may grow 7.2 percent in the year ending March 31, 2006, as companies expand capacity to meet demand from local consumers as well as overseas customers, a research group said in its quarterly review. ‘Driven by consumption, investment and exports, growth this time is real,’ the New Delhi-based National Council of Applied Economic Research said in an e-mailed statement today. ‘Capacity expansion and investment decisions are based on rigorous assessments of the market and competition.’”
April 29 – Bloomberg (Kartik Goyal): “Indian exports rose 8.3 percent in March from a year earlier boosted by shipments of textiles, gems and jewelry to the U.S., the country’s biggest overseas market… Imports rose 26 percent to $10.08 billion in March…”
April 28 – Bloomberg (Seyoon Kim): “South Korea’s industrial production rose in March at the fastest pace in almost three years as consumer spending picked up and exports of Samsung Electronics Co. cell phones and Hyundai Motor Co. cars surged. Output rose a seasonally adjusted 3.8 percent from February, when it fell 4.6 percent…”
April 28 – Bloomberg (Seyoon Kim): “South Korean manufacturers’ confidence stayed at a one-year high this month, supported by record exports and a pickup in consumer spending at home… Exports, which account for about two-fifths of the economy, rose 14 percent to $24.2 billion in March…”
April 29 – Bloomberg (Kate Mayberry): “Malaysia’s broadest measure of money in circulation expanded more than 13 percent in March, the central bank said late Thursday. That’s the fastest pace in seven years…”
April 25 – Bloomberg (Anuchit Nguyen): “Thailand’s government will increase spending 8.8 percent to a record in the next financial year to help the economy, Finance Minister Somkid Jatusripitak said.”
April 26 – Bloomberg (Anuchit Nguyen): “Thailand’s fuel bill rose to 17 percent of imports in March from 12 percent a month earlier, resulting in a widening of the trade deficit for Southeast Asia’s second-largest energy user.”
Global Reflation Watch:
April 27 – Bloomberg (Sam Fleming): “The number of home loans approved by U.K. banks rose for a second month in March to the highest since July 2004, the British Bankers’ Association said, suggesting demand for housing is strengthening.”
April 26 – Bloomberg (Simon Packard): “French housing starts rose 13 percent in the first quarter from a year earlier as homebuilders kept pace with demand underpinned by tax breaks and borrowing costs at their lowest in France since 1946.”
April 27 – Bloomberg (Joao Lima): “The average price for new and second-hand homes in Spain increased 15.7 percent in the 12 months through the end of March, newswire Efe reported, citing Spain’s housing ministry.”
April 26 – Bloomberg (Matthew Brockett): “Import prices in Germany, Europe’s largest economy, rose the most in four and a half years in March as the cost of oil surged. Import prices advanced 1.3 percent from February, the biggest monthly increase since September 2000…”
April 26 – Bloomberg (Halia Pavliva and Michael Teagarden): “Russia’s inflation rate may exceed government forecasts and top 13 percent this year after the government set aside more of the country’s windfall oil revenue for fiscal expenditure, a presidential aide said.”
April 29 – Bloomberg (Tracy Withers): “New Zealand home-building approvals rose in March for a third month in four, suggesting a housing boom that stoked economic growth in 2004 won’t slow anytime soon.”
Latin America Watch:
April 27 – Dow Jones (Tom Barkley): “Mexico’s government Tuesday announced plans to begin offering mortgage insurance to provide further backing for the country’s housing boom and nascent mortgage-backed securities market. The Federal Mortgage Society will be the initial provider of the mortgage insurance… Mortgage insurance is the government's latest financial reform that has helped the housing market reach a growth rate of between 15% and 20% a year…”
April 27 – Bloomberg (Alex Kennedy): “Venezuelan President Hugo Chavez said he will raise the minimum monthly salary 26 percent after record oil prices boosted government revenue last year.”
April 25 – Bloomberg (Alex Emery): “Peru’s exports rose 31 percent in the first quarter, led by shipments of copper, hydrocarbons and fishmeal. Exports rose to $3.61 billion for the quarter…”
Speculative Financial Bubble Watch:
April 26 – Bloomberg: “Hedge funds attracted a record $27.4 billion from institutional and wealthy investors in the first quarter, helping to push assets to more than $1 trillion for the first time, according to Hedge Fund Research Inc… Pension funds, endowments and other big investors have been pouring money into the loosely regulated private pools to boost returns and diversify their investments. Hedge funds pursue a wide range of investment strategies, unlike most conventional mutual funds, which tend to buy and hold stocks or bonds. Hedge fund assets have grown from $39 billion in 1990, when there were 610 funds. There now are more than 7,900 funds.”
Bubble Economy Watch:
Nominal Gross Domestic Product was up 6.2% (nominal) from Q1 2004 to $12.183 Trillion (annualized). Personal Consumption Expenditures were up 6.0% to $8.541 Trillion. Durable Goods were up 6.0% from one year ago to $1.019 Trillion, while Non-Durable Goods were up 7.3% to $2.487 Trillion (Food 7.4%, Clothing 3.7%, and Gasoline & Fuel 16.3%). Services were up 5.6% to $5.036 Trillion (Housing 5.1%, Elect. & Gas 8.3%, Transportation 3.8%, Medical Care 7.2% and Recreation 4.2%). Gross Private Investment was up 15.3% to $2.099 Trillion. Non-Residential Fixed Investment was up 13% to $1.31 Trillion (Structures up 11.1%, Information Processing 11.9%, Industrial Equipment 13.7%, and Transportation Equipment 18.1%). Residential Investment was up 13% to $706 billion. Federal government expenditures were up 6.0% to $841 billion, and State & Local expenditures were up 5.4% to $1.419 Trillion. Goods Exports were up 10.6%, while Goods Imports were up 18.4%.
April 28 - i-Newswire: “At $2.7 billion, Wynn Las Vegas will be the most expensive resort ever built. It also has the highest per-room cost ever at $1 million, exceeding the $775,000 average cost of the Grand Wailea Resort in Maui, Hawaii, previously the most expensive. It also will be more than twice the $415,000-per-room cost of The Venetian, and nearly double the per-room cost of Atlantic City’s Borgata ($550,000) and the Strip’s Bellagio ($533,000). While some industry observers question whether Wynn will be able to turn his colossus into a profitable venture, Wynn himself acknowledges the importance of the challenge. ‘The responsibility of using capital is much more daunting than getting it. The qualitative and quantitative judgments that you have to make when capital is being used responsibly are far more daunting than raising capital,’ Wynn said in the weeks leading up to Thursday’s opening of Wynn Las Vegas.”
April 28 – Bloomberg (Jack Kaskey): “Dow Chemical Co., the largest U.S. chemical maker, said first-quarter profit almost tripled to a record on higher demand and prices for plastics and caustic soda. Net income rose to $1.35 billion…from $469 million… Sales jumped 25 percent to $11.7 billion, the highest ever. Chief Executive Andrew Liveris raised prices 26 percent, outpacing more than $1 billion in higher costs for energy and raw materials.” April 28 – MarketWatch: “Georgia-Pacific Corp. said Thursday its earnings rose on higher profit at its consumer products, packaging and paper segments… ‘Overall prices remained strong across all North American businesses, as increases we announced in 2004 continued to be implemented,’ said A.D. ‘Pete’ Correll, G-P’s chairman and chief executive. He added that higher manufacturing costs across the company in energy, fiber and chemicals offset some of the gains from higher prices.”
April 29 – The Wall Street Journal (Jonathan Karp): “Northrop Grumman Corp.’s first-quarter profit soared 73% and Raytheon Co.’s rose 30% as the defense contractors benefited from continued strong Pentagon demand and leaner operations.”
April 25 – Bloomberg (Linda Sandler): “Andy Warhol sold a portrait of movie star Elizabeth Taylor for a pittance in the 1960s. Next month, the red silkscreen picture may fetch as much as $12 million at a Sotheby’s Holdings Inc. auction… ‘Liz’ will be one of the top-priced works for sale at four evening auctions at Christie's and Sotheby’s valued at as much as $570 million… Contemporary art prices have tripled since 1996, according to index-maker Art Market Research’s tally of the 25 percent most expensive works.”
April 26 – PRNewswire: “For certain jobs in selected industries, signing bonuses are making a comeback, says CareerJournal.com, The Wall Street Journal’s executive career site. ‘Even though awards remain less prevalent than during the tech boom of the late 1990s, there are still opportunities for employees in hot areas to snag a bonus,’ says Tony Lee, publisher, CareerJournal.com.”
Mortgage Finance Bubble Watch:
March New Home Sales were reported at a much stronger-than-expected and record 1.431 million annualized pace. For comparison, New Home Sales averaged 698,000 annually during the nineties. “Blow-off” period transactions are now double this amount. And with Sales up 12.7% and Average Prices up 7.8%, Calculated Transaction Value (CTV) was up a notable 21.4% from March 2004 (then a record) to a record $402.5 billion annualized. New Homes CTV is up an astonishing 73% over two years, 94% over 3 years and 146% over 6 years. Factoring in the new furniture and furnishings that go along with new home purchases, and there is no diminishing the major impact the housing boom is having on the real economy.
At a stronger-than-expected 6.89 annualized units, Existing Home Sales were up 4.9% from a robust March 2004. This is about 70% above the nineties average of 4.025 million. And with last month’s average price up 11.4% from one year ago to a record $248,500, CTV was up 16.9% to $1.712 Trillion annualized. CTV was up 43% over two years, 57% over 3 years, and 108% over six years. Combined year-to-date New and Existing CTV is running 19% ahead of a record 2004.
Year-to-date, New Home Sales are running 8.2% above last year’s record pace, with Existing Home Sales 8.3% ahead. Combined New and Existing Home Sales were at a record 8.321 million pace during March, 76% higher than the nineties average.
April 27 – Bloomberg (Kevin Carmichael and Howard Liberman): “Record sales of new homes reflect local conditions rather than a nationwide surge driven by speculation, Treasury Secretary John Snow said in an interview. ‘I don’t see any evidence that there is a national housing bubble. This is not a national market. It is a series of local markets reflecting the particular issues of a local market.’”
April 26 – Boston Globe (Kimberly Blanton): “Prices of single-family houses and condominiums in Massachusetts surged at double-digit rates in March amid strong sales activity. The median price for a single-family home in Massachusetts rose 12.7 percent to $350,000 in March from $310,500 a year earlier… That was the biggest price gain since last November. The median price of condos in the state rose 10.9 percent to $265,000…”
April 26 – RisMedia: “Out-of-state buyers and those moving within Florida's borders are pushing up demand for existing single-family homes in the Sunshine State, driving statewide sales in March to a total of 24,045 homes – a 6 percent increase over March 2004's sales of 22,748 homes, according to the Florida Association of Realtors (FAR)… Last month, the statewide median price rose 28 percent to $212,300; a year ago, it was $165,700. In March 2000, the statewide median sales price was $121,600, resulting in a 74.5 percent increase over the five-year-period…
April 27 – Bloomberg (Dianne Finch): “Housing prices that are more than 20 percent above the national median and weak job growth threaten Boston’s ability to retain skilled workers, a panel of economists and civic leaders said… The median house price in the Northeast in March was 24 percent higher than for the U.S. as a whole, the National Association of Realtors reported… The median home price in Massachusetts was $369,878 in 2003 compared with $255,751 in 2000…”
April 29 – AP: “The American dream of having a job and owning a tidy home is becoming a fantasy for more people. Housing prices are outstripping wage increases in many areas, meaning more people are either spending above their means… according to a pair of studies…by the Center for Housing Policy… It’s generally accepted that a family should not spend more than 30% of its income on housing…But in a recent six-year period, the number of low- and middle-income working families paying more than half their income for housing has increased 76%. In 2003, 4.2 million working families spent more than half their income on housing, up from 2.4 million in 1997.”
Earnings Watch:
Countrywide Financial reported Net Earnings of $689 million during the first quarter, up 27% from last year’s first quarter. “Total loan production volume was $92 billion for the quarter, up 21 percent from the comparable quarter last year. The servicing portfolio has grown by $211 billion since March 31, 2004 to a record $893 billion.” “Total assets at Countrywide Bank reached $51 billion, compared to $24 billion at March 21, 2004… The Bank raises retail deposits through the Internet, call centers and 65 financial centers…” The company’s Total Assets expanded at a 27% annual rate during the quarter to $137.0 billion (due to coming 2004 revisions, y-o-y comparisons are not today possible). And examining Liabilities, it is worth noting that Securities Sold Under Agreements to Repurchase jumped $10.4 billion during the quarter to $30.85 billion.
Digging a Little Deeper into “Financial Sphere” Analysis:
Listening to Larry Kudlow (& Company) yesterday afternoon - lambasting “market analysts” for selling stocks based on a slightly weaker-than-expected GDP report – I thought to myself, “Financial Sphere Larry, Financial Sphere.” It is my contention that financial developments these days lead the economy and not vice versa. Those focused on the current generally robust and seemingly sound “Economic Sphere” (decent growth, strong profits, and relatively tame CPI) are these days at a decided analytical disadvantage when it comes to appreciating the many nuances of the financial market environment. The Financial Sphere is sputtering and convulsing, and if this situation is not rectified, the widening schism between the Financial and Economic Spheres will be resolved in favor of finance. But is it amenable to rectification?
Admittedly, the concept of “Financial Sphere” and “Economic Sphere” is more than somewhat nebulous analysis. On a macro scale, we can think of the Financial Sphere in terms of Credit and financial systems, certainly including the markets, where myriad institutions, players and individuals borrow, lend, invest and speculate in securities, debt instruments, currencies and, more generally, speculative assets including homes, businesses and collectables. It has a great deal to do with confidence, perceptions and faith in the Fed and global central bankers. The Economic Sphere comprises scores of businesses, entrepreneurs, investors, governments, employees, and consumers involved in all aspects of production, distribution and consumption of real economic output – goods, services, commodities, structures and fixed investment. The Economic Sphere never appreciates how its behavior and fortunes are dictated by the Financial Sphere.
There is, of course, interplay and overlap between “The Spheres.” But in some regards their activities are rather distinct. On a more micro level, a company such as GM has intertwined operations in both Spheres. It invests in plant & equipment, manufacturing a variety of vehicles and other products. It is, as well, a formidable player in the Financial Sphere. For some time the company has expanded lending and financial operations. Indeed, as GM struggles with an increasingly hostile Economic Sphere, it will continue to significantly reduce its real investment in production capacity in favor of expanding its financial services operations and holdings. What is burdening GM is burdening America, and a ballooning Financial Sphere should be recognized as a byproduct of underlying structural maladjustment.
When it comes to envisaging important distinctions between the two Spheres, GM provides additional insight. In years past, GM offered dedicated employees the promise of retirement pension and health care benefits. To meet future obligations, the company would invest in productive plant and equipment (the Economic Sphere) that were expected to provide sufficient future (economic) profits. Most unfortunately, the major inflation in the cost of these retirement benefits coupled with deteriorating manufacturing profits has created a funding black hole (spiraling asset and liability mismatch). GM (like many) has been compelled to make a dramatic shift to leveraged holdings of securities and other financial assets in an effort to keep pace with its ballooning liabilities. The upshot is a Rapidly Expanding Financial Sphere, especially in comparison to the stagnant Economic Sphere. Somehow, holdings of auto receivables and MBS are to provide the wherewithal to procure future real goods and services for its retirees.
Credit Bubble analysis is focused on the Rapidly Expanding Financial Sphere, as well as its distorting effects throughout the Economic Sphere. What is the nature of the increase in financial claims; what are the ramifications for spending and investing decisions; do the consequences include unsustainable asset price booms; how do inflationary forces distort risk perceptions and market pricing mechanisms; what is the scope and how destabilizing are the resulting speculative market dynamics? “Inflation” is fundamentally the expansion of financial claims (generally Credit). In this context, the premise of an inflationary environment should not be contested and is actually far removed from the popular “inflation vs. deflation debate.” And I would add that talk of the “promised land of secular price stability” arises from a focus on a narrow index aggregating selected consumer prices within the Economic Sphere. Such a cramped focus neglects paramount contemporary inflationary manifestations and is thus anathema to Financial Sphere and Credit Bubble Analysis.
It used to be that The Spheres were Kindred Spirits. Financing profitable investment in the Economic Sphere was the commanding source of expansion for the Financial Sphere. Economic profits and prudent lending were, in conjunction, self-adjusting mechanisms, not repealing the business cycle but at least suppressing boom and bust dynamics. Moreover, tight control over Financial Sphere expansion (implemented post ‘30’s financial collapse) for some time nurtured both financial and economic stability. The Spheres shared common interests and growth dynamics. Sound economic investment was the key to financial stability; sound finance the lifeblood of balanced, sustainable economic growth.
But memories faded, historical revisionism prevailed and, over time, the Financial Sphere was set free and left to its own powerful devices. Once unleashed, it was an historic case of a progressive multi-decade bias to asset-based lending and securities speculation. Computerization, financial innovation and the evolution of “financial engineering” played a seminal supporting role. To be sure, the seeking of Financial Sphere “profits” became the commanding mechanism driving both lending and “investing” decisions, with real economic profits relegated to a fading and rather distorted second fiddle.
In contrast to the self-adjusting nature of economic profits (over and mal-investment fostering eventual profit disappointment and retrenchment), unfettered Financial Sphere expansion is seductively self-reinforcing over protracted periods (decades). By its very nature, financial sector expansion generates unending “profits” as long as the inflation (creation of additional financial claims) is sustained. The ballooning Financial Sphere has for some time suppressed the downside of business cycles. However, an unrestrained Credit Cycle nurtures speculation, surreptitious boom and bust dynamics, and financial and economic vulnerability to any ebbing of Credit and financial excess. Inflationary Bubbles in the Financial Sphere – such as those that culminated with the “Roaring Twenties” or 1980’s Japan – are manifestly more dangerous than inflation in the Economic Sphere. There are myriad issues related to this momentous financial and economic development, most I have surely repeated several times too many. But I am never one to let repetition dissuade my attempts at pertinent insight. Today, the Financial Sphere is massively inflated with respect to the Economic Sphere. This excess finance – Monetary Disorder – has inflated financial returns, while destabilizing pricing mechanisms within the asset markets and real economy. The massive pool of finance is today faced with paltry opportunities for true economic returns, as well as a natural proclivity for over-investing at every opportunity. Speculative excess has gone to unprecedented extremes and there are, of late, initial indications that Bubbles are strained and possibly beginning to burst. Recent market turbulence is associated with newfound crosscurrents of heightened risk aversion, on the one hand, and the necessity for massive and continuous Financial Sphere expansion on the other. It is an especially volatile, unpredictable mix.
Importantly, these types of colossal inflations involve a profound redistribution of wealth. For awhile, the finance-induced boom and consequent asset inflations appear to provide at least some benefit to all. The fleeting notion of shared wealth enhancement, however, is replaced by increasing real disparities and animosities. We are seeing this today. While many in California, Florida, Manhattan and elsewhere enjoy a housing wealth bonanza, many less fortunate are being priced right out of home ownership. While the finance, housing and energy industries wallow in windfall “profits,” our nation’s auto and airline industries are left for financial ruin. As the U.S. and its inflationary partners in Asia boom, a more financially stable Europe stagnates. Its citizens are growing restless. Here at home, the American consumer enjoys an endless consumption windfall, while Asian societies accumulate massive and untenable holdings of dollar IOUs. Our Creditors are growing impatient, while our lawmakers look for scapegoats. A seemingly wonderful reflation has turned - for the duration - problematic.
Today, careful observation identifies heightened stress on many levels. And to Mr. Greenspan and others than warn against protectionism, I can only say they are correct but offer specious reasoning. The scourge of protectionism is one predictable consequence of inflation’s unjust distribution and transfer of wealth between nations.
For some time the U.S. Financial Sphere inflated largely in isolation. The Japanese Credit system was in post-Bubble intensive care, along with many financial systems throughout Asia, Latin America, and elsewhere. U.S. financial sector expansion and resulting Current Account deficits were easily and readily “recycled” directly back to booming (“King Dollar”) U.S. securities markets. This played a major role is dampening the global consequences of U.S. inflation. It supported a dollar Bubble, as well as garnering the Federal Reserve extraordinary control over the inflationary process. For example, the Greenspan Fed facilitated major “reflations” post-LTCM, NASDAQ bust, and 9/11 without the burden of risking a surge in inflation, a spike in market yields or a run on the dollar.
The backdrop is profoundly different today. There are myriad domestic Credit system inflations internationally, in what amounts to a major Global Financial Sphere Inflation. Energy and commodity prices have spiked and there is a general inflationary bias throughout the commodities markets. As I have noted many times previously, the distinguishing characteristic of the Greenspan/Bernanke 2002 reflation was its effect on global currencies, Credit systems and speculation – The Globalization of the U.S. Credit Bubble. I contend that the Fed will now face significant risk if it attempts to adjust the inflation throttle either up or down and has largely lost control of the inflationary process
For more than two years the perception held that the masterly Fed was in complete control. This was, however, only a deception made of inflating asset prices, narrowing risk premiums, and economic boom reemergence. The investment community – certainly including the massive leveraged speculating community – was lined up right behind the “transparent” Fed. Risk-taking was made incredibly profitable and it was done in self-reinforcing excess – with everyone confidently on the same side of the risk-taking boat. Everything became a “crowded trade” – from equities, to junk, to converts, to CDS, to MBS, to manic homebuying. Various markets became closely correlated, risk commoditized, and the benefits of diversification largely lost (despite what risk models contend).
I contend that this reflation was of the “blow-off” “terminal phase” variety. Hedge fund assets surpassed $1 Trillion, bank Credit exploded, Securities firms’ balance sheets ballooned, “repo” positions surpassed $3 Trillion, the Credit default swap market mushroomed, and excesses throughout mortgage finance went to historic extremes (no down payment, interest-only, subprime, home equity, etc. financing $1 Trillion-plus annual mtg Credit growth). The U.S. Current Account Deficit surged to 6% of GDP, financed by the explosion of largely Asian central bank holdings. Inflationary pressures were liberated from the U.S. Financial Sphere, while euphoric speculation became endemic to U.S. (equities, Treasuries, corporates, junk, MBS, homes, CDS, etc) and global asset markets.
There has been a major dilemma associated with allowing the Financial Sphere to be commandeered by speculative market dynamics. Years of excess only culminated into a period of spectacular excess. Importantly, the amount of risk created during the Credit system’s blow-off period grows exponentially as a huge increase in riskier Credits (i.e. mortgages, junk) is financed by mushrooming speculative leveraging (i.e. “repos,” MBS, CDOs, “spread trade”). At this point, there is no turning back, with the entire Credit system succumbing to Minskian “Ponzi Finance” dynamics. Debt structures become increasingly fragile, reliant upon progressively inflated asset prices and only more aggressive financing methods. It becomes only a case of what precipitates the crisis.
I’ve always appreciated the bull fighting analogy as it applies to the stock market: The agitated bull turns most ferocious and unpredictable after he has taken his first spear from the Matadore. Yet, when it comes to financial stability, the stock market always receives more attention than it deserves. Keen focus over the coming days and weeks will be directed at assessing the severity of the damage done to the Credit system. It has been hurt by GM, CDS, junk, wild interest-rate volatility, and consequent heightened risk aversion. But it has come charging forcefully back with lower Treasury and mortgage yields. This is positive for mortgage Credit and general market liquidity, but a negative for the spread trade and interest-rate hedging strategies. A strong case can be made that this collapse in yields is, over the intermediate term, only further destabilizing for the Economic Sphere. Liquidity and Credit availability for corporate borrowings are faltering, with only greater excess throughout mortgage finance.
At other times, I would argue that the recent blow would not prove deadly. But this is a “blow-off” period with unprecedented speculative and leveraging excess, with everyone crowded on the same side of the boat, and with the Financial Sphere Inflationary Bubble sustained only by continued massive Credit inflation and speculation. The key risk players need to willing and able to expand; they are not. The speculating community needs to willing and able to stay the course on one side of a crowded (and increasingly rocking) boat; why would they? And if the system does begin to seriously falter, the Fed will need to get everyone lined up to play yet another “reflation;” with unprecedented risk and uncertainty.
The system is today wound so tight. The unpredictability of the Marred Bull also brings to mind the old bull in a china shop. Prices throughout the financial markets are now being whipped around and about, inflicting corrosive damage upon confidence and portfolio values. With all the derivative-related hedging and risk speculating, markets demonstrate increasing leverage both on the up and downside. One week, hedging related selling pushes yields sharply higher, followed not long afterward with the forced unwind of these hedges and hedging against lower rates that pulls yields abruptly lower. Dynamics in equity, currency, Credit and commodities markets are only somewhat different. The defining feature of the Financial Sphere at this time is a massive and destabilizing pool of “hot liquidity” seeking to make a decent return but increasingly fearful of getting run over.
So, to proffer a response to the above question - Is it amenable to rectification? – I don’t think so. Could a crisis develop quickly or be delayed for awhile? I feebly answer “yes.” |
