Volatility rules the day. Two-year Treasury yields ended the week up 7 basis points to 3.72%. Five-year government yields rose 5 basis points to 3.95%, and 10-year Treasury yields added 6 basis points to 4.26%. With new supply finally on the horizon, long-bond yields jumped 11 basis points to 4.63%. The spread between 2 and 30-year government yields widened 5 to 91. Benchmark Fannie Mae MBS were unchanged, recovering much of last week’s underperformance. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note narrowed 3 basis points to 35, and the spread on Freddie’s 5% 2014 note narrowed 3 basis points to 33. The 10-year dollar swap spread declined 0.75 to 44.0. With Standard & Poor’s reducing GM and Ford debt to junk status, GM bond yields surged to 11.4% and Ford's to 9.5%. The corporate bond market was highly unsettled, with spreads widening several basis points to the widest level since November. Junk bond yields were volatile but up only moderately for the week. The implied yield on 3-month December Eurodollars jumped 7.5 basis points to a one-month high 4.01%.
It was another slow week of corporate issuance. Investment grade issuers included Bank of America $2 billion, Allstate $800 million, Countrywide $500 million, Ryland $250 million, Archstone-Smith $300 million, Private Export Funding $250 million, and Berkley $200 million.
Junk issuers included Lazard $550 million, Mandra Foresty $195 million, Greenbrier $175 million and Petroquest Energy $125 million.
Convert issuers included Ivax $350 million.
Foreign dollar debt issuers included Colombia $335 million.
May 4 – Bloomberg (Adriana Arai): “Mexico is finding more buyers for peso bonds in New York, Toronto and Luxembourg than in Mexico City. OppenheimerFunds Inc., AGF Funds Inc. and KBC Conseil-Service are among international investors that own three quarters of Mexico’s $6 billion of 10- and 20-year fixed-rate peso bonds... International buyers are attracted to yields of more than 10 percent and prospects the peso will gain as Mexico’s economy becomes more intertwined with the U.S. The lack of interest among domestic investors reflects concern about the country's history of high inflation, devaluation and default.”
Japanese 10-year JGB yields dipped 1.5 basis points to 1.22%. Emerging debt markets continue to impress. For the week, Brazilian benchmark dollar bond yields dropped 27 basis points to 8.05%. Mexican govt. yields ended the week down 8 basis points to 5.75%. Russian 10-year dollar Eurobond yields inched 2 basis points higher to 5.99%.
Freddie Mac posted 30-year fixed mortgage rates declined 3 basis points to 5.75%, a 10-week low and down 37 basis points from one year ago. Fifteen-year fixed mortgage rates dipped 2 basis points to 5.31%. One-year adjustable rates added one basis point to 4.22%. The Mortgage Bankers Association Purchase Applications Index was about unchanged last week. Purchase applications were flat compared to one year ago, with dollar volume up almost 8%. Refi applications rose 0.4%. The average new Purchase mortgage declined to $236,400. The average ARM fell to $334,700. The percentage of ARMs to slipped to 33.4% of total applications.
Broad money supply (M3) rose $19.1 billion ($73.2bn in 2 wks) to a record $9.60 Trillion (week of April 25). Year-to-date, M3 has expanded at a 4.3% rate, with M3-less Money Funds growing at 6.5% pace. For the week, Currency added $1.8 billion. Demand & Checkable Deposits jumped $14.9 billion. Savings Deposits dropped $31.9 billion. Small Denominated Deposits added $3.7 billion. Retail Money Fund deposits rose $4.7 billion, while Institutional Money Fund deposits dipped $0.5 billion. Large Denominated Deposits increased $3.5 billion, with a five-week gain of $63.3 billion. For the week, Repurchase Agreements jumped $18.3 billion, and Eurodollar deposits rose $4.5 billion.
Bank Credit rose $4.3 billion, increasing the year-to-date expansion to $313 billion, or 14.2% annualized. Securities Credit is up $99 billion, or 15.8% annualized, year-to-date. Loans & Leases have expanded at a 13.3% pace so far during 2005. For the week, Securities declined $7.1 billion. Commercial & Industrial (C&I) loans gained $4.8 billion. Real Estate loans dipped $2.7 billion. Real Estate loans have expanded at a 14.9% rate during the first 17 weeks of 2005 to $2.67 Trillion. Real Estate loans are up $318 billion, or 13.5%, over the past 52 weeks. For the week, consumer loans added $0.9 billion, and Securities loans jumped $13.5 billion. Other loans dropped $5.3 billion.
May 3 – Bloomberg (David Russell): “U.S. commercial paper outstanding increased to a four-year high of $1.49 trillion on a seasonally adjusted basis in April after companies built inventories more quickly in the first quarter, according to Federal Reserve data. The 3.8 percent increase was the biggest since at least June…”
Total Commercial Paper increased $3.9 billion last week ($55.3bn in 5 wks) to $1.485 Trillion. Total CP has expanded at a 14.5% rate y-t-d (up 11.5% over the past 52 weeks). Financial CP jumped $6.0 billion last week to $1.337 Trillion (up 9.7% ann. y-t-d). Non-financial CP dipped $2.1 billion to $148 billion (up 30.2% in 52 wks).
Fed Foreign Holdings of Treasury, Agency Debt rose $8.1 billion to $1.398 Trillion for the week ended May 4. “Custody” holdings are up $63.2 billion, or 13.7% annualized, year-to-date (up $205bn, or 17.1%, over 52 weeks). Federal Reserve Credit was about unchanged for the week at $786.5 billion. Fed Credit has declined 1.5% annualized y-t-d (up $44.3bn, or 6.0%, over 52 weeks).
ABS issuance slowed to $9 billion (from JPMorgan). Year-to-date issuance of $213 billion is 12% ahead of comparable 2004. At $142 billion, y-t-d home equity ABS issuance is 20% above the year ago level.
Currency Watch:
Currencies were volatile, with the dollar index mustering a small gain for the week. The “emerging economy” currencies continue to perform well. The Brazilian real traded to a 35-month high and the Mexican peso a 13-month high against the dollar. For the week, the Polish zloty jumped 3.6%, the Brazil real 2.8%, the Turkish lira 2.7%, the Czech koruna 1.9%, and the Chilean peso 1.7%. On the downside, the Iceland krona sank 1.7%, the British pound 1%, the Swiss frank 0.9%, and the Australian dollar 0.7%.
Commodities Watch:
May 5 – Dow Jones (Matthew Dalton): “A group of U.S. power plant owners has sued railroad giants Burlington Northern Santa Fe and Union Pacific Corp. to prevent major rate increases they fear will result from a new policy for setting shipping prices from Wyoming’s Powder River Basin… The change comes as demand for rail services in general and coal shipments in particular have soared. Shippers say the prices being quoted by the railroads are double or even triple the old prices.”
May 6 – Bloomberg (Michael Smith and Claudia Carpenter): “Jose Luis Cutrale, the world’s largest orange-juice producer, said wholesale prices will surge in the next few months and may reach a six-year high as lower production in Florida cuts into global supplies. Orange juice on the New York Board of Trade, up 55 percent from a year ago, will rise 20 percent in the next few months to as much as $1.10 a pound…said Cutrale, whose family owned company, Sucocitrico Cutrale Ltda., makes one in every four glasses of orange juice consumed on the planet.”
June crude oil rose $1.24 to $50.96. For the week, the CRB declined 1.1%, lowering y-t-d gains to 5.8%. The Goldman Sachs Commodities index was about unchanged, with 2005 gains at 13.9%.
China Watch:
May 2 – Bloomberg (Clare Cheung and Helen Yuan): “New home prices in Shanghai, China’s biggest commercial city, fell last month after the government raised interest rates and tightened rules for mortgages. Average prices fell 9 percent to 8,097 yuan ($978) a square meter…”
May 2 – Bloomberg (Clare Cheung): “Hong Kong’s property sales reached an eight-year high in April, due to strong demand for new homes... There were 14,268 transactions, valued at HK$43.04 ($5.52 billion), as of April 27, the Hong Kong-based newspaper said… The value was the highest since November 1997…”
Asia Boom Watch:
May 4 – Bloomberg (Amit Prakash): “Finance ministers from Japan, China, South Korea and Southeast Asia said they will try to boost spending at home to help sustain economic growth this year. ‘To sustain the economic growth of the region, particularly against the potential risks of persistently high oil prices and global imbalances, we reiterated our commitment to implement structural reforms as well as to take appropriate macroeconomic policy measures, including policies to promote domestic demand-driven growth,’ they said in a joint statement after meeting this afternoon in Istanbul.”
May 4 – Bloomberg (Alan Ohnsman): “Toyota Motor Corp., Honda Motor Co. and Nissan Motor Co. led Asian carmakers to record U.S. market share in April, as they challenged the dominance of domestic companies in the light-truck and sport-utility vehicle markets. Asian companies had a 37.5 percent share of new car and light truck sales last month, Autodata Corp. said… Nissan’s sales rose 32 percent, Toyota’s climbed by 26 percent and Honda’s gained 18 percent. Sales fell 3.9 percent for General Motors Corp. and 1.5 percent for Ford Motor Co. ‘It’s product, product, product on one side, and a lack of strong competing models on the other,' said Eric Noble, president of Car Lab… Asian brands ‘have been setting the pace on the passenger-car side, and now they’re starting to set the pace’ in light trucks.”
May 5 – Bloomberg (James Peng): “Taiwan’s foreign-currency reserves, the third-highest in the world, rose in April to a record $253 billion, boosted by ‘substantial’ foreign capital inflows and investment returns…”
May 5 – Bloomberg (Seyoon Kim): “South Korea plans to double the property holding tax after President Roh Moo Hyun’s administration vowed to end real estate speculation.”
May 4 – Bloomberg (Laurent Malespine): “Thailand’s tax revenue rose 11.8 percent in April from a year earlier, boosted by a continued increase in corporate and sales tax receipts.”
May 4 – Bloomberg (Stephanie Phang): “Malaysia’s exports rose 16 percent in March, a gain that exceeded the most optimistic forecast by economists, led by shipments of electronics, oil and gas. Exports rose to a record 46.67 billion ringgit ($12.28 billion) from a year earlier…”
May 5 – Bloomberg (Francisco Alcuaz Jr.): “Philippine consumer prices rose 8.5 percent from a year earlier in April, more than economists expected.”
Global Reflation Watch:
May 6 – Bloomberg (Theophilos Argitis): “Canadian employers added a more-than-expected 29,300 workers in April, pushing the jobless rate to the lowest in 4 1/2 years… The report may prompt the central bank to raise interest rates by July, some economists said. The unemployment rate fell to 6.8 percent, the lowest since December 2000…”
May 3 – Bloomberg (Alex Tanzi): “The number of bankruptcies filed in Canada fell 9.1 percent in March to 8,537 from 9,393 the same month a year ago…”
May 4 – Bloomberg (Fergal O’Brien): “Ireland’s central bank raised its 2005 economic growth forecast to 5.5 percent as rising employment boosts consumer spending and construction increases. It would be the 11th year in 12 that Ireland is the fastest-growing economy among the dozen nations sharing the euro.”
May 3 – Bloomberg (Gonzalo Vina): “An index of U.K. retail sales fell the most since July 1992, adding to evidence of weakening consumer spending and boosting the chance the Bank of England will leave interest rates on hold in coming months.”
May 5 – Bloomberg (Halia Pavliva): “Russia’s central bank added $2.8 billion to its foreign currency and gold reserves in the week to April 29, increasing its reserves to a record $144.1 billion…”
May 2 – XFN: “Domestic sales of new cars, trucks and buses, excluding mini-vehicles, rose 10.8% in April from a year earlier to 262,983 vehicles, only the third increase in 15 months, the Japan Automobile Dealers Association (JADA) said.”
May 3 – Bloomberg (Tracy Withers): “Reserve Bank of New Zealand Governor Alan Bollard said underlying demand and inflation pressures in the economy ‘remain strong,’ which may prompt him to raise interest rates again. ‘Economic data suggests that underlying demand and inflation pressures remain strong and that, in this environment, further policy tightening cannot be ruled out,’ Bollard said…”
Latin America Watch:
May 2 – Bloomberg (Daniel Helft and Andrew J. Barden): “Argentine tax revenue rose 32 percent in April as the economy expanded.”
May 4 – Bloomberg (Daniel Helft and Eliana Raszewski): “Argentina’s annual inflation rate held near a 22-month high in April as rising wages fueled consumer demand and pushed up costs at companies such as automaker DaimlerChrysler AG. Consumer prices rose 0.5 percent last month and 8.8 percent in the 12 months…”
May 4 – Bloomberg (Alex Kennedy): “Venezuela Finance Minister Nelson Merentes said he expects the country’s economy to grow more than 5 percent this year as increased oil income boosts government spending.”
May 4 – Bloomberg (Andrea Jaramillo and Helen Murphy): “Colombia’s economy may expand this year more than the 4 percent the government has forecast as construction and consumer demand continue to grow, said central bank chief Jose Dario Uribe.”
May 4 – Bloomberg (Danny King): “Mexico City Mayor Andres Manuel Lopez Obrador, the frontrunner in next year’s presidential election, has the country’s ruling class and analysts in other countries concerned that he will lead a leftist-revolt against U.S. policies, the New York Times reported. Lopez Obrador, like Venezuela President Hugo Chavez and Brazil President Luiz Inacio Lula da Silva, may challenge U.S. economic policies that have widened the gap between the wealthy and poor, the newspaper said.”
Speculative Financial Bubble Watch:
May 2 – Bloomberg (Karen Brettell): “Hedge funds owning some pieces of so-called collateralized debt obligations are concerned rising debt protection costs on companies including General Motors Corp., will trigger a CDO selloff, Derivatives Week said. Banks create CDOs by bundling together assets and using income on those assets used to repay investors. In synthetic CDOs, the assets are credit-default swaps, which pay holders a premium to insure against non-payment of debt. Many hedge funds have purchased the so-called equity pieces of synthetic CDOs, which are the riskiest and highest paying pieces, and purchasing default protection on single names to protect against moves by individual credits in the deals…”
May 5 – Financial Times (Florian Gimbel): “One of Singapore’s biggest hedge funds is thought to be facing significant derivatives trading losses, following the resignation of one of its main fund managers. Aman Capital Management yesterday confirmed that its $242m hedge fund had suffered ‘trading losses in April’ which have raised concerns about its internal risk controls. The company also confirmed the departure of Michael Syn, a former derivatives specialist at UBS, the Swiss banking group.”
Dollar Consternation Watch:
May 5 – Bloomberg (Lindsay Whipp): “Japanese Finance Minister Sadakazu Tanigaki said today Asia needs to press ahead with the creation of a bond market so more of the region’s savings can be invested locally. ‘We do have within this region an ample amount of funds and savings available and we need to see these ample funds recycled within the region,’ he said at a press briefing in Istanbul, where he is holding talks with other Asian finance ministers and attending the Asian Development Bank’s annual meeting… Malaysia’s second Finance Minister Nor Mohamed Yakcop said…that Asia needs to use more of its ‘more than $1 trillion in reserves’ for regional investments. ‘It is ironic that while Asian countries have the necessary financial resources to be tapped upon to underwrite costs for the region's development, Asian savings are often intermediated outside Asia,’ said Nor…”
May 5 – Bloomberg (Rob Delaney): “Taiwan’s central bank Governor Perng Fai-nan today called on his Asian counterparts to work toward establishing a body that would stabilize exchange rates in the region. We should ‘set up a formal regional exchange-rate coordination mechanism through which stable currency relationships can be established’… An effective mechanism ‘not only contributes to regional economic stability but also further promotes trade and investment…’”
May 4 – Bloomberg (Lindsay Whipp): “Japanese Finance Minister Sadakazu Tanigaki said Japan will manage its foreign-exchange reserves to help foster stability rather than maximize profit and urged China and South Korea to also act ‘responsibly.’ Japan’s reserves totaled $837.7 billion at the end of March, China’s amounted to $659.1 billion and South Korea’s stood at $205.2 billion… ‘The foreign reserve amounts are considerably large,’ Tanigaki said last night after meeting his Korean and Chinese counterparts for talks in Istanbul. ‘Each country has its own individual measures for the way they invest them, as does Japan, China and Korea. Because the volume is so big, they need to be handled responsibly.’”
Bubble Economy Watch:
May 4 – American Banker: “The value of purchases on MasterCard International-branded Credit and debit cards increased 11.4% to $277.2 billion, in the first quarter… It issued 697.9 million cards in the quarter, 11.2% more than a year earlier.”
May 5 – Reuters (Emily Kaiser): - “U.S. luxury and teen-oriented retailers on Thursday reported better-than-expected April sales, while discount chains sputtered as soaring gasoline prices and unusually chilly weather curbed consumer spending. Neiman Marcus Group Inc., Nordstrom Inc. and Macy’s and Bloomingdale’s… all turned in strong results, powered by demand for designer clothing and handbags, jewelry and shoes.”
May 5 – AP: “It’s only on the drawing boards, but a developer is proposing to build the world's tallest condominium tower in downtown Miami. Leon Cohen bought the property Monday for $31.7 million and is preparing to submit plans for a 110-story tower that would be 1,200 feet tall. A companion tower of the same height would be a combination hotel-apartment building.”
May 3 – Bloomberg (Courtney Schlisserman): “The number of job cuts announced by U.S. employers fell last month to the lowest level in almost five years, suggesting an improving labor market. The 57,861 job cuts announced last month were 20 percent less than the same month a year ago and 33 percent less than March’s total, Challenger, Gray & Christmas Inc. said…”
May 3 – “Mercedes-Benz USA today reported its highest April on record with sales of 18,805 new vehicles, up 2.3 percent compared to last April.”
California Bubble Watch:
May 5 – San Diego Union-Tribune: “Southern California households on average fall nearly $60,000 short of the qualifying annual income needed to buy a median-priced home in the region, according to a report released today. The quarterly report from the California Association of Realtors shows that the median home price in the Southland for the first quarter of 2005 was $477,660, while a median household income was $52,050. That’s less than half what it would take to afford a median-priced home, for which monthly payments, taxes and insurance would total about $2,780, according to CAR.”
May 2 – Bloomberg (Amy Strahan): “Housing prices in Fresno and the San Bernardino areas of California rose 58 percent during the past three years, leading the list of 55 U.S. metropolitan areas with booming real estate markets, according to an analysis by the Federal Deposit Insurance Corporation. Most of the price appreciation occurred on the coasts, with 21 of the 55 boom markets in California, 18 in New England and 11 in Florida, the FDIC said. Overall price increases in the fastest-growing markets averaged 42 percent over three years, compared with a 20 percent average increase nationwide.”
Mortgage Finance Bubble Watch:
May 5 – American Banker (Jody Shenn): “Many economic cycles hence, historians looking back at the first years of the 21st century will count them among the most misguided or innovative periods in residential real estate lending. Or maybe they will simply number them among the industry’s luckiest. Credit quality is why. Over the past 18 months the mortgage industry has undergone a revolution in the way it lends and in the kind of loans it makes. But a robust debate has sprung up as to whether this revolution has been a good thing, even as credit quality has risen to unprecedented heights. In dozens of recent interviews with lenders, regulators, insurers, investors, analysts and other experts, American Banker found a high degree of concern about how well the risks of loans being written today are understood and the possibility of adverse consequences of varying degrees.”
May 3 – Dow Jones (Dawn Kopecki): “The rising tide of investors hoping to cash in on the hot U.S. housing market is worrying some top industry executives, who said Monday the rapid growth in home prices fueling demand for residential real estate is not sustainable. ‘We have run out of adjectives to describe the housing market. Resilient doesn’t seem to do it justice,’ Nicolas Retsinas, director of Harvard’s Joint Center for Housing Studies... The market has responded to the threat of higher interest rates by offering borrowers a bevy of new mortgage products that target consumers willing to take on greater risk against rising interest rates, such as interest-only and adjustable-rate mortgage loans. The proliferation of such products, which generally offer low monthly payments in the first few years of the loan and higher payments as interest rates rise, have further fueled demand by extending credit to many borrowers and investors who might not otherwise qualify for financing.”
May 3 – Dow Jones (Campion Walsh): “The number of local real estate ‘boom’ markets across the U.S. grew nearly two-thirds last year to 55, the Federal Deposit Insurance Corp. said… Adding more recent data and analysis to a study released in February, FDIC economists Cynthia Angell and Norman Williams reiterated their view that new credit market conditions may make current housing market booms different than past ones, which have tended to taper off rather leading to busts. ‘To the extent that credit conditions are driving home price trends, the implication would be that a reversal in mortgage market conditions – where interest rates rise and lenders tighten their standards - could contribute to the end of the housing boom…’ The current 55 residential real estate boom markets are more than twice the peak of the late-1980s booms…”
May 4 – American Banker (Rob Blackwell): “Fannie Mae has announced that it will begin purchasing 40-year fixed-rate loans from lenders, saying that doing so could help borrowers in areas where home prices are high… It said that such loans reduce monthly payments and make it easier for borrowers to get approved.”
Earnings Watch:
Mortgage REIT New Century Financial reported strong first quarter growth. “The company originated $10.3 billion of mortgage loans in the first quarter of 2005, a 22 percent increase compared with…the same period in 2004.” Total Assets expanded at a 57% annual pace to $21.7 billion. Assets were up 122% from one year ago and were up from $2.8 billion at the end of Q1 2003.
Hooked on “The Hand”:
Alan Greenspan spoke (via satellite) yesterday to the Federal Reserve Bank of Chicago’s Conference on Bank Structure. His speech was titled “Risk Transfer and Financial Stability” and is available at the Federal Reserve’s website.
From the Q&A session:
Question: “Can more (hedge fund) transparency be required – should it be required?”
Chairman Greenspan: “You have to remember, that the one extraordinary important issue relating to the hedge funds is they act to increase liquidity in markets. And you have to be very careful to make sure that, on the one hand, that the hedge funds are completely transparent to their investors and that the investors are acutely aware of the nature of the risks and the level of the risk they are taking. But you also have to be careful about imposing regulation on these funds to the extent that you inhibit their actions. Remember, collecting data on hedge funds may appear to give you a degree of transparency, but most of the data you get – at best – will tell you about their strategy of last night. This morning they have a new one. Consequently, the type of data which is supposedly to be collected to create a degree of transparency and knowledge about how these funds are behaving is actually history. And it’s usually quiet unusable, because it’s their very nature to be innovative, changing and never actually to anticipate necessarily what they are going to find next in the marketplace which will suggest to them some imbalance – some potential exceptionally large profit arbitrage which they haven’t even anticipated would exist 48 hours earlier. So I think the question here is to be very careful to be sure that the people we want to protect are the counterparties to the hedge funds – meaning they have to get all the information that they need. And that will protect the marketplace and all their investors.”
Question: “Are there any financial crises brewing at the moment?”
Chairman Greenspan: “Well, not really. I mean, the problem that I have is that crises that you can see are probably already behind us. You have to remember, that the vast majority of imbalances that occur in markets are addressed very quickly by prices and we never hear of them. So, it strikes me that what we have to recall is the terrific insight of Adam Smith that there is something equivalent to an ‘invisible hand’ which continuously is readdressing market imbalances towards equilibrium is indeed what we are seeing virtually everyday – in fact, every hour and every minute – in the markets in which we deal. And I would suspect that the international context – looking at the increasing degree of globalization that we see almost on a day-by-day basis – that there is something attuned an international invisible hand that seems to be at work. Markets are always by their nature driving towards equilibrium. It looks as though it’s chaos- indeed it’s that chaos which was disposed of by Adam Smith in the great insights of more than 200 years ago – which in some respects hold up with very little revision to this day. In a certain sense that so called ‘creative destruction’ in markets which is what Schumpeter defined the process as many, many years later obviously, is a continuous train which is always creating a sense of nervousness about something going wrong. In fact, it’s normal. And it strikes me that crises are very difficult to forecast. Or, let me put it another way: the numbers of forecasts of crises that one gets day-by-day, week-by-week, is far in excess of the number of crises that actually occur. This is the reason why I’ve argued previously that since we really cannot know that we are about to get a crisis until we are right up against it, economic policy-making should be heavily focused on the issue of creating and sustaining the flexibility of markets so that when we get pressures of one form or another, the markets respond in a balanced manner and essentially remove the disruptions that are causing the difficulties.”
It is inadvisable to have one man singularly reign over monetary policy-making for 18 years. It is potentially disastrous when this individual is an ardent ideologue. And one of the painful lessons that will be ascertained from this experience is that the greatest risk with regard to discretionary monetary policy is the propensity for policy errors to engender only greater errors – along with a lot of rationalizations.
As chairman Greenspan’s views harden and become increasingly fanatical, identifying serious analytical errors is a less demanding endeavor. He has grown comfortable making grand economic declarations, ignoring the reality that many are valid only in an environment of sound and stable “money”/finance. Adam Smith’s wonderful “invisible hand” insight was made in the context of forces governing the mutually beneficial exchange of tradable goods. It is an Economic Sphere concept that certainly cannot be haphazardly projected to contemporary electronic markets for securities, derivatives and other financial instruments. As we have witnessed, an environment of Credit and liquidity excess will foster asset price distortions, speculation, and boom and bust cycles in the Financial and Economic Spheres. Unbounded finance nurtures self-reinforcing excess and distortions, the antitheses of the “invisible hand.”
Moreover, Mr. Greenspan’s assertion that “markets are always by their nature driving towards equilibrium” is categorically false. This is instead a holdover notion from Milton Friedman’s flawed belief that there is no such thing as “destabilizing speculation.” I have no qualms with the analysis that a well-anchored Financial Sphere and system pricing mechanisms will (generally) entice enterprising speculators to act when prices stray from normal bounds. In such an environment, capitalizing on speculative opportunities will tend to stabilize the system, pressuring markets back to the so-called “equilibrium” level.
Importantly, however, the financial backdrop plays a decisive role with regard to the character of - and ramifications for - speculative market dynamics. As much as a culture of sound finance tends to cultivate stabilizing speculation, profligate and unhinged finance promotes the opposite. Speculative profits become more easily captured betting that prices will continue to inflate away from normal bounds. Moreover, as Credit and speculative excesses fuel rising prices, myriad inflationary manifestations promote additional Credit and liquidity excesses. Financial Sphere excesses tend to stimulate the Economic Sphere, seductively validating the financial claims and asset inflation. Over time, as a system falls deeper into Credit Bubble dynamics, there will be an overwhelming propensity for destabilizing speculative dynamics and consequent asset price Bubbles. Left to its own devices, the Credit system will eventually succumb to dangerous speculative blow-offs. And if this Macro Credit Analysis is less than persuasive, there are hundreds of years of market history and scores of spectacular Bubbles (several over the past two decades) that are inconsistent with Mr. Greenspan’s market claims.
I am sticking again this week with Financial and Economic Sphere analysis, hoping this framework helps to clarify an especially unclear environment. I will this evening assume that today’s strong employment data will only soften the bond market’s “softpatch” fixation and the contention of many that the Fed has about completed its rate normalization project. Still, it does support my view that the Economic Sphere weakness is not the key dynamic driving markets. I take the general view that news and analysis follow the markets and not vice versa, and we have experienced an extreme example of this dynamic over the past two months. While a spate of softer data certainly didn’t hurt, I suspect that internal Treasury (and interest-rate, GM and CDS) market dynamics have played the key role in the recent rate decline and overall interest-rate volatility.
Ten-year Treasury yields traded at 3.99% on February 9th, surged to 4.64% by March 22nd, before sinking back to 4.15% yesterday (jumping 11bps today). And, let me confess, it is one thing suggesting readers be prepared to endure “manic-depressive” market behavior and quite another actually witnessing it firsthand. March’s perception of overheating morphed into April’s fears of a rapidly decelerating U.S. and global economy. Increasingly, data suggests that March’s softness did not carry into April. Perhaps the confluence of March’s surge in market yields, the media’s preoccupation with much higher rates to come, the public obsessing over daily mortgage rates as they did NASDAQ prices during 1999/2000, the spike in crude and gas prices, and general financial market tumult provided a temporary drag on U.S. activity – possibly compounded by the quarter-end timing of various negative factors. The financial horse continues to pull (and jounce) the economic cart.
There is a prevailing view that economic vulnerability precludes the Fed from significant further tightening. The unfolding issues with auto and auto-related debt and derivatives only add to the litany of financial sector fragilities. Even the discerning Stephen Roach made an abrupt u-turn after two weeks back arguing that a 5.5% Fed funds rate might be required. This week he suggested the Fed may be done. Sticking to their guns, the gentlemen at Pimco argue the Fed must soon end its tightening campaign or risk recession for the overleveraged, finance-based U.S. economy. I will dig in my heels and disagree. The Fed still has much work to do, acute financial fragility notwithstanding.
First of all, there is at this point absolutely no way around financial crisis and recession. And while there is the understandable preference to delay one’s comeuppance, when it comes to monetary and economic management it is of utmost importance to accept responsibility and take the pain early. The Financial Sphere has inflated dangerously and sustaining this Bubble is a precarious losing proposition. The wildly maladjusted and unbalanced U.S. economy must suffer through a wrenching adjustment period. Historic excess throughout mortgage finance must be reined in. The U.S. Current Account Deficit must be brought under control. The vulnerable dollar must be supported with significant yield differentials. The global economy must be weaned from the massive destabilizing pool of largely dollar-denominated liquidity.
The bottom line is that the Fed faces an enormously arduous task dealing with these now intransigent imbalances. The wildly inflated and dysfunctional Financial Sphere is not about to magically transform itself into a mechanism soundly financing a stable and well-balanced Economic Sphere. Powerful Monetary Processes must be contained (and eventually eradicated) and the adjustment process commenced. Three percent Fed funds is not up to the task, and fear of the unavoidable adjustment process is not pardonable analysis.
I find recent “neutral rate” discussions interesting, although generally misplaced. There is a decided Economic Sphere focus: what Fed funds target rate would today put the economy “on a trajectory of sustainable non-inflationary growth?” Well, with real GDP growth supposedly moderating and narrow aggregate measures of consumer price inflation still rather tame, most analysts feel today’s rate is just fine and see little justification for tighter monetary policy. And I would not take such strong exception with this analysis in a stable Financial Sphere environment. But today the paramount issue with regard to interest-rate “neutrality” is stabilizing the Financial Sphere Bubble. And, importantly, it is not a case of whether or not the financial Bubble bursts. The stakes include outright financial collapse.
Even those integrating the financial environment into their analysis argue that recent market turbulence should force the Fed to soon terminate rate increases. Yet a strong case can be made that the prominent effect of heightened market stress is, to this point, a decline in mortgage borrowing costs – exactly what the system does not need. Throwing GM and Ford on the junk heap only has MBS (and mortgage loans) glistening more radiantly. As such, liquidity and Credit Availability may be somewhat more restrained for fringe corporate borrowers. Meanwhile, the Mortgage Finance Bubble receives wanton stimulus. Weighing one against the other, there is today little systemic Credit restraint and only further evidence of Financial Sphere Dysfunctionality. The experiment to ease the Credit Bubble down softly is, not surprisingly, failing.
And I passionately argue that the focal point for any contemporary conceptualization of interest-rate neutrality must be the identification of the principal means of systemic Credit and liquidity creation. If, as in the past, financing capital investment provided the key source of system liquidity, a “neutral rate” would be expected to correspond to the “return on capital” and corporate profitability, more generally. Today, on the other hand, Federal Reserve policymakers and pundits should recognize and incorporate into their analysis the fact that mortgage Credit and speculative leveraging are today the overwhelming source of system liquidity. Gross excess emanating from the Mortgage Finance Bubble fuels Financial Sphere inflation and consequent Monetary Disorder. And I can certainly appreciate why the Fed and Wall Street pundits avoid this issue like the plague. But this does not change the reality that only significantly higher mortgage rates will, at this point, stem gross excesses. The cost of being so far for so long behind the curve.
Mr. Greenspan’s comment that hedge funds “act to increase liquidity in markets” must make central bankers in Malaysia, Thailand, South Korea, Argentina and elsewhere bristle. Even we experienced hints of what hedge fund liquidations can do to marketplace liquidity back in 1994 and again during 1998. Our Fed chairman would more accurately state that hedge funds increase marketplace liquidity when the industry is receiving inflows, increasing leverage, and expanding positions. Under Mr. Greenspan’s watch, The Community created incredible liquidity in an expanding array of markets globally as it mushroomed from a couple tens of millions to surpass $1 Trillion in investor assets (position sizes significantly larger).
Mr. Greenspan’s protracted chairmanship has provided an astonishing windfall (wealth transfer) to the leveraged speculating community. The Fed’s decision to peg short term rates, the assurances of continuous marketplace liquidity, and moving to extraordinary transparency, along with the more recent promises of helicopter money and unconventional measures as necessary, were all major factors in nurturing exceptional speculator profits. And during the early nineties and throughout the past four years the Fed stimulated the system with ultra-low borrowing costs. The speculators were right there to take full advantage – building leverage, positions, and marketplace liquidity all along the way. There was also the explosion of GSE debt and MBS with implied government guarantees, a god-send for the mushrooming spread trade and derivatives markets. Greenspan’s public advocacy of derivatives and structured finance played a pivotal role in their respective ballooning growth. And while Mr. Greenspan trumpets Adam Smith’s “invisible hand,” I have in the past labeled the government’s towering market presence and interest-rate manipulation as “The Hand.” The relative degree of Mr. Greenspan’s faith in the “invisible hand” of free markets versus “The Hand” commanding speculative pursuits and a runway Credit Bubble is an epochal open question.
Not unjustifiably, the marketplace perceives that the leveraged speculating community is much “too big to fail.” This perception is an important aspect of the powerful inflationary bias (proclivity for higher prices/lower rates) that perseveres throughout the bond market (and stokes the destabilizing Mortgage Finance Bubble). At the first sign of system stress – GM debt problems, for example – Treasury, agency and MBS yields head lower. This ushers in “The Conundrum” – or the necessity for the huge amount of hedges against higher interest rates to be unwound, while hedges for protection from lower rates are implemented. And let's not forget the speculators intent on buying ahead of the derivative traders. The entire process has worked swimmingly to sustain excesses and avoid commencing the necessary adjustment process (although it does seem to have taken on a wrecking ball effect of late).
The question I have revolves around the possibility that Fed and leveraged speculating community interests have diverged. Perhaps Mr. Greenspan really believes that the economy and financial system are resilient and that the Fed shouldn’t be all too concerned about the risk of crisis. Could the Fed really have one eye on conspicuous excesses in mortgage finance and the other on the Current Account Deficit and vulnerable dollar? Is the Greenspan Fed prepared to call the markets bluff - to raise rates and let the “invisible hand” work its magic? This would be one hell of a change for a marketplace having grown So Hooked on “The Hand.” And, while I am daydreaming, wouldn’t it be ironic if the Fed finally attempts to find a little central banker religion right as leveraged player vulnerability and systemic fragility really begin to manifest.
