05/08/2003 The Stark Contrasts between Competing Central Banks *

Equities were choppy this week, although with an upward bias.  The Dow, S&P500, and Transports ended the week with small gains.  The Utilities and Morgan Stanley Cyclical indices added about 1%, while the Morgan Stanley Consumer index was unchanged.  The broader market outperformed the major indices.  The small cap Russell 2000 gained about 1.5%, with the index now up 21% from its March 12th low.  The S&P400 Mid-cap index added 1%.  The technology sector continues to outperform.  The NASDAQ100 rose 1%, with year-to-date gains of 16%.  The Morgan Stanley High Tech index added 2.5% and the Semiconductors 2%.  The Semis now sport a 2003 gain of 21%.  The Street.com Internet index increased 2%, with y-t-d gains of 28%.  The NASDAQ Telecommunications index added 1%, raising its 2003 advance to 21%.  The Biotechs bucked the trend, declining almost 2% this week.  The financial stocks were mixed.  The Securities Broker/Dealer index added 2%, while the Banks declined 1%.  With bullion up $7.60, the HUI gold index rose 2%.  The dollar index dropped about 2%, With help from the Fed, the Credit market melt-up has resumed.  For the week, two-year Treasury yields dropped 12 basis points to 1.44%.  The five year saw yields collapse 32 basis points to 2.51%, while the 10-year yield sank 26 basis points to 3.66%.  The long-bond yield declined 16 basis points to 4.67%.  Mortgage-backed and agency yields sank along with Treasuries.  The spread on Fannie’s 4 3/8 2013 note narrowed six to only 34.  The 10-year dollar swap spread declined 3.5 to 33.  The continuing historic collapse in spreads also helped corporates again this week, although junk bonds sputtered moderately after recent spectacular gains.  Companies issued more than $15 billion of debt this week, while the federal government sold a record $58 billion of Treasury notes.  GE Capital led with $4 billion ($6 billion in two weeks), GMAC $1 billion, American International Group $1.5 billion, Primedia $300 million, Gabelli Asset Management $100 million, Arizona Public Service $500 million, NY State Electric & Gas $200 million, Monsanto $250 million, Maytag $200 million, WMC Finance $700 million, National City $300 million, New York Life $1 billion, Viacom $750 million, and Lin Television $300 million.  Although spreads widened marginally, the junk bond market enjoyed another solid week of issuance (the previous week saw the most junk sales in three years).  Nextel Partners sold $100 million of converts, Speedway Motor Sports $230 million of bonds, CB Richard Ellis $200 million, Thornburg Mortgage $200 million, Avaya Inc. $640 million, Royal Caribbean $250 million, Titan $200 million, Key Energy $150 million, Evergreen International $215 million, Flextronics $400 million, Starwood Hotels $300 million, Avon Products $125 million, Oxford Industries $200 million, RPM International $125 million, and Wimm-Bill-Bann $150 million.  Bloomberg’s year-to-date tally of Total U.S. Domestic Debt sales is running up 24% from last year at $745 billion.  The week saw about $4 billion of asset-backed securities issued.  Year-to-date issuance of $144 billion is running up 18% year-over-year. Dollar weakness accelerated, as it continued to broaden.  The dollar ended the week at almost 115 to the euro.  The Mexican Peso rose to about a five-month high, while the Argentina peso jumped to a 13-month high (up 21% against the dollar so far this year).  The Brazilian real rose to a nine-month high, with year-to-date gains of 23%.  The benchmark Brazilian bond yield has collapsed from almost 21% in December to about 10% this week.  The CRB index jumped 3% to the highest level in almost two months.  Wheat today enjoyed its largest jump in seven months, with soybeans rising to the highest price in almost five years.   Broad money supply (M3) surged $55.4 billion last week, bringing 12-month growth to 7.2%.  Demand and Checkable Deposits added $5.7 billion. Savings Deposits jumped another $34.4 billion, increasing the 12-month growth rate to an eye-opening 19.3%.  Small Denominated Deposits dipped $2.1 billion, while Retail Money Fund deposits gained $6.4 billion.  Institutional Money Fund deposits added $2.6 billion and Large Denominated Deposits gained $8.4 billion.  Repurchase Agreements increased $1.1 billion, while Eurodollars declined $1.1 billion.  Elsewhere, Commercial Paper declined $2.0 billion, after surging $23.9 billion the previous week.  Non-financial CP is down $10.4 billion over three weeks, while Financial CP is up $19.2 billion.  Asset-backed Commercial Paper is up $33.7 billion over two weeks to the highest level since early January.  Already rapid Credit inflation from the Banking sector has accelerated.  Total Bank Assets jumped $94.5 billion last week ($127.9 billion over two weeks), increasing year-on-year growth to 11.7%.  Securities Holdings increased $35.7 billion last week, this after the previous week’s $53.1 billion expansion.  Bank holdings of mortgage-backed securities jumped $68.4 billion over two weeks.  During the past 52 weeks, Securities Holdings are up $309 billion, or 20.5%.  Over the same period, Real Estate loans are up $317 billion, or almost 18%.  Commercial and Industrial loans, on the other hand, are down $59 billion, or 6%.  The Credit system simply could not be more unbalanced or asset market-centric.  Economic data, not surprisingly, remain mixed and inconclusive.  Manufacturing continues to struggle, although Factory orders posted a stronger-than-expected gain of 2.1%.  We will, however, pay closest attention to the expansive “services” arena for clues to economic performance.  After all, many areas within the service sector maintain an inflationary bias and should be expected to respond to recent acute monetary stimulus.  The ISM Non-Manufacturing index was reported at a stronger-than-expected 50.7, up from March’s weak 47.9 reading.  New Orders were back above 50, while New Export Orders added four points to 52.5.  Elsewhere, weekly bankruptcy filings increased to 34,899, up 10% y-o-y.  And speaking of “inflationary bias,” week 46 of the Mortgage Finance Bubble blow-off saw the Mortgage Application index surge 19% to the sixth highest level on record.  Refi Applications jumped 19% for the week, and were up 247% from one year ago.  And, notably, Purchase Applications surged almost 18% to a new record (up 35% from February lows).  And while the number of Purchase Applications were 9% above a strong year ago level, in dollar terms applications were up better than 16%.  And with rates again collapsing (Credit market dislocation?), I expect mortgage applications to move only higher in the weeks ahead.  May 5 – Bloomberg:  “U.S. condominium and cooperatively owned apartment sales rose to a record in the first quarter, spurred by mortgage rates at four-decade lows, according to the National Association of Realtors. Sales rose 3.2 percent to 846,000 at a seasonally adjusted annual rate, from 820,000 in the prior quarter… The previous record was 824,000 set in the second quarter of last year… The median, or mid-point, price for condominiums was $150,700, 13 percent higher than the year-ago quarter.” May 6 – BusinessWire:  “Three years ago, a confluence of factors began to foster optimum conditions for record issuance growth in the U.S. RMBS market. However, according to panelists speaking at this year’s Standard & Poor’s Structured Finance Seminar…, that incredible rate of growth cannot be sustained for much longer.  ‘It is unusual to have such a significant drop in interest rates and appreciation of real estate prices simultaneously,’ said Rod Dubitsky, director, Mortgage ABS Research, Credit Suisse First Boston… In the first quarter of 2003, issuance of nonconforming mortgage products soared, up 42% over 2002’s first quarter, marking the fifth consecutive quarter of increasing issuance activity.” May 2 – Bloomberg:  Franklin Raines:  “This is going to be probably the best year in Fannie Mae’s history, powered by the biggest year for mortgage originations in U.S. history and another great year for housing. ‘We’ll be able to do’ at least 10 percent this year ‘easily,’ he said. ‘And we expect because the housing market is going to keep growing by 8 percent to 10 percent over the next decade, that we have a good shot of double-digit growth over the next decade,’ he said… On Fannie Mae’s forecast for more than $3 trillion in mortgage originations this year, compared with the Mortgage Bankers Association of America's $2.6 trillion estimate: ‘We’re seeing what is happening in the first half. Most of it will happen in the first half, and so most of it is already in the bank,’ he said.”            May 1- Dow Jones (Stan Rosenberg):  “A combination of low interest rates and the opportunity to refund higher-rate debt continues to drive new issuance volumes in the municipal bond market to record levels. But it remains to be seen whether this torrid pace can be maintained.  Sales of new issues by state and local governments for the first four months of the year soared to $113.5 billion, surpassing last year’s $94 billion and marking the first time the $100 billion level was breached for the 4-month period, The Bond Buyer…reported Thursday.” May 2 – American Banker (Marc Hochstein):  “Big mortgage lenders know that sooner or later this refinancing boom is going to end, the easy money will go away, and they will have to make more home-purchase loans to survive.  Homebuilders Financial Network, a Miami Lakes, Fla., firm that runs loan brokerage operations, knows it too.  It also knows that, as a reliable source of purchase loan volume, it wields considerable bargaining power with the wholesalers that fund its loans.  This is why it can make some pretty audacious requests with a straight face.  The latest:  It wants authorization to offer a riskier version of the 2-1 buydown loan.  A buydown is a fixed-rate mortgage with a deeply discounted teaser period; the rate increases a point each year for the first two years, then remains fixed…for the next 28 years.  Homebuilders Financial is trying to create a buydown product, with no prepayment penalty, that finances 80% of the home’s value, packaged with a second mortgage for the other 20%.  The builder would pay for the closings.  That means the homebuyer puts zero cash in, does not buy mortgage insurance, and can refinance or sell the home before the teaser period ends.  Oh, and could you give that same borrower the option to pay interest only for the first ten years?” The Street was all lathered up over MBIA’s 47% earnings increase, although insurance revenues were up “only” 11%. From the company’s earning release:  “Domestic municipal issuance in the first quarter…was $84.6 billion, a 25 percent increase.”  “Worldwide securitization volume was robust in the first quarter, increasing 24 percent over the same period last year.  A 46 percent decrease in worldwide CDO volume was offset by growth in U.S. public asset-backed securities and mortgage-backed securities.”  The company’s Net Debt Service Outstanding (NDSO) increased $11.7 billion during the quarter (6.0% annualized) to $793.3 billion.  NDSO was up 9.2% y-o-y.  Total Assets were up 21.8% y-o-y to $19.3 billion.  The company repurchased another 1.25 million shares of its stock during the quarter. The Greenspan Fed this week sank to further depths of misguided central banking, and our dollar suffered accordingly.  Our savings and our foreign Creditors' savings are being devalued, in an unjust and futile attempt to remedy the ills from past incompetent monetary management.  And while the Fed is surely tickled that they retain the awesome power to so easily manipulate both the marketplace (long-term interest rates) and public discourse (deflation talk everywhere), monetary policy is nonetheless impotent to remedy the true ailment.  The fundamental dilemma today is that the Greenspan Fed and Wall Street continue to work diligently (and shrewdly!) to sustain unsustainable Bubbles.  There remains an unprecedented speculative Bubble running out of control throughout the U.S. Credit market (leveraged holdings of agencies, mortgage-backs, corporates, Treasuries, etc.), with consequent liquidity effects.  There is likewise an unparalleled Mortgage Finance Bubble, fueling destabilizing housing inflation, over-consumption, and severe distortions to the nature of lending, spending and investing throughout the entire economy.  The outcome is ballooning financial sector leveraging (exponential growth in non-productive Credit/fragile debt structures), on the one hand, and massive Current Account Deficits and ballooning foreign liabilities on the other.  And, closely related, we are in the midst of an historic “Structured Finance” Risk Intermediation Bubble (The GSE’s, Credit insurers, derivatives markets, Wall Street firms, hedge funds, etc.).  These are categorically Bubbles because they will implode the day additional Credit and speculative excess is not forthcoming.  The Great Experiment that went terribly berserk will definitely not be suppressed by more and easier “money.” Today, the Fed’s egregiously inflationary monetary policy can only exacerbate – and in no way rectify – these historic Bubbles.  And, as we know, these powerful financial Bubbles have over time come to impart extreme deleterious effects on the U.S. Bubble economy.  As the governor of monetary stability, the Fed remains hopelessly lost in a quagmire nurturing disastrous Credit and speculative excess. There is no mystery surrounding dollar weakness and ongoing vulnerability.  The Fed obstinately refuses to admit its mistakes or cut its losses, and I fully expect the sinking dollar to incite unpredictable inflationary manifestations. The bursting of the technology and stock market Bubbles (nurtured by the Fed’s acquiescence of extreme financial excess as well as reckless New Paradigm blather) should have been the first leg of the requisite extensive financial and economic post-Bubble adjustment process.  Regrettably, the Fed’s aggressive “activist” response to the bursting of the equity Bubble was a derelict accommodation (patronage) of the greater Bubbles engulfing the entire Credit system.  The 525 basis point rate cuts and resulting extreme speculative and mortgage lending excesses, while exacerbating financial fragility and economic vulnerability, have done little more than suspend the imbalanced U.S. Bubble economy at tepid growth rates.  We may be in a post-stock market/technology Bubble environment, but we are firmly in the midst of a much grander and problematic financial fiasco.  Nowadays, the Fed has about run out of interest rate bullets and is increasingly desperate.  The risks, both financial and economic, are myriad and great.  Manifestly, the imbalanced U.S. Bubble economy is sustained only with unrelenting Credit excess.  Yet such financial and economic Bubbles are acutely susceptible to rising rates – a traditional market response to aggressive “reliquefication,” surging demand for borrowings, and a plunging dollar.  So the Fed and Wall Street have cleverly concocted the Deflation Bogeyman, that terrible scourge (recall the Great Depression!) that must be fought and conquered at all cost.  Never mind that excessive money supply expansion has been for years unrelenting, that households are taking on new debt at a record pace (double-digit mortgage growth!), that Credit availability is today ultra-easy for most borrowers (consumer, government and, increasingly, businesses), that government deficits are exploding, that our current account deficit is at an alarming 5% of GDP and growing, that import prices are up about 7% y-o-y, that the CRB commodity index is up 19% in twelve months, that gold is up 13%, that energy prices have been surging along with insurance, healthcare, tuition, and housing, and that general consumer price inflation is on an unmistakable rise.  Don’t be fooled.  This issue in the U.S. today is anything but “deflationary” pressures that would succumb to the sword of additional monetary stimuli.  The Fed has boxed itself into the corner of the above noted Bubbles.  It’s inflate or die, postpone the day of reckoning at all costs, and hope for a miracle.  It’s also negligent central banking of historic proportions.  Ironically, Alan Greenspan made the following comments in a speech yesterday on corporate governance and derivatives:  “It is hard to overstate the importance of reputation in a market economy.  To be sure, a market economy requires a structure of formal rules – a law of contracts, bankruptcy statures, a code of shareholder rights – to name but a few.  But rules cannot substitute for character.” Well, we agree wholeheartedly.  Yet there is absolutely no doubt that our central bank is in the process of destroying its reputation as a sound and prudent monetary system manager.  Today’s expedient focus on deflation risk – while disregarding the momentous dangers associated with runaway asset and financial Bubbles – is an act of despicable character.  There will be a huge price for all of us to pay. Surely not coincidently, the day following the Fed’s pronouncement the European Central Bankers made some strong statements related to deflation and sound central banking. The ECB’s views are worthy of our attention.  Reading and listening to recordings of their comments, I was again struck by the Stark Contrast to the economic drivel expounded by Chairman Greenspan and many of our central bankers.  The ECB today is notably informed, astute, focused and disciplined.  As central bankers should be, they remain cautious and conservative. But I also sense an air of confidence becoming of an institution that has achieved the status as the world's premier central bank.  And to appreciate the grounded nature of their monetary analysis and discourse is to recognize that the ECB is clearly winning the battle to manage the world’s premier currency.   Contrarily, the soundness and purchasing power of our currency has been severely and irreparably damaged.  The Greenspan Fed is contemptible.     To illuminate The Stark Contrasts Between Competing Central Banks, I thought it worthwhile to include some pertinent comments made yesterday by ECB officials. ECB President Wim Duisenberg:  “The reasons for not cutting rates were manifold. We need more information about whether recent developments – in particular the exchange rate – will continue or peter out or reverse.  We have to know more.” Wim Duisenberg:  “Since the end of the war in Iraq, financial market volatility has declined significantly, with a notable increase in stock prices. Nevertheless, there continue to be downside risks. First, there are the risks originating from the past accumulation of macroeconomic imbalances outside the euro area, and lately concerns have arisen with regard to the SARS virus.” Wim Duisenberg: “We explicitly do not have an activist short-term oriented policy.  We do not want it.” My comment:  It is the nature of successful central bankers to remain cautious and conservative, with a focus more directed toward monetary stability than economic expansion.  Goals are always long-term and policy is necessarily gradual, incremental, and non-experimental.  The ECB would simply not attempt “activist” policies to manipulate long-term interest rates or to stimulate short-term output growth.  Their overriding focus is on systemic, broad-based monetary and price stability.  The Fed, on the other hand, has for too long acquiesced/accommodated acute monetary instability in hasty pursuit of short-term economic growth catalysts.  This is a losing game and anathema to prudent central banking.  It is also interesting to note the ECB comment, “There are risks originating from the past accumulation of macroeconomic imbalances outside the euro area.”  As consummate central bankers, the ECB likely has a sound grasp of the nature and vulnerability of the U.S. Bubbles.  They would, furthermore, not expect such “accumulated imbalances” to be rectified by continued loose monetary policy from the Federal Reserve.  They want to have their house in order for the inevitable…    European Central Bank board member Eugenio Domingo Solans:  “The situation we analyze today has factors in both directions. On the one hand it’s clear the euro has strengthened and the price of oil has fallen. In this sense, the outlook for inflation is better. On the other hand, the situation of liquidity, of M3 and other variables we also consider, reflect an abundance of liquidity.”  My comment: Recognizing the nature of contemporary, securities-based Credit systems, central bankers must carefully consider the impact of financial market liquidity and Credit availability.  Excessive liquidity must be monitored carefully no matter what the underlying price trend in consumer prices.  Indeed, Credit creation, and the resulting liquidity effects, must be the locus of monetary analysis and management.  Problematic financial and economic imbalances, as we have witnessed repeatedly, emanate directly from Credit and liquidity excess.  The enormous financial and economic risks in the U.S. today are much more associated with the consequences of continued Credit, liquidity, and speculative excess than they are with general deflationary pressures.    ECB President Wim Duisenberg (quoted by Dow Jones – Charlene Lee):  “We also read our newspapers, and we see that here and there the word ‘deflation’ re-emerges.  We do not share this fear for the euro area as a whole. Wim Duisenberg: “To maintain price stability is defined as a rate of inflation of below two percent.  There were views who pleaded for any even tighter interpretation.  There were views who pleaded for a looser interpretation.  In the end, we all agreed that we would have a big credibility problem and create our own credibility problem if we were to even change the definition.  So there was quickly consensus that there was no need - that it would even be dangerous to change the definition.” My comment:  In Stark Contrast to the Federal Reserve, the ECB is absolutely determined to cultivate and safeguard credibility.  As part of the Fed’s “activist” policy approach, our central bank has for too long nurtured and pandered to the leveraged speculating community.  Yes, it remains an incredibly swift (although increasingly ineffective and destabilizing) policy mechanism (encouraging speculative purchases of U.S. Credit market instruments, immediately augmenting Credit availability).  But the very nature of this mechanism nurtures asset Bubbles and resulting distortions – dysfunctional Monetary Processes.  Moreover, it has placed the Fed in the dangerous position of being held hostage to the speculators, capricious financial markets, and destabilizing asset Bubbles.  Importantly, this is precisely the slippery slope of central bank credibility destruction.  And while the leveraged speculators remain to this day a captive audience to Fed pronouncements and policies, there is no doubt that the Fed’s status is in freefall with true (especially foreign) investors.  There will come a day when the manipulative Fed will no longer so easily hold sway over market perceptions (when real investors supplant the speculators as the driving force within the marketplace), and we will all dearly suffer from our central bank’s (and currency’s and markets’) tarnished reputation.  This line of analysis recalls that a key attribute of the classical gold standard was that it was self-adjusting/correcting.  Interestingly, in such a monetary regime speculators – placing bets that excesses and imbalances would be of a short-term nature and rectified either automatically or by determined monetary authorities – would actually be a stabilizing force.  Contrast this to the current environment where the speculators are quite confident in the perpetuation of Federal Reserve monetary mismanagement.  In this circumstance, they will place bets in the direction of continued excesses and imbalances, with speculation working decisively to further destabilize the system.  Again, Stark Contrasts… Otmar Issing: “There’s not the least evidence of deflation in the euro region at the moment.”  Wim Duisenberg:  “In the sixteen years that I was governor of the central bank of the Netherlands there were two years that we had deflation of minus one-half, and I publicly declared that I had lived in the central bankers’ paradise.” Question:  “How do you solve the problem of (the weak) sectors that can go into deflation?” Response from the ECB’s Chief Economist Otmar Issing:  “The concept of deflation is not a question of sectors and countries; it’s a question of the (entire) monetary area.  In all large monetary areas in the world there are regions that are slow and even sometimes negative developments in prices, and others which are higher.  So this is not specific for the euro area, but has nothing to do with deflation.  Deflation is a concept related to monetary policy for the whole entity - for the average of monetary area.  Sector price developments, this is a question of relative prices.  And it’s quite normal.  For example, in the computer sector you’re at extreme declines.  Telecommunications, this is daily lives and even strong declines in prices.  This is a question of relative prices of a market economy.  This is totally different from the concept of deflation…” My comment:  Dr. Issing’s analysis is, as expected, both quite astute and most pertinent.  The problem in the U.S. today can be succinctly explained as – in contrast to a nebulous risk of deflation - a dilemma of keenly divergent “relative prices.”  Goods prices have been under moderate downward global pricing pressure, while U.S. homes, land, bonds, mortgages, sports franchises, and many “services” prices have been inflating rapidly.  While expedient, any narrow focus by the Fed and Wall Street on “core CPI” patently misses the nature of diverse and aberrant Credit inflation that dominates contemporary monetary affairs. Further, the nature of divergent pricing pressures is easily explained by the peculiarity of the deranged U.S. financial system (Monetary Processes).  The Credit mechanism (bankers, investors, Wall Street, and the speculator community) has come to favor the inexhaustible volume and perceived (boom-time) safety of asset-based lending.  So the grossest excesses mount in asset classes such as residential real estate and securities (agency bonds, mortgage-backs, etc.).  We could drop money from legions of cargo helicopters, but it will quickly find its way into real estate, the bond market, and imported goods.  The enormous amount of created purchasing power (money and Credit) required to trickle down to spur the real economy would only further destabilize (inflate Bubbles) asset markets and trade deficits.  Today, in the aggregate, rampant money and Credit inflation runs unabated, although this monetary expansion could not be more uneven or destabilizing. But “this is totally different from the concept of deflation.”  I would add that a market economy will not function effectively over the long-term with an uncontrolled Credit system and unrestrained speculation.   Regarding the current environment, “reliquefication” runs unabated.  Yet resulting Credit excess continues to be overwhelming dominated by the mortgage arena, acting to restrict the dispersion of liquidity evenly throughout the imbalanced U.S. Bubble economy.  While it is understandable that we “bearish” analysts highlight the apparent ineffectiveness of the “reliquefication” to thus far stimulate business investment and employment gains, we need to tread carefully along this line of reasoning.  Perhaps the more salient point to garner is that the extraordinary nature of recent lopsided Credit growth (and speculative excess) is perceived quite positively in the Credit market – that the current strain of financial escapades has the potential to run to unusual excess without consequences that would tempt the Fed to take the punch bowl away anytime soon.  After all, if the enormous quantities of new Credit were instead being spread evenly throughout the real economy, there would certainly be heightened trepidation in the interest-rate markets.  Players would need to discount the probability that economic recovery could take hold, that general pricing pressures could mount, and that the Credit market (and its bevy of speculators) would need to begin contemplating the end to the halcyon days of extreme Fed accommodation.  Well, these are anything but normal times, and this is a most atypical market environment.  So there is today apparently no need for market nervousness.  The Credit system and economy are so distorted and imbalanced that a general recovery is not yet in the cards.  Thankfully, for the aggressive leveraged players, the general economy will most certainly struggle.  And, at least for now, the Fed and Wall Street can point to the weak goods sector, restrained “core” consumer inflation, and ramble on about the risk of deflation; and they can do it all with a straight face.  Meanwhile, the Great Credit Bubble runs out of control and the value of our currency and perceived financial wealth is quietly inflated away.  This is no way to run a monetary system, financial markets or an economy. 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