The Credit market remains unsettled in “melt-up” dynamics. Two-year Treasury yields declined eight basis points to 1.24%, trading this week to 52-year lows. Five-year yields dipped two basis points to 2.27%. Ten-year Treasury yields dipped two basis points to 3.35%, while the long-bond saw its yield increase two basis points to end the week at 4.40%. Benchmark Mortgage-backs and agency futures generally performed in line with Treasuries. The 10-year dollar swap spread narrowed 2.5 to 33, while the spread on Fannie’s 4 3/8% 2013 note narrowed 6 to 29. Corporate spreads were generally somewhat tighter, with junk bonds recovering some of their recent underperformance. Currencies seemingly become more volatile by the week, although the dollar index ended the week with a slight gain. The Canadian dollar traded at a six-year high against the dollar. With crude oil trading at a 2 ½ month high, the CRB index gained about 1%.
While remaining quite strong, corporate debt issuance was down marginally from recent weeks. Daimlerchrysler issued $2.5 billion (re-priced up 30 basis points to 179 over Treasuries after news of large losses), Wells Fargo $2.5 billion, Target $500 million, Greenpoint Financial $350 million, MBNA $300 million, Verizon $500 million, Union Pacific $500 million, Praxair $300 million, and MBIA $150 million. One week of convertible bond issuance has already surpassed the volume from the entire month of June 2002. Converts this week included Schlumberger’s $1.3 billion, Nabors Industries (raised $700 million of zero coupon 20-year convertible debt), Omnicom $550 million, Western Wireless $100 million, FLIR System $150 million, Lincare $250 million, and Continental Air $150 million (up from $100 million). Alcatel sold EUR 1 billion of converts with a 4.75% coupon, with other major technology companies such as Ericsson looking to similarly take advantage of market conditions.
After two weeks of slight outflows, AMG reported $1.45 billion of inflows into junk bond funds last week. These were the strongest flows since February. This week’s issuance included SPX Corp. $300 million, Warnaco $210 million, Esterline Tech $175 million, Sequa $100 million, Waterford Gaming $155 million, United Component $230 million, Burns Philp $100 million, Premcor Refining $300 million, Houston Exploration $175 million, and Texas-New Mexico Power $250 million. Williams Co. raised its junk issuance from $500 million to $800 million, with a spread to Treasuries of 573 basis points.
The state of Illinois’s $10 billion issue was the largest ever taxable municipal deal.
June 6 – Bloomberg: “The Philippine dollar bonds due in 2009 strengthened to a record after the central bank yesterday cut interest rates it pays banks on some funds and lifted restrictions on forward trading of the peso. The difference in yield between the 2009 bond, with an 8 3/8 percent coupon, and U.S. Treasuries of similar maturity narrowed to 3.81 percentage points… That’s the smallest premium since the bonds were sold in March last year…the yield fell to (a record low) 6.004 percent from 6.374.”
June 6 – Bloomberg: “Russia’s Eurobonds advanced after the country’s foreign currency and gold reserves surged to a record $64.7 billion… Russia’s 2018 dollar bond climbed 1.25 cents in the dollar to a record 146.25 cents, cutting the yield to 6.23 percent… The yield has dropped from 8.53 percent in the past six months… Russia’s reserves are soaring on rising oil-led export receipts, bolstering confidence the country’s economy can withstand any drop in crude prices… Foreign reserves rose $1.6 billion in the week ending May 30, from $63.1 billion… The reserves have risen $17 billion this year.”
June 3 – Dow Jones (Mike Esterl): “Mexico issued a EUR750 million bond Tuesday, tapping a European investor base that's warming up again to Latin America but increasingly skittish about holding dollars. The 10-year security, which will pay an annual interest rate of 5.375% in London, is the first euro-denominated debt issuance by a Latin American country since Brazil placed EUR500 million in April of last year.”
Broad money supply (M3) expanded $13.4 billion last week. Demand and Checkable Deposits gained $5.8 billion. Savings Deposits were about unchanged, while Small Denominated Deposits declined $1.8 billion. Retail Money Fund deposits added $2.3 billion and Institutional Money Fund deposits increased $5.6 billion. Repurchase Agreements declined $0.6 billion and Eurodollars added $1.9 billion. Elsewhere, Commercial Paper increased $10.8 billion to $1.36 Trillion, the highest level since the first week of December. Financial CP jumped $13.2 billion (up $57.5 billion in six weeks) to $1.224 Trillion. This is the highest level of financial sector CP borrowings since December 2001. Total Bank Assets jumped $47.4 billion last week, with six-week gains of $196 billion. Securities holdings increased $20 billion to $1.84 Trillion, with Securities up 19% y-o-y. Loans and Leases added $2.5 billion. Commercial and Industrial loans declined $1.2 billion and Real Estate loans dipped $6.2 billion. Security loans increased $4.1 billion. About $8 billion of ABS was issued this week. Fed “custody” “Foreign Holdings of U.S. Debt” increased $5.62 billion this week.
June 4 – Bloomberg: “Bank of America Corp., the biggest U.S. lender to individuals and companies, said demand for its commercial loans is accelerating, a sign of faster economic growth. The recovery ‘has got to come from the medium- and small-sized businesses who start to invest, start to build inventory, start to buy some technology and hire some of their people back,’ said bank Chief Financial Officer James Hance… ‘And all of that’s beginning.’ Commercial lending by Charlotte, North Carolina-based Bank of America was at the highest level in 15 months in April, Hance said. The bank forecasts its commercial loans will rise 6 percent in 2003. The bank’s loans grew 1.6 percent in the first quarter after an 11 percent drop in 2002.”
There were 26,619 bankruptcies in the holiday-shortened week.
It was another interesting employment report with evidence of a stabilizing yet highly unbalanced economy. Manufacturing lost another 53,000 jobs (191,000 in three months), while Construction added 26,000 (up 53,000 in three months). Service-producing added 12,000 jobs, with Credit Intermediation (Finance Activities) adding 19,000. Notably, Temporary Help added 58,000 jobs, an abrupt reversal from the 48,000 lost over the past three months. The government sector dropped 25,000 jobs. Year-over-year, Goods-producing jobs sank 592,000, while Service-producing employment jumped 248,000. Production workers dropped 505,000, while Construction jobs added 67,000. Within Services, Financial Activities jobs added 140,000 and Health, Social Assistance added 292,000, while Wholesale Trade dropped 66,000, Retail Trade dropped 75,000 and Information jobs declined 133,000 year-over-year.
Construction spending remained resilient during April, and will surely only expand over the coming months. For April, Total Construction Spending was down slightly for the month and was up 0.7% y-o-y. Similar to the general economy, the aggregates miss the important detail. Year-over-year, Single-family Residential Construction Spending was up 11.6% and Home Improvement spending increased 7%. The continued strength in residential, however, was offset by weakness in Non-residential. Year-over-year, Non-residential spending was down 13.1%, with Industrial down 24.5%, Office down 23.0%, and Hotels, Motels down 13%. From April 1997, Single-family residential spending has surged 67%, while Non-residential is down 7%. April Public sector construction spending was up 0.5% y-o-y, with Public Housing up 17.2%, and Military up 11.5%, while Industrial declined 11.4%. Total Public Construction spending is up 30% from April 1997.
In general, I would assert that the service sector maintains an inflationary bias, in contrast to the manufacturing sector. Thus we should not be surprised that “services” are more responsive to monetary stimulus. The ISM Non-manufacturing index jumped 3.8 points to a strong 54.5 during May. The last time the index was higher was this past November. New Orders jumped an impressive 4.1 points to 54.7, while Backlog jumped 5.0 points to 51.0. Curiously, Prices Paid declined almost 7 points to 49.6, and New Export Orders declined 3.5 points to 49. Import Orders surged 8.5 points to 58.5. The ISM Manufacturing index added four points to 49.4, the strongest reading since February. Production rose above 50 (51.5) for the first time since February, and New Orders jumped a noteworthy 6.7 points to 51.9. Backlog added 3.5 to 51, the highest reading since June of last year. Prices Paid dipped 12.5 points to 51.5, the lowest level since February 2002.
The California Building Industry Association this week raised their estimate for 2003 state home construction by 6% to 180,000 units. This would be up 6% from 2002 and the strongest construction boom since 1989. According to the Construction Industry Research Board, 63,626 permits for new home construction were approved between January and April, up 27.2% from the same period last year. (From Kelly Zito, SF Chronicle).
Freddie Mac 30-year mortgage rates dropped five basis points this week to a record low 5.26%. The 15-year rate dropped to 4.66% and the one-year adjustable rate dipped four basis points to 3.59%. Not surprisingly, the Mortgage Banker’s Association application index surged to new all-time highs, although the holiday-shortened week may have led to some distortions. But as the data read, the composite Market index jumped 13.6% for the week to a new record. Refi applications jumped 12.9% to a new record more than five times the year ago level. Yet Purchase applications were the eye-opener. Up 16.4% for the week, Purchase applications surged to a level more than 10% above the previous record. This was up almost 50% from the February trough level. We’ll be watching Purchase applications closely over the coming weeks.
Countrywide enjoyed “average daily application” volumes of $3.2 billion during May. This was 19% above the record set the previous month, and compares to May 2002 average daily applications of $878 million. Countrywide received on average 20,000 applications daily, with May loan funding “approximately $40 billion.” This was almost three times the year ago May funding level. Countrywide raised their estimate for total 2003 originations to $3.5 to $4.0 Trillion.
June 2 – David W. Berson, Fannie Mae chief economist: “We have raised our projection of mortgage originations in 2003 to a record $3.7 trillion - up from our previous estimate of $3.3 trillion and from last year’s previous record of $2.6 trillion. Both purchase and refinance volumes should set new records this year. Home sales through April are running about 3.5 percent ahead of last year’s record pace (new sales are 8.0 percent above last year, while existing sales are 2.4 percent above)… Home sales are likely to climb to new records in 2003… Moreover, home price gains are still fairly strong - although increases have slowed some from the rapid pace of the past three years. We project a rise of 4.5-5.0 percent for home values this year. Combining the sales and price projections, we now expect purchase originations to climb by almost 7 percent to $1.08 trillion. Strong as that is, the real origination story is a refi one. Fannie Mae’s Mortgage Market Analysis Department estimates that with primary market fixed-rate mortgage yields around 5.30 percent, about 90 percent of all fixed-rate mortgages outstanding are ‘in the money’ to refinance. We project a rise in refinance originations of 61 percent to an astounding $2.59 trillion. This by itself is almost as large as last year’s total origination figure. While we have not yet completed an estimate of the cash-out share of refi originations for 2003, the dollar volume of equity removed during these refinancings will be very large. The combination of record purchase originations and still strong cash-out refinancings should keep single-family mortgage debt outstanding (MDO) growth robust. We have raised our projection of MDO growth for 2003 to 10.0 percent, which would be the third consecutive year of double-digit growth - the first time since 1987-89 that MDO growth would be that strong for that long a period.”
It is worth pondering that the Mortgage Bankers Association earlier this year was projecting originations of $1.77 Trillion. Now it appears we’ll do about double this amount and blow through last year’s blow-out record.
The Office of the Comptroller of the Currency today reported that U.S. Commercial Bank total notional derivative positions increased $5.35 Trillion during the first quarter (35% annualized) to $61.42 Trillion. Total derivative positions were up $15 Trillion, or 33%, year-over-year. By category, the first quarter saw Interest Rate derivatives expand $5.1 Trillion, or 38% annualized, to $53.5 Trillion. Foreign Exchange increased by $167 billion (11% annualized) to $6.2 Trillion. Credit Derivatives expanded by $75 billion (42% annualized) to $710 billion. By issuer, the J.P. Morgan Chase Derivative Bubble saw total derivative exposure increase to $31.2 Trillion. Bank of America followed with $13.5 Trillion and Citigroup ended the quarter with almost $12 Trillion of notional positions. “Relative to the fourth quarter of 2002, there was an increase in trading revenues from cash instruments and derivative activities of $1.2 billion, to $3 billion in the first quarter of 2003.”
The Fed released first quarter Credit data week, our favorite quarterly “flow of funds” record of the creation and dispersion of Credit/liquidity. Gross financial excesses and imbalances are again clearly illuminated in the Fed’s own report. Total Credit Market Borrowings (non-financial and financial) increased to $32.3 Trillion, surpassing 300% of GDP. This is up from 256% of GDP at the beginning of 1998. First quarter annualized Total Credit growth of $2.363 Trillion (7.0%) compares to Q1 2002’s $1.921 Trillion (6.2%). Total Credit growth would have been stronger had it not been for the aberrational 2.2% annualized expansion of federal government borrowings. Total Credit Market Borrowings are now up $11.1 Trillion, or 52%, over the past 21 quarters (since the beginning of 1998).
Total Non-federal borrowings increased at a 7.4% rate, compared to Q1 2002’s 5.9%. Once again, Credit growth is being driven by the Mortgage sector. Household Mortgage borrowings expanded at a 12.0% annualized rate, compared to Q1 2002’s 10.3%. Non-financial Corporate borrowings expanded at a 3.0% annualized rate, the strongest pace since the Q4 2001. State & Local governments increased borrowings at a 10.1% annualized rate, almost double the rate from Q1 2002.
The historic financial sector expansion runs unabated, with financial borrowings increasing at a 9.7% annualized rate (vs. Q1 2002’s 9.3%). Financial sector debt is up 10% y-o-y. Financial sector borrowings have now increased 94% to $10.6 Trillion since the beginning of 1998. Once again, “structured finance” dominated financial sector expansion. The GSEs, outstanding Asset-backed Securities, and outstanding Mortgage-backed Securities combined for $765 billion of annualized expansion during the quarter, a growth rate of 9.4% to $8.29 Trillion (up 106% since 1998). By category, GSE borrowings expanded at a 7.9% rate to $2.6 Trillion (up 10.6% y-o-y). MBS expanded by 8.6% to $3.23 Trillion (up 9.2% y-o-y) and outstanding ABS increased at a 12.2% rate during the quarter to $2.47 Trillion (up 13.3% y-o-y). Outstanding “structured finance” borrowings (GSE, MBS, and ABS) increased to 77.5% of GDP. This is up from 47% at the start of 1998 and 28% to begin the nineties.
The vast majority of “structured finance” expansion is today financing the Mortgage Finance Bubble. Total Mortgage (Household, Commercial and other) Credit expanded at an annualized rate of $916 billion (10.8%), compared to $706 billion (9.2%) during Q1 2002. Total Mortgage Credit is up $936.7 billion, or 12.1%, to $8.7 Trillion during the past year. For comparison, non-financial Corporate borrowings increased $85 billion, or 1.7%, during the past four quarters to $4.95 Trillion. It is also worth noting that Total Mortgage Borrowings increased $1.04 Trillion during the first six years of the 1990s. The system will likely extend a similar amount of new Mortgage Credit during the twelve months of 2003.
Total Mortgage Credit is up $3.45 Trillion, or 65.5%, over 21 quarters, with Household Mortgage borrowings up $2.65 Trillion, or 66%. And now things are accelerating into problematic “blow-off” excess. It is worth noting that Household Mortgage borrowings were up $766 billion during the past four quarters (13%) to $6.64 Trillion. This compares to average Household Mortgage debt growth of $194 billion during the first seven years of the nineties ($236 billion yearly average for the decade).
It is also worth mentioning the composition of liabilities being created nowadays by the Asset-backed Securities trusts. ABS trusts expanded assets at an annualized rate of $352.2 billion during the first quarter. Yet on the liability side, Commercial Paper issued actually contracted at an annualized rate of $51.3 billion. At the same time, Corporate Bonds issued expanded at an annualized $378 billion. Let’s compare the liability composition of Q1 2003 to year 2000. For 2000, ABS assets expanded almost $190 billion. On the liability side, Commercial Paper increased $121 billion and Corporate Bonds expanded $69 billion (about 2/3 financed by short-term liabilities and 1/3 by long-term). Between 1998 and 2001 almost half of ABS asset expansion was funded through the Commercial Paper market, certainly contributing to the expansion of Money Market fund assets. Today, in contrast, ABS expansion is financed in the bond market. I would say that this, along with GSEs increasing the relative share of long-term debt issuance, helps explain why “money supply” (monetary liabilities) growth has slowed somewhat in the face of continued strong Credit expansion. This is why it is necessary to focus on “broad money” and, more importantly, sectoral Credit growth.
The Security Brokers and Dealers increased “Net Acquisition of Financial Assets” by $229 billion annualized, the strongest growth since the third quarter of 2001. Agency holdings expanded at a $145 billion annualized rate and Miscellaneous Assets increased at a $194 billion pace. On the liability side, “Security Credit” expanded at a $144 billion annualized pace, with most of the Credit coming from the banking system.
Total Commercial Banking holdings of Financial Assets expanded at a record $785 billion annualized rate (8.7%) during the quarter to $7.5 Trillion. Total Assets were up 10.2% y-o-y, compared to the 4.7% growth rate during the preceding 12 months. Security Credit (mostly lending to Securities Brokers) increased at a record $113 billion pace during the quarter to a record $207 billion. Miscellaneous Assets expanded at an annualized rate of $314.6 billion to a record $1.54 Trillion. Looking at year-over-year changes in Commercial Banking loan categories, (business) Bank Loans declined $102 billion (down 7.2%), while Mortgages surged $300 billion (up 16.7%). Consumer Credit increased $24.6 billion, or 4.5%, while Security Credit jumped $48.1 billion, or 30.3%. For comparison, let’s look at loan growth by category for the pre-Bubble year 1997. Bank (business) Loans increased $128.1 billion, or 12.3%, while Mortgages gained $99.9 billion, or 8.7%. Consumer Credit actually declined $14.2 billion (down 2.7%), while Security Credit expanded $21.7 billion (21.5%).
State and Local Governments have increased borrowings by $224 billion, or 18%, over the past 18 months. This is about the amount of total State and Local Government debt growth during the preceding four and one-half years.
During the quarter, Credit Market Borrowings by Non-financial sectors increased at a $1.34 Trillion rate, compared to $767 billion during pre-Bubble 1997. While the increase in the rate of debt growth is significant, the composition of the borrowings is even more notable. During Q1 2003, the Household sector accounted for 67.5% of non-fed non-financial borrowings ($849.2 billion annualized), compared to 43.4% during 1997 ($332.7 billion). Conversely, the non-financial corporate sector accounted for 11.8% ($148.7 billion annualized) of borrowings during the first quarter compared to 38% ($291.6 billion) during 1997. State & Local Governments have increased their share from 1997’s 5.4% ($41.5 billion) to the first quarter’s 11.6% ($146.3 billion annualized). Fed data illuminates the historic shift to non-productive Credit creation that accelerated during 1998.
The Rest of World “Net Acquisition of (U.S.) Financial Assets” jumped to $866.1 billion annualized, or to an almost 11% growth rate. This compares to Q1 2002’s annualized increase of $394 billion (about 2%). Rest of World increased holdings of Credit Market Instruments at an annualized $463 billion (13.8%), with holdings of Agencies increasing at a $139 billion pace and Corporate Bonds (including ABS and MBS) at $247 billion. Notably, Foreign Direct Investment in U.S. expanded at an annualized $75 billion during the quarter, or at a pace of less than 5%. Foreign Direct Investment in U.S. has collapsed since peaking at $307.7 billion during 2001 (averaging $220 billion between 1997 and 2000). With dollar liquidity flooding the global financial system, foreign holders are accumulating amazing quantities of U.S. securities. Since the beginning of 1998, Rest of World Holdings of Credit Market Instruments has surged $1.37 Trillion, or 65%, to $3.47 Trillion.
Well, Critical Issues become clearer in the data by the week, although one must disregard the ‘aggregates” and focus on the detail. Critical Issues conspicuously appeared in the detail of today’s employment data and in the Fed’s “flow of funds” Credit report. A dysfunctional Credit system has created and now exacerbates a severely unbalanced economy. Abundant liquidity flows to the Mortgage arena and “services,” sectors demonstrating a continued inflationary bias. With “easy money” stoking easy financial profits, the broader financial sector boom runs unabated. In stark contrast, challenging economic profits (the consequence of Credit-induced sectoral over-expansion and price distortions) has liquidity avoiding manufacturing and “goods-producing” for the lovely green pastures of financial speculation. More Liquidity Equals Further Imbalances.
Critical Issues also emerge more clearly by the day throughout the financial markets. The Fed has succeeded in inciting a major destabilizing short-squeeze throughout the stock market, and I will assume something similar has unfolded in corporate bonds and Credit default swaps. If our Fed governors actually believe they can subtly manipulate today’s unruly markets they are in the process of learning a lesson. The Treasury market has gone into melt-up mode dislocation, with negative effects on the soundness of the mortgage-back and derivatives markets. Market melt-ups are nonetheless exciting and stoke the optimistic imagination, but the resulting distortions always come back to haunt. Let there be no doubt, the seeds for future acute financial crisis have been fastidiously sown. “Buyers’ panics” do juice confidence and enliven animal spirits. They are not, however, known for allocating liquidity or resources effectively or in moderation. Let’s not forget the destruction wrought by the previous speculative melt-ups in telecom debt or technology stocks. More Liquidity Equals Further Imbalances. And it should be recognized that the confederated Credit and Mortgage Finance Bubbles are more systemic than anything previously experienced.
I recently wrote that we have today “an energized financial sphere face to face with a despondent economic sphere.” Well, the more I ponder this most extraordinary environment the more I believe this line of analysis has some merit. More than ever before, the Credit system is today the Horse pulling the economic cart. Yet the analytical and policy focus remains fixated on the cart. How is everyone missing the reality that the Horse has gone nuts, and that administering mega-doses of stimulants is not going to work out in the best interest of those riding the wavering carriage?
Over the years, our contemporary (structured finance-driven) Credit system has drifted to an overwhelming emphasis on volume, asset-based lending and leveraged speculation. It long ago lost its “reins” to prudent, economic profits-driven lending. Unharnessed and lacking any discipline or direction, the Credit system mindlessly wanders only farther from familiar and protected terrain. The financial system becomes only further distorted by the month to the point of losing the capacity to effectively allocate a reasonable quantity of financial resources to the real economy. It instead inundates destabilizing speculative finance excessively to hot sectors, especially the asset markets. (Can there be a more compelling example than the past few weeks in the stock market?) In short, the (Credit) mechanism for creating and allocating liquidity (purchasing power) has become completely dysfunctional. But this Critical Issue is lost with the Fed and others’ focus on the maladjusted and despondent economy, the very economic system that is the creation of our deranged Credit system (Crazy Horse).
The nexus of the Great Credit Bubble is, in reality, its capacity to extend enormous Credit and incite unprecedented speculation, yet do it in such an atypically unsound and uneven manner. The Bubble is sustained by its “dysfunctionality.” After all, a less unsound financial system disbursing today’s volume of Credit/liquidity effectively (To a non-bubble/non-maladjusted economy) would surely fuel a traditional recovery. The Credit market would then necessarily anticipate heightened borrowing demands, higher market rates, and eventual Fed monetary restraint. Lending excesses and wild stock market speculation would be expected to alarm our central bankers, and the thought of an alarmed Fed would induce considerable consternation (and restraint!) for aggressive lenders and leveraged speculators. Such typical market dynamics would provide a crucial regulating/self-adjusting mechanism. But today is another world. Quite mistakenly, the Fed has virtually taken fear out of the equation, and we are witnessing the consequences.
The maladjusted U.S. Bubble economy – fashioned and sustained by a hopelessly dysfunctional financial system – specifically will not demonstrate the type of traditional responses to monetary stimulus that would be expected to engender a movement back toward monetary balance (or restraint). And that is damn good news for those so aggressively feasting on financial excess; but only for them. It is also specifically why this is such an extraordinarily dangerous Bubble.
Pondering the current environment, the stock market has quickly returned to a wildly speculative, unstable environment. Junk bonds, convertible securities, and the emerging markets are all demonstrating unmistakable signs of excessive liquidity and speculation. Gross financial excess is also corroding the value of the dollar and fostering erratic global currency markets. Meanwhile, the Credit market is in a destabilizing melt-up, inciting unprecedented lending and speculating excesses. The Mortgage Finance Bubble has been prodded into its terminal stage of parabolic excess. And, guess what? Job growth is sufficiently lifeless and corporate pricing power notably tepid throughout the distorted real economy, that the Credit market has the enviable luxury of anticipating yet another rate cut. The Horse becomes only more obnoxious and disobedient by the week.
I found it rather interesting that Pimco’s Paul McCulley ended his June article with “Good Lord willing, things’ll work out.” Well, things are not going to “work out”. And I hope when this Mother of All Reliquefications inevitably blows up, The Inflationists Greenspan, Bernanke, McCulley, Kudlow, McTeer and others will admit where they went wrong. The public will deserve an honest explanation, and future generations should have the benefit afforded a forthright and accurate historical record.