06/20/2002 The Ominous Return of the Twin Deficits *

This week saw the unfolding financial crisis hit the emerging markets and technology sector hard, although the broader market generally held its own. For the week, the Dow and S&P500 declined 2%, while the Morgan Stanley Consumer index declined 1%. The Transports gained 3%, while the Utilities and Morgan Stanley Cyclical index were about unchanged. The broader market outperformed, with the small cap Russell 2000 unchanged and the S&P400 Mid-Cap index declining 1%. The technology rout runs unabated, with the NASDAQ100 and Morgan Stanley High Tech indices declining 6%. The Semiconductors were hammered for 11%, while The Street.com Internet and NASDAQ Telecommunications indices dropped 8%. The Biotechs were hit for 5%. The AMEX Securities Broker/Dealer index declined 2%, while the S&P bank index was volatile but ended the week about unchanged. With bullion up $5.30, the HUI Gold index jumped 7%.

The Credit market added to recent gains, but performance was relatively muted considering the circumstances. For the week, two-year Treasury yields declined four basis points to 2.84%, the five-year dipped three basis points to 4.03%, and the 10-year three basis points to 4.77%. The long-bond saw its yield decline one basis point to 5.40%. Benchmark Fannie Mae mortgage-back yields declined four basis points, while implied yields on agency futures sank nine basis points. The spreads on Fannie Mae’s 5 3/8% 2011 note and the benchmark 10-year dollar swap spread both narrowed 2 to 52.

The dollar this week suffered its worst decline against the euro in 10 months. It dropped 2.6% against the euro to the lowest level since April 2000. The Canadian dollar rose to the highest level against the U.S. dollar in almost one year. The Swiss franc traded to the highest level against the dollar since October 26, 1999. Notably, Asian currencies also performed well against the dollar, with the Japanese yen rising 2.6% to the highest level since November 14, 2001. The Singapore dollar traded to the highest level against the U.S. dollar in eight months, while the Taiwan dollar rose to the highest level in 13 months. This week was key for the marketplace differentiating between fundamentally strong and weak currencies. The leading currencies were the Swedish krona (plus 3.51%), Swiss franc (3.44%), Norwegian krone (3.39%), Czech koruna (3.28%), Australian dollar (2.85%), Danish krone (2.82%), euro (2.81%) and New Zealand dollar (3.05%). The leading losers against the dollar were the Uruguay peso (down 8.53%), Venezuelan bolivar (6.46%), Chilean peso (4.29%), Brazil real (4.08%), Mexican peso (2.82%), Argentine peso (3.14%), and the Peruvian new sol (1.63%).

Things went from bad to worse in Brazil this week. The Brazilian Bovespa stock index sunk 11% for the week, and is down 19% so far this month. Benchmark government yields surged 370 basis points to 21.70% this week, the highest yields since the Mexican collapse back in 1995. Brazilian yields are now up 718 basis points in three weeks. The situation is quickly turning into a problematic Credit crunch, with companies in Brazil having (according to Bloomberg) $16 billion of debt coming due this year. Yesterday Moody’s cut the outlook for Brazilian foreign-currency debt to “negative” citing the unfolding Credit crunch and the risk associated with October’s presidential election. Moody’s also cut the outlook for Brazilian banks and other large corporate borrowers. It appears Brazil has at least $350 billion of debt outstanding, with significant amounts denominated in foreign currencies. The Brazilian real was hit for almost 3.5% yesterday, with yields jumping 130 basis points. Both the currency and bonds were rallying this morning before Treasury Secretary O’Neill rattled the markets stating, “Throwing the U.S. taxpayers’ money at a political uncertainty in Brazil doesn’t seem brilliant to me. The situation there is driven by politics. It’s not driven by economic conditions.” Such comments may be good for domestic consumption, but are rather insensitive in an environment of acute global financial stress. Brazil’s Finance Minister had a much different spin than O’Neill, comments with some merit: “Nothing really happened on the real side of the Brazilian economy in the past weeks that would justify a surge in the Brazilian sovereign risk. I wouldn’t dismiss the possibility that some of this selling, mainly the larger volumes in most-traded bonds for emerging markets, is associated with soaring default rates in the U.S. corporate debt market.”

The JPMorgan Emerging Market Bond Index (EMBI+) spread to Treasuries jumped 105 basis points this week to 843, the widest level in six months. The JPMorgan Emerging Bond Index for Turkey saw its spread to Treasuries widened 142 basis points to 908 (up 287 basis points in three weeks). Russian bond spreads widened 91 basis points to 582, while Mexican bonds spreads widened 37 to 345. The Uruguay peso plunged as much as 24% yesterday after the government was forced to let the currency float freely in the markets. With debts denominated in foreign currencies and a faltering economy, Uruguay now risks following Argentina into financial collapse. The Argentine peso has now lost over 70% of its value this year, as the entire region enters financial crisis with no clear apparatus or policies to keep things from spiraling completely out of control. The heart of the issue is that the U.S. and global financial system (the “core”) are so acutely fragile that little can be done to stabilize the “periphery.” Without a solid “core”, the vulnerable “periphery” is defenseless. This is a different and much more problematic crisis than we have seen in some time.

Normally, such financial stress would provoke a Pavlovian anticipation of Fed rates cuts. But those bullets have largely been shot, while economic data this week was certainly not indicative of weakness. The Federal Reserve Bank of Philadelphia’s manufacturing index enjoyed its strongest gain since June 1998. The New Order component jumped from 10.2 to 20.1, up from November’s negative 17.3 to the strongest reading since November 1999. The Prices Paid component added 3 points to 22.9, the highest reading since September 2000. Prices Received rose to the highest level since April 2000. Unfilled Orders jumped to the highest level since early 1993. Tuesday’s jump in housing starts was up a much stronger than expected 11.6%. Starts continue to run slightly ahead of last year’s very strong pace, with starts up 15% y-o-y in the Northeast. The Mortgage Banker’s Association weekly index had refi applications at the strongest level since early March and up 11% y-o-y. Purchase applications were also up 11% y-o-y.

Freddie Mac’s May numbers were rather interesting. The company’s total “book of business” (retained mortgage portfolio growth plus mortgage-backs sold in the marketplace) expanded at a 10.1% annualized rate, down from April’s 18.9% and the slowest growth since November. The company’s retained portfolio contracted for the second consecutive month, while mortgage-backs sold into the marketplace expanded at a 27.7% rate (down from April’s 41.6%). Year-to-date, Freddie Mac mortgage-backs held in the marketplace have increased $70 billion, or at a 26% (or almost $170 billion annualized) growth rate.

Broad money supply (M3) was basically unchanged, although individual components fluctuated. Demand deposits dropped $16.6 billion, checkable deposits declined $4.7 billion, large time deposits dropped $5.0 billion, repurchase agreements declined $2 billion, and retail money fund deposits declined $2.1 billion. Savings deposits surged $30.7 billion. The asset-backed securities boom continues, with y-t-d issuance of $169 billion running 22% above last year’s record pace.

June 18 Bloomberg – “AmeriCredit Corp. and Metaldyne Corp. cut the size of their junk-bond sales this month, a sign that investors are hesitating to buy riskier securities while the economic recovery remains in doubt. AmeriCredit, which buys and services auto loans, sliced its bond sale last week by more than 40 percent to $175 million as investors balked. Auto parts maker Metaldyne trimmed a sale by $50 million to $250 million, rather than pay more than an 11 percent coupon to entice buyers.”

Whether it is emerging markets, telecommunications operators, or marginal companies and consumer lenders, the marketplace is running away from the “periphery.” The stock of subprime consumer lender Metris dropped 30% this week, although the company “is unaware of any specific reason for stock movement.” We suspect the stock is sinking because the company is losing access to additional finance. Interestingly, the company sold $1.5 billion of asset-backed securities just late last month. With Credit insurer MBIA providing wrap-around insurance, strong demand allowed the company to increase the size of the deal from the original $1 billion. The $900 million 3-year securities were sold at LIBOR plus 30 basis points, with the $600 million 5-year securities priced at LIBOR plus 38 basis points. We very much doubt MBIA would write such protection today, and we would not expect Metris to find any marketplace demand for uninsured securities. So Metris, like the emerging markets and increasing numbers of marginal borrowers, is quickly losing access to Credit. This is a big problem. Metris ended March with $11.8 billion of managed receivables, up 24% y-o-y. Total assets of $3.7 billion were supported by about $1.2 billion of shareholders equity. The company posted net income for the quarter of $43.2 million, up 30% y-o-y. We will now watch to see how quickly reported earnings will be transformed to major losses with additional finance not forthcoming. Metris, unfortunately, will be a microcosm of how quickly a rapidly expanding Credit system can falter when the liquidity spigot is turned down.

April’s trade deficit was reported at a record $35.9 billion, significantly above estimates of $32.2 billion. This number confirmed the problematic nature of the current consumption-based Credit boom. April’s imports of $116 billion (up 4.7% from March) were the strongest in 11 months and down only 2% y-o-y. For comparison, March imports were down 8.2% y-o-y, while September 2001 imports were down almost 24% y-o-y. At the same time, April’s $80.1 billion of exports (up 2.2% from March) were the strongest since August, although down 7% y-o-y. While Services remains in small surplus, the goods deficit jumped almost 10% during April to $39.9 billion, the largest since October 2000.

Also reported yesterday, the U.S. current account deficit for the first quarter jumped to a record $112.5 billion. This was up 18% from the fourth-quarter, and an increase of about 4.5% from last year’s first quarter. For comparison, the current account deficit was $94 billion during first-quarter 2000, $59.67 billion during first-quarter 1999, $40.83 billion during first-quarter 1998, and $32.42 billion during first-quarter “pre-Bubble” 1997. And we actually were running a $12.4 billion surplus coming out of the last recession during the first-quarter of 1991.

The Treasury reported a wider-than-expected deficit of $80.6 billion for the month of May. This compares to last May’s deficit of $27.92 billion, fiscal deterioration even more dramatic than we would have expected. Last month’s deficit was the largest monthly shortfall in years, with revenues down 18.4% y-o-y and spending up 19.3% y-o-y. For the first eight months of the fiscal year, total receipts of $1.219 trillion were down 11.6%, while total spending of $1.366 trillion was up 10.0%. This year’s y-t-d deficit of $147.1 billion compares to last year’s surplus of $137.1 billion. Looking at major federal agencies, year-to-date military spending is up 16% to $220 billion, Health and Human Services up 12% to $311 billion, and Social Security up 7% to $324 billion. Spending at the Agriculture Administration is up 7% to $52.2 billion, while education spending is up 16% y-t-d to $31.7 billion. On the receipt side, personal income tax payments are down 20% y-t-d to $562 billion, while corporate tax receipts are down 17% to $89.4 billion.

Perhaps it was coincidence, but with yesterday’s ominous “Twin Deficits” announcements we saw the first trading session in some time where acute financial market stress was not mitigated by rallying bond prices. In fact, the U.S. bond market was under intense pressure yesterday, although it did rally today. We will watch carefully for evidence that this week marked a key inflection point for the U.S. Credit market. With Wall Street balance sheets bloated with bonds and leveraged interest rate speculation endemic, surging bond prices have cushioned the pain of sinking stock prices and sporadic corporate debt woes. If U.S. bond prices have peaked, this would be a not insignificant development for U.S. financial fragility. At the minimum, yesterday and this week certainly provide convincing evidence that the U.S. dollar has lost its safe haven status. To see currencies and bonds throughout Latin American go into a tailspin and the dollar simultaneously under heavy selling pressure is quite disconcerting, to say the least.

After a week like the one just completed, we believe it is appropriate to keep our comments “tempered.” Clearly, the unfolding financial crisis took a major step forward the past few sessions. Latin America is in a full-fledged financial crisis at this point, which is one more major problem for our major financial institutions. To what extent derivative players and leveraged speculators have been involved in these various markets we are unsure, but we fear they have been significant in Brazil and Mexico. The prices of default swaps on Brazilian debt has surged over the past three weeks, and an Argentina-style collapse of much larger dimensions is no longer a long-shot. If Mexico catches the capital flight and “hedging” virus, we’re looking at a very major problem.

It is also clear that the telecommunications/technology sector is in an outright collapse. That ultra easy money was not capable of transforming so many negative cash flow companies into viable businesses, we are not the least bit surprised. But the dimensions of the unfolding bust in the face of ultra-easy money and continued rampant system Credit creation could not be more discomforting. Our fear continues to be that there are major unrecognized losses hidden out there in the murky world of derivatives, with players for some time hoping that a Fed-orchestrated rally would let them off the hook. But hope must be turning to fear as, instead of an industry recovery, an historic collapse is creating mushrooming losses. A derivative player that had been writing protection against declining technology stocks, telecommunications bond defaults, Latin America currency and debt woes, and a declining U.S. dollar must today be feeling the heat. Leveraged speculators in these various markets must have little choice but to run for cover. As we have tried to explain many times in the past, contemporary finance dominated by the leveraged speculating community and derivative risk markets tightly links various global financial markets. Liquidation in one market can quickly incite a domino-style financial crisis, as we began to witness this week.

The escalation of systemic stress reached the point this week where we would normally see a response from the Fed. We would expect some effort to contain the unfolding crisis at the “periphery” before it afflicts the “core.” The major problem is that we fear that the “core” of the problem is an increasingly impaired U.S. financial sector and maladjusted economy. We view the weak dollar as confirmation of this view, and this week’s announcements of a Return to Twin Deficits a stark reminder of underlying fundamentals. When the dollar remained strong, such announcements were of little concern to our foreign lenders. This week it appeared to become a concern, with changing perceptions as to the health of the U.S. financial system almost palpable.

The risk now becomes that the expanding contraction of Credit availability for U.S. corporations escalates into an issue of problematic systemic Credit crunch – or a run against U.S. financial assets. The good news is we have to this point seen no indication of faltering systemic liquidity. The bad news is how poorly financial markets are performing in the midst of abundant general liquidity. Thus far, foreign holders of our securities have enjoyed the luxury of easily (and inexpensively) hedging their dollar risk in the derivatives market. This has put the onus on the major derivative players to “dynamically hedge” their risk exposure to the protection they have written. We would suspect that the derivative players are major dollar sellers, and will be forced to continue to sell dollars into weakness. It continues to be our fear that the epicenter of the unfolding financial crisis is located with the major U.S. risk intermediaries. If confidence begins to falter in these players or the derivatives market generally, we would expect the commencement of a serious and problematic liquidation of U.S. financial assets.