The Fed statement and economic data provided no favors. For the week, two-year Treasury yields surged 18 basis points to 3.75%. Five-year government yields jumped 15 basis points, ending the week at 3.83%. The 10-year Treasury yield rose 12 basis points for the week to 4.04%. Long-bond yields gained 8 basis points to 4.30%. The spread between 2 and 10-year government yields sank to a miserly 29. Benchmark Fannie Mae MBS yields rose an unimpressive 15 basis points. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note widened one basis point to 32, while the spread on Freddie’s 5% 2014 note widened 1.5 basis points to 31.5. The 10-year dollar swap spread increased 3.25 to 43. Corporate bonds traded about in line with Treasuries. Auto bond and CDS markets were mixed. Junk bond spreads were little changed. In a notable development, the implied yield on 3-month December Eurodollars jumped 21.5 basis points to 4.07%.
Corporate issuance slowed to about $7.0 billion. Investment grade issuers included VTB Capital $1.0 billion, Sun Life $900 million, Merrill Lynch $1.15 billion, Willis Group $600 million, Fisher Scientific $500 million, Avalon RE $400 million, BB&T $400 million, Westar Energy $400 million, MDC Holdings $250 million, E.W. Scripps $150 million, and Buckeye Partners $125 million.
Junk bond fund reported inflows of $178 million (from AMG). Junk issuers included Chaparral Steel $300 million, Encore Acquisition $300 million, El Paso Corp $270 million, Texas Industries $250 million, Neff Rental $245 million, Psychiatric Solutions $220 million, and Commercial Vehicle Group $150 million.
Foreign dollar debt issuers included Air Jamaica $200 million.
June 30 – Dow Jones: “Governments, agencies and public and private corporations raised $2.9 trillion in the global debt capital markets in the first half of 2005, according to figures released… [by] Dealogic. That’s about the same as in the first half of 2004… The asset-backed segment of the global debt capital markets had its best-ever first half as issuance rose 30% from the first half of 2004 to $559.7 billion… Globally, asset-backed and mortgage-backed securities earned around $2.3 billion in revenues for investment banks in the first half of 2005. In the Europe, Middle East and Africa region, investment banking revenues from the debt capital markets rose 27% to $4.1 billion compared to the first half of 2004 and accounted for 45% of the global take - the highest proportion in nearly 10 years. Euro-denominated borrowing in the debt capital markets also increased -
rising 16% to $1.2 trillion.”
June 27 – Reuters: “The value of global mergers and acquisitions in the first half of this year surged 31 percent over the same period of 2004, financial data provider Dealogic said, as private equity firms completed ever-larger deals and industry consolidation picked up. Announced M&A deals globally totalled $1.285 trillion in the six months to June 24, compared with $979.6 billion over the same period of 2004, according to preliminary data from Dealogic.”
Japanese 10-year JGB yields declined 3 basis points this week to 1.17%. Emerging debt markets performed particularly well considering Treasuries. Brazilian benchmark dollar bond yields dropped 9 basis points to 7.63%. Mexican govt. yields ended the week down 7 basis points to 5.27%. Russian 10-year dollar Eurobond yields slipped one basis point to 5.99%.
July 1 – Dow Jones: “Emerging market debt spreads touched a new all-time low late Thursday after J.P. Morgan completed the rebalancing of its Emerging Markets Bond Index-Plus, erasing all of Argentina’s defaulted bonds from the benchmark index.”
Freddie Mac posted 30-year fixed mortgage rates declined 4 basis points to 5.53% (low since April ’04), down 51 basis points from the April peak and 68 basis points lower than one year ago. Fifteen-year fixed mortgage rates fell 4 basis points to 5.12%. One-year adjustable rates added one basis point to 4.24%. The Mortgage Bankers Association Purchase Applications Index slipped 0.4%. Purchase applications were up 10% compared to one year ago, with dollar volume up almost 22%. Refi applications declined 1.8%. The average new Purchase mortgage dipped to $239,100. The average ARM declined to $344,000. The percentage of ARMs slipped to 30.0% of total applications.
Broad money supply (M3) rose $7.8 billion to $9.709 Trillion (week of June 20), with a notable five-week gain of $89 billion. Year-to-date, M3 has expanded at a 5.0% growth rate, with M3-less Money Funds expanding at a 7.0% pace. For the week, Currency added $1.4 billion. Demand & Checkable Deposits gained $28 billion. Savings Deposits added $1.1 billion. Small Denominated Deposits increased $3.6 billion. Retail Money Fund deposits added $0.5 billion, while Institutional Money Fund deposits dropped $13.2 billion. Large Denominated Deposits increased $0.1 billion. For the week, Repurchase Agreements dropped $17 billion, while Eurodollar deposits rose $3.3 billion.
Bank Credit surged $59.7 billion last week, more than recovering from the previous week’s decline. Year-to-date, Bank Credit has expanded $465 billion, or 14.3% annualized. Securities Credit jumped $58.9 billion during the week (down $86.4bn from previous week), with the year-to-date gain increasing to $140.5 billion (15.2% ann.). Loans & Leases have expanded at a 14.4% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 18.8%. For the week, C&I loans added $0.1 billion, and Real Estate loans increased $9.7 billion. Real Estate loans have expanded at a 15.6% rate during the first 25 weeks of 2005 to $2.732 Trillion. Real Estate loans were up $332 billion, or 13.8%, over the past 52 weeks. For the week, Consumer loans rose $2.4 billion, while Securities loans declined $6.5 billion. Other loans fell $5.0 billion.
Total Commercial Paper declined $3.1 billion last week to $1.542 Trillion. Total CP has expanded $128.6 billion y-t-d, a rate of 18.2% (up 16.8% over the past 52 weeks). Financial CP jumped $10.1 billion last week (up $50.2bn in 4 wks) to $1.407 Trillion, with a y-t-d gain of $122.6 billion (19.1% ann.). Non-financial CP fell $13.2 billion to $135.5 billion (up 9.3% ann. y-t-d and 15% over 52 wks).
ABS issuance slowed to $10 billion (from JPMorgan). Year-to-date issuance of $371 billion is 24% ahead of comparable 2004. At $235 billion, y-t-d home equity ABS issuance is 29% above the year ago level.
Fed Foreign Holdings of Treasury, Agency Debt gained $3.7 billion to $1.440 Trillion for the week ended June 29. “Custody” holdings were up $104.4 billion, or 15.6% annualized, year-to-date (up $214.8bn, or 17.5%, over 52 weeks). Federal Reserve Credit rose $0.7 billion to $788.6 billion. Fed Credit has contracted 0.5% annualized y-t-d (up $36.3bn, or 4.8%, over 52 weeks).
International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi - were up $582.58 billion, or 18.0%, over the past 12 months to $3.816 Trillion. Russian foreign reserves jumped $2.7 billion last week to $149.6 billion, with a one-year gain of about 80%.
Currency Watch:
The dollar index rose 1.5%. On the upside, the Turkish lira gained 1.2%, the Brazilian real 0.8%, and the Mexican peso 0.7%. On the downside, the New Zealand dollar dropped 3.5%, the South African rand 3.4%, the British pound 3.3%, the Swedish krona 2.4%, and the Japanese yen 2.3%.
Commodities Watch:
August crude oil dropped $2.09 to $58.75. For the week, the CRB index declined 2.7%, reducing y-t-d gains to 7.0%. The Goldman Sachs Commodities index fell 1.5%, with 2005 gains slipping to 26.0%.
China Watch:
June 29 – China Knowledge: “China’s Internet users have exceeded 100 million with over 30.1 million broadband users, cited Vice Minister of the Ministry of Information, Xi Guohua…”
June 29 – XFN: “Oil prices are too high for China to start filling its strategic oil reserve, said Xu Dingming, director general of the energy bureau at the National Development and Reform Commission. ‘We won’t be building stockpiles at such high prices,’ Xu told a business conference in Beijing. ‘Completion of the reserves will still take time…’”
June 27 – Bloomberg (Yanping Li): “China’s top 100 retailers recorded 11.5 percent growth in sales in May from a year earlier, as consumers bought more food, clothing and mobile phones, the state-run Xinhua News Agency reported, citing statistics from the China General Chamber of Commerce.”
June 27 – Bloomberg (Philip Lagerkranser): “Hong Kong’s exports in May rose at the fastest pace in nine months as the city’s sea and air ports handled more Chinese-made computers and electronics parts en route to Europe, the U.S. and Japan. Overseas sales rose 16.9 percent from a year earlier to HK$193.4 billion ($25 billion), after climbing 7.8 percent in April…”
Asia Boom Watch:
June 28 – Bloomberg (James Peng): “The Taiwanese government’s focus on spurring economic development will enable the island’s economy to grow at least 4 percent this year, cable television network Unique TV reported, citing President Chen Shui-bian…”
June 29 – XFN: “[South Korea’s] Industrial output increased 4.3% year-on-year in May, accelerating from a 3.8% rise in April, as semiconductor chips and automobiles enjoyed stronger overseas demand, the National Statistical Office said…”
June 28 – Bloomberg (Kyunghee Park): “Shares of South Korean ship-part makers such as Hyunjin Materials Co. are rising faster than shipyard stocks as a record backlog of orders for 968 vessels increases demand for propellers and engines, investor Eun Hyo Sang said… Yards in South Korea, the world’s biggest shipbuilder, have enough orders for gas carriers, tankers and other vessels to keep them busy until 2008…”
June 30 – Bloomberg (Anuchit Nguyen): “Thailand posted a current-account deficit in May for the third straight month as higher prices of crude oil swelled imports… Exports rose 13 percent to $8.99 billion, slowing from a 15 percent gain in April, and imports increased 34 percent to a record $10.6 billion.”
July 1– Bloomberg (Anuchit Nguyen): “Thai inflation accelerated to a six-year high in June as higher fuel prices made transport costlier. The consumer price index rose 3.8 percent from a year earlier…”
June 30 – Bloomberg (Subramaniam Sharma): “India’s economy expanded at the fastest pace in three quarters as manufacturers built factories, harvests improved and the government increased spending on roads and railways. Asia’s fourth-biggest economy grew 7 percent in the three months to March 31 from the year-earlier period, compared with a revised 6.4 percent gain in the previous quarter…”
Unbalanced Global Economy Watch:
June 27 – MktNews: “The world economy should continue to expand vigorously for the remainder of this year, albeit in the shadow of growing imbalances, according to the annual report of the Bank for International Settlements (BIS)… ‘The consensus forecast for this year is that the global economy will grow by about 4%. With healthy profits worldwide, corporate spending is expected to remain robust in the United States and accelerate in other regions in the course of 2005,’ the report affirmed….”
June 29 – Bloomberg (Harumi Ichikura): “Toyota Motor Corp., Japan’s biggest automaker, said global production of its cars and light trucks rose 13.5 percent in May from a year earlier… Nissan Motor Co., Japan’s second-largest automaker, said global production of its cars and light trucks rose 16.7 percent in May compared with the same month last year… Honda Motor Co., Japan’s third-largest automaker, said global production of its cars and light trucks rose 14.3 percent in May compared with the same month last year.”
June 29 – Bloomberg (Lily Nonomiya): “Foreign direct investments in Japan almost doubled to a record in the year ended March 31, led by more acquisitions from financial companies, according to a report released by the Ministry of Finance. Overseas investments in the world’s second largest economy rose to 4.03 trillion yen ($36.6 bn)…”
June 29 – Bloomberg (Lindsay Whipp): “Japan’s industrial production fell in May, led by autos, digital cameras and personal computers, as demand from China and the U.S. slowed. Production dropped a seasonally adjusted 2.3 percent from April…”
June 28 – Bloomberg (Simone Meier): “Money supply growth in the 12 countries sharing the euro accelerated more than expected in May, limiting the European Central Bank’s scope to revive economic growth by cutting interest rates. M3, the ECB’s measure of money supply, rose 7.3 percent in May from a year earlier after growing a revised 6.8 percent in April…”
June 28 – MktNews: “The unexpectedly strong acceleration in eurozone M3 growth in May to the fastest pace rate in about one and a half years and the further acceleration in private sector credit growth serve as a useful reminder that markets could be barking up the wrong tree in betting that the European Central Bank will still cut interest rates.”
June 28 – MktNews: “Home construction in France remained robust in May, with the launch of nearly 33,000 units -- a rise of 12.8% from May 2004, according to non-seasonally adjusted data…The outlook for home construction also remained bright, as building permits were issued for over 40,000 units in May, up 9.7% on the year.”
June 29 – Bloomberg (Gonzalo Vina): “Foreign investment in the U.K., Europe’s second-largest economy, grew by 31 percent in fiscal 2005, the biggest annual increase on record, a government agency said.”
June 30 – Bloomberg (Brian O’Neill): “Irish mortgage lending grew at the second-fastest pace on record last month as rising employment and the lowest interest rates in 60 years bolstered demand for property.”
June 30 – Bloomberg (Trygve Meyer): “Norwegian domestic borrowing growth in May accelerated to the highest in almost four years, led by both consumer and business credits. Credit growth for households, companies and municipalities accelerated to an annual 10.5 percent, the highest since August 2001…”
June 30 – Bloomberg (Alistair Holloway): “Finland’s retail sales rose 7.3 percent in May from a year earlier, the country’s statistics office said today. Sales rose 4.7 percent in the five months through May compared with a year earlier…”
Latin America Watch:
July 1 – Bloomberg (Charles Penty and Romina Nicaretta): “Brazil’s monthly trade surplus widened in June to a record as exports rose, setting the government on course to meet its target of shipping $112 billion worth of goods from the country this year. Compared with the same month last year, the trade balance rose 6.1 percent. Exports increased 9.4 percent and imports gained 12 percent… Brazil’s trade balance in the year through June rose to $53.68 billion, from $43.31 billion a year earlier.”
June 28 – Bloomberg (Eliana Raszewski): “Argentina’s supermarket sales by volume rose 8.3 percent in May from a year earlier, the National Statistics Institute said.”
June 29 – Bloomberg (Heather Walsh): “Chilean manufacturing production climbed in May to meet an increase in sales. Production rose 6.8 percent from May 2004, marking a 33rd month of gains…”
Dollar Consternation Watch:
June 27 – Bloomberg (Kevin Carmichael): “The record U.S. current-account deficit may disrupt the global economy and President George W. Bush isn’t doing anything about it, the world’s major central banks said in a report. ‘There is no doubt that the U.S. external accounts are on an unsustainable trajectory,’ the Bank for International Settlements, whose members include the U.S. Federal Reserve and 54 other central banks, said in its annual report today. ‘The continuing absence of a policy response increases the chance of a disorderly market adjustment.’”
Bubble Economy Watch:
June 29 – Bloomberg (Henry Goldman): “While New York City’s economic growth outpaced the nation in 2005’s first quarter, so did inflation, which increased by 4.1 percent -- the most since 1991 -- topping the nation by 1.1 percentage points, the city’s chief financial officer said. ‘The city’s high rate of inflation demonstrates a widening of the gap in the cost of living between New York City and the rest of the nation,’ Comptroller William Thompson said… ‘The inflation rate could weaken the city’s growth.’”
June 29 – Bloomberg (Brian Sullivan): “Harvard University and the rest of the Ivy League for the first time will cost more than $40,000 a year in tuition and fees when classes begin in September… Increases in tuition, fees, room and board by the schools ranged from 4.3 percent at Ithaca, N.Y.-based Cornell University, which will charge $41,767, to 5.5 percent at Yale University…, which will cost $41,000… Harvard… raised its rate by 4.5 percent to $41,675. ‘It puts an enormous burden on people who a generation ago would have been considered wealthy but aren’t necessarily wealthy now,’ said Stanley Eleff…who graduated from Harvard in 1969. Colleges across the United States have boosted tuition and fees by an average 5 to 6 percent a year since the mid-1990s, outpacing inflation by as much as 4 percentage points. The schools are struggling to find ways to absorb rising costs, including those for technology and personnel, said Sandy Baum, professor of economics at Skidmore College…”
July 1 – Bloomberg (Mark Clothier): “The University of Colorado’s board of regents approved a 28 percent tuition increase for the 2006 fiscal year, the Denver Post reported.”
June 28 – PRNewswire: “More Americans will travel this Fourth of July holiday than have ever traveled for a holiday weekend. AAA estimates that 40.3 million Americans will travel 50 miles or more from home this holiday, a 2.8 percent increase… Approximately 33.9 million travelers… expect to go by motor vehicle, a 2.6 percent increase from…a year ago. Another 4.6 million…plan to travel by airplane, up 4.2 percent… A projected 1.8 million vacationers will go by train, bus, or other mode of transportation, up from about 1.7 million a year ago.”
Speculative Finance Watch:
U.S. bank derivative positions (as reported by the OCC) jumped $3.2 Trillion during the quarter (15% annualized) to $91.1 Trillion. Interest Rate derivatives rose $2.5 Trillion (13% ann.) to $78.0 Trillion. Foreign Exchange positions declined $94 billion to $8.5 Trillion. Credit derivatives surged $777 billion to $3.1 Trillion. Over the past year, Interest Rate derivatives were up 18%, Foreign Exchange 7%, and Credit 160%. By product, Swaps were up 22% y-o-y and Options 15%, while Futures & Forwards declined 2%. By institution, JPMorganChase positions were up 16% y-o-y to $45.7 Trillion, Bank of America up 38% to $20.05 Trillion, and Citigroup up 43% to $19.2 Trillion. Total derivative positions were up 48% over the past two years.
Mortgage Finance Bubble Watch:
June 28 – Bloomberg (Amy Strahan): “Adjustable-rate mortgages are increasingly popular with first-time homebuyers in regions where home price appreciations outpace gains in personal income, regulators say. The largest gaps between increases in personal incomes and home values were reported in Nevada, Hawaii, California, Washington, D.C. and Maryland… The percentage of adjustable-rate mortgages rose to 46 percent of home loans in 2004 from 18 percent the previous year in Nevada and doubled to 58 percent from 29 percent in California, according to the Federal Housing Finance Board.”
June 30 - CNN/Money: “Manhattan’s residential property market keeps getting hotter, but despite the record-high price levels, buyers aren’t shying away… The average price for residential property in Manhattan has topped $1.3 million for the first time, according to a Prudential Douglas Elliman survey… The median sales price for a Manhattan apartment hit $775,000… Tight supply on the island means homeowners today pay an average $970 per square foot of Manhattan property compared to the $762 they shelled out per square foot at the same time last year… The average studio apartment sells for about $380,000 -- about an 18 percent premium from last year's price. But if space is what you desire, then be prepared to spend big money. According to the survey, the average price of a property with four-plus bedrooms has more than doubled in price to $10.6 million…”
June 23 – PRNewswire: “A strong labor market, continued low mortgage rates and a growing economy set the stage for a 7 percent increase in existing single-family home sales in Florida in May…according to the Florida Association of Realtors…The statewide median sales price climbed 27 percent to $230,800…In May 2000, the state median price was 115,100 -- a dramatic increase of about 100 percent over the five-year period…”
Macro Confusion:
It was, in many respects, an extraordinary first half. U.S. and global interest rates surprised on the downside; the dollar surprised on the upside. GM and Ford bonds were hammered, while crude oil surged to record highs. The prospering corporate and emerging bond markets were rattled and whipped about. The leveraged speculating community entered the year with Great Expectations but has struggled.
Indeed, volatility was the defining feature of the past six months – and not just in the marketplace. Ten-year government yields surge from 4.0% in early February to 4.64% by the third week of March. Perceptions took hold that the U.S. and global economy were on the verge of an upside growth surprise. Collapsing junk and emerging market spreads reversed and shot wider. Coinciding with the break in GM and Ford bond prices, Treasury prices abruptly turned higher in late March. And when the much anticipated acceleration in European growth failed to materialize, perceptions abruptly shifted to a rapidly slowing global and U.S. economy. Ten-year yields ended the quarter at 3.92%.
And there is nothing like a major market rally to get the creative analytical juices flowing. We were introduced to the latest New Paradigm conception - Bretton Woods II and the consequential structural decline in the so-called “neutral rate.” Top policymakers spoke of a “global savings glut,” and the last vestige of any link between our Current Account Deficit and market rates was discarded. Despite all these seemingly incredible developments, we were also warned of system fragility that prevented the Fed from hiking rates above (an un-inhibiting) 3.5%. I am reminded of 1999’s New Era Onslaught.
In our contemporary over-abundant finance, frenzied speculation and media hungry world, we should expect “news” and “analysis” to chase the direction of mutable markets. This is especially true in the current environment characterized by extreme imbalances both at home and abroad. During those periods of declining bond prices, attention shifts to U.S. economic resiliency, the booming housing market, and historic Chinese growth. When yields plunge (rising bond prices), we read about and listen to analyses of slowing U.S. and global growth, global pressure on wages, deflationary risks, a Chinese hard landing, and insatiable demand for U.S. securities. And when it’s a Running of the Bond Market Bulls, even $60 crude is said to be constructive for lower global yields.
A fascinating dynamic has evolved over time – constructive for Macro Confusion. Bond and interest-rate speculation have become THE powerful driving force on Wall Street (not to mention the U.S. economy). As such, “Street” pundits, analysts and economists have developed an analytical bias toward anticipating economic weakness and waning pricing pressures. Yet, the powerful Credit mechanism, with vested interests bent on forecasting imminent U.S. and global weakness, virtually assures that such an outcome is postponed. Indeed, no sooner than forecasters pat themselves on the back for accurately divining the ebb in output, than a furious collapse in yields assures re-acceleration.
As analysts, a determined dedication to vigilant observation is a necessity. Heeding the environment, I suggest focusing first on “market dynamics” followed closely by “fundamentals.” The Credit market beckons as the focal point of market analysis, and we must today maintain a keen appreciation for speculative market dynamics. In this regard, I suspect that we witnessed a few major market developments in the first half that will continue to shape market dynamics. The GM and Ford bond and Credit default swap mini-debacle impaired some players and reminded many others of the risk of crowded trades and evaporating liquidity. Meanwhile, a major squeeze enveloped the interest rate markets.
Some argue that Asian central banks today determine U.S. bond yields. I am skeptical. With the concurrent ballooning of the leveraged speculating community and derivatives markets, it remains my view that market rates are determined by the “marginal” leveraged speculative trader and derivative player (with all eyes on the Fed!). Market dynamics are governed by a powerful trend-reinforcing (inflationary)bias. And I do believe that a huge short-squeeze was the decisive dynamic behind the first half’s surprising yield plunge, while such squeeze “capitulations” are often harbingers of imminent changes in trend.
Clearly, the system was unusually vulnerable to “squeeze” dynamics. The Greenspan Fed had guided the expansive marketplace toward hedging against higher rates, while the ever-growing speculator community was keen to profit from Treasury short positions. The dislocation in GM debt and CDS provided a catalyst for several important developments. Those playing GM and Ford spreads (short Treasuries/long corporates) were forced to reverse positions, while a general “flight-to-quality” bid developed. Widening spreads and potential speculator tumult added to the risk of economic retrenchment, and the run (gouge the shorts!) to Treasuries was on.
It is worth noting that the second-quarter plunge in bond yields was the flipside of the sharp rise that frazzled nerves over the final weeks of the first quarter. And I do believe the first-quarter’s perception that interest rates and mortgage borrowing costs were moving much higher played a pivotal factor in the temporary ebbing of the consumer boom. We will now see to what extent the solidifying notion of perpetually low mortgage rates (and rising home prices!) has set the stage for a surprising burst of spending.
Instead of dropping below 50, the ISM manufacturing index jumped to a stronger-than-expected 53.8 during May. New Orders jumped a notable 5.5 points to 57.2, the strongest reading since last December. The University of Michigan Consumer Confidence index surged 9.1 points to a stronger-than-expected 96, also the highest reading since December. Moreover, the Univ. of Michigan reading of Current Conditions rose 8.3 points to 113.2, the strongest since October 2000. The Conference Board’s reading of June Consumer Confidence – also stronger-than-expected – was at the highest level since June 2002, with the Present Situation index the highest since September 2001. How could this be?
Well, recent initial jobless claims data are indicative of a pretty decent job market, while May Personal Income was up 6.7% from one year ago (Private Industry Wage and Salary up 7.8% y-o-y, and Transfer Payments up 7.1% y-o-y). And we see that GM June sales were off-the-charts, with total U.S. vehicle sales projected at a robust 17.5 million annual pace. And I know the bond bulls’ argument. Yet it is my view that the robust response incited by the “employee discount” marketing strategy is an important indictor of the current underlying bias in consumer sentiment and spending propensities.
Mr. Greenspan and others have trumpeted the “resiliency” of the U.S. economy. I have repeatedly argued that Credit should instead go to the irrepressible U.S. Credit system. Mr. Greenspan has referred to the resilient bond market as a “conundrum.” It is my view than any serious analysis of bond valuation dynamics should also incorporate the resiliency of oil and U.S. home prices. I suggest that U.S. bond, crude oil, and American home prices are the three most important price dynamics in global finance and economics. Is it mere coincidence that all three prices have been consistently surprising on the upside? Unrelated to consistently record U.S. debt creation?
When home prices rise we are told it is “wealth creation.” We are supposedly to blame rising oil prices on the Chinese - our (“services”) economy being so energy efficient. And rising bond prices are indicative of the Fed’s wonderful success in containing “inflationary expectations.” Three confluent price dynamics and three completely divergent explanations – no wonder there’s Macro Confusion. The reality of the situation is that massive Credit and liquidity creation – most emanating from the Great U.S. Mortgage Finance Bubble – is inflating the prices of bonds, houses, and energy. The upshot is an economy demonstrating the characteristic of a powerful yet unwieldy inflationary boom.
The stage has been set for a fascinating second half. I realize that most of the bond bears have been trampled into submission; I am keenly aware of the dynamics of establishing market tops. In a manner of speaking, the bond bears were trapped by atypical Fed transparency and baby-steps. While fundamentals (mortgage finance, speculative excess, crude, current account deficit, imbalances, etc.) argued for significantly higher market rates, the bond bulls could squeeze (the impaired bears) with impunity with the precise knowledge of the Fed’s game plan. Well, things get a lot more uncertain going forward. Even the Fed now recognizes the downside to providing clear-cut market signals. Most importantly, the current structure of interest rates ensures mortgage Credit excess, housing inflation, strong consumption, massive Current Account Deficits and all the global liquidity for the Chinese and others to buy whatever they desire. And let’s not forget how impervious the technology Bubble was to 6% Fed funds? What are today's after-tax borrowing costs?
And it is worth noting today’s market action, the first session of the second half. Bond yields surged, spreads generally widened, currencies made wild moves, gold was hammered $8.10, crude jumped $2.25, and the Goldman Sachs commodity index added almost 3%. It was certainly not the type of market behavior one would associate with soundness and stability. I’ll venture a prediction that we haven’t heard that last of hedge fund travails. And in the spirit of speculative market environments tending to cause the most grief to the largest number of participants, the charmed bond bulls are way overdue. The bond bears have been impaired, the convertible arb players impaired, the dollar bears impaired, the crude and commodities bears impaired, and the equity bulls and bears (and long/short players) rattled.
And it is when speculator “impairment” reaches critical mass that underlying system fragility begins to fester. Speculator tolerance for pain is reduced by every loss. The inclination is, on the one hand, to rush into any winning trade (Google, the utilities, MBS!) to make a buck. On the other, there is heightened necessity to throw in the towel on the losers. Fear and greed take ruthless control of the markets, although either one can hold sway on any particular week, day or hour.
All the while, pundits and the media place a fundamental spin on every market gyration, oblivious to the role that the leveraged speculating community has come to play in determining system liquidity. Most mistakenly believe that the economy drives the markets. And, at times, things simply could not look much better. The Credit-induced inflationary boom just spurs the economy and the asset markets right along. Every bout of “doom and gloom” that is overcome only emboldens. But, beneath the surface, wrecking-ball volatility chips away at system stability, all within a general backdrop of extraordinary Macro Confusion. It’s going to be a fascinating six months. Finally, the Fed’s job turns tough.
