After catching its breath last week, the Treasury market was out on another sprint. For the week, 2-year Treasury yields dipped 2 basis points to 2.49%. Five-year Treasury yields sank 9 basis points to 3.54%, with yields down 54 basis points from the high set on June 14. Ten-year yields dropped 10.5 basis points to 4.355%, the lowest yields in three months. Long-bond yields ended the week down 9 basis points at 5.115%. Benchmark Fannie Mae MBS yields dropped 8 basis points, with yields down 58 basis points from their May 7 high. The spread (to 10-year Treasuries) on Fannie’s 4 3/8% 2013 note was unchanged at 38, and the spread on Freddie’s 4 ½ 2013 note was unchanged at 37. The 10-year dollar swap spread declined 0.5 to 47.75. Corporate bonds generally performed well. The implied yield on 3-month December Eurodollars declined 2 basis points to 2.305%.
Corporate debt issuance totaled a respectable $13.7 billion. Investment grade issuers included Morgan Stanley $4.25 billion, May Department Stores $2.2 billion, Merrill Lynch $2.0 billion, Nationwide Building Society $1.55 billion, Freescale Semiconductor $1.25 billion, GMAC $500 million, Pioneer Natural Resources $525 million, Monumental Global Fund $400 million, Doral Financial $400 million, Volkswagen Credit $350 million, Berkshire Hathaway $250 million, Private Export Funding $250 million, Stone Container $200 million, Puget Sound Energy $200 million, and Pan Pacific Retail Properties $100 million.
Junk bond funds reported inflows of $339.6 million for the week (from AMG). Junk issuance included Gulfmark Offshore $160 million, and Intertape Polymer $125 million.
Convert Issuance included CapitalSource $330 million,
Foreign dollar debt issuers included Hksar Government $1.25 billion, Korea Development Bank $1 billion, PTT Public $400 million, City of Kiev $200 million, Petrol Ofisi Oil $175 million, and Caribbean Development Bank $150 million.
Japanese 10-year JGB yields declined 3 basis points for the week to 1.77%. The emerging markets really came to life this week (especially today!). Brazilian benchmark bond yields sank a noteworthy 72 basis points to 9.93%, the lowest yields since April 12. The Brazilian stock market jumped 7.5%, enjoying its best week in 19 months (and putting the Bovespa index back in the black for 2004). Mexican govt. yields dropped 23 basis points this week to 5.81%. Russian 10-year Eurobond yields declined 17 basis points to 6.42%. The Russian RTS stock index gained 4.3% this week.
Freddie Mac posted 30-year fixed mortgage rates dipped one basis point this week to 6.00% (down 32bps in four weeks). Fifteen-year fixed mortgage rates declined 2 basis points to 5.40%. One-year adjustable-rate mortgages could be had at 4.02%, down 3 basis points (down 17bps in two weeks). The Mortgage Bankers Association Purchase application index declined 6.4% last week. Refi applications dipped 6.1%. The average Purchase mortgage was $213,100, and the average ARM was $285,200. ARMs accounted for 31.5% of applications last week.
Broad money supply (M3) dropped $60.2 billion (week of July 5). I won’t over-analyze one week’s data; the decline was somewhat offset by revisions to previous data, and the week of July 5 included the final day of the quarter. Year-to-date (27 weeks), broad money is up $447.7 billion, or 9.8% annualized. For the week, Currency added $2.2 billion. Demand & Checkable Deposits sank $24.7 billion. Savings Deposits rose $16.3 billion. Saving Deposits have expanded $250.8 billion so far this year (15.3% annualized). Small Denominated Deposits added $1.3 billion this week. Retail Money Fund deposits declined $6.0 billion. Institutional Money Fund deposits dropped $33.0 billion, while Large Denominated Deposits added $3.5 billion. Repurchase Agreements dropped $26.8 billion. Eurodollar deposits rose $7.1 billion.
Bank Credit rose $11.3 billon for the week of July 7. Bank Credit has expanded $290 billion during the first 27 weeks of the year, or 8.9% annualized. Securities holdings dropped $12.4 billion. Commercial & Industrial loans added $3.4 billion, and Real Estate loans jumped $9.5 billion. Real Estate loans are up $171 billion y-t-d, or 14.8% annualized. Consumer loans rose $4.0 billion for the week, while Securities loans gained $5.8 billion. Other loans added $1.0 billion. Elsewhere, Total Commercial Paper jumped $14.4 billion to $1.336 trillion. Financial CP rose $12.3 billion, with Non-financial CP up $2.1 billion. Year-to-date, Total CP is up $67.4 billion, or 9.9% annualized.
ABS issuance jumped to $16 billion (from JPMorgan) this week, with y-t-d issuance of $310 billion 33% ahead of comparable 2003. Year-to-date Home Equity ABS issuance of $185.7 billion is running 73% above a year ago.
Fed Foreign “Custody” Holdings of Treasury, Agency Debt dipped $1.5 billion to $1.234 Trillion. Year-to-date, Custody Holdings are up $167.3 billion, or 29% annualized.
Currency Watch:
On the back of today’s pounding, the dollar dropped to a four-month low against the euro. The dollar index traded today to the lowest level since March 1, declining about 0.4% to 87.30. The Brazilian real, gaining better than 1%, traded to a 10-week high. “Commodity” currencies posted another strong showing, with the Chilean peso and South African rand up almost 2%. Even the Mexican peso and Turkish lira mustered almost 1% gains for the week against the greenback. Curiously, Asian currencies were generally weak.
Commodities Watch:
Nymex heating oil today traded to the highest level in 16 months, with crude oil and copper at 6-month highs. For the week, the CRB index was about unchanged, with y-t-d gains of 6.7%. With September crude up $1.16 to $41.30, the Goldman Sachs Commodities index added 0.4% (up 15.1% y-t-d).
Global Central Banker Watch:
July 16 – Market News: “The Bundesbank came out strongly on Friday against plans to allow increased access to International Monetary Fund credit on a precautionary basis. In an opinion piece published in the Financial Times, Bundesbank vice president Juergen Stark said such a policy, which has the backing of some G-7 members, would be ‘highly counterproductive.’ ‘If the Fund took up the role of a general risk insurer, thereby making bailout operations in crises a general rule, private investor’s risk assessments would be seriously distorted and debtor countries’ incentives to pursue sound policies and build strong institutions undermined.”
China Watch:
July 16 - Bloomberg (Philip Lagerkranser and Rob Delaney): “China’s economic growth unexpectedly slowed in the second quarter, suggesting government lending curbs are cooling the world’s fastest-growing major economy. Gross domestic product rose 9.6 percent from a year earlier after climbing 9.8 percent in the first quarter, the government said in Beijing.”
July 12 - Bloomberg (Philip Lagerkranser and Tian Ying): “China’s exports surged 47 percent to a record in June, suggesting a pickup in demand in the U.S., Europe and Japan will help sustain growth in the world’s fastest-growing major economy. Overseas shipments jumped more than expected to $51 billion after climbing 33 percent in May, the Beijing-based commerce ministry said… China’s imports also beat economists’ forecasts, surging 51 percent to $49 billion, their biggest gain in more than a decade.”
July 14 - Bloomberg (Tian Ying): “China’s property prices rose 10.4 percent in the second quarter from a year earlier, led by Shanghai, the Economic Information Daily reported, citing a survey of 35 cities by the National Bureau of Statistics. Shanghai prices surged 21.4 percent…”
July 15 - Bloomberg (Jianguo Jiang): “China’s producer prices rose 6.4 percent last month from a year earlier, as the cost of crude oil, coal and fertilizer increased, the Shanghai Securities News said, citing the National Bureau of Statistics. Crude oil prices jumped 20.9 percent and the cost of coking coal climbed 18.2 percent in June…”
July 13 - Bloomberg (Philip Lagerkranser): “China attracted 12 percent more foreign direct investment in the first half as companies including Sony Corp. and General Motors Corp. sought to tap booming demand in the world’s fastest-growing major economy… ‘China doesn’t want to slow down foreign investment because it’s valuable to the economy and brings in foreign expertise,’ said Joseph Lau, an economist at Credit Suisse First Boston in Hong Kong.”
July 14 - Bloomberg (Jianguo Jiang): “China’s central bank said wholesale prices for commodities including grains and steel rose 9.3 percent last month from a year earlier, easing for a second month as government measures to slow the economy took effect. The increase in the index of prices at which factories sell to distributors compared with a 9.4 percent gain in May…”
July 14 - Bloomberg (Philip Lagerkranser): “China’s economy probably grew at the fastest pace in 8 1/2 years in the second quarter as consumer spending and exports surged. Government efforts to cool down the expansion aren't deterring Jeffrey Immelt, General Electric Co.’s chief executive officer. ‘The government has indicated that they’re going to continue to invest in energy, and we’ll be one of the recipients,’ Immelt, 48, said in a conference call with investors on July 9. In power generation, ‘we just don’t see any slowing right now in China.’”
July 14 - XFN: “Car sales in China decelerated sharply at the end of the first half of the year as price cuts and tight credit conditions hit consumers, raising fears that the mainland’s once booming appetite for cars is waning… Passenger car sales fell for their third consecutive month in June, down 7.8% over May’s 177,500 to 164,900… Analysts said that sales this year are expected to come in at around 2.5 million, implying growth of around 20-25%.”
Asia Inflation Watch:
July 13 - Bloomberg (Lily Nonomiya and Mayumi Otsuma): “The Bank of Japan said the world’s second-largest economy will grow more than it forecast this fiscal year as rising exports spark a recovery in domestic demand. Growth will exceed the median 3.1 percent forecast for the year ending March 31 that board members made in April, the bank said in a report in Tokyo. The bank affirmed its forecast that core consumer prices, which exclude fresh food, will fall 0.2 percent this fiscal year. ‘Japan’s economy is gaining momentum,’ central bank Governor Toshihiko Fukui told reporters… ‘Consumer spending will probably keep improving at a moderate pace.’”
July 12 - Bloomberg (Cherian Thomas): “India’s industrial production rose 7.5 percent in the first two months of the fiscal year from a year earlier as soaring farm production and the cheapest credit in three decades spurred consumer spending. The increase in April and May compares with a gain of 5.3 percent a year earlier…”
July 13 - Bloomberg (Ramya Venugopal): “The Indian government may tolerate 7 percent inflation this year as it strives to meet an increase in revenue, Barclays Capital said in a research report. The government expects to raise revenue to 5.37 trillion rupees ($117 billion) in the fiscal year ending March 2005, compared with 4.74 trillion rupees last year, Finance Minister P. Chidambaram said in the budget revealed on Thursday. He expects corporate tax receipts to rise 40 percent, compared with 19 percent growth last year.”
July 12 - Bloomberg (Amit Prakash): “Singapore’s economy grew at a 9.1 percent pace in the second quarter, helped by surging exports from and other computer-chip and drug companies. The faster-than-expected expansion may lead the government to raise its full year growth forecast, Nizam Idris and other economists said.”
July 12 - Bloomberg (Laurent Malespine): “Thailand’s new vehicle sales growth accelerated in June from May and helped first-half sales reach nearly 300,000 units. New automobile sales in Southeast Asia’s biggest vehicle market last month rose 16.6 percent from a year earlier…”
July 15 - Bloomberg (Aloysius Unditu and Soraya Permatasari): “Indonesia’s inflation will probably accelerate to as much as 7 percent this year, Finance Minister Boediono said.”
July 16 - Bloomberg (Jun Ebias): “Philippine economic growth may reach as much as 6.3 percent next year, boosted by sales to the U.S. and Japan, the nation's two biggest trading partners, National Economic Planning Secretary Romulo Neri said. Exports, which comprise about two-fifths of gross domestic product, may grow as much as 20 percent next year…”
Global Reflation Watch:
July 13 - Bloomberg (Kevin Carmichael): “Canadian companies imported goods worth a record C$31.6 billion ($24 billion) in May, shrinking the country’s trade surplus more than expected to C$5.22 billion, Statistics Canada said… Exports increased for a fourth month, rising 1.3 percent to C$36.8 billion as sawmills and refiners of natural gas sped production to meet U.S. demand. Imports surged 7.8 percent from April, the biggest one-month gain since January 1997, led by the highest level of machinery-and-equipment purchases in two decades, StatsCan said.”
July 12 - Bloomberg (Sam Fleming): “U.K. house-price inflation accelerated to 12.2 percent in May from 10 percent in April, a government survey showed. The average cost of a home rose to 170,719 pounds ($318,254), the Office of Deputy Prime Minister John Prescott said in a statement on its Web site. Prices increased 1.2 percent in the month…”
July 12 - Bloomberg (Julia Kollewe): “The cost of goods leaving British factories rose at the fastest annual pace for more than eight years in June, led by petroleum and metals products. Producer prices rose a non-seasonally adjusted 0.1 percent in the month, the ninth straight increase and following May’s gain of 0.4 percent, the national statistics office said. From a year ago, factory gate prices climbed 2.6 percent, the most since May 1996.”
July 14 - Bloomberg (Sam Fleming): “U.K. wages excluding bonuses rose at the fastest pace in two years in the three months through May, indicating accelerating economic growth and the lowest unemployment for three decades may continue to fuel inflation.”
July 16 - Bloomberg (Eduard Gismatullin): “Russian industrial production rose at its fastest pace in five months in June, as high oil prices boosted demand for pumping and transport equipment and helped the petrochemical industry grow. Russian industrial production, adjusted for working days, rose 7.5 percent in June from a year ago, the fastest growth since January…”
July 14 - Bloomberg (Maria Ermakova): “Russian industrial production rose in June at its fastest pace in more than three years as machinery output surged on demand from oil, metal and energy producers… Industrial output grew 9.2 percent in June from the same month last year…citing preliminary data. The rate would be the fastest since November 2000…”
July 15 - Bloomberg (Maria Ermakova): “Russia’s foreign currency and gold reserves rose to $89.2 billion, a record, the central bank said. The reserves rose by $900 million in the week to July 9 from $88.3 billion on July 2, the central bank said… The reserves have risen by $6.5 billion in eight weeks of gains since May 14.” (What a contrast to 1998!)
July 14 - Bloomberg (Tracy Withers): “New Zealand consumer prices rose at the fastest pace in two years in the second quarter, driven by more expensive gasoline, timber and electricity, which may prompt the central bank to raise interest rates this month. Consumer prices rose 0.8 percent from the first quarter, Statistics New Zealand… Reserve Bank Governor Alan Bollard, who must keep annual inflation between 1 percent and 3 percent, has raised the official cash rate three times this year to 5.75 percent and said another increase is likely to control rising prices… ‘The inflation rate is high and rising,’ said Robin Clements, chief economist at UBS New Zealand Ltd. in Christchurch. ‘This is sufficient to suggest a rate increase this month is a done deal.’”
July 13 - Bloomberg (Telma Marotto): “Richard Madigan, managing director and chief strategist for J.P. Morgan Chase & Co.’s private banking unit for Latin America, estimates the region’s economy will grow 4.7 percent this year.”
July 15 - Bloomberg (Carlos Caminada): “Brazilian retail sales rose for a sixth month in May as declining rates on consumer loans buoyed sales of cameras, computers and other goods for retailers such as Pinault-Printemps-Redoute SA. Retail, supermarket and grocery store sales, as measured by units sold, rose 10 percent from the year-earlier period…”
California Bubble Watch:
July 13 – Los Angeles Times (Annette Haddad): “Los Angeles County home prices posted their biggest increase in at least 15 years in June as the median surged 32.3% to a record $414,000… June marked the first time that the county’s median price — the point at which half the homes sold for more, half for less — topped $400,000 and was the 12th consecutive month that prices rose at least 20% year over year. The steep run-up in prices, over the last two years in particular, has prompted concern that the region’s housing market, a major engine of the economy, may be caught up in a speculative bubble. But so far, some key warning signs have yet to reach what experts consider to be dangerous levels, even as prices continue to rise at a sizzling pace. ‘There is still no indication in these numbers that the market is turning,’ said John Karevoll, an analyst at DataQuick… Adjustable-rate mortgages (which offer lower initial interest rates and therefore lower monthly payments) accounted for 66.7% of purchases in June, up from 59.8% in April. That increase tracks a corresponding rise in mortgage rates over the same period.”
Mortgage Finance Bubble Watch:
July 13 – Dow Jones (Janet Morrissey): “The average price of a Manhattan apartment in the latest quarter topped the $1 million mark for the first time as low mortgage rates and a recovering economy appeared to drive the market. However, inventories are on the rise and homes took a little longer to sell than they did in the first quarter… The Prudential Douglas Elliman Overview report, released Tuesday, showed the average price for a Manhattan apartment was $1,047,938 in the second quarter, up 5% from $998,905 in the first quarter and up 21% from $866,970 a year ago… The average price for a condo was $1,245,633, down 3% from $1,282,380 in the first quarter, but up 20% from $1,039,331 a year earlier… Coop apartments fetched $907,654 on average in the quarter, up 10% from $827,374 in the first quarter and up 17% from $775,052 a year ago.”
July 14 – The Arizona Republic (Glen Creno): “Another month, another record for resale houses in metro Phoenix as the red-hot market shattered previous marks for prices and the number of homes snapped up by eager buyers. Resales hit 11,665 in June (up 48% from June 2003), exceeding 10,000 for the first time and destroying the record of 9,845 set in May. The median price jumped to $175,000 (up 11.1% y-o-y) in June from May’s record of $169,000…”
July 14 - The Dallas Morning News (Steve Brown): “Higher mortgage rates can’t hold back the North Texas new-home market. Builders set records for home starts and sales during the second quarter, according to two reports released Tuesday. Home starts rose more than 10 percent during April, May and June, said Ted Wilson of Residential Strategies Inc. Dallas-Fort Worth builders started 11,552 single-family homes during the second quarter – an all-time high…. Builders sold more than 10,000 houses in the second quarter, an increase of about 7 percent from a year earlier… It was the highest sales total ever for the second quarter. ‘These are very, very strong numbers,’ said MetroStudy’s David Brown. ‘We keep setting new records.’ …The inventory of new houses remains low. At the end of June, there was about a two-month supply of finished new homes on the market, according to MetroStudy.”
July 12 – Baltimore Sun (Jamie Smith Hopkins): “Baltimore area home prices leaped more than 20 percent in June for the third month in a row, extending a real-estate boom unlike any seen before by local Realtors. The average buyer agreed to pay about $262,600 for a home last month, a 20.2 percent increase over June of last year, according to numbers released Monday by Metropolitan Regional Information Systems Inc. Even with nearly 900 more properties to choose from, buyers snatched up homes faster than a year earlier: The average house sat on the market 38 days, compared with 48 days the previous June. Prices rose most sharply in Baltimore County -- nearly 30 percent.”
U.S. Bubble Economy Watch:
The May Trade Deficit was reported at nearly $46 billion, the third-highest on record. Having declined from April’s record $48.1 billion, the Wall Street Journal noted that “The decline in May marked the largest monthly narrowing since October 2002…” Compared to May 2003, Goods Imports were up 14.5% to a record $119.5 billion. Goods Exports were up 18.9% to a record $68.7 billion. By Import category, Crude Oil was up 27% y-o-y, Capital Goods 14%, Consumer Goods 11%, Automotive 13%, and Food & Beverage 13.3%. On the Export side, Capital Goods were up 22% from one year ago, Industrial Supplies 23%, Consumer Goods 18%, Automotive 6%, and Food & Beverage 10%. Both Services Exports and Imports were up 15% from May 2003. And while the export sector is booming, it will require a 74% increase in Goods Exports to match Goods Imports.
The Philadelphia Fed index jumped a much stronger-than-expected 7.2 points to 36.1 (estimates were at 25), less than three points below the 10-year high set in January. Prices Received were at the highest level since 1989. The New York Fed index jumped 6.4 points to 36.6 (estimates were at 27.8). This was the strongest reading since February’s record, and compares to the year ago 20.2. Prices Paid jumped almost 4 points to 56. Bloomberg quoted the chief economist for the National Association of Manufactures: “Manufacturers are experiencing the best times they’ve had in five years.”
From Moody’s John Lonski on the PPI: “The annual rate of core intermediate materials price inflation rose from December 2003’s 2.1% to June’s 5.8% -- the steepest such gain since September 1995’s 6.1%.”
Financial Sphere Watch:
July 14 – Dow Jones (Dawn Kopecki): “The Department of Housing and Urban development has recently opened formal inquiries into Fannie Mae and Freddie Mac’s international operations as well as into Fannie’s financing of loans in key congressional districts, a top HUD official confirmed Wednesday. Assistant Secretary of Housing John Weicher told Dow Jones Newswires that HUD sent letters to both companies in recent days seeking information on those activities…Weicher would not release the letters or elaborate on their content. He was asked whether HUD was investigating the companies’ international consulting services as well as Fannie Mae’s use of its regional partnership offices to funnel financing into key congressional districts… Both government-sponsored enterprises have been expanding their reach in recent years into international markets as a source of funds to finance their massive mortgage portfolios. Fannie Mae has additionally branched out into international markets as a consultant, offering everything from portfolio management to technology infrastructure development to dozens of foreign nations considering their own secondary mortgage market... Fannie’s international operations gained notice in Egypt after Reuters news service reported in late May that Egyptian Finance Minister Medhat Hassanein announced plans for a joint venture company between Fannie Mae, the World Bank’s International Finance Corp., and Egypt’s National Investment Bank to ‘securitise home loans and help spur on the nascent Egyptian mortgage market.’”
July 15 - Bloomberg (Amy Strahan Butler): “Banks and other issuers of asset-backed securities asked U.S. regulators to scale back a plan that would require them to disclose more information on the investments, such as performance and delinquency rates. The Securities and Exchange Commission’s plan is costly and would force issuers such as Bank of America Corp. and Citigroup Inc. to gather information that may not be helpful to investors, industry groups said in comments the SEC released this week. The agency will consider the comments before taking a final vote on the plan, proposed in April.”
Citigroup reported second-quarter earnings of $1.14 billion, down sharply due to a $4.95 billion after-tax charge for the Worldcom class action settlement. Highlights included: “Citigroup continued to achieve strong business volume growth, with 24% increase in mortgage origination volumes in North American retail banking and 21% deposit growth… In international cards, net new accounts grew by 6.6 million along with 29% receivable growth… Revenue growth of 15%, as revenues reached $22.3 billion.” By business segment, Global Consumer earned income of $3.07 billion for the second quarter, up 34% from the year ago period. “In North America, cards income rose 31% to $850 million. Managed revenues increased 28%, driven by 27% growth in managed receivables…” Global Corporate & Investment Bank revenues increased 12%, with Capital Markets & Banking income up 28% to $1.5 billion. Global Investment Management revenues were up 4%. By region, “Japan’s income rose 13% to $258 million…” “Asia’s income was $644 million, increasing 50%.” “Latin America’s income increased 34% to $229 million.”
Examining Citigroup’s Balance Sheet, Total Assets expanded a record $78.7 billion during the quarter, or 24% annualized. Fed Funds and “repos” increased $10.5 billion, Trading Assets $12.8 billion, Brokerage Assets $6.9 billion, and Investments $1.9 billion. Consumer Loans jumped $14.9 billion, or 16% annualized, to $398.6 billion. Curiously, Corporate loans increased $12.4 billion to $112.9 billion. Year-over-year, Total Assets were up $209.5 billion y-o-y, or 17.7%. Trading Account Assets increased $70.7 billion (41%) to $245.0 billion; Consumer Loans expanded $68.9 billion (21%) to $398.6 billion; while Corporate Loans increased $4.0 billion (4%) to $112.9 billion.
Sallie Mae reported Net Income of $615 million, up 65% from the year ago quarter. Student loan originations were up 24% compared to the year ago period, while Managed Student expanded at a 12% rate during the quarter to $94.9 billion. Total Assets expanded $2.7 billion, or 15% annualize, with y-o-y Asset growth of 31%.
July 15 - Bloomberg (Michael McKee and Jessica Brice): “U.S. Commerce Secretary Donald Evans said he’s not worried that oil prices will lead to higher inflation. ‘Oil prices have been above $35 to $40 for quite some time now,’ Evans said… ‘If that was going to have a serious impact on inflation in this economy, it would have begun to feed its way into it. From what I can tell, inflation remains in check and remains under control.’”
The Financial Sector Earnings Illusion
I have often written that contemporary “money” and Credit are merely debit and credit journal entries in a massive global electronic ledger. Also deviating from history, financial claims (“money” and Credit) are today detached from actual economic wealth creating capacity. There is no restraint in issuance, as would be the focal point of a system backed by precious metals, nor is lending to finance business investment the commanding Monetary Process for the creation and use of financial claims. Moreover, leading monetary authorities brazenly disregard traditional mores of monetary discipline and prudence. This is why I stick with “Global Wildcat Finance” as an apt description of the current environment characterized by runaway monetary expansion.
There are myriad problems with ungrounded finance. Foremost, there is no mechanism to rein in the over-issuance of financial sector liabilities (including bank & money market deposits, agency and corporate debt, MBS, ABS, “repos” and “structured” instruments). And as we have witnessed repeatedly, inevitable bouts of financial and economic tumult – the consequence of previous excess – are routinely, if temporarily, alleviated with only greater Credit inflation.
The combination of unfettered finance and “activist” monetary management has been a recipe for momentous over-issuance (monetary inflation) and resulting myriad Bubbles. Authorities have no prescription for remedying the situation outside of stop-gap measures that foster only greater monetary inflations – providing further boon for destabilizing lending and speculating excess. I have previously written about comparable fiascos, including John Law’s Mississippi Bubble, the French assignat inflation, and the “Roaring 20s.”
The U.S. financial sector and global central banks are the fountainhead for today’s great inflation. It is worth again noting that Citigroup’s $1.3 Trillion balance sheet expanded at a 24% annualized rate during the second quarter. This is roughly in line with the ongoing growth rate for the combined $3.3 Trillion global central bank balance sheet. There is nothing comparable in history to such a massive and comprehensive global monetary inflation.
For years now, the U.S. financial sector has thoroughly delighted in its unrestrained capacity to issue liabilities and expand holdings. And with an ultra-accommodative Fed manipulating interest-rates downward, the more aggressive the financial sector expansion (Credit inflation) the greater reported accounting profits. Indeed, no industry has anything comparable to the financial sector’s control over its own expansion and reported earnings (also explaining why so many companies have wanted into the finance business). And for years now, investors and speculators have relished in this sector’s heady and consistent earnings growth. This has especially been the case since the technology bust, with enthusiasm for the financial sector a major contributing factor in the vigorousness of the recent “reflation.”
These days, I would imagine that there are some perplexed holders of bank and brokerage stocks. On the surface, things appear to be proceeding swimmingly: interest rates remain low, asset growth strong, the economy reasonably robust, and Credit losses meager. Financial sector expansion has been unrelenting and earnings growth generally stellar, yet many key stocks trade poorly. The question worth pondering this evening is whether this is normal “ebb and flow,” or is there something more significant at work. I will argue the latter.
It is worth recalling how, during the late-nineties, a torrent of liquidity pushed the technology sector into self-destructing excess. Technology was the hot sector in an environment of profligate finance. Massive speculative flows, gross over-spending, endemic over/mal-investment, and general manic upheaval fostered a spectacular industry profits boom and bust. Those caught extrapolating the “terminal phase” earnings climax were rather viciously blindsided.
Finance has since supplanted technology as the hot sector, in a decisive progression of Bubble Dynamics. Massive over-expansion will prove similarly destructive for industry profits, along with being catastrophic for the soundness of the financial system, economy and our currency. There has certainly been over-expansion and heightened competitive pressures, fostering risky and excessive lending. But I will attempt to delve beyond traditional facets of Credit excess.
The financial sector’s predicament is that its massive expansion has nurtured untenable systemic financial and economic Bubbles. This problem is truly endemic, and there is no effective way to slow or manage the process. And while these Bubbles are sustained for now through continued financial sector expansion (Credit inflation), the consequences of gross excess at this stage of the cycle are indeed perilous – and the problem is truly both domestic and global.
Examining the billions of quarterly accounting earnings reported these days by the likes of the JPMorgans, Citigroups, Bank of Americas, and Goldman Sachs of the world, I would posit that they provide today only an Illusion of True Profitabilty. Yes, financial institutions can aggressively lend to consumers and increase leveraged speculations in largely consumer loan-backed securities, but the value of these assets will be negatively impacted at any point where additional loans and speculations are not forthcoming. We have witnessed, in Minskian terms, The Ultimate Systemic ‘Ponzi Finance.’ Meanwhile, the consensus believes that the financial sector is the primary beneficiary of a New Financial Profits Paradigm.
The reality of the situation is that this earnings Bubble Illusion is maintained only by unending Credit inflation and finanical excess. And with asset markets and the economy so distorted, what will prove stunning losses are forestalled only by unrelenting lending and speculative excess.
There are two integral aspects of future financial sector losses today held at bay by expansion. First, there are Credit losses. Current Mortgage Finance Bubble excess encourages many insolvent borrowers to postpone the day of reckoning through the extraction of inflated home equity. Millions of other borrowers are unknowingly risking future insolvency by over-borrowing to purchase (or extract equity from) over-priced properties. It is a central tenet of Credit Bubble analysis that prospective Credit losses expand exponentially during the late-stage of excess, and this dynamic has become much less analytically nebulous over the past year. When the mortgage finance Bubble inevitably falters, losses will quickly mushroom and astound.
There is a second key - and likely more pressing - issue with respect to future financial sector losses. I would strongly argue that today’s huge “trading” gains are also Illusionary – and as well sustained only by massive unrelenting Credit inflation and speculative excess. As long as the “banks,” brokerages, hedge funds and others continue accumulating positions, imputed market values will create the mirage of profitability and liquidity. But only those fooled by the nature of Bubble dynamics would today extrapolate inflated trading gains. Here again, when the financial sector Bubble wanes and players seek less risk and more liquidity, unsound markets will falter. Previously reported accounting gains will be quickly transformed into problematic losses.
Yesterday’s WSJ “Heard on the Street” column by Gregory Zuckerman provided an interesting account of the boom – and apparent unwind - of hedge fund Andor Capital Management. After posting years of stellar returns and growing assets to more than $9 billion, today “Andor is Haunted by a Bad Bet.” Management made the reasonable but losing wager that technology stocks would not have a stellar 2003. Justifiable and excusable perhaps, but one bad year has nonetheless radically changed the dynamics of the firm. Once a magnet for investor flows and talent, the firm now faces an abrupt reversal of fortunes.
For hedge funds generally, when things are going well they go real well. And they’ve been going extraordinarily well for years now. As always, bull markets are a great begetter of genius and wealth. Strong fund performance attracts additional investors, and the attendant flows work to increase the size of positions. Pressing winning positions will help produce only bigger winners, better performance, and heftier (self-reinforcing) investor flows (as well as scores of copycat strategies). And with a service fee of between 1% and 2% and a big incentive fee (often 20% of realized and unrealized gains go to fund management), an expanding fund company will have resources to attract “the best and brightest.” Others, having enjoyed the fruits of bull market success at various firms, on trading desks or from trading their own (and family) accounts, will use impressive track records to set up their own shops, raise funds and build positions.
“Masters of the universe” – fledgling and otherwise - meet fervid investors and speculative dynamics take over. Much too much (free-wheeling) finance chases a limited quantity of sound investments, although this seemingly serious predicament is for some time mitigated by enterprising investment bankers fabricating myriad securities, instruments, and derivative contracts. As fast as lenders can lend (to consumers and the asset markets) and securitizers can securitize, leveraged speculators will speculate in these instruments to the perceived benefit of all mankind.
Andor’s problem is that one year of losses has decisively altered the nature of the game. Since they will no longer receive the coveted incentive fee until previous losses are recovered, their pool of talent is easily enticed away. At the same time, previously giddy investors are left disappointed and increasingly distressed. Not only are they fearful of the ensuing talent exodus, they have further reason to rush to the exit: In a mirror image of the bullish dynamics/“inflationary bias” comprised of self-reinforcing strong performance, heightened inflows, position building and higher prices -- the downside of speculative dynamics has poor performance inciting outflows, position liquidations, lower prices and greater disappointment. And to make matters worse, opportunists are quick to seek gains from Andor’s hardship in the dog-eat-dog world of speculative finance. One wrong bet in one area can jeopardize all bets.
I highlight the Andor predicament this evening as I view it as an instructive “microcosm” of the unfolding vulnerability inherent to both the “leveraged speculating community” and the U.S. financial sector more generally. Importantly, a major reversal in speculative dynamics does not require a major development. And as much as speculative dynamics nurtures a self-reinforcing upward bias over the life of the boom, weakness rather rapidly begets vulnerability and fragility on the downside. Indeed, from reading history I have always been fascinated by the innate susceptibility of seemingly robust financial booms. As analysts, we are today afforded an incredible menu of Bubbles to study and scrutinize.
I would today argue that only as long as financial sector assets and total speculative returns expand will there persist The Illusion of Soundness and Stability. The liquidity to sustain this massive financial scheme is derived from financial sector ballooning – the expansion of risky consumer loans, securities holdings, leveraged trading positions, and derivatives (with few new financial claims backed or financing economic investment). Along with global central bank balance sheet growth, these unrestrained expansions have been perceived as a boon and generally non-problematic. I doubt this will remain the case going forward. In fact, a strong argument can be made that both U.S. financial sector and global central bank expansions are increasingly destabilizing.
For one, there are the deleterious effects to real economies that I have highlighted on numerous occasions (including over-consumption and incessant trade deficits here at home, and inflation in Asia). Second, there is the unfolding dollar problem. It is my view that we are nearing the point where the massive liquidity creation necessary to sustain the U.S. financial and economic Bubbles risks overwhelming the foreign exchange markets. Third, the bloated “leveraged speculating community” is acutely vulnerable to disappointment.
The final “blow-off” inflows into leveraged speculation, along with the amazing proliferation of funds and strategies, have ensured unfulfilled expectations and disenchantment. And with global markets – equities, debt, currencies, and commodities – turning increasingly tumultuous, many funds will suffer a fate worse than Andor’s. With this in mind, I sense that the leveraged speculator Bubble is more vulnerable today than it has been in almost two years. And for the complacent that would argue that hedge funds have withstood hardship in the past, I would retort that the industry has mushroomed to unwieldy dimensions, while the Fed today basically has no room to collapse rates and once again foment easy speculator profits (bailouts).
And this gets us back to The Financial Sector Earnings Illusion. Going forward, only continued financial sector ballooning will hold trading losses and bad debt expenses at bay – only gross excess will prolong The Ultimate Systemic ‘Ponzi Finance.’ But is this possible if the leveraged speculator community turns cautious? And what about the The Dollar Paradox? The financial sector expansion necessary to sustain U.S. financial and economic Bubbles today provides a clear and present danger to global currency markets and financial stability. The game is changing, and I don’t expect the unfolding environment to be especially hospitable to Financial Dreamland.
