Did the Fed lose a little credibility? For the week, two-year Treasury yields gained 6 bps to 4.965%. Five-year yields rose 8 bps to 4.91%, and bellwether 10-year yields jumped 8 bps to 4.97%. Long-bond yields surged 10 bps to 5.09%. The 2yr/10yr spread ended the week only slightly positive. The implied yield on 3-month December ’06 Eurodollars jumped 6.5bps to 5.485%. Benchmark Fannie Mae MBS yields rose 7 bps to 6.13%, this week modestly outperforming Treasuries. The spread on Fannie’s 4 5/8% 2014 note ended the week little changed at 34, and the spread on Freddie’s 5% 2014 note also little changed at 34. The 10-year dollar swap spread declined one to 55. Corporate bonds generally made up some lost ground this week, with junk spreads narrowing about 7 bps.
Investment grade issuers included Bank America $3.0 billion, Credit Suisse USA $2.5 billion, CVS $1.5 billion, Bear Stearns $1.25 billion, Pacific Corp $350 million, PMI Group $340 million, Eaton Corp $250 million, Public Service of Oklahoma $150 million, West Penn Power $145 million, and Equity One $125 million.
Junk bond funds saw inflows of $129 million during the week (from AMG). Junk issuers included TDS $900 million, Liberty Mutual $750 million, Clear Channel $750 million, Constellation Brands $700 million, CIT Group $350 million, Hartford Financial $330 million, Allis-Chalmers Energy $255 million, Range Resources $250 million, Reichhold Industries $195 million, AMB Property $175 million and Southern Union $125 million.
Convertible issuers included BRE Properties $400 million and Digital Realty $150 million.
International dollar debt issuers included Siemens $5.0 billion, FMG %1.58 billion, Hansen PLC $750 million, Canadian Natural Resources $700 million and Banco FMG $350 million.
Japanese 10-year “JGB” yields declined 3 bps this week to 1.83%. The Nikkei 225 index added 0.4%, reducing 2006 losses to 3.4%. German 10-year bund yields rose 7 bps to 3.98%. Emerging debt and equities markets generally hung in there pretty well. Brazil’s benchmark dollar bond yields dropped 8 bps to 6.45%. Brazil’s Bovespa equity index declined 2.4%, lowering 2006 gains to 10.4%. The Mexican Bolsa dipped 0.4% this week (up 13.9% y-t-d). Mexico’s 10-year $ yields fell 7 bps to 5.81%. Russian 10-year dollar Eurobond yields added 2 bps to 6.83%. The Russian RTS equities index surged 4.7%, increasing 2006 gains to 47% and 52-week gains to 106%. India’s Sensex equities index rose 3% (up 19.1% y-t-d).
Freddie Mac posted 30-year fixed mortgage rates dropped 8 bps to 6.55%, down 25 bps in three weeks - but up 66 basis points from one year ago. Fifteen-year fixed mortgage rates fell 7 bps to 6.20% (12-wk low), 73 bps higher than a year earlier. One-year adjustable rates were unchanged at 5.69%, an increase of 112 bps y-o-y. The Mortgage Bankers Association Purchase Applications Index rose 3.4% this week. Purchase Applications were down 21% from one year ago, with dollar volume down 23%. Refi applications jumped 7.1% last week. The average new Purchase mortgage increased to $223,600 and the average ARM surged to $356,800.
Bank Credit rose $18.3 billion last week (5-wk gain of $91.5bn), surpassing $8 Trillion ($8.011TN) for the first time. It is worth noting that Bank Credit surpassed $1 Trillion during 1979, $2 Trillion in 1986, $3 Trillion in 1993, and $4 Trillion during August 1997. Bank Credit has since expanded another $4 Trillion, doubling in nine years. Year-to-date, Bank Credit has expanded $504 billion, or 11.3% annualized. Bank Credit inflated $687 billion, or 9.4%, over 52 weeks. For the week, Securities Credit dipped $1.5 billion. Loans & Leases surged $19.7 billion during the week, and were up $343 billion y-t-d (10.5% annualized). Commercial & Industrial (C&I) Loans have expanded at a 16.9% rate y-t-d and 14.2% over the past year. For the week, C&I loans jumped $21 billion, and Real Estate loans increased $1.7 billion. Real Estate loans have expanded at a 12.4% rate y-t-d and were up 11.2% during the past 52 weeks. For the week, Consumer loans dipped $0.5 billion, and Securities loans declined $3.5 billion. Other loans added $1.0 billion. On the liability side, (previous M3 component) Large Time Deposits jumped $12.2 billion.
M2 (narrow) “money” supply dropped $30.3 billion to $6.825 Trillion (week of July 31). Year-to-date, narrow “money” has expanded $135 billion, or 3.4% annualized. Over 52 weeks, M2 has inflated $265 billion, or 4.0%. For the week, Currency dipped $0.3 billion, while Demand & Checkable Deposits rose $10.1 billion. Savings Deposits sank $50.1 billion, while Small Denominated Deposits gained $5.5 billion. Retail Money Fund assets increased $4.4 billion.
Total Money Market Fund Assets, as reported by the Investment Company Institute, rose $4.9 billion last week to $2.176 Trillion. Money Fund Assets have increased $119 billion y-t-d, or 9.4% annualized, with a one-year gain of $254 billion (13.2%).
Total Commercial Paper expanded $5.3 billion last week to $1.795 Trillion. Total CP is up $154 billion y-t-d, or 15.2% annualized, while having expanded $232 billion over the past 52 weeks (14.8%).
Asset-backed Securities (ABS) issuance this week increased to $13 billion. Year-to-date total ABS issuance of $429 billion (tallied by JPMorgan) is running about 4% below 2005’s record pace, with y-t-d Home Equity Loan ABS sales of $297 billion 4% above last year.
Fed Foreign Holdings of Treasury, Agency Debt jumped $8.7 billion to a record $1.662 Trillion for the week ended August 9th. “Custody” holdings were up $143 billion y-t-d, or 15.3% annualized, and $201 billion (13.8%) over the past 52 weeks. Federal Reserve Credit dropped $7.8 billion to $825 billion. Fed Credit has declined $1.2 billion y-t-d, or 0.2% annualized. Fed Credit is up 4.2% ($33.5bn) over the past year.
International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $534 billion y-t-d (21% annualized) and $672 billion (17%) in the past year to $4.580 Trillion.
August 11 - Bloomberg (Anoop Agrawal): “India’s foreign-exchange reserves rose by $1.77 billion to $165.8 billion in the week ended Aug. 4, central bank data showed.”
The dollar index rallied 1.2% to 85.39. On the upside, the New Zealand dollar gained 1.4%, the Brazilian real 0.9%, the Thai baht 0.8%, and the Turkish lira 0.6%. On the downside, the Norwegian krone dropped 2.0, the Swiss franc 1.4%, the Romanian leu 1.2%, and the Swedish krona 1.1%.
August 10 - Bloomberg (Wing-Gar Cheng): “China, the world’s largest oil
consumer after the U.S., imported 13 percent more oil in the first seven months of this year because of rising energy demand.”
Gold slumped 2.2% to $632.15, and Silver dropped 4.8% to $11.885. Copper fell 4.3%, reducing y-t-d gains to 80%. September crude dipped 41 cents to end the week at $74.35. September Unleaded Gasoline dropped 8.1%, and September Natural Gas dipped 0.2%. For the week, the CRB index declined 1.6% (y-t-d up 3.8%). The Goldman Sachs Commodities Index (GSCI) dipped 0.6%, reducing 2006 gains to 14.4%.
August 8 – Financial Times (David Pilling): “Japanese bank lending leapt 2.9 per cent in July, underpinned by pent-up demand for loans from small companies that have been starved of credit for 15 years. Tuesday’ s figures, the strongest in a decade by some measures, underline the way in which reflation has helped revive an economy until recently trapped in a vicious deflationary circle… Richard Jerram, economist at Macquarie Securities in Tokyo, said: “The difference in having an economy with a functioning banking system and one without a functioning banking system is like night and day.”
August 10 - Bloomberg (Mayumi Otsuma): “Japan’s producer prices are rising at the fastest pace in a quarter of a century, increasing pressure on companies to pass on surging oil and commodity costs… An index of prices that companies pay for energy and raw materials such as iron ore increased 3.4 percent…”
August 9 - Bloomberg (Lily Nonomiya): “Japan’s machinery orders unexpectedly climbed 8.5 percent in June, adding to the central bank’s case that interest rates may need to rise.”
August 9 - Bloomberg (Irene Shen): “China’s 2006 trade surplus may widen
to $146 billion as the nation’s companies increase exports amid a domestic glut and more overseas investors set up factories, the Shanghai Securities News said, citing a government report. Chinese exports may increase by 24 percent from 2005 while imports may gain 21 percent…”
August 10 - Bloomberg (Nerys Avery): “China had a record trade surplus for the third straight month in July… The surplus widened to $14.6 billion from $14.5 billion in June…Exports jumped 22.6 percent and imports increased 19.7 percent…”
August 9 - Bloomberg (Ying Lou): “China, the world’s biggest energy consumer after the U.S., invested 74 billion yuan ($9.3 billion) on grid expansion and upgrading in the first half of this year to meet rising demand for electricity. China’s cross-region electricity transmission increased 7.8 percent to 35.5 million megawatt-hours in the first six months…”
August 8 - Bloomberg (Luo Jun and Nerys Avery): “China’s money supply growth held at 18.4 percent in July and banks reined in lending, the China Business News reported…”
August 10 - Bloomberg (Nipa Piboontanasawat): “China’s producer prices unexpectedly rose at a faster pace in July as companies passed on higher energy costs. Producer prices climbed 3.6 percent…from a year earlier…”
August 7 - Bloomberg (Yanping Li): “China’s fixed-asset investments in cities and rural areas may rise by around 27 percent this year, the official Shanghai Securities News reported, citing a government economist.”
Asia Boom Watch:
August 11 - Bloomberg (Cherian Thomas): “India’s industrial production grew more than expected in June as cement makers doubled output to supply a construction boom and vehicle manufacturers… Production at factories, utilities and mines rose 9.6 percent from a year ago…”
August 8 - Bloomberg (Cherian Thomas): “India’s trade deficit is widening because higher oil prices have increased the cost of the nation’s imports, Commerce and Industry Minister Kamal Nath said. India’s imports rose 22.4 percent to $13.7 billion in June, widening the trade deficit to $3.8 billion during the month…”
August 7 - Bloomberg (Theresa Tang): “Taiwan’s export growth unexpectedly accelerated in July… Overseas shipments rose 21.2 percent from a year earlier to a record $19.6 billion after climbing 16.5 percent in June…”
August 10 - Bloomberg (Yu-huay Sun): “Taiwan’s transportation ministry has approved inter-city bus fares being raised by as much as 19 percent next month, the China Times reported…”
August 9 - Bloomberg (Seyoon Kim): “South Korean employment fell in July as manufacturers and farmers cut workers… The number of people employed dropped 22,000… The jobless rate was unchanged at 3.5 percent…”
August 8 - Bloomberg (Anand Krishnamoorthy): “Honda Motor Co.’s Civic and Ford Motor Co.’s Fiesta models led a 28 percent gain in car sales in India last month, the second-fastest pace of growth this year. Car sales rose to 81,038 units in July…”
August 9 - Bloomberg (Shamim Adam): “Singapore raised its growth forecast for the third time this year after the economy expanded 9.4 percent in the first half, Prime Minister Lee Hsien Loong said. The $118 billion economy will expand between 6.5 percent and 7.5 percent in 2006…”
August 8 - Bloomberg (Stephanie Phang and Shamim Adam): “Malaysia’s industrial production growth unexpectedly accelerated in June… Production at factories, utilities and mines increased 7 percent from a year earlier…”
August 10 - Bloomberg (Luzi Ann Javier): “Philippine exports growth in June unexpectedly accelerated to a three-month high… Overseas sales…rose 20.6 percent from a year earlier…”
Unbalanced Global Economy Watch:
August 10 - Bloomberg (Theophilos Argitis): “Canadian new-home prices rose at their fastest pace since 1989 in June, led by the western province of Alberta, where an energy boom has led to a housing shortage. New home prices jumped 1.4 percent during the month and have gained 9.8 percent in the 12 months ended in June…”
August 8 - Bloomberg (Brian Swint): “U.K. economic growth accelerated in the three months through July as the value of a U.K. home reached a record, suggesting interest rates may have to rise again. The rate of growth in Europe's second-largest economy was 0.8 percent…”
August 10 - Bloomberg (Fergal O’Brien): “Ireland’s annual inflation rate climbed to a three-year high in July… Inflation accelerated to 4.2 percent from 3.9 percent in
August 8 - Bloomberg (Gabi Thesing): “German exports rose more than economists expected in June, as global growth fueled demand for products such as cars and chemicals made in Europe’s largest economy… Exports rose 7 percent from a year earlier…”
August 11 - Bloomberg (Francois de Beaupuy): “France’s economy grew the most in five years in the second quarter as faster expansion in Europe drove demand for exports and the soccer World Cup spurred consumer spending.”
August 10 - Bloomberg (Alice Ratcliffe): “Swiss consumers in July were the most optimistic in five years as companies created more jobs, making people feel financially more secure.”
August 10 - Bloomberg (Evalinde Eelens): “The Dutch economy expanded at its
fastest pace in two years during the second quarter, driven by strong growth in consumer spending.”
August 7 - Bloomberg (Tasneem Brogger): “Sweden’s economic growth held at 1.4 percent in the second quarter, the fastest pace in six years, led by exports, business investment and faster consumption growth. From the year earlier, gross domestic product expanded 5.5 percent…”
August 9 - Bloomberg (Tasneem Brogger): “Swedish unemployment fell in July from a year earlier as faster economic growth boosted demand for workers. The…jobless rate fell to 5.2 percent from 5.9 percent in the same month a year ago…”
August 7 - Bloomberg (Maria Ermakova): “Russia’s economy will grow an annual 6.6 percent this year, Interfax reported, citing Andrei Klepach, head of macroeconomic forecasting at the Economy Ministry. The forecast was raised from 6.1 percent…”
August 10 - Bloomberg (Samantha Shields): “Russia posted a trade surplus of $38.8 billion in the second quarter, up 8.4 percent from the first three months of the year… Exports rose to $76.6 billion from $59.6 billion, while imports climbed to $37.8 billion from $29.4 billion.”
August 9 - Bloomberg (Garfield Reynolds): “Russia’s budget surplus reached 1.258 trillion rubles ($47.1 billion) in the first seven months of the year, helping the nation pay its foreign debt and paving the way for higher credit ratings.”
August 8 - Bloomberg (Hannah Gardner): “Russia received $26 billion in foreign direct investment in the first half of this year, Deputy Economy Minister Kirill Androsov said… Russia is benefiting from a commodities-led boom as oil and gas prices surge.”
August 8 - Bloomberg (Mark Bentley): “Turkey’s industrial production rose 11.4 percent in June from the year-earlier period, the fastest pace of expansion since July 2004, as a drop in the value of the lira boosted exports.”
August 10 - Bloomberg (Hans van Leeuwen and Gemma Daley): “Australian employment surged 10 times as much as expected in July… Employment rose 50,700 after gaining a revised 53,800 in June. The jobless rate fell to 4.8 percent… the lowest since monthly records began in 1976.”
Latin America Watch:
August 11 - Bloomberg (Valerie Rota): “Mexico will save as much as $350 million after borrowing in domestic markets to pay $12.4 billion of foreign debt ahead of schedule, Deputy Finance Minister Alonso Garcia Tames said. The government yesterday sold local bonds to pay $9 billion of debt owed to the World Bank and Inter-American Development Bank and to buy back $3.4 billion of dollar-denominated bonds. Mexico raised more money from the sale than the $7 billion it originally sought.”
August 8 - Dow Jones: “Fixed investment in Mexico surged 14.4% in May from the year-ago month, helped by strong increase in machinery and equipment, the Finance Ministry said…”
August 10 - Bloomberg (Thomas Black): “Mexico will receive almost $24 billion in remittances from abroad this year, a 20 percent rise from a year ago…”
August 7 - Bloomberg (Romina Nicaretta): “Brazilian new vehicle registrations rose 19.5 percent in July from a year earlier, the country’s automakers association said in a report.”
August 7 - Bloomberg (Matthew Walter): “Chile, the world’s biggest copper producer, said its economy grew 4.5 percent in June from a year earlier, as it benefited from a surge in prices for copper…”
Central Bank Watch:
August 7 - Bloomberg (Simone Meier and Andreas Scholz): “European Central Bank council member Klaus Liebscher said the bank is ready to raise interest rates further to keep faster economic growth and near-record oil prices from spurring inflation. ‘Upward risks to price stability haven’t receded but rather worsened,’ Liebscher, 67, said… ‘If we see, based on the data, that a further tightening of the relatively accommodative course is needed, then it will happen. We’ll do what’s needed at the right time.’”
August 10 - Bloomberg (Kim Kyoungwha): “South Korea’s central bank unexpectedly raised its benchmark interest rate a quarter percentage point to a five-year high to quell inflation… Bank of Korea Governor Lee Seong Tae and his fellow policy makers…lifted the overnight call rate to 4.5 percent, the highest since September 2001. ‘Price pressures will strengthen,’ Lee told reporters…”
Bubble Economy Watch:
August 9 - Bloomberg (Joe Richter): “Worker productivity in the U.S. slowed last quarter and labor costs accelerated at the fastest pace since the end of 2004, indicating inflation risks persisted even as the economy moderated. Productivity, a measure of how much an employee produces for each hour of work, increased at an annual rate of 1.1 percent after a 4.3 percent gain the previous three months, the Labor Department said today in Washington. Labor costs rose at a faster-than-expected 4.2 percent pace, compared with a 2.5 percent rise in the first quarter.”
“Compensation per hour” was up an eye-opening 5.7% y-o-y during the second quarter, a sharp increase from the first quarter’s 4.8% - and compared to Q2 2005’s 4.0% and Q2 2004’s 3.4%.
At $64.8 billion, June’s Trade Deficit was up 11% from a year earlier. Goods Imports were up 14% to a record $156.9 billion, and Goods Exports were up 16% to a record $86.6 billion.
August 8 - Bloomberg (Vincent Del Giudice): “Consumer borrowing unexpectedly accelerated in June as Americans used credit cards to finance more of their purchases, a Federal Reserve report showed today. Consumer credit, or non-mortgage loans to individuals, rose $10.3 billion to $2.19 trillion following a revised $5.89 billion increase in May. The two-month gain was the biggest since September-October 2004. Americans are relying more on credit-card debt because rising interest rates and a cooling housing market make it harder for them to take out home-equity loans.” Consumer Credit has increased $26.5 billion over the past three months.
Real Estate Bubble Watch:
August 9 - PRNewswire: “Data released today by Foreclosure.com indicates that July registered the highest number of new residential foreclosures in 2006, with Michigan, Colorado and Ohio among the states hardest hit. According to Foreclosure.com’s monthly nationwide data report, there were 28,130 new residential foreclosures in July - a 4.95 percent increase over June and a 10 percent increase from July 2005.”
August 10 – New York Times (Vikas Bajaj): “The brand new 6,000-square-foot vacation home, backing on a boat dock on Moriches Bay, has been on the market for more than a year. After plenty of showings, but no offers, the investor who built the house recently cut the price twice, by a total of $600,000, to $4 million. It has still not been sold… It is not just the most expensive vacation homes that are going begging. The once-bustling deal making in a wide variety of popular locations for second homes — areas like Florida, the Jersey Shore and Lake Tahoe, as well as the high-price playground on the East End of Long Island — has slowed markedly in recent months. As the overall housing market weakens, the interest in buying vacation homes, from the most modest condominiums on up, appears to be falling faster.”
August 8 - Bloomberg (Kathleen M. Howley): “The National Association of Realtors…said home prices probably will gain 4.3 percent this year, a third the pace of 2005… The median price for an existing home will increase to $229,000 in 2006 from $219,600 last year, the group said…”
Financial Bubble Watch:
August 7 - Bloomberg (Jennifer Ryan and Sebastian Boyd): “Kohlberg Kravis Roberts & Co., the world’s biggest buyout firm, is seeking a European record 4.5 billion euro ($5.79 billion) high-yield bond sale to fund its purchase of Royal Philips Electronics NV’s chip division…”
Energy Boom and Crude Liquidity Watch:
August 9 - Dow Jones (Jeanine Prezioso): “Americans used more electricity last week than any week for which records have been kept… For the week ending August 5, Americans consumed 98,583 gigawatt-hours of electricity, erasing the previous single-week record of 96,314 gigawatt-hours set during the week ending July 22…”
August 8 - Bloomberg (Tina Seeley): “The Atlantic Coast from New York City to Virginia and Southern California are areas facing ‘critical congestion’ of their power grids, a government report said. New England, the Phoenix-Tucson area, the San Francisco Bay region and the Seattle-Portland area are also areas of concern, according to a grid study released today by the U.S. Energy Department. The department said in a 2002 congestion study that the nation’s clogged power grid was adding billions of dollars a year to power costs. ‘It’s a critical step in identifying those places where transmission lines are needed,’ said Jimmy Glotfelty, former director of the Energy Department's office of electric transmission and distribution. ‘This sets the ball rolling’ for new transmission projects’, he said.”
August 10 - Dow Jones (Edward Evans): “First Reserve Corp., a U.S. buyout firm, raised $7.8 billion for the biggest fund targeted at the energy industry.”
August 9 - Bloomberg (Bill Koenig): “Ford Motor Co. may invest as much as $1 billion in Michigan to make factories more efficient and fund development of hybrid vehicles.”
August 9 - Bloomberg (Denise Kee): “Mirant Corp., a U.S. power producer that emerged from bankruptcy in January, boosted a loan by 75 percent to $700 million and scrapped a $800 million junk bond sale… The six-year loan, originally planned to be $400 million, is backed by Mirant’s Philippine coal-fired power assets… Mirant received underwriting commitments for about $1.2 billion from 16 banks for the loan which pays an interest margin of 2.25 percentage points over…or Libor…”
August 9 - Bloomberg (Garfield Reynolds): “OAO Russian Railways, the country’s rail monopoly, shipped 23 percent more oil to China in the first seven months of the year than in the year-earlier period. Crude transportation rose to more than 5.4 million tons (187,000 barrels a day)…”
August 9 - Bloomberg (Andy Critchlow): “Migrant workers in Arab Persian Gulf states that account for 70 percent of the region’s workforce are sending $27 billion home annually, Gulf News reported…”
August 9 - Bloomberg (Sarah Tolkoff): “U.S. farmers will harvest 23 percent less cotton than a year ago, as a seven-month drought reduces yields from west Texas to the Mississippi Delta, a survey shows.”
August 9 - Bloomberg (Andy Burt): “U.S. weekly electricity output rose for the week ending Aug. 5, according to the Edison Electric Institute. U.S. electricity output rose 6 percent from a year earlier…”
August 10 – Financial Times (Tony Barber, Andrew Bounds, Victoria Burnett, Jan Cienski, Fiona Harvey, Peggy Hollinger and Gerrit Wiesmann): “As Europe wilts under a blistering sun, water levels in the region’s rivers and reservoirs are plummeting. The night skies over Spain’s forests glow orange with deadly wildfires. Cracked mud-flats border shrinking waterways. Fish lie stranded on the dry beds of lakes and rivers. Water levels on parts of Italy’s longest and most commercially vital river, the Po…have dropped to their lowest in living memory. On the Rhine, Europe’s busiest waterway, low waters have forced ships to carry less cargo and make up for lost revenue with surcharges of up to 50 per cent. Spain’s reservoirs were filled to just 45 per cent of capacity… Farmers predict a sharp fall in crops and face losses of billions of euros.”
August 10 – Financial Times (Fiona Harvey): “The melting of Greenland’s ice sheet is accelerating, threatening an increasing rise in sea levels. Satellite measurements showed that the speed of ice-sheet melting had risen threefold in the last two years compared with the average for the previous five years, according to a paper published in today’s edition of the peer-review journal Science… Jianli Chen, a research scientist at the University of Texas and lead author of the paper, told the Financial Times: ‘This [research] gives strong evidence telling us that global warming is there.’”
After 10 months of the fiscal year, y-t-d 2006 federal receipts are running 12.8% ahead of 2005 at $1.970 Trillion. Individual Income Tax Receipts are running 14.6% ahead of last year. Year-to-date spending is 7.8% ahead of comparable 2005. Education & Social Welfare spending is running 13.8% ahead, Medicare 12.7%, and National Defense 5.8%. Interest Expense is 22% above comparable 2005.
After some hard thought – some soul-searching, if you will - I felt compelled to write about Something Different. How ‘bout…well, let me think for a moment…ok, “inflation.” I know what you’re thinking, and it is not so much that I am analytically obsessed with this topic these days as much as I believe the inflation issue is currently of utmost importance – and, at the same time, commonly misunderstood. But, mainly, I’m just fascinated by it all.
To get this analytical ball rolling, there are nowadays two general notions with respect to inflation that may very well prove erroneous. First, there is a perception that current heightened inflationary pressures will soon wane, concurrent with the onset of a housing-induced U.S. economic slowdown. Second, there is a well-ingrained view that “globalization” is dis-inflationary. On both counts, it is my view that an unhappy realization may be looming for the markets: the housing slowdown could very well coincide with the emergence of problematic inflation dynamics, while global financial and economic forces might now play a prominent role in buttressing inflationary pressures in the U.S. and elsewhere instead of checking them.
There is the traditional monetarist theory that “inflation is always and everywhere a monetary phenomenon” – that a general price level can be expected to adjust to changes in the underlying quantity of money (with the Fed exerting adept control over the process). This is outdated and particularly unhelpful doctrine, and our central bank is certainly in no way actively managing – let alone restraining/”tightening” - the money supply. Contemporary inflation analysis must place only minimal importance to the (narrow) “quantity of money.” “Monetary” should be conceptualized and analyzed in the broadest sense as a reflection of the creation of purchasing power through the establishment of additional Credit and other financial instruments (“finance”). Finance is created largely outside of the Fed’s (central banks’) control.
“Monetary phenomena” (today largely computerized financial sector debit and Credit journal entries) augment purchasing power for a vast range of goods, services, real estate, securities, commodities, and myriad other assets, along with stimulating investment-related outlays. The nature and scope of resulting Inflationary Manifestations are dependent upon highly complex interactions of a multitude of supply and demand relationships, as well being dictated by (often fanciful) marketplace practices, traditions, perceptions and expectations. The key to sound contemporary inflation analysis lies with recognizing the predominant and evolving sources, uses, and flows of finance.
Pondering the housing slowdown, there are a multitude of factors and considerations with respect to forecasting future “inflationary” effects. Most prominently, will a downturn lead to a meaningful general slowdown in system Credit creation? And, more specifically, what about the various influences upon non-household mortgage sectors? To what extent will aggressive lenders seek to shift business focus away from housing to other arenas (i.e. commercial RE, consumer non-mortgage, small business, corporate, energy, M&A, international, education, etc.)? Do fewer housing transactions suggest reduced total household expenditures, or will it prove more a case of altered spending patterns (less new furniture and more energy-efficient appliances, for example)? Does a slowdown in transactions necessarily portend a general decline in national home prices – even in the face of accelerating household income growth? Does a downturn in the more overheated housing markets imply trouble for the majority of markets? Will lenders shy away from individual markets or run away from the entire asset class?
Keep in mind the incredible Financial Sphere Inflation that has transpired over the course of the Mortgage Finance Bubble. During the past six years, Bank Credit inflated $2.90 Trillion (57%) to $8.01 Trillion, GSE Assets expanded 61% (to $2.83TN Q1 2006), the MBS marketplace 62% (to $3.75TN) and ABS 94% (to $1.55TN). Broker/Dealer Assets surged 130% to $2.30 Trillion since the beginning of year-2000. With the majority of system Credit Inflation having been dedicated to mortgage finance, the resulting housing price spike and transactions Bubble were by far the most conspicuous Inflationary Manifestations. Curiously, however, inflationary pressures have increasingly emerged outside of the housing arena, and it should be noted that these pressures have in fact intensified as housing price inflation has abated.
So, should we expect today’s financing infrastructure of unprecedented dimensions to willingly moderate and downsize, or will the intense expansionary (inflationary) bias persist? Inflated stock prices – and massive stock option grants and share repurchases - point to the latter. Thus far, rising short-term rates and contracting lending margins have incited a push for lending volume (bank Credit up 11.3% annualized y-t-d). Stagnating mortgage profits have to this point nurtured aggressive expansion in capital markets, trading, international and prime brokerage (hedge fund services) businesses. Until proven otherwise, I will stick with the view that the profligate Financial Sphere expansion runs unabated until it is interrupted – and perhaps terminated - by financial crisis or some exogenous event.
I see serious problems associated with the current Financial Structure. All throughout the Financial Sphere ballooning process, the intense bias for financing asset and speculative Bubbles has become only more pronounced. This poses serious consequences and ramifications for the nature of both price effects and economic development. For one, the size and now commanding bias for financing speculation will ensure a wave of (over)finance and over-spending to roll through every hot sector. Myriad Credit and Asset Bubbles are sustained only with unending Credit and liquidity excess, something too easily provided during this late phase of an historic inflationary boom. This type of backdrop – unless quashed by determined central bankers - virtually ensures runaway boom and bust dynamics, along with a parlous cumulative residual of debt and economic maladjustment.
It is the nature of Credit booms that financial fragility becomes more acute over time, which ironically these days elicits increasingly timid central bankers blatantly unwilling to meaningfully tighten financial conditions and/or burst Bubbles. Inflationists would today convince themselves that sustaining the boom will work – through inflating incomes - to rectify the dilemma of inflated home prices. The upshot, however, will be a Credit system pyramiding additional layers of highly suspect debt, in the process fueling more Bubbles at home and abroad and a hopelessly unbalanced global economy. What affect this Monetary Disorder will have on “core CPI” – the Fed’s inflation gauge - is at this point not the major issue.
Certainly, the aged Mortgage Finance Bubble has left a sordid legacy of frailty throughout both the Financial and Economic Spheres. And while I appreciate how some could view such a Bubble predicament as inevitably deflationary, on a more near-term basis we are left with a potent confluence of an over-sized financial apparatus, abundantly liquid markets, an over-liquefied speculator community, and a highly maladjusted economy. Our nation’s inadequate power grid and corroded Prudhoe Bay pipeline are but the tip of the iceberg in regard to consequences of misdirected past spending ("mal-investment") that will now require only greater borrowings and expenditures.
And don’t be surprised when huge spending on energy exploration, research and development - along with investment and maintenance for our nation’s neglected energy infrastructure - does not usher in a new round of the so-called “productivity miracle.” Enormous resources will now be employed that will not result in commensurate output growth – definitely nothing on the order of how the technology investment boom yielded extraordinary increases in GDP, complete with extraordinarily high profit margins and an extraordinarily low labor cost component. Recent trends in labor costs (rising) and worker productivity (declining) are indicative of the new post-technology and housing boom environment. Housing slowdown or not, the unfolding landscape is not inflation friendly.
Recalling how the bursting technology Bubble welcomed the emerging housing finance Bubble, it is today imperative to remain cognizant of the fledgling Bubbles waiting to be over-financed at home and abroad. The expansive “energy/energy-related” super-sector is primed for unprecedented investment, spending, speculation, waste and fraud. There are, as well, intense Inflationary Biases throughout global finance, bolstered by a confluence of massive trade imbalances (foremost the U.S. Current Account Deficits), energized Credit systems across the globe, the ongoing Chinese/Indian/Asian boom, frenetic worldwide M&A activity, frenzied leveraged speculator community activity, and the swelling liquidity being accumulated by the oil exporting economies. And as much as the Fed expects inflation to abate, the bottom line is it's a fact of economic life (and history) that inflationary pressures have a stronger propensity to amplify and broaden than they do to dissipate.
Just briefly examining the inflationary boom enveloping the energy sector, there are some rather conspicuous mechanisms ensuring that higher prices marshal heightened borrowing and, hence, additional inflationary fuel. Think of the stretched consumer today allowing Credit card balances to drift higher to pay for more expensive fill-ups. Scores of homeowners will simply increase – on the margin – the size of home equity loans to pay for rising electricity and gas bills, not to mention more expensive airfares and travel/vacation costs. Others will reduce – again, on the margin – the size of home or auto loan down-payments after rising costs have diminished savings balances. Many will lease – perhaps even new hybrids – rather than buy. Many will increase the size or even delay repaying student loans or other debts, while others will borrow against their 401k plans or succumb to reverse mortgages to offset higher living expenses. The urge will be to sustain living standards for as long as possible.
Many companies – certainly the airlines and trucking companies – are expanding borrowings to finance higher energy and commodities prices. Loss-making companies such as the U.S. automobile manufacturers have been tapping the junk, ABS, and bank loan markets to plug cash-flow deficits. Our trading partners – especially the oil exporters – use inflated trade receipts to finance additional investment and imports (in the process stoking domestic Credit expansion), stimulating local economies and bolstering our and others’ booming export sectors. Yet, by far the best example of “monetizing” rising energy and other costs is our Federal government that simply increases the size of Treasuries issues to finance outlays boosted by higher prices. Later, with cost-of-living adjustments and second-round price effects, government borrowings will grow even faster.
All the while, the additional liquidity and income associated with rising household, corporate, and government borrowings provide the monetary fuel to accommodate (“knock-on”) price increases and expanding pricing power throughout the economy. And that is a much too simple explanation, but one that hopefully captures the essence of an inflationary spiral.
According to CreditSights, first-half LBO (leveraged buyout) “volume of $85.5 billion suggests we are on track to surpass 2005’s record of $130.5 billion. Deals are more aggressive, while private equity continues to rake in funds at a supersonic pace…” The M&A boom, especially throughout the energy and commodities sectors, is another excellent example of how inflationary booms prove inherently self-reinforcing. The leveraging (liquidity creation) incorporated in this year’s record LBO and M&A activity is certainly working to offset any slowdown in U.S. mortgage debt growth.
Witnessing the current Texas boom and resurgent local real estate market first-hand, I’ll assume employees from Exxon, ConocoPhillips, Apache, Anadarko and Valero are enjoying booming incomes, bonuses and stock option packages. They then go out and increase spending on goods and services, while buying more expensive homes with larger mortgages. Real estate agents – along with attorneys and accountants – prosper as well. Incomes rise throughout the community, while Texas Credit and spending growth works to offset waning real estate booms in, say, Florida.
Examining the financial and economic landscape, it is not difficult to grasp today’s heightened inflationary pressures and risks. We are in the midst of a synchronized global expansion and the world is awash in liquidity. Unlike much of the past two (“dis-inflationary”) decades, global liquidity is today keener to acquire energy, commodities, and emerging market assets than to be parked in U.S. securities markets. This indicates nothing less than a sea-change in the character of the global flow of finance. The question then becomes, how does a U.S. housing slowdown impact what has all the appearances of a profound change in the nature of Inflationary Manifestations?
Candidly, I don’t yet see the backdrop for an imminent nationwide housing bust – the type of development that would foster a dramatic slowdown in system Credit growth, spending, and marketplace liquidity. Of course, all bets are off come the arrival of financial crisis. Yet, for now, MBS spreads indicate continued strong demand for mortgage securities. Outside of a limited number of markets and higher-risk borrowers, banks remain more than happy to finance real estate purchases. Importantly, with the ballooning of Fannie, Freddie, and the FHLB system over the past decade, much of U.S. mortgage finance has been effectively nationalized. This dynamic should in the near-term continue to deaden nerves in the MBS marketplace, thereby increasing the “resiliency” of the Mortgage Finance Bubble. Indeed, it could very well prove to be a case of the Fed acquiescing to the most vulnerable markets, only to have Bubble excesses run unabated throughout others.
The bond market’s curious reaction to The Pause is worth a brief comment. With data this week indicating economic and price pressure resiliency, the market actually increased the odds of another rate hike before year-end (to about 50%). Not anxious to admit a mistake, the Fed’s inclination will be to stay paused for at least a meeting or two. This raises the possibility for the marketplace over the coming weeks to decide that the Fed erred in not hiking - and that the Fed is in the process of falling further behind the curve.
It’s going to be interesting, with some pundits calling for rate cuts and significantly lower bond yields by next year’s first half. It appears, however, altogether possible the inflationary backdrop might dictate sharply higher bond yields. So much uncertainty – along with inklings of major shifts in the flow of finance through the real economy – doesn’t seem all too bullish for the stock market.