| Unsettled conditions prevail throughout global financial markets, although U.S. stocks were generally little changed. The Dow, S&P500, Transports and Utilities were largely unchanged for the week. The Morgan Stanley Cyclical index dipped 0.5%, while the Morgan Stanley Consumer index gained 1%. The broader market was flat, with the Russell 2000 and S&P400 Mid-cap indices about unchanged for the week. Technology stocks remained under pressure. The NASDAQ100 dipped 0.5%, and the Morgan Stanley High Tech index was hit for 2%. The Semiconductors were hammered for 5%. The Street.com Internet and NASDAQ Telecommunications indices were both down 1%. The Biotechs were about unchanged. Financial stocks performed better, with the Broker/Dealers up 1% and the Banks up 1.5%. Bullion gave back only 70 cents of last week’s strong gain, while the HUI gold index added 3%. For the week, 2-year Treasury yields rose 7 basis points to 2.45%. Five-year Treasury yields added 2 basis points to 3.41%. Ten-year yields were unchanged at 4.22%. Long-bond yields ended the week at 5.02%, down 2 basis points on the week. Benchmark Fannie Mae MBS yields increased 2 basis points, underperforming Treasuries. The spread (to 10-year Treasuries) on Fannie’s 4 3/8% 2013 note narrowed 3 to 33, and the spread on Freddie’s 4 ½ 2013 note narrowed 3 to 32. The 10-year dollar swap spread narrowed 2.75 to 47, the smallest spread since April 30. Corporate bond spreads were generally little changed for the week. The implied yield on 3-month December Eurodollars gained 6 basis points to 2.17%. Corporate debt issuance totaled a respectable $13.5 billion (from Bloomberg). Investment grade issuers included SBC $1.5 billion, United Health Group $1.5 billion, Motorola $1.2 billion, Consumer Energy $800 million, Duke Capital $750 million, Northrop Grumman $690 million, Prudential $690 million, Allstate $650 million, American General $500 million, Pitney Bowes $350 million, Newfield Exploration $325 million, TXU $290 million, Anheuser Busch $250 million, Vornado Reality $250 million, Aspen Insurance $250 million, Duke Realty $250 million, Markel $200 million, Reckson $150 million, Georgia Power $125 million, Kimco $100 million, Maytag $100 million, and Idaho Power $55 million. Junk bond funds reported outflows of $91.3 million for the week (from AMG). Junk issuance included Rainbow National $800 million, THL Buildco $625 million, Qwest $575 million, MGM Mirage $550 million, Collins & Aikman $415 million, Blockbuster $300 million, Sino Forest $300 million, Century Aluminum $250 million, and Norcraft Holdings $120 million. Convert issuance included Alliant Techsystems $180 million. Japanese 10-year JGB yields dropped 12 basis points for the week to 1.57%, “the biggest two-week gain in more than five years,” according to Bloomberg. Brazilian benchmark bond yields sank 42 basis points to 9.93%, as the Brazilian real enjoyed its third straight week of gains against the dollar. Mexican govt. yields declined 4 basis points this week to 5.51%. Russian 10-year Eurobond yields were unchanged at 6.40%. Freddie Mac posted 30-year fixed mortgage rates dropped 14 basis points this week to 5.85%, the lowest level since the week of April 9. Fifteen-year fixed mortgage rates declined 16 basis points to 5.24%, down 25 basis points in two weeks. One-year adjustable-rate mortgages could be had at 4.08%, unchanged for the week. The Mortgage Bankers Association Purchase application index dipped 2.5% last week. Purchase applications were up about 8% from one year ago, with dollar volume up 16%. Refi applications rose about 3%. The average Purchase mortgage was for $214,500, and the average ARM was $291,300. ARMs accounted for 34.2% of applications last week. Broad money supply (M3) declined $5.9 billion (week of August 2). Year-to-date (31 weeks), broad money is up $465.4 billion, or 8.9% annualized. For the week, Currency added $0.3 billion. Demand & Checkable Deposits gained $1.7 billion. Savings Deposits added $0.9 billion. Saving Deposits have expanded $256.5 billion so far this year (13.6% annualized). Small Denominated Deposits rose $0.6 billion. Retail Money Fund deposits dipped $2.1 billion. Institutional Money Fund deposits gained $1.8 billion ($19.3 billion in three weeks). Large Denominated Deposits declined $4.6 billion. Repurchase Agreements declined $2.7 billion and Eurodollar deposits dipped $1.6 billion. Bank Credit declined $6.1 billon for the week of August 4. Bank Credit has expanded $299 billion during the first 31 weeks of the year, or 8.0% annualized. Securities holdings declined $3.3 billion, and Loans & Leases dipped $2.8 billion. Commercial & Industrial loans were up $0.3 billion, while Real Estate loans jumped $11.6 billion. Real Estate loans are up $183 billion y-t-d, or 13.7% annualized. Consumer loans declined $2.3 billion for the week, and Securities loans dropped $5.0 billion. Other loans declined $7.5 billion. Elsewhere, Total Commercial Paper dipped $0.5 billion to $1.351 Trillion. Financial CP added $2.3 billion, while Non-financial CP declined $1.8 billion. Year-to-date, Total CP is up $82.5 billion, or 10.6% annualized. ABS issuance totaled $14 billion (from JPMorgan) this week, with $10 billion of home equity loans securitized. Year-to-date ABS issuance jumped to $370 billion, 35% ahead of comparable 2003. Year-to-date Home Equity ABS issuance of $228 billion is running a stunning 80% above a year ago. Fed Foreign “Custody” Holdings of Treasury, Agency Debt rose $8.3 billion to $1.256 Trillion. Year-to-date, Custody Holdings are up $189.5 billion, or 28.9% annualized. For comparison, Federal Reserve Credit has expanded $8.2 billion so far this year, or 1.8% annualized, to $754.8 billion. Currency Watch: The dollar was pounded today after the release of June’s terrible trade data. Gaining 1.7%, the Canadian dollar enjoyed its biggest one-day gain since 1988 (from Bloomberg). The dollar index declined 0.5% this week. The New Zealand dollar, Argentine peso, and Norwegian krone enjoyed about 2% gains for the week. The South African rand sank 5%. Commodities Watch: August 13 – AFP: “China’s imports of crude oil in the first seven months rose nearly 40 percent from a year ago as the energy-hungry economy expanded at close to double-digit levels, state press reported. In the seven months to July crude imports rose an annualised 39.5 percent to 70.63 million metric tones… Crude oil imports rose 39.3 percent year-on-year to 61.02 million tons in the first six months… The world’s second largest oil consumer after the United States has seen oil imports soar as flagging domestic production has failed to keep up with booming economic growth and demand for gasoline in the auto market… The world’s fastest growing economy imported 91 million tonnes of crude oil last year, a 31.3 percent increase over 2002.” August 10 – MarketNews (Gary Rosenberger): “Steel prices have skyrocketed into new record territory, driven by surging raw materials costs and domestic and global demand, with the trajectory seemingly unabated by this summer’s economic hiccup, say steel industry executives. Hot-rolled sheet, a benchmark product, has tripled to about $800 ton (including surcharges) after having sunk to around $260 a ton early in 2003…” August 11 – MarketNews (Gary Rosenberger): “U.S. lumber prices are seesawing at five-year highs on record demand from residential building and remodeling and tight supplies fomented by transportation bottlenecks and diminished capacity at mills, industry officials say… Average monthly framing lumber composite prices hit a cyclical peak of $456 per thousand board feet in May, retreated to $423 in June then sharply turned up to $472 the first week of August, 52% above the prior-year price of $311…” August 11 – Bloomberg (Antony Sguazzin and Dylan Griffiths): “De Beers, the world’s biggest diamond company, said it will raise the price of rough diamonds by an average of 5 percent this month as jewelry demand remains ‘strong’ for the rest of the year. The increase, De Beers’s third this year, follows a 7 percent increase in retail diamond sales in the year’s first six months…” Copper jumped 4% today, trading to a three-month high. Weighed down by week grain and soybean prices, the CRB index added 0.5% (y-t-d gains of 5.4%). October crude surged $2.51 to a record $46.03. The Goldman Sachs Commodities index jumped 2.5% to the highest close since the spike on June 1. Year-to-date gains increased to 21%, with gains from 2002 lows of 95%. China Watch: August 13 – Bloomberg (Philip Lagerkranser and Wing-Gar Cheng): “China’s exports and imports rose 34 percent from a year earlier last month, the official Xinhua News Agency reported… Exports reached a record $51 billion and imports climbed to $49 billion, leaving a trade surplus of $2.04 billion… Overseas sales rose 47 percent in June and imports jumped 51 percent…” August 12 – Bloomberg (Wing-Gar Cheng): “China’s central bank said wholesale prices of energy products including crude oil, coal and power rose in July because of shortages and surging demand. Crude oil prices rose 8.9 percent in July from a year earlier and were 1.2 percent higher compared with June, People’s Bank of China said… Prices of coal rose 40 percent from a year earlier and gained 0.6 percent from June…” August 12 – Bloomberg (Philip Lagerkranser and Tian Ying): “China’s consumer prices rose last month at their fastest pace in more than seven years as food costs surged, making it harder for the central bank to avoid raising interest rates…. Consumer prices rose 5.3 percent from a year earlier after climbing 5 percent in June… That’s the biggest gain since February 1997…” August 11 – Bloomberg (Philip Lagerkranser and Tian Ying): “China’s producer prices rose 6.4 percent from a year earlier last month as crude oil costs surged. The gain matches June’s increase, which was the biggest in at least five years…” August 13 – Bloomberg (Philip Lagerkranser and Tian Ying): “China’s retail sales rose 13.2 percent last month as rising incomes made cars, cell phones and computers more affordable… The gain followed a 13.9 percent increase from a year earlier in June…” August 9 – Bloomberg (Allen T. Cheng): “China’s property prices will rise at a similar pace in the second half to the first six months even as the government clamps down on project loans and approvals, the state-run Xinhua news agency reported… Housing demand remains particularly strong in the cities of Beijing, Shanghai and Guangzhou, where prices will continue to surge, the report said… Home prices in 35 major cities rose by an average of 10.4 percent from a year earlier in the second quarter, led by a 21.4 percent increase in Shanghai…” August 9 – Bloomberg (Michele Batchelor): “The number of people in China’s cities of Beijing, Shanghai and Guangzhou holding a credit card increased to 22 percent of the population at the end of February, according to a survey by ACNielsen.” August 10 – Bloomberg (Philip Lagerkranser and Tian Ying): “China’s industrial production rose in July at the slowest pace in a year as government restrictions on bank lending curbed manufacturing of cars, cement and glass in the world’s fastest-growing major economy. Production rose 15.5 percent from a year earlier after climbing 16.2 percent in June…” August 11 – Bloomberg (Philip Lagerkranser and Tian Ying): “China’s export growth flowed more than expected last month as higher fuel costs curbed spending in the U.S. and sliding wages hurt Japanese demand. Exports rose 34 percent from a year earlier to a record $51 billion after jumping 47 percent in June…” August 11 – Bloomberg (Philip Lagerkranser and Tian Ying): “China’s money supply grew last month at its slowest pace in two years after the government ordered banks to curb lending to curb investment by state-owned companies. M2, which includes cash and all deposits, expanded 15.3 percent from a year earlier to 23.8 trillion yuan ($2.9 trillion) after growing 16.2 percent in June…” Asia Inflation Watch: August 9 – Bloomberg (Yu-huay Sun): “Taiwan’s exports rose by about a quarter for a second month in July as the island’s electronics makers shipped more flat-panel displays, semiconductors and laptop computers to China. Shipments increased 26 percent from a year earlier to $14.7 billion after climbing 25 percent in June…” August 11 – Bloomberg (Seyoon Kim): “South Korean exports will probably rise 36.5 percent from a year earlier to about $21 billion this month, the commerce ministry said. Exports, which account for about two-fifths of Asia’s third-largest economy, rose 38 percent in July…” August 10 – Bloomberg (Amit Prakash): “Singapore’s economy expanded a faster-than-expected 11.9 percent in the second quarter on surging exports by manufacturers… Annual growth in gross domestic product in the quarter ended June 30 outpaced the government’s initial estimate of 9.1 percent…” August 11 – Bloomberg (Dominic G. Diongson and Nanthaphol Rattanaphanish): “Thai tax receipts rose 19 percent in July, exceeding the government’s forecast by a fifth…” August 9 – Bloomberg (Heather Walsh): “Malaysia’s industrial production rose at a faster pace in June as manufacturers and power producers increased output to meet rising demand. Production at Malaysia’s factories, mines and utilities expanded 13.3 percent from a year earlier, also up from a revised 12.5 percent increase in May…” August 12 – Bloomberg (Kartik Goyal): “India’s industrial production rose faster than expected in June as record farm incomes and the cheapest credit in three decades boosted demand for manufactured goods. Output at factories, utilities and mines rose 7.3 percent from a year earlier, faster than May's revised 6.7 percent rate…” August 13 – Bloomberg (Kartik Goyal): “Indian inflation, measured by the rise in wholesale prices from a year earlier, accelerated to 7.61 percent in the week ended July 31 from 7.51 percent in the previous week… It was the highest since Feb. 17, 2001…” Global Reflation Watch: August 10 – Bloomberg (Greg Quinn): “Canadian new home prices rose in June at the fastest annual pace since February 1990, surging 6.2 percent as builders raised prices to cover higher costs for labor, drywall and lumber.” August 9 – Bloomberg (Kevin Carmichael): “The value of construction permits issued by Canadian municipalities surged 27.1 percent in June, six times more than economists expected, led by record demand for apartments and condominiums.” August 11 – Bloomberg (Lily Nonomiya and Julie Ziegler): “Japan’s economy, the world’s second largest, will expand at its fastest rate in more than a decade this year and is likely to continue growing for the next few years, the International Monetary Fund said. Economic growth is projected to reach 4.5 percent this year, compared with an April forecast of 3.4 percent…” August 9 – Bloomberg (Sam Fleming): “U.K. house-price inflation accelerated in June to the fastest annual pace for 10 months as higher interest rates failed to damp demand for property, a government survey showed. The average cost of a home rose 13.9 percent in June compared with the same month last year to 173,756 pounds ($320,241)…” August 12 – Bloomberg (Sam Fleming): “English new home starts rose 9.5 percent in the second quarter of the year from the same period in 2003, according to government figures, as homebuilders boosted construction amid 20 percent house-price inflation.” August 12 – Bloomberg (Eduard Gismatullin): “Russia will boost its defense spending by 40 percent to 700 billion rubles ($23.9 billion) next year, Interfax reported, citing Finance Minister Alexei Kudrin. Salaries for servicemen will be raised by more than 50 percent, the news service said.” August 11 – Bloomberg (Simone Meier): “Swiss retail sales in June increased the most in three years as households boosted spending ranging from furniture to computers and watches. Sales rose an inflation-adjusted 6.2 percent from the year-earlier period after a 3.5 percent drop in May…” August 11 – Bloomberg (Andrew J. Barden): “Mexican industrial production rose for a seventh month in June as manufacturing companies increased production to meet rising U.S. demand. Industrial output, which includes manufacturing, construction, mining, and utilities, rose 5.2 percent, said Mexico’s Finance Ministry…compared with the median estimate of 4.5 percent…” August 13 – Bloomberg (Romina Nicaretta): “President Luiz Inacio Lula da Silva was told Brazil’s gross domestic product grew between 4.5 percent and 5 percent in the first half of the year compared with the same period a year earlier, Folha de S. Paulo newspaper reported… The 5 percent growth in GDP would be the biggest growth for that period in nine years…” August 11 – Bloomberg (Jeb Blount): “Brazil’s inflation rate surged to a 15-month high in July as rising demand for machinery, steel and other goods led manufacturers that are running near full capacity to boost prices. Consumer prices, as measured by the government’s IPCA index, rose 0.91 percent in the month after rising 0.71 percent in June… A 2.5 percent surge in gasoline prices at the pump led the increase in the month.” August 9 – Bloomberg (Heather Walsh): “Chile’s trade surplus rose in July after prices for copper, Chile’s top export, surged 56 percent in a year because of stronger demand in China and the U.S.” California Bubble Watch: August 11 – MarketNews (Chris H. Sieroty): “After a drawn-out budget battle last month that left lawmakers and the governor bruised, August, so far, has been relatively kinder to California. State Controller Steve Westly announced late last week that state revenues, which had come in below forecast for most of the year, totaled $4.05 billion, a 9.1% jump from the same month last year.” U.S. Bubble Economy Watch: August 10 – Bloomberg (Stephen Cohen): “A record number of the financial analysts, bankers and traders who took the Chartered Financial Analyst exam in June failed the test. Almost two-thirds of the 24,241 people who took the first of the three tests needed for certification didn't pass, according to the CFA Institute… The institute said it was the fifth straight year that the passage rate declined. In 1999, 36 percent of candidates flunked; this year, 64 percent failed… More people than ever are taking the test, with an estimated 85,000 enrolled for all levels of the June exam.” August 10 – Bloomberg (Michael B. Marois): “U.S. states tax revenue increased for a third quarter in a row because of an improving economy, helping many states meet or exceed budget forecasts for their fiscal year… State tax revenue collections increased 11.4 percent in the April through June quarter compared with the same period last year, according to a report by the Nelson A. Rockefeller Institute of Government… In fiscal 2005, the projected budget gap for all U.S. states was $36.3 billion, less than half that of a year earlier…” August 9 – Bloomberg (Tony Capaccio): “Rising costs for the Pentagon’s largest aircraft, ship, space and ground combat systems are likely to result in major cuts in weapons-buying budgets, the Congressional Research Service warned in a new report. Defense analysts, including those with the Congressional Budget Office, have warned since the 1990s of a looming budget crunch, with too many systems chasing too few dollars. The crisis is coming to a head because of the cumulative impact of escalating costs recently documented in nine top programs…” July Retail Sales were up 6.5% from July 2003. Ex-autos, sales were up 7.8%. Inflation effects were conspicuous, with Gasoline Stations reporting an 18.6% rise from one year ago, with Building Materials up 10.9%. Furniture sales were up 6.7% and Electronics 6.8%. Eating and Drinking establishments enjoyed an 8.4% increase from July 2003. In contrast, Department Store sales were down 1.7%. Our federal government ran a $69.2 billion deficit during July, up from the year ago number of $54.2 billion. After 10 months of the fiscal year, the y-t-d deficit of $395.8 billion is running 22% ahead of last year. And while y-t-d Receipts are up 4%, Total Spending has jumped 7.2%. By largest category, National Defense spending is running 14.8% higher than last year, Social Security 4.3% higher, Income Security 1.2% higher, Medicare 8.6% higher, and Health 10.2% higher. Mortgage Finance Bubble Watch: August 12 – Bloomberg (Kathleen M. Howley): “U.S. home resales rose 9.1 percent to a record in the second quarter as the economy improved and people rushed to secure the lowest mortgage rates of the year, according to a report from the National Association of Realtors. Sales of existing single-family homes, condominiums and cooperatively owned apartments increased to an annualized, seasonally adjusted pace of 7.79 million units from 7.14 million in the first three months of the year, NAR said. The previous record was a 7.36 million-unit pace in the third quarter of 2003…” August 9 – Bloomberg (Kathleen M. Howley): “The National Association of Realtors, the U.S. industry’s largest trade group, increased its estimate for home sales for the eighth time this year… Sales of existing homes probably will reach 6.45 million, higher than the 6.31 million the Washington group forecast a month ago. New-home sales will be 1.2 million, more than NAR’s previous forecast of 1.16 million. Those results would make this year the best on record for both categories.” August 9 – “The exceptionally strong performance of home sales this year, combined with a favorable economy and affordability conditions, means the record expected for housing this year will be larger than earlier projected, according to the National Association of Realtors. David Lereah, NAR’s chief economist, said the biggest surprise this year has been the performance of interest rates… ‘The momentum of existing-home sales this year is unprecedented, rising steadily each month and hitting a new record in June,’ Lereah said. ‘In addition, new-home sales have been at or near-record levels each month in 2004.’ NAR forecasts existing-home sales to rise 5.7 percent this year to 6.45 million, well above the record 6.10 million in 2003. New-home sales also should hit a record, increasing 10.8 percent to 1.20 million in 2004. Housing starts are expected to come in at 1.90 million, 2.6 percent above 2003, and would be the strongest level of housing construction since 1978.” August 12 – “Strong housing market fundamentals propelled total existing-home sales to the highest pace on record in the second quarter, according to the National Association of Realtors. Sales rose by double-digit rates in 34 states and the District of Columbia compared to the same quarter in 2003 and no state recorded a decline… The strongest year-to-year increase was in Nevada, where the second quarter resale pace rose 32.5 percent over the second quarter of 2003. Next came Idaho, which rose 31.0 percent from a year ago. Arizona posted the third highest increase, up 25.1 percent from last year’s second quarter rate. Regionally, the West experienced the strongest increase with sales activity in the second quarter at a record annual rate of 2.17 million units, up 19.8 percent from a year ago. After Nevada, Idaho and Arizona, the next highest increase was in Colorado, where existing-home sales rose 23.5 percent; Oregon resales were up 21.8… The South, with a record resale rate of 3.17 million units, posted a 17.5 percent rise… The strongest increase was in North Carolina, where the resale pace was 24.8 percent higher than the second quarter of 2003. South Carolina was up 23.5 percent, while Florida rose 22.8 percent in the last year. In the Northeast, total existing-home sales jumped 12.6 percent to a record pace of 903,000 units in the second quarter… Leading the region was Connecticut, where existing-home sales rose 23.3 percent… At the same time, both Massachusetts and New Jersey increased 22.5 percent while Maine was up 20.3 percent. In the Midwest, total existing-home sales increased 10.1 percent to a record annual pace of 1.54 million units… The strongest increase in the region was in North Dakota, with a gain of 19.8 percent in resale activity…followed by Kansas with a rise of 15.2 percent and Minnesota, which increased 13.8 percent.” August 12 – “Home prices in the second quarter increased at a strong rate in most metropolitan areas in comparison with the same period a year earlier, according to the latest survey by the National Association of Realtors. The association’s second-quarter metro area home price report, covering changes in 128 metropolitan statistical areas,* shows 49 metros with double-digit annual increases in median existing-home prices and 11 metros with generally small price declines. David Lereah, NAR’s chief economist, said that 49 is the largest number of areas ever to experience double-digit annual price gains. ‘A tight supply of available homes in a record sales market has been favoring sellers.’ The national median existing-home price was $183,800 during the second quarter, up 9.1 percent from the second quarter of 2003... The strongest increase was in Las Vegas, with a median price of $269,900, up 52.4 percent from the second quarter of 2003. Next came Anaheim-Santa Ana (Orange Co., Calif.), at $655,300, up 38.7 percent. Third was Riverside-San Bernardino, Calif., where the second quarter median price of $294,500 was 38.5 percent higher than a year earlier.” Other notable gains included San Diego 37.5%, Los Angeles 30.4%, and Miami 25.9%. August 12 – “Sales of single-family existing homes in Florida remained at record levels during second quarter 2004 with a 28 percent increase in resale activity compared to the same time last year, according to the Florida Association of Realtors. Statewide, a total of 73,437 homes sold during the second quarter, which surpassed the volume from the same period in 2003 by more than 15,000 homes. The statewide median sales price for second quarter 2004 rose 18 percent to $181,800; a year ago, it was $153,600.” The Federal Home Loan Bank System (FHLB) expanded assets by $39.1 billion, or 18% annualized, to $896.1 billion during the second quarter. This was the largest increase since the fourth quarter of 1999. Total Assets were up $73.3 billion over the past two quarters, also an 18% growth rate. And while Assets were up $87.2 billion from one year ago (11%), second-quarter Net Income increased $79 million to $530 million. Since the beginning of 1998, Total Assets have increased 157%. Countrywide Financial enjoyed another booming month. The company posted Purchase Fundings of a record $17.5 billion, up 31% from July 2003. ARMs accounted for a record 57% of fundings, with the dollar volume of ARM loans almost double the year ago level. But with refi fundings down 68% y-o-y, Total Fundings were down 43% y-o-y. Home Equity Fundings were a record $2.84 billion, up 67% y-o-y. Subprime Fundings were up 119% y-o-y to a record $3.89 billion. Countrywide Bank Assets were up 103% y-o-y to $28.6 billion. The Bond Market Association’s Research Quarterly was released this week with the headline “Bond Issuance Stable in Q2 at $1.45 Trillion.” While debt issuance has generally lagged last year’s pace due to the decline in mortgage and corporate debt refinancings, net Credit growth continues at record levels. Some details from the report: “Treasury gross coupon issuance totaled $427.0 billion in the first half of 2004, up from the $328.4 billion issued in the same period one year ago.” “Daily trading volume of Treasury securities by primary dealers averaged $501.3 billion during the first half of 2004, up 19.3 percent from…the same period one year ago.” “Asset-backed issuance increased 38.1 percent, to $389.1 billion, up from the $281.7 billion issued during the same period one year ago.” “Issuance of asset-backed securities (ABS) is on pace to break the record $585.0 billion set in 2003. During the first six months of 2004, ABS new issue activity set a half-year record of $389.1 billion, a remarkable 38.1 percent higher than the previous half-year record of $281.7 billion set last year… Second quarter issuance was 7.0 percent higher than the first quarter of 2004, and 34.5 percent greater than the second quarter of 2003. The ABS market offers investors a combination of safety, liquidity and stellar credit quality as most of the securities carry a triple-A rating and pay a floating coupon… The HEL (home equity loan) sector continues to dominate the ABS sector, accounting for nearly half of total ABS volume in the first half of the year. New issue activity totaled $192.8 billion for the period, up 68.9 percent from the $114.2 billion issued in the first two quarter of 2003. Issuance increased to $103.2 billion in the second quarter, up 15.2 percent from the [first quarter]… The student loan sector continues to increase in size and surpassed the credit card sector this quarter as the third largest ABS sector on issuance volume. In the first half of the year, new issue activity of student loans increased 32.8 percent, to $27.1 billion… Issuance of $16.9 billion in the second quarter was 63.4 percent higher than the first quarter of the year, and 54.5 percent higher than the second quarter of 2003.” “Volume in the mortgage-related securities market increased 33.4 percent, to $536.3 billion in the second quarter when compared to the first quarter of 2004.” “The average daily volume of total outstanding repurchase (repo) and reverse repo agreement contracts totaled $4.66 trillion in the first half of 2004, an increase of 20.4 percent from $3.87 trillion during the same period in 2003. Daily outstanding repo agreements averaged $2.71 trillion in the first half of the year, an increase of 20.2 percent from the $2.26 trillion through June 2004… Total repo and reverse repo average daily outstanding volumes increased every month in 2004, with the exception of April… In the first half of 2004, over $164.8 trillion in repo trades were submitted by Government Securities Division participants, with average daily volume of approximately $1.3 trillion.” “Net foreign purchases of U.S. fixed-income securities totaled $411.6 billion year-to-date through May 31, 2004, 40.3 percent higher than the first five months of last year.” The Fragile Stability of Monetary Disorder Atypical market developments again compel me to dive into some contemporary monetary theorizing. The nature of contemporary finance and economies provides some important nuances that often contradict conventional doctrine. Analysts that fail to appreciate some of the intricacies of contemporary “money” and Credit are left at a decided disadvantage. Hoping to make this more than an academic exercise, I will direct my analysis to the current financial environment, along with the ongoing “inflation vs. deflation” debate. Interestingly, we are again in an environment of rather diametrically opposed views on the rate of “money” growth. Some argue that money growth has slowed significantly, while I have posited that we are in the midst of the “blow-off” in monetary expansion. Looking at the latest Fed figures, I do see that M2 has a rather tepid year-over-year increase of 4.2%. Yet the same Fed report has M3 expanding at a notable 9.4% rate over the past 26 weeks. Additionally, issuance of “money”-like asset-backed securities is booming at a record pace. It is my view that, when it comes to contemporary monetary analysis (focusing on the entirety of the financial sector and not just the banks), broader (M3) is much better than narrower (M1 or M2). What’s more, year-over-year money growth calculations are rather tricky right now, as there was a significant “conversion” of monetary liabilities into higher risk (non-money) instruments that resulted in a decline in the “M’s” during last year’s fourth quarter (borrowers issued long-term debt to pay down short-term borrowings, as lenders concurrently sought higher-yielding instruments). There are some other realities that cannot be ignored. The vast majority of contemporary “money” is comprised of electronic journal entries (debits and Credits). Of the almost $9.3 Trillion of M3, government issued currency accounts for $686.2 billion, or 7.4%. The remainder is made up of liabilities issued by various financial institutions, including Demand Deposits ($315 billion), other Checkable Deposits ($183 billion) Savings Deposits ($3.42 Trillion), Small Denominated Deposits ($795 billion), Retail Money Fund deposits ($736 billion), Institutional Money Fund deposits ($1.10 Trillion), Large Denominated Deposits ($ 1.04 Trillion), Bank Repurchase Agreements ($517 billion), and Eurodollar deposits ($345 billion). And there are now about $2.5 Trillion of outstanding asset-backed securities. Banks are only one of myriad institutions that issue monetary liabilities, and reserve requirements are today virtually irrelevant to the process of issuing new “money.” A diverse group of financial institutions – including banks, GSEs, savings & loans, insurance companies, brokerages, money market funds, finance companies, “captive” finance units (i.e. GE, GMAC) and Wall Street structured entities (special-purpose vehicles, CDOs, MBS, ABS) are all tightly linked through the money and capital markets. These institutions issue new liabilities to each other and expand assets (increase holdings of other’s liabilities), creating marketplace “liquidity” throughout the expansion process. Funds are created and “transferred” among various types of institutions through adjusting journal entries (debiting and crediting accounts), and there is today absolutely nothing special about bank “money.” Many types of financial “intermediaries” debit and Credit accounts using the same processes as banks. But having said all of that, the M’s are only one facet of monetary analysis. The examination and analysis of Credit are actually far the more important. Traditionally, money supply (bank deposits) expanded right along with bank lending (the commanding source of Credit growth). The Fed could manage Credit expansion through adjusting bank reserve positions, and bank deposit expansion was a good proxy for Credit growth. Generally, the monetary aggregates still expand as Credit expands. But - as was demonstrated clearly last fall - there are episodes where significant Credit growth is accomplished through the expansion of non-monetary liabilities (longer-term, riskier debt instruments). Sound analysis requires diligent observation of the nature and degree of lending – what is being financed, to what extent, and to what end of Inflationary Manifestations. Are new financial claims backed by productive investment; is new lending financing asset inflation or financial speculation? Analysts of boom sustainability, along with financial and economic fragility, want to know! And just as we must look to broad money as an indicator of the degree of Credit expansion, we must think broadly when it comes to inflation as well. Inflation is a Credit phenomenon with myriad and divergent manifestations. There are a few things that should not be in dispute. First, total system Credit growth remains massive and at record levels. Second, the Mortgage Finance Bubble today dominates the Credit creation process, with historic over-lending fueling housing inflation and over-consumption. The Credit system is extraordinarily unbalanced; the economy is demonstrating incredible imbalances; and today’s news of June’s $56 billion trade deficit is indicative of the extreme nature of current maladjustments. Third, there is a powerful confluence of unprecedented U.S. trade deficits, huge speculative flows to non-dollar markets and asset classes, and historically low global interest-rates. Accordingly, the global liquidity backdrop today is as loose as one could imagine. There is no mystery surrounding the inflationary Asian boom or the spike in oil and commodity prices. Unstable financial markets are, as well, no surprise. And with global liquidity abundant and central banks almost universally quite accommodative, there is today good reason to assume that surging energy and commodity prices will be “monetized” through heightened global Credit excess. Inflationary pressures will continue to broaden. Still, the old Inflation vs. Deflation debate is not much closer to being resolved today than it was several years ago. It is, however, my view that momentous developments over the past couple of years do add some degree of clarity to our analysis. It should be apparent at this point that inflation and general price instability will impact our lives more going forward than they have in decades. Not only has the war on inflation not been won, it is being lost. The enemy has dispersed and turned elusive, and there is absolutely no acceptable strategy for regaining control of the theater of combat. The Fed and global central bankers will, neither irrationally or unjustifiably, continue to view the risk of debt collapse as much greater than the risks of inflation, monetary disorder, and unstable markets. And the continuing environment of downward pressure on technology and manufactured goods prices will support central banker rationalizations. Appreciating that inflation begets greater inflation, it is tempting today to extrapolate significantly higher inflation over the coming years. And with my view that the dollar will fall significantly from current levels, the likelihood of heightened inflationary pressures does only increase. But is there a meaningful risk of hyper-inflation developing? I don’t think so, and in fact I view the developments over the past two years as actually lowering the probability of hyper-inflation. While heightened general inflation pressure is the most likely scenario, I would at this point expect the risk of a major pricing cataclysm is more on the downside (systemic debt collapse) than upside (hyper-inflation). In my mind, the key issues have always been the sustainability of the Credit Bubble and with the risks associated with a Credit breakdown and resulting economic dislocation. And with the Mortgage Finance Bubble having been nurtured to “blow-off” extremes; with “money” supply expansion/intermediation having gone to “blow-off” extremes; with leveraged speculation having gone to parabolic extremes; with global over-liquidity having risen to “blow-off” extremes; and with extraordinary Monetary Disorder having been unleashed at home and abroad, I certainly view the probability for a devastating Credit collapse as much higher today than it was 24 months ago – significantly higher. Returning to monetary analysis, I believe I understand the nature of hyper-inflation. Despite numerous complexities, it does very much revolve around the government printing press and uncontrolled fiat money inflation. Yet this dynamic has very little to do with contemporary “money” and Credit. And I think it is important to appreciate that current inflation is also divorced from Federal Reserve “printing” or “pumping.” The expansion of the Fed’s balance sheet has been basically inconsequential in comparison to total system-wide Credit expansion. The Fed does not today “control” money creation. It has, however, been too successful in encouraging lending excess and inciting leveraged speculation. Moreover, the Fed has nurtured the mushrooming of the U.S. financial sector, and with it the “intermediation” of Trillions of risky loans into perceived safe and liquid “money” and Credit instruments. But we need, today, to be very cautious when it comes to extrapolating the Fed’s capacity for inciting sufficient lending, speculating, and intermediation – the commanding forces underpinning today’s key inflationary manifestations. When financial crisis arrives - and de-leveraging and disintermediation commence - the Fed will certainly aggressively expand its balance sheet and incorporate “unconventional measures.” But years of runaway systemic excess (not to mention dollar vulnerability) leave the Fed today a rather atrophied and timid little player confronting A Big & Nasty Credit Bubble. The Fed will be surprisingly impotent in ameliorating bursting Bubbles, and the notion of “pushing on a string” will become topical. Why did NASDAQ collapse in 2000? Well, cumulative market and industry distortions/imbalances from the preceding boom years – culminating with 1999’s spectacular Monetary Disorder and terminal “blow-off” excesses – ensured its eventual bust. It was only a matter of from what level of excess and how spectacular the bust. Today, very similar dynamics have come to apply with respect to a much larger and comprehensive Mortgage Finance Bubble. Out in California (and elsewhere), reckless excesses ensure a housing Bubble collapse. But dangerous Bubble dynamics go way beyond mortgage finance. The ongoing explosion of liabilities owed to our foreign creditors risks a run on our currency and a collapse in dollar confidence. The unparalleled ballooning of leveraged speculation risks unstable markets and dislocation. The derivative markets – where various market risks have been concentrated within a small group of institutions employing dynamic-hedging strategies – present a very real risk of systemic breakdown. Not only do I view developments over the past two years as having significantly upped the ante on the dangers of Credit collapse, I believe the character of Fed-induced excesses and imbalances have significantly increased the likelihood of markets eventually “seizing up” – the LTCM debacle having provided an omen that should have been heeded. Today, with Bubble dynamics and speculative leveraging at full intensity, any significant move to de-leverage or liquidate dollar exposure would precipitate systemic liquidity crisis. And the way things are currently developing, a dislocation in the dollar/currency markets would appear to pose the greatest risk as the catalyst for such a financial dislocation. Most unfortunately, the contemporary U.S. Credit system has demonstrated zero capacity for self-regulation or adjustment. The lack of a monetary “anchor” is a defining feature of contemporary finance. There is no mechanism (gold standard, reserve requirements, lending restrictions) to restrain issuance. Myriad financial institutions are capable of creating liquidity (backed by almost any quality of loan), a powerful dynamic that continues to be instrumental in sustaining the Credit Bubble. The “moneyness” of Credit (the capacity to create perceived safe and liquid Credit instruments from risky loans) is also a defining characteristic of contemporary finance. Combined, “anchorless” and “moneyness” have been instrumental in fostering the U.S. Credit Bubble and, thus, financing the U.S. Bubble economy. At the same time, these characteristics and consequent propensity for over-issuance and asset Bubbles have for some time been at the heart of dollar vulnerability. Central banks have played a critical role in sustaining U.S. Bubble excess, as well as supporting the dollar. The Fed collapsed interest-rates and guaranteed marketplace liquidity. Last year in particular, Asian central banks ballooned dollar holdings. Not surprisingly, the now evident end result is only more acute Monetary Disorder – unwieldy Credit and speculative excess fostering only greater financial and economic imbalances – at home and abroad. Watching, over the past few weeks, bond prices move higher along with surging crude has been something to behold. And then today, to again witness bond prices surge as the dollar gets hammered, provides further evidence that something is amiss in the financial markets. Dollar strains and heightened systemic stress are a boon to the Treasury market. Declining Treasury yields then provide a powerful anchor for other market interest-rates, especially mortgage borrowing costs. And mortgage lending – with the seemingly limitless capacity for the financial sector to transform increasingly risky loans into perceived safe and liquid instruments – lies at the very epicenter of unending liquidity excess. And the Bubble blows larger and tighter. I see little evidence that unfolding systemic stress is yet impinging Credit excess in the U.S. or globally. Ironically, contemporary finance (along with New Age central banking) has created a strange Stability of Monetary Disorder. But it is this peculiarity that, at least at this point, dictates the continued inflation of non-productive Credit, dangerous financial sector leveraging, economic distortions, and excess dollar liquidity. I see no reason to back away from the view that we are on course for a dollar problem. And perhaps cataclysm in the currency markets will test the mettle of contemporary “money,” the “moneyness” of Credit, and the viability of prodigious derivative markets. Could such a scenario and associated acute financial fragility explain today’s 4.2% 10-year Treasury yield in the face of surging energy costs, a faltering dollar, heightened inflationary pressures and prospective Fed rate increases? |
Saturday, September 6, 2014
08/12/2004 The Fragile Stability of Monetary Disorder *
