| The stock market run continued. For the week, the Dow and S&P500 added 1.5%. The Transports added 1.6%, increasing 2004 gains to 21%. Up 3% for the week, the Utilities’ y-t-d gain rose to 20%. The Morgan Stanley Cyclical index jumped 2.6%, and the Morgan Stanley Consumer index added 1%. The broader market rally runs unabated, with the small cap Russell 2000 rising 3% (up 12% y-t-d), and the S&P400 Mid cap index up 2% (up 10% y-t-d). The NASDAQ100 gained 2%, and the Morgan Stanley High Tech index rose 3%. The Semiconductors gained 1.5% and the NASDAQ Telecommunications index added 1%. The Street.com Internet index gained 3%, increasing y-t-d gains to 29%. The Biotechs were about unchanged. The Broker/Dealers increased 2% (up 10% y-t-d), and the Banks gained 1% (up 6% y-t-d). With bullion up $4.30 to $437.85, the HUI gold index rose 1.5%. For the week, 2-year Treasury yields rose 5 basis points to 2.82% (up 25bps in 8 sessions). Five-year Treasury rates added 3 basis points to 3.50%. Ten-year Treasury yields were about unchanged at 4.18%. Long-bond yields ended the week unchanged at 4.90%. Benchmark Fannie Mae MBS yields were also unchanged. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note narrowed 2 to 44, and the spread on Freddie’s 5% 2014 note narrowed 2 to 40. The 10-year dollar swap spread declined 1 to 42.5. Corporate bonds continue to trade well. The implied yield on 3-month December Eurodollars added 1 basis point to 2.43%. Corporate debt issuance surged to about $19 billion this week (from Bloomberg). Investment grade issuers included Bellsouth $2.0 billion, KWF Bank $2.0 billion, Bank of America $1.0 billion, IBM $1.0 billion, American Express $1.0 billion, XL Capital $950 million, Ford Motor Credit $800 million, Barrick Gold $750 million, Kraft $750 million, Citizens Communications $700 million, Countrywide $650 million, FPL Group $553 million, Flextronics $500 million, Kinder Morgan Energy $500 million, Jetblue Airlines $500 million, Axis Capital $500 million, Petro-Canada $400 million, Alabama Power $300 million, Dex Media West $300 million, Entergy $275 million, Nevada Power $250 million, Indiana Michigan Power $175 million, and OGE Energy $100 million. November 9 – Dow Jones (Simona Covel ): “After months of expectation, the high-yield market faces an explosion of new issuance as about $1.6 billion in deals is expected to hit the market Tuesday and Wednesday. The new deals come from issuers all over the rating spectrum… The new deals are expected to fare well in an environment where investors, frustrated by the last few months’ trickle of issuance, are desperate for fresh buying opportunities.” Junk bond inflows jumped to $601.5 million (from AMG), with funds now enjoying positive flows in 11 of the past 12 weeks. Issuers included Elan $1.15 billion, Tenneco $500 million, Inmarsat Finance $450 million, Thornburg Mortgage $305 million, Alrosa Finance $300 million, Affina Group $300 million, Williams Companies $270 million, Ultrapetrol $180 million, AAC Group Holding $132 million, Integrated Alarm $125 million, and Gabelli Asset Management $71million. Convert issuers included NCI Building Systems $150 million. Japanese 10-year JGB yields dropped 5 basis points to 1.46%. Brazilian benchmark bond yields declined 5 basis points to 8.38%. Mexican govt. yields ended the week at 5.20%, down 2 basis points. Russian 10-year dollar Eurobond yields added 5 basis points to 5.79%. Freddie Mac posted 30-year fixed mortgage rates basis rose 6 points this week to 5.76%, with rates up 12 basis points in two weeks. Fifteen-year fixed mortgage rates were up 8 basis points to 5.16% (up 15bps in 2 weeks). One-year adjustable-rate mortgages could be had at 4.16%, up a notable 16 basis points for the week (20bps in 2 weeks) to the highest level in 15 weeks. The Mortgage Bankers Association Purchase application dipped 2.7% last week, giving up little of the previous week’s big jump. Purchase applications were up about 30% from one year ago, with dollar volume up 44%. Refi applications declined 6.7% during the week. The average Purchase mortgage was little changed at $224,500, while the average ARM rose to $310,100. ARMs accounted for 35.3% of total applications last week. Broad money supply (M3) expanded $5.6 billion (week of November 1). Year-to-date (44 weeks), broad money is up $483.6 billion, or 6.5% annualized. For the week, Currency rose $2.0 billion. Demand & Checkable Deposits dropped $12.9 billion. Savings Deposits jumped $21.7 billion, with a year-to-date gain of $342 billion (12.8% annualized). Small Denominated Deposits added $1.5 billion. Retail Money Fund deposits dipped $1.0 billion, while Institutional Money Fund deposits rose $7.0 billion. Large Denominated Deposits declined $1.3 billion. Repurchase Agreements declined $4.9 billion, and Eurodollar deposits fell $6.4 billion. Bank Credit increased $3.5 billion for the week of November 3 to $6.713 Trillion. Bank Credit has expanded $438.9 billion during the first 44 weeks of the year, or 8.3% annualized. For the week, Securities holdings rose $6.0 billion, while Loans & Leases dipped $2.5 billion. Commercial & Industrial loans declined $3.8 billion, while Real Estate loans jumped $9.4 billion. Real Estate loans are up $270.7 billion y-t-d, or 14.4% annualized. Consumer loans were down $1.7 for the week, while Securities loans dropped $9.4 billion. Other loans were up $3.0 billion. Elsewhere, Total Commercial Paper declined $7.0 billion to $1.369 Trillion. Financial CP dipped $1.8 billion to $1.234 Trillion, expanding at a 7.3% rate so far this year. Non-financial CP declined $5.2 billion (up 28.8% annualized y-t-d) to $134.9 billion. Year-to-date, Total CP is up $100.0 billion, or 9.1% annualized. November 11 – Financial Times (Jennifer Hughes and David Wells): “Issuance of asset-backed bonds in the US has reached a record level this year and is set to overtake more traditional corporate sales for the first time. Data from the American Securitization Forum and the Bond Market Association show that $662.9bn worth of asset-backed securities was issued in the US in the first three quarters of 2004 - already a record for the market - compared with $535bn of corporate bonds. Last year, corporate issuance was much higher than its asset-backed counterpart at $764.8bn compared with $585bn. Home equity issuance was the biggest driver of the rise in asset-backed securities." November 9 – Bloomberg (Mariko Yasu): “JPMorgan Chase & Co., the second-largest U.S. bank by assets, will nearly triple sales of securities that repackage loans this year, tapping rising demand from investors in Japan… JPMorgan expects to sell about $4 billion of so-called collateralized loan obligations arranged in the U.S., 2.7 times more than last year… Banks create CLOs by bundling together loans and using the income from the credits to repay investors. Global sales of repackaged high-yield loans amounted to $21.2 billion in the first nine months, nearly as much as in all of 2003…” This week’s ABS issuance amounted to about $10.5 billion (from JPMorgan). Total year-to-date issuance of $549 billion is 38% ahead of comparable 2003. 2004 home equity ABS issuance of $348 billion is running 81% ahead of last year’s record pace. Fed Foreign “Custody” Holdings of Treasury, Agency Debt rose $5.15 billion to $1.306 Trillion. Year-to-date, Custody Holdings are up $239.2 billion, or 25.9% annualized. Federal Reserve Credit added $1.4 billion for the week to $774.8 billion, with y-t-d gains of $28.2 billion (4.4% annualized). Currency Watch: The euro closed today at an all-time high of 1.2975 against the dollar. The dollar index lost about 0.3% this week to close below 84 for the first time since November 1995. The Swedish krona gained 1.45%, the Thai baht 1.43%, the Polish zloty 1.13% and the Brazilian real 1.0%. The dollar this week made up ground on the Zimbabwe dollar (1.78%), the Romanian leu (0.75%), and Botswana pula (0.5%). Commodities Watch: November 10 – Bloomberg (Koh Chin Ling): “China, the world’s biggest producer of corn, may this year become a net importer of cereals including rice, corn and wheat for the first time since 1996, a state grain administration affiliate said. China may buy 5.36 million metric tons more of cereals this year than it exports… The last time China imported more than it exported was in 1996…” November 10 – Bloomberg (Jeff Wilson): “Hog prices rose 2 cents a pound, the maximum allowed by the Chicago Mercantile Exchange, as pork demand by meat processors and exporters climbed. The wholesale value of a 185-pound hog carcass rose 1.7 percent to a four-week high yesterday as ham prices soared 7 percent to a record… Turkey supplies in U.S. frozen storage fell 18 percent on Sept. 30 from a year earlier… ‘There is a real shortage of holiday entrees that will support a very strong ham market into December,’ said Dan Vaught, a livestock analyst…” November 10 – Bloomberg (Laura Humble and Jason Gale): “Coffee prices rose the most in almost three months in London after the U.S. Department of Agriculture cut its export forecast for Brazil, the world’s biggest producer of the beans, by 12 percent for 2004-05. Farmers in Brazil are holding back supplies to try to boost prices, the department said in a report.” November 10 – Bloomberg (Jeff Wilson and Daniel Goldstein): “An aggressive fungal disease known as soybean rust has been found on plants in Louisiana, the first U.S. case, threatening a crop valued at $17.8 billion last year, the government said. Soybean futures gained the most in two weeks. The fungus was found on two Louisiana State University research plots near Baton Rouge, the U.S. Department of Agriculture said. A team of USDA specialists is being sent to the state to determine how far the disease spread.” Gold today closed at a 16-year high, copper at a 1-month high, and wheat at an 18-month low. With December crude declining $2.29 to a $47.32, the Goldman Sachs Commodities index dipped 1.7% for the week. This reduced year-to-date gains to 28.6%. The CRB index was about unchanged for the week, with y-t-d gains of 11.0%. China Watch: November 9 – XFN: “China’s gross domestic product growth will reach 9.25% in 2004 compared with last year's 9.1% rise, with growth slowing to about 8% in 2005, the World Bank said.” November 10 – Bloomberg (Philip Lagerkranser): “China’s exports grew in October at the slowest pace in nine months as high oil prices left consumers in the U.S., Europe and Japan with less to spend on Chinese-made toys, televisions and clothes. Overseas sales increased 29 percent from a year earlier to $53 billion after climbing 33 percent in September…” November 10 – Bloomberg (Philip Lagerkranser): “China’s industrial production growth slowed in October as government lending restrictions hurt sales of automakers including General Motors Corp. and exports flagged. Production rose 15.7 percent from a year earlier after climbing 16.1 percent in September…” November 8 – Bloomberg (Clare Cheung and Philip Lagerkranser): “Hong Kong’s retail sales growth picked up in September as surging tourist arrivals and falling unemployment helped boost spending in the city. Sales rose 8.7 percent from a year earlier to HK$15 billion ($1.9 billion) after climbing a revised 5.7 percent in August…” Asia Inflation Watch: November 10 – Bloomberg (Sumit Sharma and Kartik Goyal): “India’s President A.P.J. Abdul Kalam wants the country’s foreign-exchange reserves to be used for investments, he told a bankers' conference in New Delhi. ‘The bankers can have a mission -- how to invest and multiply a portion of foreign-exchange reserves, if they are made available for investing in relatively higher-yield enterprises.’” November 9 – World Bank: “East Asia’s economies are growing at their swiftest pace since before the financial crisis with fewer people than ever living in extreme poverty, according to the latest East Asia and Pacific Regional Update… Economic growth is expected to top 7 percent for East Asia and Pacific (excluding Japan), while developing economies in the region are expected to expand by more than 8 percent.” November 8 – Bloomberg (Theresa Tang): “Taiwan’s exports rose in October at their slowest pace in seven months as high crude-oil costs left companies and consumers in the world’s biggest economies with less to spend on computers, flat-panel displays and cell phones. Shipments increased 17.5 percent from a year earlier to $15.4 billion after climbing 19.2 percent in September…” November 10 – Bloomberg (Laurent Malespine): “Thailand’s new vehicle sales rose about 20 percent last month from a year earlier to 55,341 units, Toyota Motor…said.” November 8 – Bloomberg (Stephanie Phang): “Malaysia’s industrial production rose at its weakest pace in a year in September as mining barely grew. Output may slow further as record oil prices curb spending on electronics and other manufactured goods, analysts said. Output at factories, mines and utilities rose 9.8 percent from a year earlier…” Global Reflation Watch: November 10 – Bloomberg (Kevin Bell): “Canada may end the fiscal year with a budget surplus of C$7.7 billion ($6.5 billion), almost twice a government forecast made earlier this year, according to the Canadian Centre for Policy Alternatives, the Globe and Mail reported.” November 9 – UPI (Robin Shephard): “Fancy making a quick buck? You could have done a lot worse this year than if you’d put your money into the stock exchanges of the new members of the European Union from central and eastern Europe. In the first 10 months of 2004 Hungary’s benchmark BUX index was up 57 percent. Prague’s PX50 gained 49 percent and Poland’s WIG 20 was up 29 percent. If you’d invested in the BET-C, the key index of EU candidate Romania…you’d now be sitting on whopping 82 percent return. The figures from central and eastern Europe are calculated in dollar terms and, therefore, partly reflect declines in the U.S. currency against non-dollar denominated assets.” November 8 – Bloomberg (Gonzalo Vina): “The cost of goods leaving British factories rose in October at the fastest annual pace since December 1995 as the price of metals and oil jumped. Producer prices rose a non-seasonally adjusted 3.5 percent, from 3.1 percent in September, the National Statistics office in London said.” November 11 – Bloomberg (Tracy Withers): “New Zealand’s economy added almost twice as many jobs as economists expected in the third quarter, cutting the unemployment rate to 3.8 percent, the lowest in more than 18 years.” November 11 – Bloomberg (Victoria Batchelor): “Australia’s unemployment rate fell to 5.3 percent in October, the lowest in more than 26 years, and the economy added twice as many jobs as expected as higher corporate profits spurred hiring.” November 9 – Bloomberg (Adriana Arai): “Mexico’s 12-month inflation rate rose in October to its highest in 19 months, fueling speculation that the central bank will lift interest rates twice more this year. Consumer prices jumped 0.69 percent last month… that boosted the 12-month inflation rate to 5.4 percent…” November 10 – Bloomberg (Romina Nicaretta): “Brazil will end 2004 with a current account surplus of about $10 billion, Antonio Palocci, Brazil’s Finance Minister, said. ‘We had a very significant change in term of trade balance and current account,’ Palocci said…” Dollar Consternation Watch: November 10 – Market News International: “French Prime Minister Jean-Pierre Raffarin argued Wednesday that the dollar exchange rate is out of line with economic fundamentals and called on international leaders to remedy the situation. ‘The dollar is too low and this does not correspond to state of the various economies… The crisis of the dollar, the collapse of the dollar is a real problem and I truly hope the international community will deal with all the consequences of the situation.’” November 11 – Bloomberg (John Fraher): “Former European Central Bank President Wim Duisenberg said the U.S. current account deficit is the biggest risk to the dozen-nation euro region’s economy, the Frankfurter Allgemeine Zeitung said, citing an interview. The record deficit ‘can’t continue’ and the euro’s exchange rate will probably bear the brunt of any dollar depreciation adjustment as a result of it…Duisenberg retired in November last year. Duisenberg said the deficit will probably eventually lead to Asian and Latin American currencies appreciating against the dollar…” California Bubble Watch: November 11 – Los Angeles Times (Annette Haddad ): “After a summer of flattening prices, the median home price in Los Angeles County edged higher last month to $409,000, a 23% increase over a year ago… That made October’s median price the second-highest recorded for Los Angeles County in nearly 17 years, according to DataQuick…. The county’s median peaked at $414,000 in June… Meanwhile, the total number of homes sold fell 17.8% to 9,709 last month, down from 11,805 a year ago, and down 7.5% from September.” Bubble Economy Watch: November 10 – Market News International (Gary Rosenberger): “Cargo entering the U.S. in September and October overwhelmed ports, railways and trucks, gumming up real-time inventory deliveries in what marks the heaviest peak-shipping season ever, industry officials say. By mid-October there were 94 ships idling around the ports of Long Beach and Los Angeles, the nation's gateway for most Asian goods, unable to discharge. The bottlenecks were two-thirds as severe as during the worst of the port lockout two years ago and could leave a misleading impression of slowing imports. If anything, the trade gap would continue to balloon if undelivered goods were factored in to port data. Indeed, diversions away from southern California are generating record inbound volumes at other ports and are likely to widen the trade gap in September, and more so in October and November as sea-lanes are cleared.” The September Trade Deficit contracted marginally to $51.6 billion (up 25% from Sept. ’03). Goods Exports were up 15.4% to $68.9 billion, while Goods Imports were up 17.2% to $124.5 billion. Goods Exports would need to rise 81% to match Imports. October year-over-year Import Prices were up 9.7%, the strongest rise since 1988. To illustrate how the pricing environment has changed, it is worth noting that year-over-year Import Prices were negative from March 2001 through September 2002. November 9 – Bloomberg (Mark Shenk and Jim Kennett): “Homeowners in the U.S. Northeast will pay 37 percent more for heating oil this winter than a year earlier and natural gas users in the Midwest will see costs rise 15 percent, the Energy Department said in a monthly report.” Mortgage Finance Bubble Watch: Freddie Mac raised its 2004 forecast for mortgage originations 3.7% to $2.725 Trillion. The company expects residential mortgage debt to grow at an annual rate of 15.4% during the third quarter, then to slow to 14.3% during the fourth quarter. For all of 2004, residential mortgage debt is expected to expand 13.4%, followed again by 13.4% during 2005. Growth is then expected to slow somewhat to 11.6% during 2006. It is worth noting that 2004 growth of 13.4% would be the strongest rate of growth since 1985. And the forecasted $958 billion increase in residential mortgage debt this year would compare to the average during the 90’s of $234 billion. And if Freddie’s forecasts for 2005 and 2006 prove accurate, this would have mortgage debt ending 2006 at $10.3 Trillion – six straight years of double-digit growth, with residential mortgage debt having ballooned 160% over nine years (since the beginning of 1998). Countrywide Financial enjoyed a strong October. Average daily fundings of $1.99 billion were up 27% from October 2003. The Total Pipeline of $52.0 billion was an increase of 22% from one year ago. Purchase fundings were up 20% from a year earlier to $14.9 billion, while Refis were down 14% to $14.3 billion. ARMs comprised 56% of total fundings (down from Sept.’s 68%) at $16.3 billion, but ARM volume up 53% from comparable 2003. Home Equity fundings were up 73% from one year ago to $3.1 billion and Subprime 35% to $3.3 billion. Total Bank Assets were up 113% from one year ago to $36.4 billion. Mortgage REIT Redwood Trust Total Assets expanded at a 34% annualized rate to $23.9 billion, with assets up 60% from one year ago. Shareholders’ Equity ended the quarter at $902 million. November 11 - Dow Jones (Allison Bisbey Colter): “Fannie Mae is expanding its mobile home-lending program, allowing more borrowers to purchase a manufactured home with a down payment of just 5% on a 30-year mortgage. In the past, borrowers who wanted to purchase manufactured housing, or mobile homes, with a 30-year mortgage had to come up with a downpayment of at least 10%. But in February, Fannie Mae began a pilot program with 10 lenders allowing would-be borrowers to finance up to 95% of the value of a mobile home with a 30-year mortgage. The program is now being expanded to allow all of the lenders with whom Fannie Mae does business to offer the lower-cost financing.” November 10 – Bloomberg (James Tyson): “The senior Democrat on a congressional panel that oversees Fannie Mae today opposed increased funding for the company’s regulator pending the public release of a report into the agency’s political impartiality. The regulator, the Office of Federal Housing Enterprise Oversight, has said it may have to curtail next month its investigation into Fannie Mae’s accounting unless it receives a budget increase to $59.2 million for the fiscal year that began on Oct. 1, from $39.9 million in the prior year…” November 10 – Bloomberg (Miles Weiss): “Bear Stearns Cos. invested $25 million with a former executive who started a hedge fund specializing in securities backed by commercial mortgages, a regulatory filing shows… Commercial mortgage-backed securities are bonds backed by loans on properties such as office and apartment buildings, hotels and shopping centers. The securities recently have become more popular among hedge funds. ‘There is a proliferation of these’ types of hedge funds, said Tad Philipp, managing director of commercial mortgage-backed securities for Moody’s…‘A lot of people sense the opportunity… As more firms come to the table, the arbitrage begins to shrink. Spreads are narrowing for junior bonds and subordinated loans on properties.’” U.S. Bubble Watch: November 9 – New York Times (Mark Landler): “Commerzbank, stung by its foray into the volatile world of proprietary trading, announced Tuesday that it would shut the bulk of its investment banking operations outside Germany… Commerzbank’s securities division, which encompasses trading and investment banking, lost 171 million euros ($221 million) in the third quarter, after losing 47 million euros ($61 million) the previous quarter. ‘Despite strained market conditions, there is no acceptable excuse,’ the bank’s chairman, Klaus-Peter Müller, said…adding that the division was a ‘problem child.’ The mounting problems forced Mr. Müller, a genial commercial banker who once ran Commerzbank’s office in New York, to all but erase the bank’s presence there.” Excerpts from the Bond Market Association Research Quarterly The average daily volume of total outstanding repurchase (repo) and reverse repo agreement contracts totaled $4.82 trillion for the first three quarters of 2004, an increase of 21.4 percent from the average volume of $3.97 trillion during the same period of 2003. Daily outstanding repurchase agreements averaged $2.8 trillion through September, an increase of 21.0 percent from the $2.32 trillion volume during the same period of 2003… Through the third quarter of 2004, over $256.8 trillion in repo trades were submitted by Government Securities Division participants, with an average daily volume of approximately $1.4 trillion. With three months to go in 2004, the asset-backed securities market already surpassed the previous issuance record of $585.0 billion, set in 2003. New issue activity totaled $661.1 billion in the first three quarters of the year, 54.8 percent higher than the $427.1 billion issued in the same period of 2003… The resilient housing market has created an environment in which consumers extensively use home equity as a source of additional funds. Issuance in the HEL (home equity loan) sector increased 75.1 percent in the first three quarters of the year, to $309.2 billion, compared to $176.6 billion in the same period in 2003… The student loan ABS sector continued to grow despite a significant decrease in issuance during the third quarter. Year-to-date issuance totaled $38.4 billion [up 27% from comparable 2003]... Gross issuance of U.S. coupon Treasury securities totaled $639.2 billion in the fist three quarters of 2004, a 20.5 percent increase over the $530.3 billion issued in the same period in 2003… TIPS issuance of $21 billion in the quarter was more than twice the volume of the fourth quarter of last year. Daily trading volume of Treasury securities by primary dealers averaged $496.3 billion during the first three quarters of the year, up 13.2 percent from the $438.6 billion over the same period a year ago. During the third quarter, daily trading volume by primary dealers rose, peaking at $517.6 billion in September. Issuance of long-term debt by federal agencies totaled $732.2 billion in the first three quarters of 2004, down 27.5 percent… [During the past year, Freddie’s short-term debt has increased 9.3% to $218.5bn and Fannie’s 7.2% to $340.4bn]. Total short- and long-term municipal issuance declined in the fist three quarters of 2004 to $315.3 billion, 9.2% lower than the $347.1 billion issued in the same period of 2003.” Corporate bond issuance rose sharply in the third quarter, regaining the momentum from earlier in the year after a pause in the second quarter. New issue volume totaled $171.5 billion in the third quarter, up 25.9 percent from the $136.1 billion issued a quarter earlier and up 9.1 percent from the volume issued during the third quarter a year ago… Over the past year, profits and cash flows have increased significantly for corporate issues, resulting in an ample supply of internally generated funds… Stone and McCarthy Research Associates reports that the Merrill Lynch index spread for investment grade hit a five-month low in mid-October…and its speculative grade index hit its tightest spread since 1998 in early October… Issuance of mortgage-related securities, which include agency and private-label pass-throughs and CMOs, totaled $407.1 billion in the third quarter, down from the $539.3 billion issued in the second quarter, but nearly unchanged from the first quarter… The private-label MBS sector was the bright spot in the mortgage-related market. Issuance decreased slightly in the first three quarters of the year, to $272.1 billion… The private-label performance reflects product innovation in this sector and the demand for jumbo mortgage refunding… Average daily trading volume in agency mortgage-backed securities by primary dealers decreased 6.4 percent, to $205.2 billion in the first three quarters of the year… The hedge fund industry has grown at a rapid pace in the past 10 years. At the end of the second quarter of 2004, there were over 5,000 funds managing nearly $900 billion, up from less than 2,000 funds and $160 billion managed in 1994. Monetary Disorder: I would like to proffer that the primary issue today with respect to unrelenting Credit inflation is missed in the interminable “inflation vs. deflation” debate. Instead, we should focus our analytical attention on Monetary Disorder and attendant destabilizing excess Liquidity. Granted, this is not an area without significant challenges. There are no price indices to measure for upward or declining trends, nor is there really much that we could hope to quantify. One might have expected that the phenomenon of heightened Monetary Disorder would have manifested in expanding risk and Credit premiums. Instead spreads have done just the opposite and collapsed. Monetary Disorder has much to do with speculative market dynamics, as it does with provoking unpredictable and aberrant system behavior. I am again drawn to the use of the “Financial Sphere” and “Economic Sphere” framework in an attempt, in this case, to raise some issues relevant to the concept of Monetary Disorder. It is valuable to examine the effects of Credit inflation and attendant liquidity excesses on the structure of the economy, as well as on financial system and asset market dynamics. Imagine a prosperous small community that had accumulated tremendous (economic and financial) wealth over generations. Over time it had become possible to import most of its goods from less wealthy communities operating with cheaper labor and generally lower cost structures. Prosperous Community - with a gradual but steady increase in prices - lost its capacity to competitively manufacture most goods. Yet there was little concern, as the air was fresher, and most workers preferred the employment opportunities and environment offered by the “service” sector. Imported goods became only cheaper and more plentiful, and Prosperous Community was able to use a larger percentage of its rising income for the purchase of services and luxury items. And the more income and wealth rose, the greater the demand for the expanding array of services and luxury items offered by the New Economy. Traditional inflation was quite low and quiescent. The powerful combination of steadily rising income, declining interest-rates and easy Credit Availability stoked asset inflation and the booming “financial services.” Citizens could spend most income on consumption, but still have plenty of resources for accumulating “wealth” for retirement. An increasing amount of funds were directed to investment and retirement accounts, much of it borrowed directly or indirectly against inflating home prices. A few points: First, over time, spending patterns changed rather profoundly. A much reduced percentage of income went toward the purchase of the traditional basket of basic necessities (associated with “CPI”). This, combined with downward price pressure commensurate with the flood of imported goods, basically made the CPI a useless (at best) indicator of general monetary conditions. Indeed, a stable CPI in the “Economic Sphere” became a leading factor supporting the ballooning “Financial Sphere.” Second, the move to a “services” economy significantly altered the character of output, as well as income and profits generation. Local businesses borrowed to fund advertising campaigns, increasing “output” and income for the booming media sector. The “hospitality” sector was a major contributor to local economic growth, along with the construction and home improvement trade. Agents selling inflating assets or asset-related services saw incomes surge. Third, investing in the capacity to produce and sell widgets was a dying force. Lending – as opposed to investment – became the economy’s driving force. The community’s entrepreneurs and risk-takers all gravitated to finance and the markets. The Titans of Industry “ran money.” Fourth, no longer would over-stimulation foster bottlenecks, inefficiencies, shortages and price pressures in the goods-producing area. Rather, the community’s citizens would enjoy eating out more and enjoying the expensive entrees at their neighborhood bistros, buying luxury foreign autos, moving up to more expensive McMansions, purchasing more insurance and annuity products, acquiring more technology gadgets, downloading more digital music, movies, publications and video games, and going on more lavish vacations. Expensive fad diets, bright white teeth, Lasik eye repair, and plastic surgery all became the rage. GDP expansion was almost as certain as Credit growth, although few appreciated the the "business cycle" had been supplanted by the "credit cycle." With lending and “liquidity” abundant throughout the community, interest-rates remained low, asset price inflation persistent and Credit growth unrelenting. And the old CPI - well, it hardly budged. The newly created liquidity and wealth – with a hankering to flow to the asset markets - caused minimal additional demand or price pressure for items comprising the “core” of that anachronistic basket of basic goods and services. Goods imports surged, but fortunately our trading partners were happy to accept our IOUs and stuff them in mattresses. Prosperous Community, after all, had been prosperous for a very long time. There are several hopefully pertinent dynamics that I will try to illuminate by examining the two “spheres.” Economic Sphere: Through the perspective of traditional analysis, it was near economic nirvana. “Wealth’ surged, with rising home and asset prices. Consumer prices were stable, while rising “output” was created by fewer working less hours. Profits from making widgets continued to erode, although businesses providing services and finance enjoyed a growth and profits windfall. And the more the economy transformed away from producing goods to providing services and lending, the better “returns” appeared for the system as a whole. The dynamics of de-industrialization became powerful. Spending throughout the economy was dictated by financial profits, led by financing housing and consumption. Few goods-producing ventures were funded because the risk was perceived as much higher than was the case for mortgage, securities and credit card lending. Systemic liquidity excess and pricing distortions incited a major building boom for housing, sports venues, campus upgrades and additions, "hospitality" and retail space. There was no appreciation for how deep structural changes had signficantly increased the economy's vulnerability to any reduction in Credit growth or liquidity. Analytically, the Economic Sphere sets trap after analytical trap. The more impaired the underlying structure of the economy, the greater the boon for the Financial Sphere. Lending and speculating excess for some time sustain the Bubble economy, while embarrassing the naysayers. Policymakers, attempting to mitigate effects from previous mistakes, can be expected to take extreme measures to sustain booms and hope for the best. Financial Sphere: Funding business investment was no longer the chief source of new liquidity for the economy. Instead, financing asset purchases (homes and securities) and borrowing to fund (imports and “services”) consumption were the primary sources of new liquidity. Over time, there was an unprecedented decoupling of the liquidity-creating mechanism away from actual wealth creation in the real economy, while liquidity and asset markets became tightly interlinked. The era of self-reinforcing asset Bubbles had taken hold. The more liquidity created, the greater asset prices inflated. This begat only more lending and liquidity excess. Speculative finance and its powerful liquidity-creating capacity took increasing command over the Economic Sphere. A seductively dangerous circumstance evolved where massive ongoing inflation in financial claims corresponded with little of anything “real” to support their value (non-productive debt growth) or demonstrated little if any impact on CPI. Lending would fund spending on services, which would drive income and asset inflation. But at the end of the day the economy had added no real wealth or wealth creating capacity. And, importantly, with policymakers and lenders trapped in a bygone framework of judging the appropriateness of monetary conditions from changes in CPI, monetary policy became largely detached from monetary conditions. This is where Monetary Disorder really took hold. Monetary expansion was no longer limited by the authorities. Moreover, traditional inherent limitations to Credit excess available from funding finite profitable investments were inapplicable. On the contrary, perceived limitless financial profits ushered in an historic market dislocation in the guise of A New Era of Unlimited Liquidity. And it is important to appreciate that over years a confluence of factors afforded the Financial Sphere dominance over the Economic Sphere. These factors also fomented Monetary Disorder. For one, the expanding quantity of financial claims created enormous financial sector profits (lending and managing assets) and power. For everyone, there was an increasing proclivity to play the financial profits boom, which eventually led to egregious "blow-off" lending and speculating excess. The resulting heavy debt load and exposure to market forces also led to some strange social and political trends. And every year the pool of liquidity seeking financial profits increased, only exacerbating destabilizing speculation, asset inflation and Bubbles, and general boom and bust dynamics – the very essence of Monetary Disorder. When the unsuspecting public suffered from a stock market boom gone bust, the ever enlarging pool of liquidity simply rushed to play the sure thing of bond and real estate inflation. And the latest hot game captured imaginations: professional speculators positioned (“hedged”) to make out-sized returns no matter what the stock market environment. And while the speculators would play any market to try to eek out a trading gain, the bread and butter was borrowing cheap and lending dear. The old “inflation” saw of “too much money [in the Economic Sphere] chasing too few goods” was replaced by “too much liquidity [in the Financial Sphere] aggressively chasing financial profits.” Each year only more liquidity was created in the process of financing (leveraging) Credit Bubble-induced non-productive debt, and much of this liquidity flowed right to financial profit speculators. Leveraged speculation became the instrumental source of liquidity for the Financial Sphere that had taken complete command of the Economic Sphere. And while true economic wealth was stagnant at best for the Economic Sphere, Credit and asset Bubbles ensured that increasing amounts of liquidity flowed into the ballooning financial sphere every day, week, month and year. Moreover, each year the accumulated claims held by Prosperous Community’s trading partners ballooned. They finally decided to begin cashing a few IOUs and spending the proceeds, both impacting the value of the IOUs and forever changing the global pricing environment (additional sources of Monetary Disorder). When the margins from building and selling widgets contract, viable options don’t usually include aggressively increasing volume. But when lending and speculating “profits” narrow - as they do when too many rush to play the same game - more aggressive lending and leveraging will suffice for awhile. All the while, rising community perceived “wealth” and liquidity incite a rising appetite for risk. And there is a great dilemma associated with Monetary Disorder being unleashed in contemporary economies and financial systems: there is no monetary authority or self-adjusting mechanism to bring it back into line. I will return to reality and try to get this less-than-cohesive analysis wrapped up. This year we have now witnessed destabilizing “melt-up” behavior in the three most important markets in the world: U.S. fixed income, global energy, and now American Equities. Globally, emerging debt and equity markets have enjoyed spectacular returns, with generally strong gains for most “developed” stock and bond markets. The proliferation of leveraged strategies and unprecedented leveraged speculation has created an environment of unparalleled global over-liquidity. And in an age of trend following speculations and derivative trading, the global liquidity backdrop creates a system with a proclivity for inciting bouts of panic buying. And, as always, rising speculative markets create their own liquidity. The U.S. bond market remains the epicenter for liquidity excess. With Fed assurances of continuous marketplace liquidity; guarantees that they will act to support stable and strong markets; and promises that they will forewarn participants to rising rates, the U.S. Credit system has become a bastion of over-liquidity and speculative excess. Strong economic data has had minimal impact on market yields, while weak data incites big bond rallies. Big stock gains are a yawner, while appearances of equity market vulnerability incite major bond rallies. And, amazingly, surging energy prices incited – what else but a bond market rally. Importantly, these bond market rallies created additional liquidity that then stimulated stocks and underpinned the economy. And these dynamics rest at the heart of today’s Monetary Disorder - destabilizing liquidity that has created unstable asset inflation, boom and bust dynamics, and financial asset prices increasingly detached from underlying economic wealth. Financial markets have been extricated from reality. In short, the Fed has remained ultra-easy because of the systemic risk brought on by unprecedented financial leveraging and speculation. This has only nourished the dysfunctional Financial Sphere to greater Credit inflation, liquidity excesses, and endemic Bubble excess. Fed policy nurtures the Great Credit Bubble. And those merely focusing on the seductively deceiving exploits of the New Economic Sphere and asset prices have no appreciation for the great risk posed by our vulnerable currency and Intransigent Monetary Disorder. |
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