| Equities were mixed, with the broader market outperforming the major indices. For the week, the Dow and S&P500 were slightly negative. The Transports declined 1%, and the Utilities posted a small decline. The Morgan Stanley Cyclical index rose 1%, having now rallied 15% off October lows. The Morgan Stanley Consumer index was unchanged. The small cap Russell 2000 rose 1% to a record high, increasing y-t-d gains to 6%. The S&P400 Mid-cap index rose slightly to a new all-time high, with 2005 gains of 12.4%. The NASDAQ100 added 0.5%, while the Morgan Stanley High Tech index was about unchanged. The Semiconductors surged 4.3%, increasing y-t-d gains to 16.7%. The Street.com Internet Index added 0.2%. The NASDAQ Telecommunications index was about unchanged. The Biotechs declined 1%, reducing y-t-d gains to 24.4%. The Broker/Dealers fell 1.4%, with 2005 gains slipping to 28.5%. The Banks declined 1.3%. Although bullion surged $7.30, the HUI index declined 2.7%. The reality of a booming economy weighed on Treasuries. For the week, two-year Treasury yields rose 11 basis points to 4.42%. Five-year government yields increased 11 basis points to 4.44%, and bellwether 10-year yields basis points jumped 9 basis points for the week to 4.52%. Long-bond yields rose 5 basis points to 4.72%. The spread between 2 and 10-year government yields increased 2 to 10bps. Benchmark Fannie Mae MBS yields jumped 14 basis points to 5.90%, this week underperforming Treasuries. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note was about unchanged at 38.5 and the spread on Freddie’s 5% 2014 note widened one to 39. The 10-year dollar swap spread increased 2.25 to 56. The implied yield on 3-month December ’06 Eurodollars jumped 16 basis points to 4.855%. Investment grade corporate issuance rose to $10 billion (from Bloomberg). Issuers included American Express $1.5 billion, Citigroup $1.0 billion, Allstate $750 million, Caterpillar $500 million, Temple-Inland $500 million, Ambac $400 million, Carolina Power & Light $400 million, Entergy $350 million, Colonial Bank $280 million, Georgia Power $250 million, Overseas Private Investment $200 million, McCormick $200 million, Federal Realty Trust $125 million, and GSC Capital $100 million. Junk bond funds saw inflows of $225 million this week. Junk bond issuers included Plastipak Holdings $250 million and Omega Healthcare $50 million. Convert issues included Frontier Airline $80 million. Foreign dollar debt issuers included Brazil $2.5 billion, ANZ National $1.5 billion, ING $1.0 billion, African Development Bank $500 million, Adaro Finance $400 million, Orcal Geothermal $165 million, and Barbados $125 million. November 28 – Bloomberg (Alex Kennedy and Peter Wilson): “Venezuela, the world’s fifth-largest oil supplier, sold $3 billion of dollar-denominated bonds to domestic investors… Investors placed $7.1 billion worth of orders for the bonds, Finance Minister Nelson Merentes said… Venezuela initially intended to sell $750 million of bonds maturing in 2016…and $750 million of bonds maturing in 2020…” Japanese 10-year JGB yields jumped 6.5 basis points this week to 1.505%. Emerging debt and equity markets remain generally impressive. Brazil’s benchmark dollar bond yields sank 12 basis points to 7.31%. Brazil’s Bovespa equity index gained 2.6% to a record high, increasing y-t-d gains to 25%. The Mexican Bolsa rose 2.5% to a new all-time high, with 2005 gains rising to 34%. Mexican govt. yields jumped 11 basis points to 5.50%. Russian 10-year dollar Eurobond yields jumped 7 basis points to 6.48%. The Russian RTS equity index jumped 2.7%, increasing y-t-d gains to 74.8%. Freddie Mac posted 30-year fixed mortgage rates dipped 2 basis points to 6.26%, a five-week low. Rates were up 45 basis points from one year ago. Fifteen-year fixed mortgage rates were unchanged at 5.81%, but were up 58 basis points in a year. One-year adjustable rates added 2 basis points to 5.16%, an increase of 97 basis points from one year ago. The Mortgage Bankers Association Purchase Applications Index rose 0.8% last week. Purchase Applications were up 4.4% from one year ago, with dollar volume up 12%. Refi applications dropped 6.3%. The average new Purchase mortgage was little changed at $241,600, and the average ARM was unchanged at $362,700. The percentage of ARMs declined slightly to 33.0% of total applications. Broad money supply (M3) surged $42.7 billion (week of November 21) to a record $10.114 Trillion. Over the past 27 weeks, M3 has inflated $489 billion, or 9.8% annualized. Year-to-date, M3 has expanded at a 7.4% rate, with M3-less Money Funds expanding at an 8.3% pace. For the week, Currency added $1.6 billion. Demand & Checkable Deposits surged $29.1 billion. Savings Deposits fell $10.6 billion. Small Denominated Deposits rose $1.6 billion. Retail Money Fund deposits declined $1.8 billion, while Institutional Money Fund deposits increased $2.0 billion. Large Denominated Deposits fell $3.5 billion. Year-to-date, Large Deposits are up $263 billion, or 26.9% annualized. For the week, Repurchase Agreements jumped $21.4 billion, and Eurodollar deposits gained $2.7 billion. Bank Credit surged $33.2 billion last week (up $68bn in 3 wks). Year-to-date, Bank Credit has inflated $680 billion, or 11.4% annualized. Securities Credit dipped $2.1 billion during the week, with a year-to-date gain of $150 billion (8.7% ann.). Loans & Leases have expanded at a 12.8% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 16%. For the week, C&I loans increased $6.6 billion, and Real Estate loans jumped $9.3 billion. Real Estate loans have expanded at a 14% rate during the first 47 weeks of 2005 to $2.863 Trillion. Real Estate loans were up $349 billion, or 13.9%, over the past 52 weeks. For the week, Consumer loans fell $4.9 billion, while Securities loans rose $5.6 billion. Other loans jumped $18.9 billion. Total Commercial Paper declined $4.3 billion last week to $1.666 Trillion. Total CP has expanded $244.5 billion y-t-d, a rate of 18.7% (up 19.1% over the past 52 weeks). Financial CP added $2.0 billion last week to $1.499 Trillion, with a y-t-d gain of $214.7 billion, or 18.1% annualized (up 19.1% from a year earlier). Non-financial CP fell $6.3 billion to $159.3 billion (up 24.9% ann. y-t-d and 19.1% over 52 wks). ABS issuance slowed to $16 billion, with total November issuance of $85 billion (from JPMorgan). Year-to-date issuance of $725 billion is 22% ahead of comparable 2004. Home Equity Loan ABS issuance of $474 billion is 22% above comparable 2004. Fed Foreign Holdings of Treasury, Agency Debt rose $4.3 billion to $1.504 Trillion for the week ended November 30. “Custody” holdings are up $168.2 billion y-t-d, or 13.6% annualized (up $181.3bn, or 13.7%, over 52 weeks). Federal Reserve Credit jumped $6.2 billion to $812.7 billion. Fed Credit has expanded 3.0% annualized y-t-d (up $27.2bn, or 3.5%, over 52 weeks). International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $549 billion, or 15.9%, over the past 12 months to a record $4.011 Trillion. Brazil’s official reserves jumped 28% over the past year to $60.1 billion. Currency Watch: The dollar index was about unchanged this week, although it certainly lost ground to the commodity currencies. On the upside, the South African rand jumped 2.5%, the New Zealand dollar 2.4%, the Chilean peso 1.9%, and the Australian dollar 1.8%. On the downside, the Iceland krona fell 0.9%, the Japanese yen 0.8%, and the Indian rupee 0.8%. Commodities Watch: December 1 – Bloomberg (Peter McGill): “Sugar prices rose to a 10-year high in New York, capping a 52 percent rally since April, on concern that exports will decline from Europe and Brazil, the world’s largest producer. Brazil is diverting more sugar cane to make ethanol, a crop-based fuel, after a surge in gasoline prices spurred an increase in alternative-fuel cars.” December 1 – Bloomberg (Xiao Yu and Danielle Rossingh): “Aluminum prices rose to their highest in 16 years after 23 smelting companies in China, the biggest producer of the metal, agreed to cut production by 10 percent. The smelters, which produce more than 60 percent of China’s aluminum, will reduce output to lower demand for the raw material alumina and force suppliers to lower prices… Rising raw-material costs have caused losses at 80 percent of the smelters.” It was another interesting week in the commodities markets. Copper traded to a record high, gold to a 22-year high, silver an 18-year high, aluminum a 16-year high, zinc a 15-year high, sugar 10-year high and cattle a 2-year high. January crude oil rose 61 cents to $59.32. January Unleaded Gasoline rose 5.5%, and January Natural Gas surged almost 16% to $13.93. For the week, the CRB index rose 2.8%, increasing y-t-d gains to 13.9%. The Goldman Sachs Commodities index jumped 4.3%, with 2005 gains rising to 39.9%. China Watch: December 1 – Bloomberg (Wing-Gar Cheng): “China’s crude oil imports through its ports increased 12 percent in the first 11 months of the year as the country consumed more fuel to support economic growth, a transport ministry official said.” November 29 – Bloomberg (Rob Delaney): “China’s prices for industrial raw materials and fuel rose 8.9 percent in the first 10 months this year, state news agency Xinhua reported, citing data from the country's top planning agency.” Asia Boom Watch: November 30 – Bloomberg (Cherian Thomas): “India’s economy grew 8 percent in the second quarter as financial services expanded at the fastest pace in almost six years… Gross domestic product grew 8.1 percent in the fiscal first quarter from a year earlier. Indian lenders including ICICI Bank Ltd. are increasing credit at the fastest pace since 1971 as borrowing costs near record lows and the benchmark stock index near an all-time high spur corporate investment and consumer spending. India's expansion makes it the second-fastest growing of the world’s 20 largest economies after China. ‘Unprecedented credit growth is giving strength to financial services and agriculture is boosting growth as well,’ said Shuchita Mehta, an economist at Standard Chartered Bank in Mumbai.” November 28 – Bloomberg (Cherian Thomas): “India’s exports will surge 26 percent in the current financial year, Commerce and Industry Minister Kamal Nath said, helping industrial production to accelerate in Asia’s fourth-biggest economy. Exports will increase to $100 billion in the year to March 31…” November 29 – Bloomberg (Kartik Goyal and Bibhudatta Pradhan): “India’s direct tax collection, including taxes on business profits and personal income, rose 27 percent from a year earlier in the seven months ended Oct. 31 as faster economic growth boosted company earnings.” November 29 – Bloomberg (Cherian Thomas): “India’s economy could expand by 10 percent a year in the next two to three years, Prime Minister Manmohan Singh said, which would help him achieve his goal of lifting millions out of poverty.” November 30 – XFN: “Japanese housing starts in October rose 9.1% year-on-year to 115,769 units, the first rise in two months, data issued by the Ministry of Land, Infrastructure and Transport showed…” December 2 – XFN: “A survey by the Ministry of Health, Labor and Welfare shows that Japanese companies are facing their most severe labor shortage in 13 years, the Nihon Keizai Shimbun reported…” November 30 – Bloomberg (Heejin Koo): “South Korea’s exports and imports combined will exceed $500 billion for the first time this year, Korea Economic Daily newspaper said, citing the Ministry of Commerce, Industry, and Energy… South Korea's exports probably surged more than 10 percent this month to a record amid buoyant demand from the U.S. and China…” December 1 – Bloomberg (Seyoon Kim): “South Korean exports rose 13 percent in November as companies including Samsung Electronics Co. shipped more flat screens and semiconductors. Inflation slowed, giving the central bank room to leave interest rates near a record low. Overseas sales climbed to a record $26.1 billion…” December 1 – Bloomberg (Seyoon Kim): “South Korea’s economy expanded a revised 1.9 percent in the third quarter, the fastest pace in almost two years, buoyed by rising manufacturing and output in the service industry…” November 30 – Bloomberg (Laurent Malespine): “Thailand’s Finance Ministry said Southeast Asia’s second-largest economy is expected to expand 4.3 percent in 2005 after accelerating export growth led to an improvement in the second half. The economy will likely expand 4.6 percent in the second half, compared with 3.9 percent in the first six months…” November 30 – Bloomberg (Stephanie Phang): “Malaysia’s economy expanded at a faster than expected pace in the third quarter as consumer spending rose and manufacturers such as Eng Teknologi Holdings Bhd. increased production. The $118 billion economy grew 5.3 percent in the three months ended September after a revised 4.4 percent gain in the previous quarter…” December 1 – Bloomberg (Aloysius Unditu and Arijit Ghosh): “Indonesia’s inflation accelerated to a six-year high in November… Consumer prices in Southeast Asia’s largest economy surged 18.4 percent from a year earlier after a 17.9 percent gain in October…” Unbalanced Global Economy Watch: November 30 – Bloomberg (Alexandre Deslongchamps): “Canada’s economy expanded at a 3.6 percent annual rate in the third quarter, the fastest in a year, as exports of cars surged and high energy prices boosted corporate profits. Growth in the world’s eighth-largest economy accelerated from a 3.4 percent pace in the second quarter…” December 2 – Bloomberg (Greg Quinn): “Canada’s jobless rate unexpectedly fell last month to the lowest since at least 1976 and wages rose at the fastest pace in more than four years, adding to signs the world’s eighth-largest economy may be overheating. The jobless rate fell to 6.4 percent from October’s 6.6 percent…” November 29 – Bloomberg (Sebastian Boyd): “Banks in Europe are selling a record $101 billion of mortgage-backed bonds this year as governments increasingly provide incentives for home ownership that may invigorate their economies.” December 1 – Bloomberg (Fergal O’Brien): “Manufacturing growth in the dozen nations using the euro accelerated to the fastest pace in 14 months in November…” November 29 – Bloomberg (Craig Stirling): “Home-loan approvals by U.K. mortgage lenders reached the highest in almost a year and a half in October, suggesting a pickup in the $6 trillion property market is being sustained after a yearlong slowdown.” November 30 – Bloomberg (Brian Swint): “Orders for German plant and machinery rose 18 percent in October from a year earlier, led by an increase in demand from abroad, the VDMA industry association said. Orders placed by companies outside the country rose 30 percent while those from German companies fell 3 percent…” December 1 – Bloomberg (Jacob Greber): “Growth in Switzerland’s economy, Europe’s eighth-largest, accelerated to the fastest pace in five years, reinforcing the central bank’s case for a rate increase as early as this month.” November 30 – Bloomberg (Dara Doyle): “Irish borrowing surged 29.4 percent in October from a year earlier, the fastest pace in more than five years, as rising employment and the lowest interest rates in 60 years boosted demand for money.” November 30 – Bloomberg (Fergal O'Brien): “Irish house prices rose in October at the fastest pace in 18 months as population growth and rising employment lift property demand, according to a survey by Irish Life & Permanent Plc. House prices rose 1.2 percent from the previous month to an average of 271,385 ($320,000)…” November 29 – Bloomberg (Tasneem Brogger): “Denmark’s economic growth in the third quarter unexpectedly accelerated at the fastest annual pace in more than a decade on rising exports and consumer spending. The Danish economy grew an annual 4.8 percent…” November 29 – Bloomberg (Jonas Bergman): “Swedish retail sales rose 0.8 percent in October, the most since June, led by purchases from furniture and clothing stores. Sales rose 7.3 percent from the same month last year…” December 2 – Bloomberg (Jonas Bergman): “Sweden’s central bank signaled it will raise interest rates early next year for the first time since April 2002 and sent bonds plunging by warning that borrowing costs may rise more than investors anticipate. ‘It is reasonable to assume that the repo rate will need to be increased in future, as the market is currently assuming… However, one cannot rule out the possibility that the repo rate will need to be raised more during the winter and spring than market rates imply.” November 30 – Bloomberg (Trygve Meyer): “The pace of borrowing by Norwegian households and businesses accelerated for a ninth consecutive month in October, putting pressure on the central bank to raise interest rates for a third time this year. Credit growth for households, companies and municipalities was an annual 12.4 percent, the highest since February 2001…” Latin America Watch: November 28 – Dow Jones: “Argentine building activity heated up in October, with increased private-sector construction supplementing a steady stream of public works projects… The government’s monthly construction index for October posted a 23.2% rise on the year…” December 1 – Bloomberg (Eliana Raszewski): “Argentina’s tax revenue rose 25 percent in November as a surge in consumption boosted collection of value-added taxes, the government said.” November 28 – Bloomberg (Peter Wilson): “Venezuela will invest $100 billion over the next five years in infrastructure projects funded by record oil revenue, President Hugo Chavez said.” Bubble Economy Watch: Third quarter preliminary nominal GDP expanded at a 7.4% annualized rate, the strongest expansion since Q2 2004. October Durable Goods Orders were stronger-than-expected. Total New Orders were up 11.1% from October 2004. Capital Goods Orders were up 16.3% y-o-y, with Non-Defense Capital Goods Orders up 20% y-o-y. November 28 – The Wall Street Journal (Ian McDonald): “Cash-rich American companies are showering a record windfall on their shareholders -- and in the process stirring some concern about future growth of the U.S. economy. This year, the companies in the Standard & Poor’s 500-stock index are on track to pay out more than $500 billion to shareholders in the form of dividends and share repurchases, or buybacks, according to S&P. That’s up more than 30% from last year’s record -- and equivalent to nearly $1,700 for every person in the U.S.” Speculator Watch: December 2 – Financial Times (Peter Smith): “Blackstone, the world’s largest independent alternative asset manager, is planning an aggressive move into hedge funds, where it believes it can be a significant force with potentially $10bn under management. ‘The first brick is in place,’ Tony James, Blackstone president, said… He said the group planned to build a ‘flagship fund’ that would be a central plank of its hedge fund strategy. That fund is likely be long/short equity or multi-strategy. Mr James warned that the roll-out would take time and depend on attracting the right people to run the funds, but that it was possible for it to have $5bn-$10bn devoted to hedge funds… The expansion into hedge funds comes as Blackstone raises unprecedented amounts of capital in both private equity and real estate.” “Project Energy” Watch: December 1 – Bloomberg (Eduard Gismatullin): “Russia’s government raised by 32 percent its cost estimate for the first stretch of a pipeline to transport oil from Siberia to China and other Asian markets because of route changes and inflation, an official said. Spending will rise to $7.9 billion from an earlier estimate of $6 billion…” December 1 – Bloomberg (Will Kennedy and Nesa Subrahmaniyan): “Saudi Aramco, the world’s biggest oil company by output, plans to expand refineries in the U.S., South Korea, the Philippines and China after a global shortage of capacity drove fuel prices to records.” December 1 – Bloomberg (Tom Cahill): “Turning hydrogen into a practical energy source for autos and electricity could cost as much as $6 trillion by 2050, according to the International Energy Agency. The investment needed includes as much as $2.3 trillion for fuel-cell technology, $2.5 trillion for pipelines to handle hydrogen and $700 billion on fuel stations. The costs compare with $16 trillion in overall energy spending needed by 2030, the Paris-based adviser to oil-importing nations said.” Mortgage Finance Bubble Watch: Highlights from OFHEO’s third-quarter house price appreciation report: “Average U.S. home prices increased 12.02 percent year over year from the third quarter of 2004 through the third quarter of 2005. This represents a two percentage point decline from the previous four-quarter appreciation rate… Appreciation for the most recent quarter was 2.86%... ‘Appreciation rates in the third quarter were extremely strong, although some deceleration can be seen in a number of the faster-appreciating markets,’ said OFHEO Chief Economist Patrick Lawler. ‘Price momentum in the Pacific and New England states, in particular, has pulled back.’ House prices grew more rapidly over the last year than did prices of non-housing goods and services reflected in the Consumer Price Index. Housing prices rose 12 percent, while prices of other goods and services rose only 4.5%. …Price growth in Arizona continues to accelerate, with a one-year appreciation rate of 30 percent… Florida became the second fastest-appreciating state, with four-quarter appreciation of 25 percent…” One can glean Credit Bubble Dynamics from OFHEO data. With the California housing Bubble accommodated by continued loose monetary conditions, the strong inflation bias has jumped to neighboring states. California’s (up 19.26% y-o-y) neighbors occupy three of the top nine one-year price gains: Number one Arizona has enjoyed 30.33% appreciation; number eight Nevada has gained 17.59%; and number nine Oregon has seen 16.92% housing inflation. Washington’s (#10) prices were up 15.64%; New Mexico’s (#14) 12.65%; and Wyoming’s (#16) 12.03%. It is worth noting that half of the states recorded double-digit y-o-y price gains. Rounding out some of the other top performers, home prices in Hawaii jumped 21.33%, District of Columbia 20.53%, Maryland 19.29%, and Virgina 18.66%. At the bottom of the list, Michigan home prices have gained 4.01% over the past year, Ohio 4.47%, Nebraska 4.83%, and Kansas 5.05%. October Existing Home Sales were reported at a somewhat weaker-than-expected 7.09 million annualized pace. It was, however, the seventh highest monthly sales level ever. Sales were up 3.7% from October 2004 and 10% from October 2003. Average (mean) Prices were up 11.3% from a year earlier and 22% from two years ago. Calculated Annualized Transaction Value (CTV) was up 15.3% from one year ago, 34% from two years ago and 63% from three years ago. Year-to-date Existing Home Sales are running 6.1% ahead of last year’s record pace. The inventory of unsold Existing Homes rose to 2.868 million. New Home Sales surged to a much stronger-than-expected and record 1.424 million pace. Sales were 9% above October 2004, at the time a new record, and were 25% ahead of October 2003. Average Prices were down 1.1% from one year ago, although they remained 18% above the October 2003 level. Year-to-date New Home Sales are running 7.5% ahead of last year’s record pace. The Inventory of Unsold New Homes rose 3,000 to 493,000, rising 20% over the past year. Total Home Sales are running 6.4% head of last year’s record pace. From the California Association or Realtors: “While California is still experiencing year-over-year double-digit price appreciation, prices are starting to level off compared with the statewide peak reached in August… Regionally, the median price continues to post strong gains, with the High Desert, Riverside/San Bernardino, and San Luis Obispo regions hitting record highs last month.” California median prices were up $79,240 over the past year, or 17.2%, to $538,770, with a 2-year gain of $159,650, or 42%. Median Condo prices were up $56,490, or 15.2%, to $429,090, with a 2-year gain of $133,050, or 45%. It is worth noting that some of the previously hottest regions have posted significant declines in y-o-y sales (San Diego, San Francisco, Los Angeles, Northern California, Santa Barbara, and Sacramento all experienced double-digit declines), while the less expensive markets such as High Desert (up 24%) demonstrate much more positive sales trends. This dynamic is impacting the state’s median price. November 30 – Bloomberg (James Tyson): “Former Fannie Mae Chief Executive Officer Franklin Raines received more than $40 million in bonuses and other pay as a result of inflated earnings at the biggest U.S. mortgage finance company, according to a supplement of a lawsuit filed by Ohio Attorney General Jim Petro. Fannie Mae added ‘tens of millions of false revenue’ to meet ‘Raines’ 1999 publicly announced goal to ‘double’' earnings over the next five years, Petro alleged in a Nov. 23 filing with the U.S. District Court in Washington. ‘Raines personally profited by over $40 million by this false earnings history.’” Bill and Paul’s Wild Analytical Adventure: I look forward each month to new commentaries from Pimco’s Bill Gross and Paul McCulley. Mr. Gross, trading kingpin at the world’s largest bond fund, and my “analytical nemesis” Mr. McCulley, nominated by Dr. Bernanke for one of the vacant Federal Reserve governor posts and one of the more astute commentators on all matters Fed and financial, at least possess the wherewithal to analytically dazzle. And after a few months of rather uninspiring articles (I should have known better than to briefly ponder that Mr. McCulley had “thrown in the towel”), they are back this month with a creative vengeance. And while I often take strong exception with the direction of their analysis, it’s usually quite thought-provoking. Besides, when I am searching for something to write about they are seemingly right there and happy to deliver. They are exceptionally formidable “opponents” – recalling memories back when I was a scrawny 15 year old with my daily scratching and clawing against the much more powerful upperclassmen to earn a spot on the Cottage Grove Lion’s varsity basketball team. They motivate me. Mr. McCulley is an especially clever Fed watcher/proponent. Now plainly in the Bernanke camp, he blends insightful analysis with really creative rationalization for today’s flawed American experiment in central banking. This month he provides his clearest analysis yet of how a deregulated financial apparatus has profoundly altered the nature of Credit (he says “savings”) intermediation, with the capital markets now the marginal provider of Credit and liquidity both at home and abroad. He also astutely writes that deregulation of the Credit system has changed “the central banking game,” with the Fed’s role much diminished from the days when it enjoyed “colossal power” over the price and availability of Credit. Good enough. One may be tempted to presume that we may be closer than many think in our analyses, but it occurs to me that our views have converged only on the most obvious and indisputable points. Mr. McCulley remains firmly entrenched in his hypothesis that the Fed has attained the promised land of price stability, and it is this postulate that provides the foundation for his analytical framework. He goes so far as to link the achievement of price stability to the collapse of risk premiums and the propensity for Bubbles. I take very strong exception to this analysis, and there really can be no reconciliation between his “price stability” view and my assertion of the polar opposite, Monetary Disorder – none. It is the foundation of my analysis that the “evolution” to an unrestrained capital markets and asset-based Credit system has, not unpredictably, nurtured a highly unstable monetary environment. More specifically, Credit has become progressively more readily available, is being systematically under-priced, and that these dynamics over time radically impact the nature of spending, investment, and resource allocation. The dangerous proclivity of self-reinforcing asset Bubbles and an expanding and increasingly powerful leveraged speculator community (and their expansive global pool of speculative finance) are natural outgrowths of just such a monetary backdrop. And while a flexible, deregulated and risk-taking economy is its boon (“Economic Sphere” analysis), Limitless Profligate “Wildcat Finance” is the Bane of Capitalism (“Financial Sphere” analysis). As we have witnessed, when the effects of Credit inflation become increasingly powerful and unwieldy, policymakers abandon any hope of reining in excesses - succumbing instead to untoward rationalizations and justifications (just read today’s speech from chairman Greenspan!). And, as was the case during the “roaring twenties” in the U.S. and the booming eighties in Japan (and one can go back almost 300 years to John Law’s monetary experiment and the resulting Mississippi Bubble in France), periods of acute Monetary Disorder can very well manifest with seductively quiescent consumer prices. Not only do asset markets tend to attract the lion’s share of Credit growth, general liquidity over-abundance fosters investment booms and an increased variety and supply of consumer goods/services (not to mention a flurry of new technologies). Periods of acute asset inflation also tend to concentrate (redistribute) wealth creation, altering the nature of spending (i.e. more services, luxury goods and imports). As such, it is a fundamental analytical error to base systemic price stability and monetary conditions upon an aggregate measure of core consumer prices – especially considering the current radically altered Credit system. Making matters far worse, the Federal Reserve and Wall Street pundits have developed this “zero lower bound” rationalization for asymmetrical policy responses: Having reached so-called “price stability,” the Fed must respond vigorously to preclude any potential dip into a recession that would risk a problematic deflationary spiral. In the Fed’s public view, rising asset prices now pose significantly less systematic risk than declining core consumer prices. As the thinking goes, the Fed can always inflate and “mop up” after a bursting Bubble, while they are constrained by a zero Fed funds rate when it comes to combating The Scourge of Deflation. So, not only have Credit inflation and consequent asset Bubbles become endemic due to the nature of the Credit system apparatus, the Fed openly manipulates the risk/return profile of asset and interest-rate speculation (accommodating Bubble excess and promising to cushion any potential disruptions). The Fed has created a quagmire, although precarious financial excess still enjoys the beguiling capacity to masquerade as the golden age of prosperity. Not only has the Fed lost control of the Credit system to a highly speculative (and leveraged!) and powerful marketplace, it has waved a big white flag of policy risk aversion. Meanwhile, the Greenspan Fed’s “risk management” approach provides cover for adopting open mandates to both aggressively act to avoid recessions and to partake in post-Bubble reflations. I agree that we do not want central banks micromanaging the asset markets – markets will inevitably fluctuate. But it is a fundamental responsibility of the Fed to champion financial stability and safeguard the integrity of our financial system. An activist Fed should never accommodate major asset inflations, no matter what its views with respect to consumer prices or the potential for recession. Moreover, it should never toy with Capitalism’s playing field to the betterment of financial speculators. Such expedients only ensure increasingly unmanageable Bubbles and maladjustments. And it is the very nature of Bubbles that, once they become entrenched, central banker moves toward moderate policy tightening will quite likely have the opposite effect (It is fundamental macro Credit analysis that excess begets excess and that mature Bubbles scoff at timidity). As we see today, in a world awash in speculative liquidity, baby-step Fed rate increases only incite greater speculative endeavors, including inflows to take advantage of widening interest-rate differentials. The objective must be to endeavor to recognize and early on ward off Bubbles and the mechanisms cultivating them, while never obliging speculation. An effective central bank must be willing to discipline and inflict pain. That the Fed has actively used both the leveraged speculating community and mortgage finance as reflationary policy tools is a serious dereliction of duties. All the rationalization and justification rubs me the wrong way. The inflationists have a keen affinity for regulation. This should be explored and, I contend, strongly rebuked. Taking Bubble suppression out of the policy mandate, (the anti-Bubble popper) Dr. Bernanke believes that a diligent regulatory environment can be left to effectively restrain Credit excess. It is certainly captivating to fancy that the Fed can bypass the risky proposition of Bubble intervention, leaving individual market regulators to rein in bouts of excess. The problem is it is completely unrealistic and without a historical basis. The fundamental problem with asset inflation is that there are scores of constituencies that absolutely love it and few if any that have a problem with it. Who has confidence that our Washington lawmakers would have the resolve to support more obtrusive regulation of the stock market, leveraged lending, hedge funds, M&A, or mortgage finance? Not going to happen – or at least not until after busts, which is precisely why an independent Federal Reserve was created to regulate the nation’s Credit system in the first place. The Fed and Congress couldn’t even adequately regulate Fannie and Freddie, and the GSE’s were operating with obvious reckless abandon right there in their own backyard. It’s now been more than three years since Dr. Bernanke suggested in his initial Fed speech that regulation is a preferred approach to “Bubble popping.” Well, where’s the beef? He’s certainly had ample opportunity to initiate reform or call for a stricter regulatory mandate. But he’s understandably not interested in committing career suicide. And, oh that’s right, he also recently stated he didn’t believe there was a housing Bubble. Meanwhile, in three years home prices in California and other hot markets have doubled, and the regulators have been powerless. The same for derivatives, hedge funds and ABS – all doubled while regulation doddered. Mr. McCulley advises cracking down on exotic mortgages, apparently believing that this would temper housing excess and restrain system excesses generally. Nice try, but it’s too late for that. U.S. “exotic” mortgage Credit has become immaterial in the grand scope of Global Credit Bubble and Liquidity Excess fueled by a universal real estate lending boom, a “repo”/securities finance boom, M&A boom, derivatives boom, hedge fund boom, energy boom, commodities boom, equities boom, emerging markets boom, and general global economic boom. Mr. Gross examines the current extraordinary landscape and comes to the conclusion that secular factors such as globalization, mercantilist Asian economies/central banks, a global savings glut, demographics and a transparent Fed have likely lowered global market yields for some years to come. He then proceeded on a Wild Analytical Adventure where he equated today’s 4% short rates with 6% rates from the past, arguing – and I kid you not – that the Fed is these days much tighter than most believe. And while I am willing to contemplate the premise that extraordinary developments have taken in the neighborhood of 200 basis points out of 10 year global yields, I would tend to believe that overly abundant global liquidity and speculative excess are the commanding dynamics. And while Mr. Gross is content to shave 200 basis points off the entire yield curve, my analysis would instead contemplate that artificially low long-term rates have essentially reduced the effectiveness of short-term interest rates as a restraining mechanism. Or, stated differently, today’s 4% Fed funds rate is equivalent to previous years’, say, 2% - and definitely not 6%. And while Mr. Gross argues that short-term rates are too high and will follow waning global economic growth and inflationary pressures lower, my analysis of the global environment would argue for the distinct possibility that the opposite develops. The reality of the situation is that the global liquidity and inflationary backdrops are more robust than generally appreciated (by those watching market yields!). The highly unsound global economic boom is poised to surprise on the upside, forcing the Fed and central bankers to push short-term rates higher than markets are currently discounting. Indeed, the global inflationary boom thesis seems to draw weekly support from both the data and market developments. And I will venture out on the analytical limb myself with a forecast: we haven’t heard the last from the energy bull market. The incessant liquidity (and low market rates!) induced global boom will engender quite a thirst for oil and energy generally. The recent market correction will prove short-lived, and the Federal Reserve and global central bankers will finally be faced with the necessity of orchestrating a true tightening of global monetary conditions. |
Tuesday, September 9, 2014
12/02/2005 Bill and Paul's Wild Analytical Adventure *
