| It was a good week for financial assets. The Dow gained 2.3%, increasing 2003 gains to 23%. The S&P500’s better than 1% advance increased y-t-d gains to 24%. The leading S&P groups this week were Steel, Office Electronics, Construction & Farm Machinery, and Aluminum. The Transports were unchanged (up 29% y-t-d), while the Utilities added 2% (up 17% y-t-d). The Morgan Stanley Cyclical index surged another 3%, with quarter-to-date gains of 22% and y-t-d gains of 48%. The Morgan Stanley Consumer index rose 2% (up 9% y-t-d). The small cap Russell 2000 (up 43% y-t-d) and S&P400 Mid-cap (up 32% y-t-d) indices were little changed. The NASDAQ100 (up 45% y-t-d) and Morgan Stanley High Tech (up 60% y-t-d) indices rose about 1%. The Semiconductor’s 1% decline reduced y-t-d gains to 69%. The Street.com Internet Index was slightly positive (up 72% y-t-d) and the NASDAQ Telecommunications index added 1% (up 60% y-t-d). The Biotechs’ 1% advance increased 2003 gains to 41%. The Broker/Dealers (up 53% y-t-d) and Banks (up 28% y-t-d) rose about 1%. Although bullion added 50 cents to $409.35, the HUI Gold index dropped 5%. Credit market instrument prices rose also. For the week, 2-year Treasury yields dipped 3 basis points to 1.78%. Five-year Treasury yields declined 7 basis points to 3.15%. Ten-year yields sank 10 basis points to 4.13%, the lowest yields since early October. The long-bond saw its yield drop 13 basis points to 4.96%. Benchmark Fannie Mae mortgage-backed yields declined 11 basis points. The spread on Fannie’s 4 3/8 2013 note widened 1 to 36, and the spread on Freddie’s 4 ½ 2013 note was unchanged at 36. The 10-year dollar swap spread increased 1.25 to 38. Corporate spreads were generally little changed, with spread indexes at near 5-year lows. The implied yield on December 2004 Eurodollars declined 2.25 basis points to 2.20%. Debt issuance, at about $8 billion, was double the comparable week from one year ago (according to Bloomberg). Investment grade issues: BB&T $1 billion, Exelon Generation $500 million, Berkshire Hathaway $500 million, L-3 Communications $400 million, Piedmont Natural Gas $200 million, Hyundai Motor $400 million, Oakmont Asset Trust $350 million, and Huntington National $200 million. Junk bond funds enjoyed their seventh consecutive week of inflows, although flows of $170 million (from AMG) were about half of the previous week. Junk issues: NRG Energy $1.25 billion, Telenet Communications $1.1 billion, CSN Islands VIII $350 million, Asbury Auto Group $200 million, Suburban Propane $175 million, Resolution Performance $140 million, Nexstar Finance $125 million, and El Pollo Loco $110 million. Foreign dollar debt issuers included Region of Sicily $981 million and Autopista Central $250 million. Convert issues: Adaptec $200 million, Agco $175 million, Kroll $150 million, Mentor $125 million, and Fleetwood Enterprises $80 million. Commodities Watch: December 19 – Bloomberg: “Soybean futures rose in Chicago after U.S. exporters reported a record purchase by China, the biggest customer for U.S. beans. The U.S. Agriculture Department said Chinese buyers bought 1.8 million metric tons, or 66.1 million bushels, of soybeans, the biggest sale ever in a single day… Rising demand from China has helped fuel a 37 percent rally in prices in the past year. Yesterday officials from the Chinese Commerce Ministry agreed to purchase 2.5 million metric tons of U.S. soybeans and took an option for another 2.5 million tons. ‘China’s back, we’re friends, everybody’s happy,’ said Tim Hannagan, an analyst with Alaron Trading Company…” December 16 – Bloomberg: “China paid 45 percent more for a ton of imported iron ore in September than a year earlier amid surging demand for the commodity used to make steel, the Tex Report said, citing Chinese government statistics.” December 18 – Bloomberg: “U.S. Energy Secretary Spencer Abraham said more than $100 billion needs to be invested in liquefied natural gas projects to meet the nation’s energy needs by 2025. ‘The U.S. will have to become a much larger importer of LNG than it is today,’ Abraham said in a speech at a government-sponsored LNG summit in Washington. He said LNG imports could reach 13 billion cubic feet a day -- more than 20 times today’s rate -- in 2025, and account for 15 percent of total natural gas supplies.” The CRB index was unchanged this week at 7-year highs. Depleting inventories saw crude oil rose to prices not seen since war-worried March. Fears of shortages were behind 14-year highs in nickel prices. China Watch: December 16 – Bloomberg: “China’s retail sales rose about a 10th for a fifth straight month in November as rising incomes and a credit boom enabled consumers in cities such as Beijing and Shanghai to buy more cars, homes and cell phones. Sales increased 9.7 percent from a year earlier to 420 billion yuan ($50.7 billion) after growing 10.2 percent in October, their fastest pace in two years…” December 16 - Financial Times (James Kynge): “China’s boundless commercial energy has begun to bump up against finite capacity. It is too early to tell how soon and to what extent these capacity constraints will start to slow the world’s fastest-growing large economy. But it is clear that shortages - in some areas - of electricity, transport capacity, coal, grain and other commodities are forcing up prices and restraining new investment… The clearest capacity constraint to growth is in the power industry. Broad swathes of China’s industrial heartland are now chronically short of electricity. The State Power Information Network, a government organisation, has forecast worse shortages and more power rationing next year… One reason for the shortage of electricity has been the soaring price of coal, which supplies 70 per cent of China’s energy needs. Although official figures show coal prices have risen by just 3 per cent this year, this measure is misleading because it does not include the vast volumes sold on the black market. The price of black-market coal has risen at least 20 per cent, industry executives said… There are 390 Chinese cities that depend on coal mining, but the mines in 80 per cent of them are already mature or in decline, according to statistics from the China Mining Association. Bottlenecks are also apparent on China’s vast network of railways, which transport 60 per cent of the country’s staple foodstuffs and 80 per cent of the coal at tariffs largely fixed by the state… The lack of rail capacity has shifted the burden to road transport, where prices are set by the market and have therefore been climbing. Indeed, one reason behind the sharp increase in the price of soybeans, maize, wheat, rice, vegetables and pork has been the rising cost of transport.” The consensus remains generally fixated on the “China exporting deflation” story. But the truth of the matter is that China is providing us with an extraordinary example of Credit inflation and boom dynamics. An out of control investment boom is now challenged by expanding bottlenecks and shortages. In turn, runaway Credit excess has nurtured a real estate boom, general asset inflation, and rampant speculation. China fever has afflicted the world. What had appeared a healthy, stable and easily manageable boom is being transformed to something more capricious and unwieldy. And with cautious authorities understandably hesitant to “slam on the brakes” (a boom of this ferocity, breadth and duration will not succumb to inhibited monetary management), we will now have the opportunity to follow and analyze an economy with increasingly problematic Inflationary Manifestations. At some point, perhaps Chinese authorities will come to recognize that the over-liquefied global financial system and faltering dollar compound their unfolding dilemma. The Bank of Japan can buy mountains of dollars – adding liquidity to their domestic financial system – seemingly without an inflationary care in the world. The same is certainly not true for the Chinese with myriad inflationary biases throughout their economy and markets. Global Reflation Watch: December 20 – Bloomberg: “Parmalat Finanziaria SpA hired Weil, Gotshal & Manges LLP to advise it on a possible bankruptcy reorganization after Bank of America Corp. contested documents claiming the Italian food company had a $4.9 billion account at the bank, people familiar with the matter said. Parmalat, which owns Europe’s largest dairy, hired the New York law firm as it begins talks with creditors owed more than $7.1 billion, the people said.” There is Parmalat exposure in the structured finance and derivatives markets, so this could prove an interesting development. December 19 – Bloomberg: “Japan’s economy needs to sustain about 2 percent real economic growth in order to overcome deflation, Economic and Fiscal Policy Minister Heizo Takenaka said. Japan should also work toward achieving 2 percent nominal economic growth by the fiscal year starting April 2006, Takenaka said... Takenaka added that the government and the Bank of Japan would need to work together to create conditions in which money supply would rise.” December 18 – Bloomberg: “Japan’s plan to use 61 trillion yen ($567 billion) to protect exports by weakening its currency may only stem the yen’s appreciation, said strategists at ABN Amro Holding NV and Goldman Sachs Group Inc. The Ministry of Finance will ask the cabinet for 21 trillion yen in an extra budget for the year ending March 31, said a ministry official familiar with the matter. Another 40 trillion yen will be earmarked for sale to buy currencies such as the dollar and the euro the following fiscal year, said the official. Japan, pulling out of 12-year slump, has spent more than 17.8 trillion yen, a record, in an effort to stem the yen’s 10 percent rise against the dollar this year…” December 18 – Bloomberg: “German business confidence rose in December to the highest in almost three years, indicating the recovery in Europe’s largest economy is strengthening, a survey by the Ifo economic institute showed. Ifo’s index of western German executive optimism, one of Europe’s most-watched economic indicators, rose to 96.8 from 95.7 in November. The increase is the eighth in a row.” December 18 – Bloomberg: “China’s economy will probably expand more than 8 percent next year, according to Li Xiaochao, a director at the National Bureau of Statistics. ‘Economic growth will likely exceed 8 percent in 2004,’ he said. ‘It is expected to be about 8.5 percent this year.’ China’s economy grew 9.1 percent in the third quarter, giving 8.5 percent growth for the first nine months of 2003. Citigroup predicts the economy will grow 8.7 percent next year, Goldman Sachs Group Inc. forecasts a 9.5 percent expansion and Deutsche Bank AG is projecting growth of 8.4 percent.” December 18 – Bloomberg: “Hong Kong’s jobless rate in November had its biggest drop in 20 years, sliding more than expected as a tourism boom helps revive the city’s economy. The rate fell to 7.5 percent -- the lowest it’s been since March -- from 8 percent in October, the government said in a statement. That’s the largest decline since July 1983, when the British and Chinese governments began formal negotiations over Hong Kong's return to China. ‘The economy is clearly picking up quite strongly. Corporates are hiring workers,’ said Joe Lo, a Hong Kong-based economist at Citigroup Inc.” December 19 – Bloomberg: “Shares of Shipping Corp. of India Ltd. and Great Eastern Shipping Co. may extend their gains as accelerating global growth and China’s need of oil and gas allow Indian tanker owners to raise charter prices… Tanker owners Worldwide are headed for their most profitable year since 1973, according to ship brokers such as London-based Simpson, Spence & Young.” December 18 – Bloomberg: “South Korea’s economy will probably grow more than 5 percent in both the first and second halves of next year, according to Korea Development Institute, a state-funded research group… The central bank, which predicts full-year growth of 5.2 percent, forecasts growth will accelerate to 5.6 percent in the second half of next year from 4.8 percent in the first six months.” December 19 – Bloomberg: “Argentina’s economy grew at its fastest pace in at least nine years in the third quarter, led by a surge in manufacturing and construction, the government said. Gross domestic product expanded 9.8 percent in the July to September period from the same period a year ago after growing 7.6 percent in the second quarter.” December 18 – Bloomberg: “Brazil’s state development bank, the country’s biggest bank, plans to boost lending 39 percent to 47.3 billion reais ($16.1 billion) next year in an effort to help pull the nation out of the worst economic slump in seven years.” December 17 – Bloomberg: “Latin America’s economy is set for its fastest economic expansion in four years in 2004, fueled by increased demand from the U.S. and higher prices for the region’s commodities, the United Nations said. The region will expand 3.5 percent in 2004, up from this year’s growth estimate of 1.5 percent. For the first time since 1997, the UN’s Economic Commission for Latin America and the Caribbean said none of the 19 economies it tracks in the region will shrink.” December 18 – Bloomberg: “Brazil has cut its domestic dollar-linked debt by more than two-thirds this year, taking advantage of growing investor confidence to sell more debt in local currency.” December 18 – Bloomberg: “Russia paid $17 billion on its external debt this year, President Vladimir Putin said in remarks broadcast by state-owned television Rossiya.” Domestic Credit Inflation Watch: December 19 – Reuters: “U.S. stock funds could have their second best year of inflows, although six firms connected to improper trading scandals suffered combined outflows of $21.3 billion in November… Despite the scandals, U.S. equity mutual funds enjoyed inflows overall of $22 billion in November, down from $23.8 billion inflows in October, said Lipper… ‘In the equity funds arena, a very strong December could bring the year’s total inflow to near $200 billion – better than the 1999 total and the second best on record. And the recent monthly paces, when annualized, have been near or above the record high of $270 billion set in calendar 2000.’ (From Lipper’s Don Cassidy) Another fund research firm, Strategic Insight, said Thursday that inflows into all long-term mutual funds are projected to reach $300 billion for 2003, ‘the highest pace since 1997 and just shy of an all-time record.’” December 17 – Bloomberg: “Wall Street firms, flush with profits amid a revival in stocks and investment banking, will increase bonuses in 2003 by 25 percent from a year earlier, New York State Comptroller Alan Hevesi said. Brokerages and investment banks will award bonuses of about $10.7 billion, or an average $66,800 per employee, to the 161,000 New York City workers in the industry, up from $8.6 billion last year, Hevesi said in a statement. Bonuses peaked at $19.5 billion, or an average $101,000 per employee, in 2000.” Economy Watch: December 19 – Bloomberg: “Michael Randles’s Christmas tree is so big it took a crane to erect it on the front lawn of his Stone Mountain, Georgia, home. Randles, owner of M&M Mortgage Corp., spent more than $50,000 to buy the 60-foot Norway spruce, truck it from Sugar Mountain Nursery in Newland, North Carolina, and decorate it with 30,000 lights and 500 red and gold ornaments, some as big as basketballs. ‘Without the year I’ve had in my business, I would not have been able to afford it,’ said Randles, 36, who also has a shorter tree inside his house. U.S. homeowners are buying bigger, more expensive Christmas trees, and some are taking home a second or third tree, according to growers… Sales of Christmas trees will rise as much as 25 percent this year to 28 million, after three years of decline, according to the National Christmas Tree Association…” December 17 – Bloomberg: “The U.S. government will probably run a budget deficit next year of around 4-4.5 percent of gross domestic product, a top White House economic adviser said… Mankiw’s prediction for the year that ends Sept. 30 means that the federal government would run a higher deficit in percentage terms than they did this current year. The fiscal 2003 deficit, reflecting increased government spending, tax cuts and slower economic growth, grew to a record $374.2 billion -- about 3.5 percent of GDP.” November Housing Starts jumped to an amazing annualized 2.07 million units, the strongest level since February 1984 (when homes were smaller and much less expensive!). Single Family Starts were up a stunning 20.8% y-o-y to a new all-time record. Multi-family Starts were up 5.0% y-o-y. It is also worth noting that Housing Starts were up 25% from April. November Housing Permits were up 6.2% y-o-y. The Philly Fed’s factory activity index surged to the highest level in 10 years. The index of New Orders shot to the best reading in 23 years. The pricing index was the highest in more than 4 years. The index of Employment surged and Prices Paid was up strong, November’s stronger-than-expected 0.9% rising in Industrial Production was the largest increase since October 1999. Industrial Production is the highest since March of 2001. Capacity Utilization has not been higher since August 2002. The four-week average of continuing unemployment claims dipped to the lowest level since September 2001. There were 27,811 bankruptcy filings last week. The November Consumer Price index posted a 0.2% decline, with y-o-y gains of 1.8%. Historically, consumer prices have been one of many indicators of general monetary conditions. Yet it has evolved into likely the least effective tool for judging the appropriateness of monetary policy (Japan in the late-eighties and the U.S. in the late-nineties, as cases in point). Ironically, it has become Wall Street’s and the Fed’s favorite “inflation” indicator. Foreign Net Purchases of U.S. Securities jumped from September’s dismal $4.19 billion to a more respectable, although insufficient, $27.65 billion. Foreign Official Institutions purchased $19.5 billion of Treasuries (the Bank of Japan accounted for more than $17 billion), up from September’s $8.0 billion. The bottom line is that the $15.9 billion September and October average foreign Net Purchases compares to the $62.6 billion monthly average over the preceding 12 months. And digging into a bit of detail, we see that the (financial center) UK accounted for $13.5 billion of total Net Purchases. With net Treasury purchases of $21.5 billion, total Japanese Net Purchases surpassed $18 billion. Following September’s net liquidations of $2.3 billion, Chinese Net Purchases of U.S. Securities almost reached $5 billion. Curiously, Total Caribbean saw $2.9 billion of net liquidations following September’s $10.7 billion net sales. Total Caribbean had averaged $14.4 billion of Net Purchases over the preceding six months. At $199 billion, Total Caribbean accounted for 65% of total agency transactions for the month. It is worth recalling that Securities Broker and Dealers' holdings of Total Financial Assets expanded at a 25% annualized rate during this year’s first half to $1.5 Trillion. This asset growth was associated with a major increase in leveraged speculation (especially in the mortgage-backed arena). Tumult in the Credit and interest-rate derivatives markets brought this expansion to an abrupt halt during the third quarter. There are indications, however, that (with Fed assurances) aggressive leveraged speculation has returned. Lehman Brothers’ Total Assets increased $19.0 billion during the quarter, or 25.8% annualized, to $314.0 billion. This more than reverses the previous quarter’s $7.4 billion contraction. Total Assets were up $53.7 billion over 12 months, a 20.6% expansion. From the beginning of 1998, Total Assets have more than doubled (up 107%). Net Revenues almost doubled from the year ago quarter, with Net Income up 157%. Morgan Stanley saw Consolidated Net Income surge 43% from the year ago quarter to $1.04 billion. From the company: “Institutional Securities posted net income of $753 million, an increase of 69% versus fourth quarter 2002. Net revenues rose 42 percent to $2.6 billion… Fixed income sales and trading net revenues were $977 million, up 66 percent from fourth quarter 2002. Tighter credit spreads, a steeper yield curve and increased interest rate, currency and commodities market volatility – drove the overall increase. Equity sales and trading net revenues of $919 million were up 48 percent from the prior year’s fourth quarter.” Trading (principal transactions) income more than doubled to $894 million. Compensation and Benefits were up 55% to $1.782 billion. Morgan Stanley Total Assets increased $22.2 billion, or 15.3% annualized, to $602.8 billion. This follows the previous quarter’s $6.2 billion contraction. Year-over-year, Total Assets were up $73.3 billion, or about 14%. Goldman Sachs’ fourth quarter earnings almost doubled to $971 million, with Trading accounting for more than half of total revenues. “Net revenues in Trading and Principal Investments were $2.62 billion, 48% above the fourth quarter of 2002…” For the year, “Fixed Income, Currency and Commodities (FICC) generated record net revenues of $5.60 billion.” This was up 20% from the previous year. With special thanks owed to the Fed, 2003 Interest Income declined 5% to $10.751 billion, while Interest Expense dropped 14% to $7.60 billion. Net Earnings for the year were up 42% to $3.01 billion. (Goldman asset data is not yet available) Bear Stearns’ quarterly Net Income was up 51.3% from the year ago period to $288.3 million. Principal Transaction revenues were up 28.7% from a year ago to $790.5 million. Interest and Dividends were down 1.9% to $495.5 million for the quarter, while Interest Expense declined 15.3% to $333.8 million. Employee Compensation and Benefits jumped 32.5% to $748.9 million. (Asset data not yet available) Major California mortgage lender GoldenWest Financial grew its loan portfolio at a 27% annualized rate during November to $75.6 billion. Over the past three months, Golden West’s loan portfolio has expanded at a 29% rate. This compares to the 4% growth rate during the preceding three month period. Fannie Mae had a somewhat slower November. The company’s Book of Business expanded $18.5 billion, or 10.8% annualized, to $2.171 Trillion. Year-to-date, Fannie’s Book of Business has surged $350.8 billion, or 21.0% (up $591bn or 37% since Jan. 02). And while Fannie’s Retained Portfolio contracted $6.3 billion during the month to $906.4 billion, MBS sold into the marketplace surged. For the month, non-retained MBS increased $24.7 billion, or 26.8% annualized (indicative of heightened leveraged speculation). Over two months, non-retained MBS were up $53.6 billion, or 27% annualized. This is quite a reversal from August and September’s $37.8 billion contraction (when the leveraged players were liquidating). December 17 – Los Angeles Times (Mary MacVean and Roger Vincent): “Home buying should continue to be a - perhaps unwelcome - thrill in Southern California in the months ahead as the still-heated market continues to drive quick sales and reward decisive, competitive buyers. Median home prices in November jumped 14.1% in Orange County and 20.6% in Los Angeles County from the same period a year ago, according to a report by DataQuick… ‘We have a lot of buyers who aren’t able to act fast enough,’ said Mike Cocos, general manager of ERA Real Estate in north Orange County. ‘Eventually they do get a house after they lose out on three or four properties.’ The chronic shortage of homes for sale coupled with attractively low mortgage rates will keep the pressure on buyers, said Leslie Appleton-Young, chief economist for the California Assn. of Realtors. ‘The message is ‘Boy, this is the time,’ Young said. ‘It doesn’t look like the situation is going to change any time soon.’ November was the strongest month of the year for home sale closings in his office, Cocos said. Factors fanning the market are an improving economy, steady low interest rates, a shortage of new housing and high demand. ‘There’s a perfect storm in Orange County,’ said Cocos… ‘We’re always looking for a turn in the market, but there’s no way to cook the books and come up with the conclusion that prices are going to decline,’ said Karevoll. ‘Any signs of distress are virtually absent.’” Freddie Mac posted 30-year mortgage rates declined 6 basis points last week to 5.82% (down from the year ago 6.03%). This is the lowest average rate in 11 weeks. The average 15-year fixed-rate mortgage declined 10 basis points to 5.14% (down from the year ago 5.42%). One year adjustable-rate mortgages could be had at 3.77%, unchanged again for the week (vs. year ago 4.07%). The Mortgage Bankers Association application index jumped 12.6% last week. Purchase applications increased 9.4% to a strong 437.2 (up 15.7% y-o-y). Purchase applications dollar volume was up 24.9% from the comparable week one year ago. Refi volume increased 16.8% this week and we should expect recent rate declines to spur increased refi activity. Bank Credit increased $5.9 billion. Securities holdings declined $5.4 billion, while Loans & Leases expanded $11.3 billion. Commercial & Industrial loans increased $2.5 billion, Real Estate loans added $3.6 billion, and Consumer loans gained $2.3 billion. Security loans declined $2.4 billion and Other loans increased $5.2 billion. Broad money supply (M3) declined $14.1 billion for the week ended December 8. Demand and Checkable Deposits added $6.7 billion, while Savings Deposits declined $5.7 billion. Retail Money Fund deposits declined $3.5 billion. Institutional Money Fund deposits dropped $4.5 billion, with a two-week declined of $22.5 billion. Large Denominated Deposits added $5.5 billion. Repurchase Agreements dropped $11.0 billion and Eurodollar deposits dipped $1.2 billion. With all my liquidity indicators pointing to abundance, and with debt issuance remaining heavy, I will stick with the view that the declining “Ms” are definitely not indicative of either waning liquidity or tepid Credit growth. Instead, I believe that issuance and (investor and speculator) flight into long-term debt instruments, ballooning foreign central bank balance sheets, and disintermediation out of money market mutual funds go far in explaining the recent money contraction. Importantly, there are indications that the leveraged speculating community is “releveraging,” – expanding speculative positions. The Fed’s Foreign (Custody) Holdings of U.S. Debt, Agencies increased $9.1 billion. Custody Holdings are up $51.8 billion over the past five weeks. No Inflating Out of this Quagmire: This truly is a most incredible environment; we’re in uncharted, turbulent waters, where – with the occasional lifting of the dense fog - things just aren’t as they seem. A lot of the “old rules” simply no longer apply. Reputations will be confidently wagered in the face of extraordinary uncertainty, and there will be losers. And it is fascinating to watch these dynamics in play and to sort through such divergent views. The discerning Bill Gross recognizes that the U.S. is leading the worldwide charge to reflate. He sees opportunities in commodities, tangible assets, foreign currencies, real estate, TIPS, and non-dollar bond and equities. Robert Prechter, focused on the recent contraction in the monetary aggregates and fixated on his own analytical framework, takes the opposite view: “Deflation – a drop in the money supply – is now a reality…” ISI’s renowned Ed Hyman has a much different take: declining money supply “may reflect a portfolio shift into stocks, bonds, and real estate.” He has a sanguine view on stable prices and continued economic expansion. Barton Biggs recently averred to a CNBC audience, “I think we’re having a perfect recovery, and we’ve got a perfect economic environment.” And then there’s Art Laffer making Mr. Biggs appear a pessimist by comparison. He, this time, takes direct aim at the “latest negativism” propagated by those of us worried about our devaluing currency. His take is that the Fed is following masterful monetary policies, with the Fed’s tight reins on the monetary base adeptly controlling the inflationary engines. According to Laffer, the dollar is declining because of improving economic and investment prospect around the globe. These seasoned players are all examining the same environment through their individual analytical prisms and coming to extremely divergent conclusions. My sense is that incorporating a sound analytical framework has never been more important. From my own Credit Bubble Analytical Framework, I am compelled this evening to give strongest weight to the analysis of Mr. Gross (while completely dismissing the ruminations from Art Laffer). Mr. Gross resides in the Credit system’s “Catbird seat” and fully appreciates the precarious nuances of contemporary finance and the risks of excessive debt at home and abroad. And he certainly hits the nail mostly on its head when he writes this month that “when too much debt infects the heart of capitalism you either default or inflate it away and the latter is by far the easiest (although not necessarily the wisest) policy.” (Mr. Gross’s parenthetical remarks) I would argue that attempting to inflate away global debt problems, while definitely the “easiest” course, is as well definitely the un-wisest. Such follies only postpone the inflating amount of pain associated with the inevitable day or reckoning. The gist of the dilemma is that central bankers some years back lost control of the processes of Credit inflation, as well as inflation's manifestations and consequences. American central bankers are, instead, under the control of the U.S. financial and economic Bubbles, as are the Chinese of theirs. And the Bank of Japan - with one bleary eye on U.S. Bubbles and the other on its own post-Bubble financial and economic quagmire - apparently sees little alternative than a massive inflation. The resulting Credit, liquidity, and speculative excess are now distorting borrowing, spending, and investing decisions all over the world. Today, global central bankers are not achieving a traditional (re)inflation as much as they are, at this point, successfully sustaining myriad Bubbles. I believe this is a most important analytical distinction. Especially with respect to contemporary finance, inflation is a Credit phenomenon and not a central bank-controlled monetary base phenomenon. Central banks can nurture, incite and energize Credit inflation, but these days have little capacity to manage or control its manifestations. Moreover, the general Credit system and systemic liquidity creation have been commandeered by Wall Street speculative finance. The Fed, and global central bankers to a lesser extent, retains incredible power. But this power is wielded through the blunt object of empowering the speculative community. The Fed does today definitely enjoy a captive audience – a global speculating community and sophisticated financing operations - unlike anything experienced in history. A year ago this past summer this community was increasingly betting against systemic stability (shorting stocks, corporate bonds, buying derivative insurance against deflating asset prices). The vicious dynamics of debt collapse were in play. The Fed and central bankers responded in force (fighting “deflation”), and the speculative community reversed bearish plays to place bets on “reflation.” The results were sea changes in risk-taking, Credit availability for corporate America, and (in the face of major dollar devaluation) liquidity for economies and markets across the globe. Reflation speculations have been huge winners. As always, successful speculating is self-reinforcing and captivating. The ever-expanding speculator community has burst forth with larger size and much greater domination. One major risk – the potential for higher rates to incite problematic deleveraging and derivative problems – began to manifest over the summer. The GSEs, once again, responded forcefully, and the Fed has since taken this risk out of the equation (for now). A second major risk – a rampant U.S. Credit inflation-induced flight out of the dollar, impacting U.S. interest rates and securities markets – has been quelled by unprecedented foreign central bank purchases. Resulting historic liquidity excess has inflated asset prices globally. Things have never appeared so good – to the naked analytical eye. Today, the Powerful Speculator Community has good reason to believe it has three important things working in its favor. 1) The Fed will act in their (the speculator’s) best interest, keeping short-rates low for as long as possible, while moving quickly to lower rates in the event of future systemic risk. 2) The Enormous and Powerful GSEs will continue to act as quasi-central banks, aggressively buying unlimited quantities of securities in the event of any systemic liquidity/interest rate stress. The implied Fed and GSE liquidity guarantees have never appeared as credible. 3) The Bank of Japan, the Bank of England, the Fed, Asian central banks generally, and perhaps global central bankers en masse, are today committed to sustaining the global speculative Bubble in Credit instruments. These powerful, unprecedented, layers of market support have evolved over time; they are revered by the fortunate speculators; and they are an important fact of life for economies and markets all over the world. The Great Credit Bubble is clearly now a global phenomenon. And while this week’s market action brings holiday cheer, there were unmistakable signs of a new degree of excess. Despite surging stocks and continued strong economic data, Treasury and corporate prices rose (yields sank). The general financial and economic environment beckons for higher rates and restraint, but receives the opposite. Yet we should not be surprised, as we’ve witnessed dysfunctional (boom and bust) market dynamics for years now. Boom and Bust Dynamics are an unfortunate reality of contemporary finance. The stock market is, as well, demonstrating conspicuous speculative Bubble dynamics. Typical and healthy pullbacks are not forthcoming, giving way instead to price surges and speculative runs. And I would argue that speculative Bubbles in both the equity and Credit markets place the faltering dollar at significant risk. The dollar sinks in the face of booming financial markets and unprecedented foreign central bank purchases. The worst is yet to come. Over the years we’ve witnessed several of these “reliquefications.” This one, however, is much more extreme and global. Previous “reliquefications” usually ran their course in a year to 18 months, creating only bigger problems and bigger forthcoming “reliquefications.” The current one is no youngster, but it is, admittedly, a different animal than we’ve analyzed before. Global reflation has taken firm hold. Yet, as I have followed developments closely, I am more convinced than ever that it is simply not possible for central banks to Inflate Their Way Out of this Quagmire. There is no general price level to raise, and there is no general income level to inflate. Such notions are from a bygone era. And, importantly, central banks have been playing right into the hands of the Commanding Leveraged Speculating Community. The harsh reality is that the longer and more aggressively global central bankers accommodate inflation, the greater the leverage and speculation; the greater the size of weak debt structures; the greater systemic financial fragility. Importantly, there is no inflating out of gross financial leveraging and major speculative Bubbles. Global speculative stock markets are increasingly destabilizing, and I would strongly argue that there has been renewed vigor in leveraged Credit market speculation. Resulting inflationary manifestations are sporadic and especially uneven. Global central bankers, more than ever, are held hostage to inflating asset markets. And sure, asset Bubbles do foster income growth. One need only ponder how much California (and national) real estate brokers have made this year. It has been a banner year for those profiting from asset inflation, including real estate agents, Wall Street bankers, builders, farmers, mortgage brokers, and insurance salesmen. But let’s not get carried away and convince ourselves that this is either healthy or sustainable (or just). One dynamic of asset Bubbles is that they are sustained by only increasing amounts of new Credit creation. And with each new inflation and speculation – commodities, equities, farm land, emerging markets, fine art, etc. – come additional Credit growth requirements. The more global central bankers stimulate Credit inflation, the greater next year’s requisite Credit inflation to sustain mushrooming Bubbles, distortions and imbalances. And having monetary policy fuel speculative Bubbles is risky, reckless business. The higher home prices, the greater stock and bond values, and the more extreme commodity inflation, the greater the required Credit and speculative excess to sustain them and the increasingly vulnerable financial and economic systems. Global central bankers have painted themselves into a dark corner. |
Wednesday, September 3, 2014
12/19/2003 No Inflating Out of this Quagmire *
