01/09/2004 Issues 2004 *

Global financial markets have commenced 2004 with extraordinary volatility and instability. As for U.S. equities, the Dow is about unchanged year-to-date and the S&P500 is up almost 1%. The Transports and Utilities are largely unchanged. The Morgan Stanley Cyclical index is up 1% and the Morgan Stanley Consumer index is about unchanged. But these major market averages do not illuminate the frenzied behavior exhibited by the broader market. The small cap Russell 2000 has gained better than 3% already. The S&P400 Mid-cap index is up 2% to a new all-time high. Speculative impulses are running rampant throughout the technology arena. The NASDAQ100 has surged 4% and the Morgan Stanley High Tech index 6%. The Semiconductors have y-t-d gains of 7%. The Street.com Internet index is up 4% and the highflying NASDAQ Telecom index is up 8%. The Biotechs have gained 2%. The financial stocks have been somewhat less robust, with the Broker/Dealers up 1% and the banks about unchanged (at a record high). With bullion up $10.50, the HUI gold index added 2%. Similar to technology stocks, foreign currencies and some commodities, bond prices are seemingly in dislocated “melt-up mode”. Two-year Treasury yields collapsed 28 basis points this week to 1.66%. Five year yields sank 20 basis points today and 34 for the week to 3.01%. Ten-year yields sank 18 basis points today (largest price gain since October 2001) and 31 for the week to 4.08%. The long-bond saw its yield sink 21 basis points this week to 4.96%. Benchmark Fannie Mae mortgage-backed yields collapsed 33 basis points this week. The spread on Fannie’s 4 3/8% 2013 note was unchanged at 33, and the spread on Freddie’s 4 ½ 2013 note widened 1 to 34. The dollar swap spread narrowed 2.25 to 37.5. Corporate spreads continue to narrow, with junk bond meaningfully outperforming again this week. The implied yield on December 2004 Eurodollars sank a notable 25 basis points today and 43.5 for the week to 1.885%. The nature of the yield collapse has been nothing short of astonishing. Bloomberg tallied $26 billion of debt issuance this week, “the most since last January.” “Investment banks and financial firms paced companies that brought $12.6 billion in issues to the market Tuesday, the most in one day in about a year.” Investment Grade issuers included Goldman Sachs $4.0 billion (up from $2 billion), Morgan Stanley $3.5 billion (up from $2 billion), Credit Suisse FB $1 billion, HBOS $1 billion, Southern California Edison $975 million, New York Life $500 million (up from $300 million), Monumental Global Fund $550 million, Nova Chemicals $400 million, Paxson Communications $365 million, Pacific Life $300 million, Fifth Third Bank $250 million, FGIC $250 million, John Deere Capital $200 million, Enbridge Energy $200 million, D.R. Horton $200 million, Principal Life $150 million, and Indianapolis Power & Light $100 million. January 9 – Dow Jones (Simona Covel): “Despite sinking yields and risk premiums moving closer and closer to Treasury rates, investors’ love affair with high-yield bonds shows no signs of abating as 2004 gets underway. Though the new issuance pipeline is building, some industry watchers believe the impending supply may not be enough to meet the market’s burgeoning demand, as investors pour more money into higher-yielding assets… Last year set records in the junk sector. AMG recorded $27.2 billion in total annual inflows to high-yield funds in 2003, breaking a record of $17.9 billion set in 1997… According to the Merrill Lynch High-Yield Master II Index, the average spread as of the end of the day on Thursday was 345 basis points, a level that hasn’t been seen since the end of May 1998.” Junk funds received inflows of $506 million for the week (from AMG). Junk funds have enjoyed $3 billion of inflows over the past 10 weeks. Junk issuers included: Elizabeth Arden $200 million, Vale Overseas $500 million and CSK Auto $225 million. Foreign dollar bond issuers included the European Investment Bank $3 billion, Northern Rock PLC $2.0 billion, Turkey $1.5 billion, United Mexican States $1 billion and Venezuela $1 billion. I found it somewhat entertaining that two Bloomberg headlines under the story of Venezuela's 30-year bond issuance was the headline “Venezuela’s Chavez may Take Over Central Bank Amid Dispute Over Farm Loans.” A list of emerging market borrowers including Indonesia and the Ukraine are preparing debt issues. Convert issues included Red Hat $500 million and Coeur D’Alene Mines $160 million. Freddie posted 30-year fixed mortgage rates added 2 basis points to 5.87% this past week. Fifteen-year fixed rates increased 2 basis points to 5.17%, while one-year adjustable rate mortgages averaged 3.76%, up four basis points. Holiday-week distortions continue to impact the usefulness of the Mortgage Bankers application indices. However, the Purchase application index rose moderately to a level up 6% y-o-y (dollar volume up 13.8%). This week’s yield collapse should incite stronger application activity. Currency Watch: The dollar index traded today at the lowest level since March 1, 1996. Weakness is broadening, with even the Mexican peso now gaining ground against the greenback (up 3.8% y-t-d). The euro today surpassed 128.5. Commodity Watch: The CRB index surged 4% this week to the highest level since July 1988. Crude oil jumped to a 10-month high. Heating oil had its strongest weekly price gain in 10 months, with heating oil and natural gas trading to 10-month highs. Gold prices rose this week to a 15-year high. Global Reflation Watch: January 7 – Financial Times: “China yesterday announced the launch of an aggressive programme to recapitalize the country’s insolvent state banks, injecting $45 bn from its vast foreign exchange reserves into two large institutions that are preparing for a stock market listing next year… The CCB (China Construction Bank) and BoC (Bank of China), both of which hope to list on the Hong Kong stock market in 2005, plan to use the injection to boost their levels of capital, not to write off bad loans. Their aim is to generate more income from an expanded loan portfolio and attract foreign strategic investors more easily.” January 9 – Bloomberg: “The first German hedge funds will be started in March after a law lifting a ban on the sale of such funds took effect Jan. 1, the Financial Times Deutschland reported… Deutsche Bank AG’s DWS mutual fund unit wants to sell six hedge funds in as soon as two months for which it sees 1 billion euros ($1.27 billion) in inflows from investors this year…” January 9 – Bloomberg: “Poland will sell at least 1 billion euros ($1.3 billion) of bonds today, the first of several sales this year to raise up to a record 5 billion euros to finance the country’s biggest budget deficit since the collapse of communism. Poland’s bonds probably will be priced to yield about 0.32 percentage points more than the mid-swap rate, a benchmark for corporate borrowing…” January 7 – Bloomberg: “U.K. companies boosted wages last month at the strongest pace since May 2001 as the demand for staff increased the most in 3 1/2 years…” January 7 – Financial Times: “Favourable sentiment from Mexico’s tight 2004 budget, and evidence of an economic upturn, led the government yesterday to launch a $1bn bond on the international markets at the lowest interest rate at which it has ever been able to borrow (4.34%).” January 7 – Bloomberg: “Venezuela sold 30-year bonds for the first time since 1997, joining Turkey, Mexico and other emerging-market countries in borrowing on overseas markets since the start of the year to take advantage of tumbling yields. Venezuela’s ($1 billion) dollar-denominated bonds were priced at $929.76 per $1,000 face amount to yield 5.03 percentage points over Treasury bonds, or about 10.13 percent… Turkey sold $1.5 billion of 30-year bonds today at a yield of 8.23 percent… Venezuela is borrowing after its most-traded bond…climbed to a six-year high of 94.55 cents on the dollar yesterday, cutting the yield to about 9.8 percent... The yield has fallen from 16.2 percent in January 2002 as oil prices have gained… Turkey’s bonds were priced at $974.37 per $1,000 face amount to yield 3.16 percentage points over Treasuries of comparable maturity, 8.23 percent. In September, Turkey sold 10-year bonds at a yield of 9.65 percent.” January 7 – Bloomberg: “Brazil’s central bank is reviving daily auctions to buy dollars for the first time in five years in a bid to stem a 17 percent rally in its currency in the past 12 months that threatens an export-led economic recovery.” January 8 – Bloomberg: “Brazil’s auto sales rose 30 percent in December from November as falling interest rates prompted consumers to buy cars… Vehicle registrations rose 32 percent from the same month a year earlier…” Asia Boom Watch: January 7 – Bloomberg: “Goldman Sachs Group Inc. and Merrill Lynch & Co. were the top stock and bond underwriters in Asia outside Japan and Australia last year, using their ties in China and Taiwan to capture 20 percent of the region’s record $78 billion of business... The value of debt and equity transactions in Asia outside Japan and Australia rose about 71 percent from 2002…” January 9 – Bloomberg: “China’s exports grew 51 percent from a year earlier in December, their fastest pace in more than eight years, as factories accelerated shipments to the U.S., Europe and Japan before tax rebates were cut at the start of this month. Overseas sales rose to a record $48 billion after climbing 34 percent in November… The trade surplus for the month was $5.73 billion, close to October’s all-time high of $5.74 billion.” January 7 – Bloomberg: “Nippon Steel Corp., Japan’s biggest steelmaker, said it will pay 22 percent more for coal in the year beginning April 1 after completing negotiations with its Australian suppliers last month. Tokyo-based Nippon Steel ended the annual price talks with Australian suppliers on Dec. 24, with next year’s prices rising to $56 a ton from $46…” January 6 – Bloomberg: “Australian companies’ confidence in the economy is at its highest level in more than a decade, a survey showed. An index measuring the proportion of companies that expect the economy to remain strong in the first quarter rose to 66.2 from 63.6 in the previous quarter, the Australian Chamber of Commerce and Industry said in report released in Canberra. It’s the highest level recorded since the survey began in June 1992.” January 7 – Bloomberg: “Taiwan’s exports rose in December at their fastest pace in a year, climbing to a record $14 billion as electronics makers shipped more notebook computers, flat-panel displays and other goods. Exports rose 21 percent from a year earlier… Taiwan’s sales to China and Hong Kong rose 30 percent in December to $5 billion” January 8 – Bloomberg: “South Korean consumer confidence rose to a 10-month high in December, suggesting households are becoming more inclined to spend.” January 8 – Bloomberg: “Malaysia’s industrial production rose at its fastest pace in almost three years in November…” January 8 – Bloomberg: “Hong Kong’s retail sales in November had their largest gain in 10 months as tourism boomed, and sliding unemployment and rising asset prices helped revive consumer confidence. Sales rose 5.2 percent from a year earlier…” January 9 – Bloomberg: “Thailand, Southeast Asia’s third-largest oil consumer, will cap gasoline and diesel prices in the country because the government is concerned that rising fuel costs may accelerate inflation and slow economic growth.” Domestic Inflation Watch: January 7 – Bloomberg: “U.S. consumers can expect to spend 8 percent more to heat their homes with natural gas this winter than a year ago because of a rally in wholesale prices, the U.S. Energy Department said… Homeowners in the Midwest, the biggest residential-gas market, can expect to spend an average $866 this winter on natural gas… That would be 8.4 percent higher than costs last winter.” January 8 – BusinessWire: “2004 The Van Global Hedge Fund Index rose 2.3% net of fees in December and ended 2003 with an 18.2% net gain, according to preliminary results announced today by Van Hedge Fund Advisors International (VAN). The Index reflects the average net return of hedge funds worldwide that report to VAN, a leading hedge fund consultant. The Index, a widely cited benchmark for hedge fund performance, has been positive in each of the sixteen years since its 1988 inception. ‘Hedge funds had their best year in 2003 since 1999,’ stated George Van, Chairman of VAN. ‘I think investors can be pleased that hedge funds generally lived up to expectations in preserving capital through the lean years of the bear market and then returning to double-digit gains as conditions improved in 2003.’” January 8 – Bloomberg: “The European Central Bank’s governing council has no plans to curb the euro’s recent appreciation by intervening in the currency markets, Market News International said, citing unidentified central banking officials. The ECB sees selling euros to reduce the currency’s value against the dollar as futile without the cooperation of the U.S. government, which is showing little inclination at present to reverse recent exchange rate moves, Market News reported.” January 9 – MarketNews: “The following is (an excerpt from) the 2004 economic outlook released Friday by U.S. mortgage financier Freddie Mac, forecasting ‘brisk’ housing activity for this year… We raised our 2003 mortgage originations estimate after careful examination of market indicators not directly feeding our models; given the relative strength of home sales, housing starts and refinance activity, the year was extraordinary by every means. Our 2004 forecast is 40% below 2003 at $2.2 trillion, owing largely to less mortgage refinancing. In terms of product shares, we expect the ARM share to average around 24% in 2004, given the upward trend in fixed-rate mortgage rates. And the refinance share of originations will fall dramatically to around 37% in 2004. Nonetheless, residential mortgage debt growth will remain quite strong (up 11%) in 2004, albeit slower than the past two years…” Broad money supply (M3) declined $10.5 billion. Currency increased $2.0 billion and Checkable Deposits declined $0.2 billion. Savings Deposits dropped $7.4 billion and Small Denominated Deposits declined $1.1 billion. Retail Money Fund Deposits dipped $4.4 billion, while Institutional Money Fund deposits were unchanged. Large Denominated Deposits added $1.4 billion and Repurchase Agreements increased $3.2 billion. Eurodollar deposits declined $4.0 billion. Fed Custody holdings of Treasury and Agency debt (for foreign central banks) increased $5.9 billion to $1.073 Trillion. Custody holdings have jumped almost $100 billion in just 14 weeks. Bank Credit declined $23.4 billion during the final week of 2003. Securities holdings were about unchanged, while Loans & Leases dropped $23.6 billion. Commercial & Industrial loans declined $6.6 billion, while Real Estate loans added $6.8 billion. Consumer loans added $1 billion. Security loans declined $13.3 billion and Other loans dropped $11.3 billion. Elsewhere, Commercial Paper added $8.7 billion during the first week of the year. Non-financial CP increased $5.4 billion and Financial rose $3.3 billion. The Greenspan Legacy and Issues 2004: Alan Greenspan’s speech Saturday at the American Economic Association’s annual meeting in San Diego – Risk and Uncertainly in Monetary Policy – has not received the attention it deserves. Our Fed chairman forges ahead with painstaking efforts to fabricate an analytical perspective that places his reign at the Fed (as well as the current environment) in a most positive light. To read his carefully crafted reasoning, one would believe that U.S. monetary policy has been almost flawless for the past sixteen years. Moreover, central bankers have made monumental progress in advancing economic thought and monetary management. Listening to Greenspan, one would also be left with the sanguine sense that contemporary economic and financial systems have evolved to a status superior to anything previously experienced. After decades of toil, we can now celebrate the achievement of the “price stability” holy grail. The economy? It has evolved to unprecedented flexibility and stability, with market forces readily capable of resolving imbalances like never before. Contemporary financial systems? It goes without saying that today’s risk management systems are unparalleled to anything from the past. Once again, Mr. Greenspan’s cheerleading has proved music to the ears of hyper-speculative global markets. Yet “obfuscation” is too kind for Dr. Greenspan’s latest brainchild. For years, I have often pondered: “Greenspan: Inept or Fraud?” Something is just not right. As for his latest, I don’t believe “fraudulent” is either an inaccurate or excessive characterization. “Dishonorable” doesn’t seem strong enough; dangerous "historical revisionism", certainly. After all, truly monumental policy errors have been committed and negligently perpetuated. Back in 1999, at our Credit Bubble Symposium, Dr. Henry Kaufman stated, “The Fed missed its timing,” and there would be a heavy price to pay. More than 4 years later, Greenspan (“The Nick Leeson of central banking”) not only refuses to cut his escalating losses, but insolently claims he has brilliantly orchestrated a winning trade. For the public interest and for the benefit of future generations, a statesman – or any person with a sense of honor, for that matter – would come clean. He refuses, choosing instead to succumb to revisionism and deceit. But his speech does provide the most comprehensive framework of current Fed “thinking.” It’s Greenspan’s interpretation of history and the present. It’s his “story” and we should expect that our central bank will be “sticking to it.” So it is definitely worth reading carefully and contemplating. I will somewhat cut to the chase and begin with one of his concluding paragraphs: “As we confront the many unspecifiable dangers that lie ahead, the marked improvement in the degree of flexibility and resilience exhibited by our economy in recent years should afford us considerable comfort.  Assuming that it will persist, the trend toward increased flexibility implies that an ever-greater part of the resolution of economic imbalances will occur through the actions of business firms and households. Less will be required from the risk-laden initiatives of monetary policymakers.” “…we at the Fed, to our credit, did gradually come to recognize the structural economic changes that we were living through and accordingly altered our understanding of the key parameters of the economic system and our policy stance.” I expect future students of economics and history to find Dr. Greenspan’s reasoning hard to fathom: economic structural change created an environment where “less will be required from the risk-laden initiatives of monetary policymakers”? Clearly, there have been some crucial flaws in analysis of the U.S. economy and contemporary finance. First, consumer price inflation is no longer an effective gauge of the appropriateness of monetary policy. One must look first to Credit growth, the current account, financial speculation, asset inflation, and the nature of consumer and business borrowing and spending. A single index will not suffice. And in spite of Greenspan’s (and Milton Friedman’s) claims, inflation is no longer “everywhere and always a monetary phenomenon.” Inflation is today a Credit phenomenon with myriad and complex manifestations. With unconstrained global electronic Credit/financial systems (including government issued fiat currencies, but largely non-government liability creation), never has financial stability been as reliant on central banker diligence and restraint. And the most significant economic structural changes include a massive global (but predominantly Asian) investment in manufacturing capacity coupled with a momentous change in the character of U.S. “output.” This combination has created economic systems where truly massive Credit and destabilizing asset inflations now have minimal effect on the traditional aggregate consumer price level. The global Credit inflationary manifestation of endemic over/mal-investment in consumer goods production capacity ensures at least adequate supplies. And, most importantly, the nature of the contemporary U.S. economy has evolved fundamentally, although not as Dr. Greenspan professes. The crucial issue is the character of “output,” having “evolved” from predominantly manufactured goods to today’s multifarious intangible “services.” We will save for another day the debate over services’ (as compared to manufacturing) capacity to create true economic wealth. But it is simply sloppy - and it seems to me disingenuous - to herald a “productivity revolution,” while disregarding the fundamental change to predominantely contemporary services “output.” Furthermore, and most importantly, today’s service sector economy has an unprecedented capacity to absorb Credit excess. First, a “digital” (technology) economy – including microchips, computers, the Internet, telecommunications services, entertainment and the general media – today has the capacity to expand (and absorb Credit creation) to a degree unlike a manufacturing-based economy. But we must be mindful that, while such Credit excess may not manifest into rising prices per se, there is nonetheless a residual of debt/financial claims with attendant issues (potentially weak debt structures, heightened speculation, destabilizing asset inflation, financial fragility, fraud and corruption, spending distortions, etc.). Second, the evolution to an asset price-centric economy – financial, real estate, sports franchises, media, etc. – also creates an economy with an unparalleled capacity to create and absorb Credit inflation with minimal impact to the aggregate consumer price level. And, third, the “services” sector – government, financial, medical, attorneys, accountants, consultants, real estate agents, insurance salesmen, etc. – can thrive (and generate “output”) on the Credit excess emanating from booming asset inflation. It is an especially deceptive and seductive inflationary environment. And contemporary finance and the modern structure of the U.S. economy simply could not have a stronger proclivity and capacity for dangerous Credit excess that manifests into asset inflation and economic maladjustment. With unconstrained Credit and an economy that can appear to accommodate even extreme excess, I strongly argue that the marketplace is incapable of self-regulation. It is simply too prone to self-reinforcing and ultimately uncontrollable Bubbles. Besides, there is the reality that Credit and speculative excess inherently distort the market pricing mechanism. There is great irony: with Dr. Greenspan’s fallacious focus on stable consumer prices and “productivity” advances, he proclaims an environment where the Fed can gleefully allow the marketplace to correct imbalances. Wow… This is one - if not the greatest - blunder in the history of central banking. From Dr. Greenspan: “Perhaps the greatest irony of the past decade is that the gradually unfolding success against inflation may well have contributed to the stock price bubble of the latter part of the 1990s.” “It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization -- the very outcomes we would be seeking to avoid.” “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies ‘to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.’” “There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful…As I discuss later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability.” First of all, asset inflation and the propensity for destabilizing Bubbles should be recognized as a paramount risk to financial and economic stability, hence a fundamental focus/fixation of contemporary central banking. And as we have witnessed over the past decade (going back at least to what were at the time extreme speculative excess in the U.S. bond/fledgling interest rate markets back in 1993), once speculative forces are unleashed they are quite difficult to control. If they are not dealt with early – and only a disciplined central bank has such capacity – then they will inflate to the point of posing significant risk to the economy and financial system. Greenspan addressed the issue of stock and bond market Bubbles as early as 1994 (in Fed meetings), but these Bubbles some years ago grew to unmanageable (at least not without considerable pain and dislocation) proportions. Held hostage to financial and economic Bubbles, the current environment is only an illusion of stability. Conveniently, Dr. Greenspan today avoids the issue of a massive Bubble throughout the U.S. Credit system (leveraged speculation/the GSEs/derivatives/Credit insurance), choosing instead to trumpet his postulate and celebrate his strategy for dealing with the aftermath of the late-nineties stock market Bubble. But the harsh reality of the situation is that the stock market remains but one aspect of a monumental Credit/financial Bubble that I argue is in the midst of historic “blow-off” excess. Greenspan’s approach for “addressing” the aftermath of the bursting of the late nineties stock market Bubble was to further invigorate the bond/mortgage finance/real estate Bubbles. Credit Bubble excess has of late taken a decided turn for the worst with the direst of consequences, yet Dr. Greenspan glorifies his accomplishments. From Greenspan: “As this episode illustrates (the Fed’s aggressive response last year to ward off deflation risk), policy practitioners operating under a risk-management paradigm may, at times, be led to undertake actions intended to provide insurance against especially adverse outcomes. Following the Russian debt default in the autumn of 1998, for example, the FOMC eased policy despite our perception that the economy was expanding at a satisfactory pace and that, even without a policy initiative, it was likely to continue doing so.  We eased policy because we were concerned about the low-probability risk that the default might trigger events that would severely disrupt domestic and international financial markets, with outsized adverse feedback to the performance of the U.S. economy.” I found it fascinating that Robert Rubin annunciated a similar philosophy in his recent book: Policymaking should weigh a potentially high-risk outcome heavily, even if a negative outcome is a relatively low probability. But what about a trader mitigating losses and closing out losing positions? There must be recognition that the risk associated with inflating financial and economic Bubbles grows exponentially over time. With Greenspan professing that Bubbles are not recognizable at the time, aren’t they thus signaling that the government and Fed is in the Bubble perpetuating business? At the minimum, such an approach incites speculation and excessive risk-taking. It is today, as we contemplate Issues 2004, useful to appreciate the great paradox of the failed “Greenspan Doctrine.” Uncontrolled finance (“money,” Credit, and leveraged speculation) has nurtured an acutely vulnerable Bubble economy and unprecedented financial fragility (asset Bubbles, weak debt structures, derivatives) and economic vulnerability (maladjusted economy). Negligent monetary policy has created an environment of exceedingly high risk. Accordingly, the Greenspan Fed now explicitly promises the massive and expanding Global Leveraged Speculating Community that the Fed will not only avoid moving to rein in excess, it will be quick to stimulate and flood the system with liquidity at any sign of trouble. Well, Dr. Greenspan may fabricate a cheery story, but we have witnessed the worst case scenario unfold before our eyes: The Fed Condoning Runaway Credit and Speculative Excess. The Fox has taken complete control of the henhouse. We are now in the midst of history’s greatest global speculative Bubble, and it simply could not appear more appealing and enticing to the eager participants. A strong argument can be made that, here at home, stock market speculation is much broader than even (the technology-centric Bubble) during 1999. Bond and interest-rate market speculation are unprecedented, encompassing Treasuries, agencies, mortgage-backs, corporates, converts, asset-backed securities, junk and “structured finance.” Leveraged speculation has engulfed the emerging markets, both in equities and debt. The currency and commodity markets are, as well, as bastion of speculation. Seemingly no country or market is being overlooked. History’s greatest Credit inflation (and increasing dollar revulsion) is spewing dollar liquidity throughout the global financial system. At the same time, the Bank of Japan balance sheet is ballooning unlike anything previously experienced. The Chinese and Asian economies are in the midst of an historic Credit inflation. The global financial system is over-liquefied like never before. A massive global Leveraged Speculating Community has become the “investment” vehicle of choice, with a virtual global buyers’ panic in search of yield and strong returns. The U.S.-based Credit and speculative Bubbles have engulfed the world. Massive Credit inflation is, today, working its seductive wonders, much as it did for awhile during some of history’s infamous financial fiascos. As I have tried to explain many times, the problem is that inflation of this variety – ingrained asset inflation and gross financial speculation - is impossible to manage: It becomes impractical to turn down, let alone to shut off. Excess begets only greater excess, with only more problematic manifestations. Yes, prices of U.S. stocks, bonds, homes, and other assets prices are today inflating, and many have never perceived as much wealth. As fast as liabilities rise, perceived wealth inflates much more rapidly. It appears miraculous. But with these rising prices comes only the greater requisite Credit inflation to sustain levitated asset values and keep the increasingly maladjusted U.S. Bubble economy pumped up. The amount of Total Credit growth to keep these Bubbles afloat is enormous, but possible – for now. One can envisage for 2004 $1.2 Trillion of new household borrowings, $500 billion Federal debt growth, $200 billion State & Local government, and perhaps $500 billion of net new corporate borrowings. This $2.4 Trillion of new non-financial debt would be about 10% growth on top of a massive debt mountain, in what would perpetuate the greatest ever expansion of non-productive debt. It would also perpetuate one of the great currency debasements in history. But such is the heavy price for central bank incompetence and futile Bubble preservation. One would typically expect the local central bank to move aggressively against gross excess to protect the value of its citizens’ currency. Greenspan has promised not to safeguard our dollar. One would typically then expect the marketplace to discipline a runaway Credit inflation. The Bank of Japan, Asian central banks, and many central banks around the world (ex the ECB) are committed to circumventing market forces. Thus, reckless excess runs unabated. And, again, this massive inflation will appear miraculous until “the wheels come off.” Yesterday the Bank of Japan reported that Official Foreign Reserves increased $29.1 billion during December to $652.8 billion. These largely dollar reserves were up an astonishing $201.3 billion, or 45%, for the year. There is market speculation that the Bank of Japan expended as much as $30 billion this week supporting the dollar. The size of these unrelenting interventions/liquidity injections is simply incredible, especially in the face of today’s wildly overheated global financial system. That unprecedented interventions are barely stabilizing the dollar is indicative of an unfolding crisis. Over-liquefied global financial markets are a key Issue for 2004. The Wall of Liquidity is poised to inundate economies and markets with inflationary biases (of which there are many). Virtually the entirety of greater Asia appears on the brink of problematic overheating. Expect myriad inflationary manifestations to take hold, especially in China, India, and SE Asia. Procuring sufficient future energy supplies will become an important concern and issue for the future. And, increasingly, the Wall of Liquidity has its sights on Latin America. With such a backdrop, economies could surprise on the upside. Inflation will not be far behind. Here at home, markets are bringing new meaning to “financial fragility.” The Great Credit Bubble is in the midst of gross “blow-off” excess. The speculative stock market is in speculative blow-off excess. The bond market is at risk to melt-up dynamics -- at the cusp of another self-reinforcing and destabilizing yield collapse. One key consequence of the over-liquefied global financial system (stoked by dollar weakness and Fed accommodation) is that the U.S. bond market is nudged toward dislocation. The massive derivatives market – hedging ballooning MBS, GSE, and speculative positions – is prone to self-reinforcing dislocation, with the specter of another refi wave always looming. Furthermore, acute systemic risk to higher rates precludes rising yields (for now!). And if yields are not allowed to go up, the nature of market dynamics dictates that they could surprise on the downside. Artificially low yields would be destabilizing in many ways, including throwing gas on the mortgage finance fire. The bias will remain for “blow-off” excess throughout residential real estate, setting the stage for an inevitable crash. Mr. Greenspan’s revisionism also referred to the Savings & Loan “crisis” “that had its origins in a serious maturity mismatch as interest rates rose.” Well, the truth of the matter is that the S&L collapse was a massive fraud, with the Fed and government policymakers complicit for fostering a huge fiasco rather than dealing with it early on. In this regard, the S&L debacle was a forerunner for the GSEs, leveraged speculation, derivatives, and other unfolding fiascos. The bottom line is that, as history has made so clear, “easy money” nurtures fraud and corruption and I am willing to prognosticate that the current runaway mortgage finance Bubble is cultivating fraud what will be shocking in its scale. And fraud and corruption will certainly be an increasing problem down the road for financial markets at home and abroad. But for now, there is certainly sufficient risk associated with market dynamics. Extraordinary moves are now commonplace in global equity, fixed-income, currency, and commodity markets. It is an environment conducive to accidents in a marketplace dominated by highly leveraged speculators. And with the dollar in virtual free fall – albeit thus far managed by enormous foreign central bank buying – the possibility of a derivative-related dislocation is not insignificant. It then does not take a wild imagination to envision a problem in the currency derivatives marketplace impinging other markets, especially the convoluted U.S. interest rate market. And a scenario of collapsing yields, a rekindled refi boom, overheated mortgage finance and the resulting massive Credit creation (dollar claims inflation) feeding a dollar collapse is not a remote possibility. The sinking dollar will be an ongoing and increasingly problematic Issue for 2004. The U.S. is “exporting” Credit inflation, this exportation is self-reinforcing, and the consequent manifestations will not indefinitely appear so benign (or darn right wonderful!). The Pandora’s Box of a Collapsing Dollar is now Agape. As for the U.S. Bubble economy, its fate is in the hands of the Great Credit Bubble. At this point, there appears such an inflationary bias in the U.S. interest rate markets (certainly exacerbated by the over-liquefied global financial system) that any weak economic data will be met with exaggerated declines in market yields. Today’s reaction to the disappointing jobs data is a case in point. For now, this will tend to support real estate inflation – the key to the consumer borrowing and spending Bubble. The farm and manufacturing sectors appear poised to overheat. Ultra-easy money has, regrettably, rekindled the technology Bubble. Yet, the bottom line is that years of Credit and speculation-induced maladjustment have severely distorted the U.S. economy, and these distortions are in “blow off” mode as well. And even massive stimulation – while creating incredible perceived wealth for some – is incapable of supporting broad-based employment gains. Importantly, the now highflying manufacturing sector has been so weakened and diminished to the point of being incapable of being a meaningful jobs creator for the general economy. Employment gains will be spotty and feeble relative to the degree of stimulation. Economic performance will be extraordinarily uneven, income growth extraordinarily uneven, and spending – as was demonstrated during the Christmas retail season – will be extraordinarily uneven (stagnant real wages for the majority, with inflating incomes and perceived wealth for those fortunate enough to profit from asset markets and other inflations). Inflationary manifestations will broaden, with energy prices and supplies an ongoing concern. To wrap this up, Issues 2004 will likely revolve around ongoing extreme financial and economic risk and uncertainty. And that the marketplace has lunged into such incautious optimism and gross speculative excess portend ominous developments. Importantly, participants are mistaking the terminal stage of (prolonged) “blow off” Credit Bubble excess for the commencement of a new equity bull market. Moreover, confidence is running high that the powers that be will ensure strong markets through the election. Perhaps, but this is precisely the type of market psychology that sets the stage for disappointment. Surely, the spectacular Russian debacle would not have been possible without the insouciant boom-time perceptions that “the West” would never allow Russia to collapse. Leveraged speculators flocked to Russia in droves. Today, the U.S. (and global) marketplace goes to truly unprecedented extremes with the comfort that the all-knowing, all-powerful, all-beneficent market administrator, Alan Greenspan (and global central bankers), would never allow collapse or even major disappointment. He has certainly done everything imaginable (and then some) to nurture this dangerous mindset. Accordingly, I would strongly argue that 2004 is distinguished from any year since 1929 for the Great Divide Between Optimistic Perceptions and an Acutely Fragile Reality. Such circumstances dictate that the risk of spectacular financial tumult is today considerable and rising. And when tumultuous times arrive, Mr. Greenspan will surely wish he had more than 100 basis points. He will also regret nurturing a massive Leveraged Speculating Community, as well as cajoling U.S. savers into risky assets and reckless mortgage borrowings. He will come to appreciate that there is a profound difference in kind between “output” that we can exchange with our trading partners and much of services “output” that only inflates GDP and productivity measures. He will come to appreciate the great risk of using financial speculators as the key monetary transmission mechanism. And our Fed chairman will also bemoan his lack of friends at the ECB, while wishing for much larger foreign reserves and a large cache of gold bullion. There is surely a greater probability of this painful process commencing during 2004 than the markets appreciate today.

01/02/2004 The Great Reflation of 2003 *

I won’t make too much out of one session, but it was interesting to watch the dollar immediately succumb to continued selling pressure. The dollar index closed today below 87 for the first time since November 1996. Bonds were aggressively sold while commodities were bought. Ten-year Treasury yields jumped 12 basis points to the highest level in a month. Even before the strong ISM report, U.S. fixed income and equities were noticeably underperforming Europe. The CRB index added 1% today. An index of Emerging Markets American Depository Receipts (ADRs) was up 3.4% this afternoon. The Fed’s Foreign (Custody) Holdings of U.S. Debt increased $6.2 billion last week and $12.7 billion over two weeks. For the year, Custody holdings surged $216 billion, or 25%, to $1.067 Trillion.  Total Bank Credit increased $16.7 billion over the past two weeks. Securities holdings added $2.1 billion. Loans & Leases were up $14.6 billion. Commercial & Industrial loans dipped $3.7 billion, and Real Estate loans declined $5.2 billion. Consumer loans added $3.9 billion and Securities loans were about unchanged. Other Loans jumped $19.3 billion. Broad money supply (M3) declined $30 billion over the two weeks ended 12/22. Currency was up $1 billion and Checkable Deposits were up $10.5 billion. Savings Deposits dropped $18.4 billion and Small Denominated Deposits dipped $3.6 billion. Retail Money Fund deposits were down $8.2 billion and Institutional Money Fund deposits declined $5.9 billion. Large Denominated Deposits added $2.1 billion. Repurchase Agreements declined $9.3 billion and Eurodollars were down $0.4 billion. Junk bond funds saw inflows of $92.1 million (from AMG), the ninth straight week of positive flows. Next week I will take a shot at “Issues 2004,” but 2003 is deserving of an end of year recap. It was an historic year for the Great Credit Bubble, with U.S. led lending, speculating and liquidity excess prevailing across the globe like never before. January 2 - Dow Jones (Tom Sullivan and Christine Richard): “Low interest rates and a recovering economy fueled a record $4.938 (up 25% y/y) trillion in global private sector bond sales for 2003. The final data, released Wednesday by Thomson Financial Securities Data, underscore just how big the bond business has become. The numbers include issuance of corporate debt, federal agency debt, taxable municipal bonds, debt backed by mortgages and debt backed by assets such as credit card receivables and home equity loans. By comparison, issuance in 2002 totaled $3.938 trillion, according to Thomson. In 1990, global private sector debt issuance stood at just over $500 billion, or about one-tenth of this year’s level… For 2003, however, debt issuance climbed in almost all categories and there were records in many. Nearly 60% of the total debt sold in 2003 was issued by companies located in the Americas, with the vast majority of that issuance by U.S. corporations.” Here in the U.S., the Dow Jones Industrials gained 25%, the S&P500 26%, Dow Transports 30%, and Dow Utilities 24%. The NASDAQ100 surged 49% and the NASDAQ Composite 50%. In the technology sector, the Morgan Stanley High Tech index jumped 65%, the Semiconductors 76%, The Street.com Internet index 79%, and the NASDAQ Telecommunications index 69%. The small Cap Russell 2000 gained 45% and the S&P400 Mid-Cap index was up 34%. The AMEX Biotech index gained 45%. The AMEX Securities Broker/Dealer index jumped 59% and the Philly/KBW Bank index gained 30%. The NYSE Financial index gained 28% and the “NASDAQ Other Financial” index was up 71%. The leading S&P groups included Internet Software and Services (up 175%), Diversified Minerals and Mining 144%, Homebuilding 97%, Semiconductors 96%, Computers & Electronics 93%, Internet Retailers 90%, Wireless Services 78%, Office Electronics 71%, and Construction & Farm Machinery 70%. For the fourth quarter, the leading S&P groups included Steel (up 49%), Aluminum (45%), Diversified Metals & Mining 43%, and Automobile Manufacturing 39%. January 1 Bloomberg – “More than 90 percent of the stocks in the Standard & Poor’s 500 Index rallied in 2003, the benchmark’s broadest advance in at least 23 years… The biggest gains came in shares of companies such as Avaya, which had little or no earnings at the start of 2003 and stock prices in the single digits. Avaya, unprofitable in 2002, made money in its fiscal third quarter… ‘We’ve been very surprised by the strength of the lower-quality, unprofitable companies,’ said James Gribbell, who helps manage $1.5 billion at David L. Babson & Co… ‘Companies with lower returns on capital and low returns on equity have outperformed more highly profitable companies by two to three times.’” January 2 - Dow Jones (Mike Esterl): “Equities enjoyed a banner year around the globe in 2003, but nowhere were the returns as dramatic as in emerging markets. Emerging market stocks soared 17% in the fourth quarter and 52% for the full year in dollar terms, according to Morgan Stanley’s benchmark MSCI index… Thailand was the top equities performer among developing countries, jumping 134% in dollar terms… China, the World’s fastest-growing economy, watched its stocks soar 81% last year, including a 34% rise in the fourth quarter… Turkey was the No. 2 performer among emerging market equities, lifting 122% as the country continued to edge back from financial collapse… The hottest region for investors in 2003, though, was Latin America, where equities rose 67% amid receding insolvency fears…” Other gains (in local currencies) included Mexico’s Bolsa index up 44%, Argentina’s Marvel up 104%, Chile up 48%, Venezuela 177%, Peru 75%, Columbia 41%, and Jamaica 49%. In Europe, UK’s FTSE 100 gained 14%, Paris’ CAC40 16%, Germany’s DAX 37%, Spain’s IBEX 28%, Italy’s Milan 12%, Sweden’s OMX 29% and the Swiss Market Index 19%. Emerging European bourses posted strong gains. Greece jumped 30%, Poland 45%, Czech Republic 43%, Russia 58%, and Hungary 20%. Equities surged throughout Asia. Japan’s Nikkei 225 added 24.5%, Hong Kong’s Hang Seng 35.0%, Taiwan 32%, South Korea 29%, New Zealand 25.6%, Thailand 117%, Indonesia 63%, India 76%, Singapore 32%, Malaysia 23%, and Philippines 42%. Stock gains were buttressed by collapsing yields and surging global debt issuance. January 2 - Dow Jones (Angela Pruitt): “In another stellar year, emerging market debt posted its best performance in 2003 in seven years, while it also outshined its fixed-income peers. The asset class posted a whopping 28.825% return last year as measured by J.P. Morgan’s widely-tracked Emerging Markets Bond Index Plus (EMBI+), double the 14.24% return booked in 2002. The index closed out the year with a spread of 418 basis points over U.S. Treasurys, compared with 765 basis points at the end of 2002. The gains in emerging markets dwarfed the 2.44% rise in U.S. Treasury bonds and were a tad better than the 27.9% return seen in the U.S. high-yield sector in 2003… The last time emerging market debt had a better year was in 1996, when the EMBI+ rose 39%. It has booked positive returns in four of the last five years, however. There wasn’t one sovereign listed on the 19-country EMBI+ that posted a negative return.” Domestic Credit Inflation Watch: For the year, Treasury yields rose moderately as the yield curve steepened. Two-year Treasury yields rose 22 basis points to 1.83%. Five-year yields jumped 51 basis points to 3.25% and 10-year yields rose 43 basis points to 4.25%. Long-bond yields increased 30 basis points to 5.075%. Risk assets dramatically outperformed. The S&P Corporate Investment Grade index spread to Treasuries narrowed 77 basis points to 164. Junk bond spreads collapsed, with the S&P Speculative Grade index spread to Treasuries sinking 550 basis points. December 31 – Bloomberg – “U.S. corporate bonds finished their best year since at least 1986 as an expanding economy boosted investors’ confidence in the ability of companies to make debt payments. The extra yield, or spread, investors demand to own corporate debt rather than Treasuries narrowed to 93 basis points from 185 a year ago, according to New York-based Merrill Lynch & Co. One basis point is 0.01 percentage point. The spread is the narrowest since August 1998.” December 31 – Bond Week: “Nearly all of the performance measures indicate just how solid of a year the high yield market had, but perhaps the best one has to do with the growth in supply. New issuance rose a whopping 95% this year, to $112 billion, according to Standard and Poor’s. Meanwhile, positive fundamental and technical developments helped create one of the best years in the junk bond market in recent memory… The Merrill Lynch High Yield Index posted a 25% return up to the end of November.” According to Merrill Lynch, “The all US Convertibles index picked-up 8.5% in 4Q03 and is up 27.2% in 2003 as underlying stocks expanded 58.0%.” Speculative Grade Convertibles surged 12.0% during the quarter (underlying stocks up 20.1%) to end the year up 42.0%. According to Thomson Financial Services, Total U.S. Debt Issuance surged 19% to $3.209 Trillion. Long-term Issuance increased 20% to $2.752 Trillion, while Short-term Issuance was up 9% to $444 billion. High-grade Corporate Issuance increased 20% to $659 billion. MBS issuance increased 12% to $900 billion. Issuance of Convertible securities increased 61% to $96.4 billion. Preferred issuance surged 98% to $35.5 billion. Yankee (foreign dollar denominated debt) Issuance increased 58% to $93.6 billion. Bloomberg tallied CMO (collateralized mortgage obligations) issuance of $1.052 Trillion, up 26% from 2002 and almost double volume from 2001. Bloomberg’s total Agency MBS Pool issuance through November sums to $2.0 Trillion, up about 40% from the comparable total from 2002. January 2 – Bloomberg: “Citigroup, UBS Financial Services and Merrill Lynch & Co. took the top municipal bond underwriting slots as state and local governments borrowed a record $379.1 billion to close budget gaps at low interest rates… Total municipal bond issuance rose 6.5 percent from a record $355.9 billion in 2002.” January 1 – Chicago Sun-Times (David Roeder): “Chicago’s futures markets Wednesday celebrated a record-setting year in business for 2003… For the first time in any year, combined volume at the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) topped 1 billion contracts in 2003. Both exchanges easily shattered volume records set just a year ago. Many trends worked in the exchanges’ favor. The return of U.S. government deficits sparked volume in futures on Treasury debt. Fluctuations in the dollar brought out the foreign currency traders. Wild cards ranging from quirky weather to mad cow disease encouraged trading in agricultural futures. And perhaps most important potent of all, an appreciating stock market led to more activity in stock index futures, a product that increasingly became the domain of electronic traders. Merc officials said 2003 volume was 640 million contracts, up 15 percent from last year. The Board of Trade reported a yearend count of 454 million contracts, about a third more than its result in 2002.” S&P 500 index volume was up 23% for the year. December volume at the CME was up 53%. Currency Watch: December 31 – Dow Jones (Jamie McGeever): “What a year it was for the dollar and there’s little sign of respite on the horizon. The world’s premier reserve asset, trading currency and traditional store of value in times of war and global political tension plummeted to new depths in 2003, with the speed of its fall in the last quarter surprising even the most seasoned currency veterans and long-time dollar bears. Hit by a wave of negative sentiment, the greenback closes the year at its lowest point against the euro since that currency’ inception on Jan. 1, 1999 and at multiyear troughs against most other major and second-tier counterparts.” December 31 – Bloomberg: “Canada’s dollar wrapped up its biggest year against the U.S. dollar in more than five decades, as international investors flocked to Canadian debt securities for their higher yields. The Canadian dollar surged 21 percent, the most since 1951 when the Bank of Canada began recording foreign-exchange data.” December 31 – Bloomberg: “The Australian dollar, the best-performing major currency this year, had its biggest annual gain since the government allowed it to trade freely 20 years ago as the country’s higher yields lured investors. The Australian currency has risen 34 percent against the U.S. dollar this year.” The British pound ended the year at the highest level against the dollar since September 1992, up 11% for 2003. The South African rand rose 28%, New Zealand dollar 25%, Chilean peso 22%, Swedish krona 21%, the euro 20%, and Danish krone 20%. December 31 – Bloomberg: “The Brazilian real rose 22 percent in its first yearly gain against the U.S. dollar as record exports and slowing inflation restored investor confidence in the country. The real, created on July 1, 1994, was the sixth-best performing currency against the U.S. dollar this year among the 60 currencies tracked by Bloomberg, as President Luiz Inacio Lula da Silva restored investors’ confidence that Brazil would repay its debts and that the economy would grow. ‘We see Brazil in an increasingly virtuous cycle, the inflation dynamics have been improved, and everything is working together because monetary and fiscal policy is on track,’ said Mohamed El-Erian, who manages $12 billion of emerging market debt…” In a harbinger of a stronger 2004, Brazil posted a record 2003 trade surplus of $24.8 billion. Exports were up 21% y/y to $60.2 billion. Commodities Watch: The CRB index ended the year up 9%, with the Goldman Sachs Commodity index up 11%. The Journal of Commerce Industrial Commodities composite index was up 22%. By index component, Textiles were up 10%, Metals 38%, Petro 20%, and Miscellaneous 20%. Gold rose almost 20% to approach a 14-year high. Global Reflation Watch: December 30 – Bloomberg: “Japan sold its currency in December for a 10th month this year, according to the Ministry of Finance, trying to stem gains that threaten the nation’s exports and may slow economic growth. The Bank of Japan sold 2.25 trillion yen ($21 billion) from Nov. 27 through Dec. 26. The figure boosts yen sales for 2003 to a record 20.1 trillion yen.” My tally has Bank of Japan foreign reserves (largely dollars) up 43% for the year to about $645 billion. The expansion of foreign central bank balance sheets has been nothing less than amazing, providing one rather conspicuous explanation for this year’s unprecedented global liquidity. December 31 – Dow Jones: “Total issuance of international bonds (global bonds, eurocurrency bonds and foreign bonds) rose 37.5% this year to a record $2.2 trillion, says Thomson Financial. The buoyancy of the securitization market, which increased by 71% from the previous year, contributed to this result. Meanwhile, sovereigns overall increase was 39%.” December 31 – Bloomberg: “OAO Gazprom, the Russian natural gas producer, and Petroleo Brasileiro SA, a state-owned oil company, led a record $88 billion of bond sales by emerging-market borrowers in 2003, tapping into demand for higher-yielding assets after U.S. interest rates fell to four-decade lows. Companies in developing nations helped fuel a 70 percent increase in the debt by selling $44.5 billion of international bonds, surpassing government sales for the first time. Latin American companies alone tripled sales to $17 billion. The surge in sales came as credit ratings were raised for Russia and Argentina and amid prospects for faster global economic growth. The premium emerging market bonds pay above U.S. Treasuries narrowed to 4.18 percentage points from 7.65 percentage points at the end of last year… The demand for yield helped boost flows into emerging-market funds this year. Funds that had $13.6 billion at the start of the year showed $3 billion was added during 2003, the most since EmergingPortfolio.com Fund Research in Cambridge, Massachusetts began collecting the data in 1995.” January 1 – Financial Times: “Hedge fund assets are expected to grow by 20 per cent to almost $700 billion in 2004, fuelled by US and Japanese institutional investment, in spite of growing regulatory scrutiny…Japanese investment in hedge funds has risen three-fold in the past two years. Japan’s $300bn Government Pension Investment fund, the biggest in the world, said last month it would ask its government for permission to begin investing in hedge funds.” December 28 – Bloomberg: “Japan’s Economic and Fiscal Policy Minister Heizo Takenaka said the proportion of bad loans held by large banks in Japan is declining quicker than he expected and is approaching a level of less than 5 percent. ‘Japan's financial appearance is changing,’ Takenaka said…including action by the banks, ‘is in line with what we assumed a year ago, or rather a bit faster.’” January 1 – Bloomberg: “South Korean exports in December rose 32.5 percent from a year earlier to $19.9 billion, the Ministry of Commerce, Industry and Energy said. Imports rose 22.1 percent to $17.6 billion, giving the country a $2.3 billion trade surplus for the month… For the year, exports rose 19.6 percent to $194.3 billion, while imports were up 17.5 percent to $178.8 billion, giving a surplus of $15.5 billion.” January 1 – Bloomberg: “India’s exports accelerated in November as Steel Authority of India Ltd. and other steel companies stepped up sales to China and automobile companies sold more abroad as competition from rivals increased at home. Exports rose 13.7 percent to $4.49 billion from a year earlier after gaining 5.1 percent in October… India’s oil imports rose 12.4 percent to $12.7 billion in the eight months through November…” December 31 – Bloomberg: “India’s economy grew at its fastest pace in more than six years in July to September…putting it on target for growth in excess of seven percent in the current fiscal year. The $505 billion economy, Asia’s third biggest after Japan and China, expanded 8.4 percent from a year earlier in the quarter, accelerating from 5.7 percent growth in the three months to June 30…” December 31 – Bloomberg: “South Africa’s central bank bought $1.1 billion in the currency markets in November as it bolstered its foreign-currency reserves. The South African Reserve Bank’s net foreign reserves, known as the net open position in foreign currency, rose to $3.77 billion at the end of November, from $2.69 billion the month Before…” “South African private borrowing growth accelerated in November after the central bank cut its benchmark lending rate to the lowest in 23 years, boosting demand for credit. Borrowing by households and companies, known as private-sector credit extension, increased an annual 21.8 percent, from 19.7 percent in October.” December 31 – Bloomberg: “U.K. house price growth accelerated in December as bankers in the City of London spent bigger annual bonus payments on property, Nationwide Building Society said, increasing the risk of another interest rate increase. The average cost of a home rose 1.5 percent to 134,444 pounds ($241,000), after growing 1.2 percent in November… Prices climbed 15.6 percent in 2003. The Bank of England lifted its benchmark lending rate a quarter point in November to 3.75 percent, the first increase in almost four years designed to slow inflation and house price growth.” Economy Watch: The December Institute for Supply Management (ISM) Manufacturing index added 3.4 points to 66.2, the strongest reading since December 1983. New Orders surged almost 4 points to 77.6, the highest since July 1950. The Employment component rose to the highest level since December 1999. Prices Paid added 2 to 66, and New Export Orders gained 2.5 to 60.4 (highest since May 1989). December 30 – Bloomberg – “New York City area business activity expanded in December at the fastest rate in at least a decade, a survey of services and manufacturing executives showed, adding to evidence of an economic recovery in the region. The National Association of Purchasing Management-New York’s business activity index, which gauges general economic health, surged to 80.7 this month from 51.9 in November, the highest reading since the survey began in May 1993. A reading of more than 50 indicates expansion. The index measuring service industries, which employ nine of 10 city residents, also expanded at a record pace, climbing to 80.5 from 51.6 last month.” GSE Watch: December 30 – Bloomberg: “When Treasury Secretary John Snow called on Congress in September to create a ‘world-class’ regulator to crack down on Fannie Mae and Freddie Mac, the two largest buyers of U.S. home mortgages were ready for him. Fannie Mae and Freddie Mac between them had hired 46 lobbying firms in the first half of this year, including seven of the 20 largest, to reinforce their permanent staffs of 20. They spent at least $9.7 million on lobbying during that time, more than any other company or association, according to PoliticalMoneyLine.com, a nonpartisan group tracking such funds. It wasn’t just the numbers, it was the names. Among other recruits, Freddie Mac took on Patrick Cave after he resigned in January as a top official in the Treasury office that’s seeking authority over the companies. It hired Terry Haines after he quit that same month as staff director for the House Financial Services Committee, which is considering the legislation. The companies ‘are in a class by themselves,’ with the most potent lobbying force in Washington, said Senator John Sununu…co-sponsored a bill that would strengthen oversight, in response to accounting errors that led to a $5 billion profit restatement by Freddie Mac this year. The lobbying effort paid off.” California Housing Bubble Watch: December 29 – California Association of Realtors: “Propelled by double-digit price appreciation that was twice that of the nation, California homesellers reaped a record median gain of $150,000 in 2003, according to the ‘State of the Housing Market 2003’ report by the California Association of Realtors (C.A.R.). ‘Net cash to sellers has never been higher since C.A.R. began conducting our annual survey of the California housing market.’ The ‘State of the Housing Market 2003’ report also revealed that nearly one out of four transactions in 2003 involved a second mortgage, an 18 percent increase compared to 2002 and well above the 20-year record low of 4.4 percent in 1988” December 30 – Associated Press (Jim Wasserman): “Construction crews wielding saws, hammers and nail guns this year began work on the most new houses in California since 1989 and the most apartments since 1990 – but it isn’t enough to ease the nation’s worst housing shortage, experts say. California builders Monday reported starting 191,866 homes and apartment since 2003, and predict slightly more next year before rising interest rates force a slowdown in 2005… Home builders credit the construction spree to the lowest interest rates in a generation, giving thousands of people more buying power even as prices surged because of supply and demand. Home values rose an estimated 17% during the year, reaching a median price of $369,500…” December 30 – California Association of Realtors: “Sales of detached existing single-family homes are expected to decline in 2004 from 2003’s record-setting pace, while price appreciation will continue to be driven by strong demographics and higher, though historically low, interest rates in 2004… The median price of a single-family home is forecast to increase 13 percent from $369,500 in 2003 to $417,500 in 2004, while sales are projected to decline 2 percent to 584,600 in 2004 from a record 596,500 in 2003.” December 30 – Florida Association of Realtors: “A strong housing sector pumped up Florida’s economy in November and also continued to boost the nation’s economic recovery: A total of 10,322 existing single-family homes were sold statewide last month for a 4 percent increase over last year's sales activity of 9,917 homes… Last month, the statewide median sales price rose 13 percent to $172,500…” Year-over-year median prices were up 21% in West Palm Beach/Boca Raton, 20% in Miami, 18% in Naples, 17% in Fort Lauderdale. Its Wildness Lies in Wait: As for 2003, the debt issuance and market return numbers speak for themselves. Global markets experienced history’s greatest liquidity surge and reflation. Asset inflation – both real and financial – was powerful and all-encompassing. Speculation and inflation were vigorous and indiscriminate. Debt and equity markets were stoked by an unprecedented surge in dollar liquidity and renewed speculation, along with a massive short squeeze. The upshot was a market abnormality with virtually all boats being lifted. Credit market speculation, which had been concentrated in the U.S., was unleashed to play the world. Unprecedented mortgage Credit growth and leveraged speculation fostered excessive dollar liquidity, while the faltering dollar played an instrumental role in the flood of global liquidity. It has had the look and feel of an historic “blow-off,” yet it is being dangerously extrapolated into the future. The liquidity and Credit inflation genie was purposely set loose to goad a seductive boom. Working its usual magic, the latest boom has captivated the gullible imaginations of policymakers, speculators, investors, and the general public. The great havoc such an endeavor creates Lies in Wait. The American Economic Association holds its annual conference this weekend in San Diego. Chairman Greenspan is on tap to speak tomorrow, with vice chairman Ferguson and governor Bernanke lined up for Sunday.