05/15/2003 The Desperate Experiment of Maximum Global Liquidity *

With the spotlight on the incredible collapse in market yields, the stock market generally posted decent gains.  For the week, the Dow and S&P500 added about 1%, yet the major indices masked significant divergences between groups.  The Transports declined 2%, while the Utilities gained 4%.  The Morgan Stanley Cyclical index rose 2% and the Morgan Stanley Consumer index added 1%.  Today’s late sell-off wiped out most of what had been a 2% gain for the unrelenting small cap Russell 2000.  The S&P400 Mid-cap index posted a 1% gain for the week.  The tech sector remains strong, although the NASDAQ100 mustered only a 1% gain.  The Morgan Stanley High Tech index jumped 4.5% and The Street.com Internet index gained 5%, increasing respective y-t-d gains to 22% and 34%.  The Semiconductors added 1%, boosting the 2003 advance to 23%, while the NASDAQ Telecommunication’s 4% rise increased its y-t-d rise to 25%.  The biotechs enjoyed a 6% increase this week.  The Securities Broker/Dealer index jumped 5% and has now surged 40% off its March 12th lows.  The Bank index gained 2% this week.  Although bullion jumped $6.0, the HUI gold index was about unchanged. The Treasury market enjoyed its best two-week performance since 1995 (according to Bloomberg).  Melt-up conditions saw two-year yields drop 13 basis points (1.31%) and five-year yields sink 22 basis points (2.39%).  The 10-year Treasury yield dropped 26 basis points (3.42%), with a stunning 52 basis points two-week collapse.  The long-bond saw its yield drop 26 basis points to 4.41%.  Benchmark mortgage-back yields declined 26 basis points, although agency bonds appeared to have somewhat underperformed.  The spread on Fannie’s 4 3/8% 2013 note widened two to 36, while the 10-year dollar swap spread narrowed 2.5 to 30.5.  One has to go all the way back to early 1994 to find the 10-year dollar swap spread below 30.  Investment grade and junk issues participated in the melee, although spreads widened marginally.  It is noteworthy that spreads have not widened significantly in the face of such a dramatic collapse in Treasury yields.  The dollar index declined 1% to the lowest level since early 1999.  The dollar was hammered for almost 2% today, with global currency market trading volatility increasing noticeably this week.  The CRB commodity index added about 1% this week. The bond issuance boom runs unabated, with one of the strongest weeks of corporate sales this year. Citigroup issued $2.5 billion, General Dynamics $2 billion, American Express $1.5 billion, Countrywide $1 billion, Fund American $700 million, Centerpoint Energy $575 million, Cargill $500 million, Midamerican Energy $450 million, Clear Channel $500 million, Comcast $1 billion, American Electric Power $300 million, John Deere $200 million, Duke Realty $150 million, and Northwest Airlines $150 million.  General Motors raised their expected $300 million issuance of 45 year bonds to $1 billion. High yield is hot, hot, hot.  Capital One sold $600 million, Lyondell Chemical $325 million, Forest City Enterprises $300 million, US Steel $450 million, PT Medco Energi $250 million, Semco Energy $300 million, Sinclair Broadcast$100 million, Dole Food $400 million, L-3 Communications $400 million, Standard Pacific $175 million, Interline Brands $200 million, Smithfield Foods $350 million, LSI Logic $350 million, Forest City Entertainment $300 million, and Rite Aid $150 million. Dow Jones reported that emerging-market bond funds posted record inflows last week.  Year-to-date flows are already double the amount for all of 2002. AMG reported another $331 million (after the previous week’s $1.3 billion) flowed into junk bond funds for the 12th straight week of positive flows, increasing year-to-date inflows to $18.5 billion.  This is more than double last year’s pace and already surpasses 1997’s record (according to Dow Jones’ Nicole Bullock). Year-to-date junk issuance is up 34% to $42 billion. May 16 – Bloomberg: “Private investment in emerging market nations will rebound 26 percent this year to $139 billion as falling oil prices and a quick end to the Iraq war buoy global growth, a group of international banks said. The flow of private capital to Latin America will more than double to $34 billion from $14 billion posted in 2002, said the Institute of International Finance, which represents Citigroup Inc. and more than 300 other banks.” Freddie Mac’s 30-year mortgage rate sank 17 basis points to a record low 5.45% (down 40 basis points in five weeks and 144 basis points from 52 weeks ago).  The 15-year borrowing rate dropped 13 basis points to a record low 4.84%.  Bloomberg’s tally of Mortgage-Backed Security issuance had April sales of $189 billion ($2.27 Trillion annualized!), with a five-month total of $713 billion.  Last April saw MBS issuance of $102 billion. Broad money supply (M3) jumped another $29.1 billion ($108.6 billion in three weeks).  Demand and Checkable Deposits added $6.2 billion.  Savings Deposits jumped $33.2 billion ($67.5 billion in two weeks), and have been expanding at a 21% annualized rate thus far in 2003.   Institutional Money Fund deposits declined $18.6 billion, while Large Denominated Deposits added $7.3 billion.  Repurchase Agreements declined $4.7 billion as Eurodollars increased $6.2 billion.  After several weeks of big gains, Bank Total Assets dipped an insignificant $2.5 billion.  Securities holding declined by $15.3 billion, while Loans and Leases jumped $23.1 billion.  Real Estate loans surged $23 billion, as Commercial and Industrial loans declined $4.9 billion. Commercial Paper increased $6.2 billion.  Non-financial CP declined $1.6 billion, while Financial CP added $7.8 billion.  Financial CP is up $34.9 billion over three weeks to the highest level since early December.  The asset-backed securities marketplace remains hot.  This week saw troubled subprime lender AmeriCredit increase the size of its securitization by more than a third to $825 million.  As lenders to marginal Credits, as well as themselves marginal borrowers in the capital markets, I view the subprime lenders as decent “canaries in the mind shaft.” Well, with AmeriCredit’s stock up five-fold from March lows, the gasping little bird has miraculously begun whisking around the cage again.  Elsewhere, Honda’s $1.55 billion securitization was as much as three-times oversubscribed, while Harley-Davidson saw record narrow spreads on its six-times oversubscribed ABS deal. Surging demand for its bonds led Volkswagen to increase the size of its bond offering 50% to 4.5 billion euros, its largest debt sale. May 11 – Financial Times:  “Seven of the top 10 US law firms saw fee revenue increase more than 10 percent last year, despite clients in corporate America suffering from a slowdown in the economy…  The survey (of the top 50 firms) found revenues and profits per partner – the industry standard measure – both rose an average 8 percent last year…  In spite of a dearth of lucrative merger and acquisition deals and initial public offerings, US firms saw strong gains in litigation, bankruptcy cases and corporate restructurings.” Last week's 34,669 bankruptcy filings were up 7% y-o-y.  Preliminary May University of Michigan Consumer Confidence jumped a much stronger-than-expected 7.2 points to the highest reading in one year.  The Economic Outlook component surged 13.4 points.  The Empire State (New York) Manufacturing index posted a stronger-than-expected gain in May to the highest reading since January.  New Orders, Shipments and Prices Paid posted strong recoveries from a weak April.  In a notable sign of stronger confidence, the index of general business confidence six months out surged 18 points to the strongest reading since November.  While improving from April, the Philadelphia Fed index was unimpressive.  Initial Jobless Claims declined for the third straight week.  The 1.9% decline in Producer Prices reduced the y-o-y price gain from February’s 4.2% to 2.4%.  And April’s 2.7% decline in Import Prices reduced the y-o-y price gain from 6.7% to 2.3%.  The National Federation of Independent Businesses “Small Business Optimism” index jumped better than 5% in April to the highest level since November.  Only 2% of respondents saw Credit Harder to Get, down from February and March’s 5%.  April Housing Starts were weaker-than-expected, although they were up 4% from April 2002.  Building Permits were slightly stronger-than-expected, with the 1.708 million unit rate up 4.7% from one year ago.  But clearly the mortgage rate environment has improved dramatically since April.  The May National Association of Home Builders housing activity survey index posted a four point gain to 56.  This was the highest reading since February.  The index of future expectations for single-family sales jumped six points to the strongest reading since January.  Prospective Buyers Traffic also gained six points. May 11 – Los Angeles Times (Jesus Sanchez):  “The hillside house Linda Lutz has lived in for 25 years isn’t only her home.  It’s her bank too.  The character actress has had little work in recent years, but she has been able to cover her expenses by cashing in on the equity of her house in Encinitas in northern San Diego County.  In September, Lutz refinanced for the sixth time in five year, taking out $100,000… ‘Every time I thought we had tapped out, the property value had increased again…’ without refinancing, she said, ‘I would have been out on the street.’” May 15 – “The Mortgage Bankers Association of American (MBA) today announced it is now forecasting that $3.0 trillion in mortgages will be written during 2003, beating last year’s record-setting mortgage origination volume by more than half a trillion dollars (the MBA raised their estimate from $1.77 Trillion to $2.4 Trillion last month).  MBA estimates that approximately $1.95 trillion of that total, or 65 percent, will be due to mortgage refinancings. ‘We knew that originations had been strong for the first half of the year because rates had remained at very low levels. However, we had been expecting the refinance market to dry up as increased economic activity in the second half of the year caused interest rates to increase," said Doug Duncan, MBA’s chief economist.  ‘The Federal Reserve’s announcement last week that it was concerned with potential deflationary pressures in the economy has moved deflation from being a theoretical consideration to an active policy issue. The market sees this announcement as increasing the probability that the Fed will further lower short-term rates and, more importantly for mortgages, influence downward long-term rates through its open-market purchases of bonds,’ Duncan said.” May 14 – Dow Jones:  “‘The housing market is remarkably strong,’ (Fannie Mae’s Franklin) Raines said, adding that those who believe the housing market is a cyclical one are wrong.  It doesn’t appear to be the case this time,’ he said. ‘There have been enough changes in the housing market through the growth of the high-production builders and the connection to the capital markets that it is no longer the old-fashioned cyclical market that we all thought it should be.’” Countrywide Financial enjoyed another incredible month.  April Total Loan Fundings of $42.3 billion were up 12% from March’s huge record, and have ballooned 200% from April 2002.  Non-purchase Fundings (Refis) surged 320% y-o-y to $32.7 billion, while Purchase Fundings jumped 52% to $9.6 billion.  Home Equity Fundings were up 56% y-o-y and Subprime Fundings doubled.  The company’s announcement made reference to an origination market share that has grown to 12.5%.  This would put system-wide April originations at $338 billion, or a stunning $4 Trillion annualized.  The Parabolic Rise in Mortgage Credit... Fannie also posted a spectacular April.  “Total business volume (mortgage purchases) rose to a record high of $139.0 billion, up almost 28 percent from March.  Fannie Mae’s book of business grew at an extremely strong compound annual rate of 36.6%.  Outstanding MBS grew at the highest rate in a decade, at a compound annual rate of 67.6 percent.”  Fannie’s Book of Business surged $50.6 billion during the month, or a stunning $600 billion annualized.  For comparison, April 2002 saw Fannie’s Book of Business increase $19.6 billion, with Total Business Volume of $58 billion.  Year-to-date, Fannie's Book of Business has surged $154 billion, or 27.6% annualized.  For comparison, the Book of Business expanded $105 billion for the entire year-2000.  This year's Total Business Volume (mortgage purchases) is running at an amazing annualized pace of $1.4 Trillion. The National Association of Realtors this week released first quarter housing pricing data.  Nationally, median prices were up 7% y-o-y to $161,500 (up 15.6% over two years).  Y-o-y Median Prices were up 16.7% in the Northeast, 4.1% in the Midwest, 7.5% in the South and 8.0% in the West.  It is worth underscoring the Top 10 price gaining markets:  Philadelphia was up 25.7%, Providence, RI 25.7%, Melbourne, FL 25.4%, Sacramento, CA 25.3%, Trenton, NJ 24.0%, Monmouth/Ocean, NJ 23.4%, New Haven, CT 21.8%, Bergen/Passaic, NJ 21.1%, Orange County, CA 20.5%, and San Diego, CA 19.5%.  Other notable gainers include San Bernardino, CA 18.3%, Nassau/Suffolk, NY 17.6%, Los Angeles 16.2%, Baltimore 15.2%, NY/NJ/CT 15.1%, Chicago 11.1%, Washington D.C. 10.3%, Minneapolis 9.3% and Milwaukee 9.2%.  Of the more than 120 metropolitan areas, only eight had y-o-y declines.  Only three had price drops of more than 2%, with the worst performer (Chattanooga, TN) down just 4.4%.    While the national median sales price may have been $161,500 during the first quarter, the Mortgage Bankers Association reported average new loan size this week of $188,800.  The mortgage application index jumped another 13.7% this week (35% over two weeks!) to the fourth highest level on record.  For perspective, the index that surpassed 1400 this week traded above 800 for the first time (and for only two weeks) during the infamous month of October 1998.  It traded above 1400 for the first time during the month before last.  This week the Refi Application index surged 19.3% (42% over two weeks!) to the fourth highest on record (up 366% y-o-y).  The number of Purchase Applications was basically unchanged from the previous week’s record.  Purchase Application volumes were up 16.5% from the strong year ago level, while dollar volume was up a noteworthy 26%.  The average Purchase Application mortgage amount was $199,400 last week.  The average size of adjustable rate mortgages rose to $314,100. California home prices set another record during the first quarter, with the median price up 14.3% to $337,780.  The Florida Association of Realtors reported a strong first quarter, with both sales and median prices up 10% ($145,600) from one year earlier.  Median prices were up 18% in Miami and 24% in West Palm Beach/Boca Raton.  Statewide median prices have inflated 50% since 1998.    Unrelenting mortgage Credit excess is fueling absolutely dreadful (gone parabolic) trade Deficits, and it is today difficult to see this circumstance changing any time soon.  March’s deficit of $43.5 billion was up 33% from March 2002.  Year-over-year, Goods Exports were up 6%, while Goods Imports surged 15%.  Goods Imports were 81% larger than Exports during the month.  Crude oil imports were up 76.8% y-o-y, Consumer Goods 15.9% (Pharmaceuticals 34.2%), Automotive 7.7%, and Food & Beverage 16%.  Capital Goods Exports declined 1.3%, while Food & Beverage Exports jumped 10.0%.  Year-to-date, our trade deficit with China is up 30.0% ($24.67bn), Japan 1.5% ($16.37bn), Canada 18.1% ($14.50bn), Mexico 28% ($10.84bn), Germany 25.3% ($8.56bn), Ireland 18.4% ($4.1bn), and Saudi Arabia 146% ($3.58bn). We read analysis these days that the weak dollar will likely induce the U.S. to export “deflation.”  Well, this is one area where we should surely avoid the nebulous “inflation” vs. “deflation” debate.  And one issue should be beyond dispute: these massive and unrelenting U.S. trade deficits are now “exporting” aberrant liquidity globally.  Throughout the world – from China and greater Asia, to OPEC, India, Russia, Europe, Mexico and Canada – central banks’ dollar reserve assets are surging.  Today, the world is awash in liquidity, with Credit Availability the most accommodative in quite some time.  In many ways the environment recalls the Credit market speculative frenzy and pre-Mexico crisis period of 1993.  It is inarguably a much different world than late last year. From a global Credit-centric perspective, the parabolic rise of King Dollar from the depths of the 1998 financial crisis was a significant impediment to liquidity and Credit availability for many economies internationally.  Post-LTCM crisis, there was absolutely no doubt that the U.S. financial system provided (with the systemic liquidity assurances and “buyers of first and last resort” functions courtesy of the Fed and GSEs - our “twin” central banks) THE cozy safe-haven for the expansive global speculating community.  Hot “money” flows abandoned Brazil in early 1999, Turkey in 2001, and later sidestepped the Argentina debacle.  The resulting financial and economic crises were all too similar to previous “hot money” booms turned busts in Mexico (late 1994-95), Thailand (summer of 1997), S. Korea and SE Asia (late 1997), and Russia (summer of 1998).  By 1999, The Reign of King Dollar was taking firm control.  And, in reality, the year-2000 NASDAQ collapse/equity bear – and the Fed’s and GSEs’ consequent historic accommodation/"reliquefication” - only solidified the dominance of dollar denominated Credit instruments as the surefire way to easy speculative “trading” gains.  How could one lose?  Understandably, global financial flows were keen to avoid the emerging markets and commodities, enticed instead by the incredibly powerful King Dollar liquidity magnet.  Why play anything else?  A strong case can be made that King Dollar was restraining liquidity, Credit availability, and economic growth for many economies.  The liquidity feast in America was the mirror image of famine elsewhere.  And during each respective crisis, the SE Asia melt-down in particular, it appeared that the intense flight to dollar denominate financial assets was on the verge of stoking severe deflationary forces.  The final speculative dollar melt-up certainly exacerbated the Argentine collapse and nearly sank Brazil. But the King Dollar Bubble also sowed the seeds of its own destruction.  Incredible Credit and speculative excesses fed The Great Mortgage Finance Bubble, the GSE and “Structured Finance” Bubble, and acute financial fragility, while further distorting the maladjusted Credit and consumption-driven Bubble economy.  The inevitable reversal of dollar fortunes and last year’s serious systemic stress very nearly pierced the U.S. Credit Bubble.  Yet this Day of Reckoning was postponed by historic assurances from the likes of Ben Bernanke and Alan Greenspan.  I’ll stick to my view that in the guise of fighting the evil of “deflation,” the Greenspan Fed is really signaling to the marketplace that they are prepared to do everything in their power to bankroll the continued Credit and speculative excesses required to sustain the U.S. Bubble.  The Greenspan Fed is determined to nurture leveraged speculation, they will buttress any cracks in the frail foundation of Structured Finance, and that they will stand fully behind the daisy chain of institutions comprising our contemporary Credit system (banks, derivative players, GSEs, Wall Street firms, Credit insurers, ABS/MBS markets, etc.).  They will disregard all excesses and ignore escalating financial and economic imbalances and distortions.  And, in a seminal departure from established and prudent central banking, they have intimated that they will in no way move to assuage Credit, speculative, or liquidity excesses to defend a sinking dollar.  This will prove a momentous mistake.  In short, the Fed this past autumn initiated a guarantee that it would not allow the runaway U.S. Credit boom to wane, let alone go bust.  This is heady, historic stuff, with profound ramifications both domestically and globally. So nervous markets, both at home and abroad, made an abrupt u-turn.  Now markets would no longer need to discount for the seemingly imminent termination of gross U.S. Credit and speculative excess – and resulting liquidity effects from massive trade deficits and speculative financial flows emanating from the U.S. financial sector.  Today, the Federal Reserve has players believing they have promised that excesses and the liquidity torrent from the U.S. Credit Bubble will be sustained as far as the eye can see.  May 14 – Bloomberg (Gavin Serkin):  “Sergey Pakhomov, Moscow’s municipal debt chief, spreads a map across a polished boardroom table, indicating plans to build new 10-lane roads, create more subway lines and replace decaying, Soviet-era apartment buildings.  ‘Those ugly prefabricated houses with shoddy construction, they really have to be demolished,’ says Pakhomov, pointing to areas in the north and south of Russia’s richest city. A new subway line linking the suburb of Butovo and downtown has already cut the daily commute for half a million people by 45 minutes. Who’s financing it all? Bond investors. The City of Moscow, along with businesses such as OAO Gazprom, Russia’s largest company, are leading an increase in domestic bond sales that may reach 320 billion rubles ($10 billion) this year. That’s up from 196 billion rubles last year and triple the amount in 2001… Five-year federal government bond yields have dropped to a record of 8.14 percent, half the rate of a year ago. That compares with more than 100 percent at the end of 1998 on three-year paper. Moscow city government’s four-year ruble bonds recently traded at a yield of 8.6 percent, compared with the 16 percent rate on one-year bonds a year ago. Russia’s bonds aren’t the only emerging market bonds gaining. J.P. Morgan Chase & Co.’s EMBI Global emerging market bond index jumped 17 percent this year, with Brazil's bonds up 44 percent, as international investors seek alternatives to the lowest U.S. Treasury yields in four decades.” Emerging market debt spreads have narrowed 80 basis points during the past month, and have collapsed more than 450 basis points since October.  Mexican government bond yields this week sank to a record low 5.14%.  This is down 155 basis points since February and 225 basis points from a year earlier.  Brazilian yields have collapsed 700 basis points since February, while Argentine yields have crashed 2,450 basis points.  Over the past twelve months India has seen yields decline 220 basis points to 5.90%.  Australian yields are down 140 basis points to 5.0%, while New Zealand yields have sunk 230 basis points to 5.65%.  Ten-year yields are down 220 basis points to 5.85% in Poland over the past year, and are only slightly higher in Hungary.  Yields have collapsed about 300 basis points in South Korea (5-year yields at 4.39%), while Thailand 20-year government bonds today yield just over 4%.  Russian 10-year Eurobonds yield 5.58%, down about 300 basis points since September.  Ten-year yields are down about 140 basis points over the past year throughout the eurozone (from Germany to Greece) to generally less than 4%.  I am attempting to convey that it looks increasingly likely that something very significant has developed that requires careful contemplation.  We have witnessed no less than an all-encompassing collapse in global risk premiums, and the riskier the asset class the more dramatic has been the market’s revaluation.  Yes, many will aver that this collapse in yields is linked to heightened global “deflationary” forces.  Yet I’m not so convinced that the nature of deflationary risks would engender the type of pervasive global equity option, Credit default swap, and junk/emerging bond premium collapses recently experienced. And would heightened deflationary pressures be consistent with this year’s major flight to “commodity” currencies such as the Australian dollar (up 16% vs. the dollar), Canadian dollar (up 15%), Brazilian real (up 20%), and South African rand (up 11.5%)?  My gut tells me that there is something more at work here than “deflation.”  Is it possible that global markets are adapting to a new and historic post-King Dollar environment, with an audacious Fed accommodating unrelenting U.S. Credit excess and, in the process, sanctioning The Desperate Experiment of Maximum Global Liquidity?  Truly nothing would surprise me anymore. Many capable analysts take a careful look at the world and see unmistakable and broadening (downward) pricing pressures, especially in the goods sector.  They also correctly see great price risk associated with inflated asset markets, especially real estate.  But at the same time, diligent Credit analysis brings to light today’s unprecedented household debt growth, enormous government deficits, unparalleled Credit market speculation, and the resulting inflationary manifestations - asset bubbles, endemic trade deficits and extreme divergences in relative prices throughout.  Indeed, the three major (interrelated) components of the Great Credit Bubble – the Leveraged Speculation Bubble, the Mortgage Finance Bubble, and the Risk Intermediation/Structured Finance Bubble – all appear to have recently commenced a state of parabolic (we would argue terminal) excess.  As evidence, look to the speculative frenzy that has engulfed the Credit market, truly incredible mortgage lending growth, and the hyper-expansion of Fannie’s Book of Business.  Then, the question becomes, how would we reconcile the outward paradox of heightened “deflationary” pressures in the face of Credit Bubble excess going parabolic?  Can we look to history for insight and/or guidance? First of all, I don’t buy into the notion that we can garner much from the Japanese experience; they are, after all, a manufacturing, saving, Creditor island nation in Asia with atypical demographics.  But the current global environment does seem to parallel the waning years of the Roaring Twenties more all the time.  As we have learned from our study of history, pricing pressures and deflationary forces gathered steam throughout the global economy as the twenties progressed.  Literally several decades of cumulative financial and economic imbalances – that went to gross Credit and speculation-induced extremes at the Bubble’s late/terminal stages – imparted profound structural effects.  Key sectors were increasingly susceptible to overcapacity, waning demand, and/or changing spending patterns.  Meanwhile, financial leveraging and speculative excess ran uncontrolled, dictated by market dynamics increasingly detached from real economy travails. It was surely much easier to make “profits” speculating in the financial markets than it was by producing products. With its well-founded fear of economic vulnerability, the Fed focused on the economy and acquiesced to financial folly.  The Fed apparently did not appreciate the extent to which the financial markets had become a key mechanism injecting liquidity into the real economy, and that the increasingly destabilizing flood of financial liquidity was emanating from unsustainable speculative leveraging.  Asset inflation became the driving force of self-feeding liquidity creation.  Such dynamics dictated that it was only a matter of when and from what degree of financial excess the Bubble would burst.  And, quite importantly, a shot of whiskey from the Fed to liven up the real economy was tantamount to serving a jug of moonshine to the drunken stock market. The very market forces and Credit mechanism that had so successfully financed prolonged economic prosperity had become increasingly detached from economic fundamentals, destabilizing, and, in reality, deranged.  Moreover, there was the key issue of speculative market dynamics, whereby speculation and Credit excess begot only greater excess that culminated in a destabilizing parabolic “blow-off.” At several critical junctures (1927, in particular) the Fed gave the Bubble a new lease on life (a shot of “liquid courage”), setting the stage for greater folly and eventual financial and economic collapse. I rehash this economic history as I believe it provides the most useful guide for making some sense out of this extraordinary environment of conflicting talk of inflation vs. deflation, post-Bubble vs. Bubble, and recovery vs. recession.  The Roaring Twenties clearly offers the closest comparison to today’s conundrum of heightened “deflationary” real economy risk in the face of parabolic Credit and financial excess.  I will add, however, that unlike the late twenties, it is my view that the paramount Bubble of leveraged speculation (and liquidity creation!) during this cycle resides within the U.S. Credit market, not the stock market.  The latest shots of liquid courage is enjoyed in gross excess by an inebriated Credit system. And while today’s historic Bubble has faced near death experiences on several occasions (this past fall the latest, and perhaps most serious), it may today appear more impervious than ever.  And yet this is perfectly consistent with speculative market dynamics, and recalls how surviving through the late-1998 crisis emboldened “animal spirits” sufficiently to set the stage for the NASDAQ/technology parabolic blow-off.  Clearly, Credit market speculators are today thoroughly “emboldened,” and never before has a central bank so explicitly conveyed the convergence of mutual interests they share with the speculating community.  Has the Fed set the stage for one final period of parabolic Credit excess?  Such a view is appearing more plausible by the week. But this scenario has set the course for dollar disaster.  Here at home, the inflation of dollar financial claims accelerates, underpinned by little in the way of true economic wealth creation (exponential rise in non-productive debt).  Endless liquidity is available for the taking, although acute financial fragility only hibernates.  Meanwhile, the (non-dollar) world has become the oyster for the energized and emboldened speculator community.  The torrent of liquidity, emanating from the deranged U.S. Credit system in the thick of historic parabolic excess, sees growing flows exiting the dollar in an endless pursuit of higher returns.  Dollar selling begets dollar asset underperformance that begets dollar selling.  And the more liquidity that flows to markets such as gold and basic commodities, or economies such as Brazil and Russia, the better these assets classes appear in comparison to dollar instruments.  And with the Fed’s current “deflation”-fighting mandate stoking over-liquefied markets globally, I am convinced that dollar weakness will only exacerbate Credit excess and self-reinforcing dollar devaluation.  If our authorities believe that the sinking dollar will settle at some level of “fair value,” they surely don’t appreciate the dynamics of runaway Credit inflation, consequent currency debasement, and speculative Bubbles.  Perhaps Washington actually believes that a weakening dollar is a good thing and that it will help us get out of our mess.  It’s not and it won't.  The Desperate Experiment of Maximum Global Liquidity is playing with nitroglycerin.

05/08/2003 The Stark Contrasts between Competing Central Banks *

Equities were choppy this week, although with an upward bias.  The Dow, S&P500, and Transports ended the week with small gains.  The Utilities and Morgan Stanley Cyclical indices added about 1%, while the Morgan Stanley Consumer index was unchanged.  The broader market outperformed the major indices.  The small cap Russell 2000 gained about 1.5%, with the index now up 21% from its March 12th low.  The S&P400 Mid-cap index added 1%.  The technology sector continues to outperform.  The NASDAQ100 rose 1%, with year-to-date gains of 16%.  The Morgan Stanley High Tech index added 2.5% and the Semiconductors 2%.  The Semis now sport a 2003 gain of 21%.  The Street.com Internet index increased 2%, with y-t-d gains of 28%.  The NASDAQ Telecommunications index added 1%, raising its 2003 advance to 21%.  The Biotechs bucked the trend, declining almost 2% this week.  The financial stocks were mixed.  The Securities Broker/Dealer index added 2%, while the Banks declined 1%.  With bullion up $7.60, the HUI gold index rose 2%.  The dollar index dropped about 2%, With help from the Fed, the Credit market melt-up has resumed.  For the week, two-year Treasury yields dropped 12 basis points to 1.44%.  The five year saw yields collapse 32 basis points to 2.51%, while the 10-year yield sank 26 basis points to 3.66%.  The long-bond yield declined 16 basis points to 4.67%.  Mortgage-backed and agency yields sank along with Treasuries.  The spread on Fannie’s 4 3/8 2013 note narrowed six to only 34.  The 10-year dollar swap spread declined 3.5 to 33.  The continuing historic collapse in spreads also helped corporates again this week, although junk bonds sputtered moderately after recent spectacular gains.  Companies issued more than $15 billion of debt this week, while the federal government sold a record $58 billion of Treasury notes.  GE Capital led with $4 billion ($6 billion in two weeks), GMAC $1 billion, American International Group $1.5 billion, Primedia $300 million, Gabelli Asset Management $100 million, Arizona Public Service $500 million, NY State Electric & Gas $200 million, Monsanto $250 million, Maytag $200 million, WMC Finance $700 million, National City $300 million, New York Life $1 billion, Viacom $750 million, and Lin Television $300 million.  Although spreads widened marginally, the junk bond market enjoyed another solid week of issuance (the previous week saw the most junk sales in three years).  Nextel Partners sold $100 million of converts, Speedway Motor Sports $230 million of bonds, CB Richard Ellis $200 million, Thornburg Mortgage $200 million, Avaya Inc. $640 million, Royal Caribbean $250 million, Titan $200 million, Key Energy $150 million, Evergreen International $215 million, Flextronics $400 million, Starwood Hotels $300 million, Avon Products $125 million, Oxford Industries $200 million, RPM International $125 million, and Wimm-Bill-Bann $150 million.  Bloomberg’s year-to-date tally of Total U.S. Domestic Debt sales is running up 24% from last year at $745 billion.  The week saw about $4 billion of asset-backed securities issued.  Year-to-date issuance of $144 billion is running up 18% year-over-year. Dollar weakness accelerated, as it continued to broaden.  The dollar ended the week at almost 115 to the euro.  The Mexican Peso rose to about a five-month high, while the Argentina peso jumped to a 13-month high (up 21% against the dollar so far this year).  The Brazilian real rose to a nine-month high, with year-to-date gains of 23%.  The benchmark Brazilian bond yield has collapsed from almost 21% in December to about 10% this week.  The CRB index jumped 3% to the highest level in almost two months.  Wheat today enjoyed its largest jump in seven months, with soybeans rising to the highest price in almost five years.   Broad money supply (M3) surged $55.4 billion last week, bringing 12-month growth to 7.2%.  Demand and Checkable Deposits added $5.7 billion. Savings Deposits jumped another $34.4 billion, increasing the 12-month growth rate to an eye-opening 19.3%.  Small Denominated Deposits dipped $2.1 billion, while Retail Money Fund deposits gained $6.4 billion.  Institutional Money Fund deposits added $2.6 billion and Large Denominated Deposits gained $8.4 billion.  Repurchase Agreements increased $1.1 billion, while Eurodollars declined $1.1 billion.  Elsewhere, Commercial Paper declined $2.0 billion, after surging $23.9 billion the previous week.  Non-financial CP is down $10.4 billion over three weeks, while Financial CP is up $19.2 billion.  Asset-backed Commercial Paper is up $33.7 billion over two weeks to the highest level since early January.  Already rapid Credit inflation from the Banking sector has accelerated.  Total Bank Assets jumped $94.5 billion last week ($127.9 billion over two weeks), increasing year-on-year growth to 11.7%.  Securities Holdings increased $35.7 billion last week, this after the previous week’s $53.1 billion expansion.  Bank holdings of mortgage-backed securities jumped $68.4 billion over two weeks.  During the past 52 weeks, Securities Holdings are up $309 billion, or 20.5%.  Over the same period, Real Estate loans are up $317 billion, or almost 18%.  Commercial and Industrial loans, on the other hand, are down $59 billion, or 6%.  The Credit system simply could not be more unbalanced or asset market-centric.  Economic data, not surprisingly, remain mixed and inconclusive.  Manufacturing continues to struggle, although Factory orders posted a stronger-than-expected gain of 2.1%.  We will, however, pay closest attention to the expansive “services” arena for clues to economic performance.  After all, many areas within the service sector maintain an inflationary bias and should be expected to respond to recent acute monetary stimulus.  The ISM Non-Manufacturing index was reported at a stronger-than-expected 50.7, up from March’s weak 47.9 reading.  New Orders were back above 50, while New Export Orders added four points to 52.5.  Elsewhere, weekly bankruptcy filings increased to 34,899, up 10% y-o-y.  And speaking of “inflationary bias,” week 46 of the Mortgage Finance Bubble blow-off saw the Mortgage Application index surge 19% to the sixth highest level on record.  Refi Applications jumped 19% for the week, and were up 247% from one year ago.  And, notably, Purchase Applications surged almost 18% to a new record (up 35% from February lows).  And while the number of Purchase Applications were 9% above a strong year ago level, in dollar terms applications were up better than 16%.  And with rates again collapsing (Credit market dislocation?), I expect mortgage applications to move only higher in the weeks ahead.  May 5 – Bloomberg:  “U.S. condominium and cooperatively owned apartment sales rose to a record in the first quarter, spurred by mortgage rates at four-decade lows, according to the National Association of Realtors. Sales rose 3.2 percent to 846,000 at a seasonally adjusted annual rate, from 820,000 in the prior quarter… The previous record was 824,000 set in the second quarter of last year… The median, or mid-point, price for condominiums was $150,700, 13 percent higher than the year-ago quarter.” May 6 – BusinessWire:  “Three years ago, a confluence of factors began to foster optimum conditions for record issuance growth in the U.S. RMBS market. However, according to panelists speaking at this year’s Standard & Poor’s Structured Finance Seminar…, that incredible rate of growth cannot be sustained for much longer.  ‘It is unusual to have such a significant drop in interest rates and appreciation of real estate prices simultaneously,’ said Rod Dubitsky, director, Mortgage ABS Research, Credit Suisse First Boston… In the first quarter of 2003, issuance of nonconforming mortgage products soared, up 42% over 2002’s first quarter, marking the fifth consecutive quarter of increasing issuance activity.” May 2 – Bloomberg:  Franklin Raines:  “This is going to be probably the best year in Fannie Mae’s history, powered by the biggest year for mortgage originations in U.S. history and another great year for housing. ‘We’ll be able to do’ at least 10 percent this year ‘easily,’ he said. ‘And we expect because the housing market is going to keep growing by 8 percent to 10 percent over the next decade, that we have a good shot of double-digit growth over the next decade,’ he said… On Fannie Mae’s forecast for more than $3 trillion in mortgage originations this year, compared with the Mortgage Bankers Association of America's $2.6 trillion estimate: ‘We’re seeing what is happening in the first half. Most of it will happen in the first half, and so most of it is already in the bank,’ he said.”            May 1- Dow Jones (Stan Rosenberg):  “A combination of low interest rates and the opportunity to refund higher-rate debt continues to drive new issuance volumes in the municipal bond market to record levels. But it remains to be seen whether this torrid pace can be maintained.  Sales of new issues by state and local governments for the first four months of the year soared to $113.5 billion, surpassing last year’s $94 billion and marking the first time the $100 billion level was breached for the 4-month period, The Bond Buyer…reported Thursday.” May 2 – American Banker (Marc Hochstein):  “Big mortgage lenders know that sooner or later this refinancing boom is going to end, the easy money will go away, and they will have to make more home-purchase loans to survive.  Homebuilders Financial Network, a Miami Lakes, Fla., firm that runs loan brokerage operations, knows it too.  It also knows that, as a reliable source of purchase loan volume, it wields considerable bargaining power with the wholesalers that fund its loans.  This is why it can make some pretty audacious requests with a straight face.  The latest:  It wants authorization to offer a riskier version of the 2-1 buydown loan.  A buydown is a fixed-rate mortgage with a deeply discounted teaser period; the rate increases a point each year for the first two years, then remains fixed…for the next 28 years.  Homebuilders Financial is trying to create a buydown product, with no prepayment penalty, that finances 80% of the home’s value, packaged with a second mortgage for the other 20%.  The builder would pay for the closings.  That means the homebuyer puts zero cash in, does not buy mortgage insurance, and can refinance or sell the home before the teaser period ends.  Oh, and could you give that same borrower the option to pay interest only for the first ten years?” The Street was all lathered up over MBIA’s 47% earnings increase, although insurance revenues were up “only” 11%. From the company’s earning release:  “Domestic municipal issuance in the first quarter…was $84.6 billion, a 25 percent increase.”  “Worldwide securitization volume was robust in the first quarter, increasing 24 percent over the same period last year.  A 46 percent decrease in worldwide CDO volume was offset by growth in U.S. public asset-backed securities and mortgage-backed securities.”  The company’s Net Debt Service Outstanding (NDSO) increased $11.7 billion during the quarter (6.0% annualized) to $793.3 billion.  NDSO was up 9.2% y-o-y.  Total Assets were up 21.8% y-o-y to $19.3 billion.  The company repurchased another 1.25 million shares of its stock during the quarter. The Greenspan Fed this week sank to further depths of misguided central banking, and our dollar suffered accordingly.  Our savings and our foreign Creditors' savings are being devalued, in an unjust and futile attempt to remedy the ills from past incompetent monetary management.  And while the Fed is surely tickled that they retain the awesome power to so easily manipulate both the marketplace (long-term interest rates) and public discourse (deflation talk everywhere), monetary policy is nonetheless impotent to remedy the true ailment.  The fundamental dilemma today is that the Greenspan Fed and Wall Street continue to work diligently (and shrewdly!) to sustain unsustainable Bubbles.  There remains an unprecedented speculative Bubble running out of control throughout the U.S. Credit market (leveraged holdings of agencies, mortgage-backs, corporates, Treasuries, etc.), with consequent liquidity effects.  There is likewise an unparalleled Mortgage Finance Bubble, fueling destabilizing housing inflation, over-consumption, and severe distortions to the nature of lending, spending and investing throughout the entire economy.  The outcome is ballooning financial sector leveraging (exponential growth in non-productive Credit/fragile debt structures), on the one hand, and massive Current Account Deficits and ballooning foreign liabilities on the other.  And, closely related, we are in the midst of an historic “Structured Finance” Risk Intermediation Bubble (The GSE’s, Credit insurers, derivatives markets, Wall Street firms, hedge funds, etc.).  These are categorically Bubbles because they will implode the day additional Credit and speculative excess is not forthcoming.  The Great Experiment that went terribly berserk will definitely not be suppressed by more and easier “money.” Today, the Fed’s egregiously inflationary monetary policy can only exacerbate – and in no way rectify – these historic Bubbles.  And, as we know, these powerful financial Bubbles have over time come to impart extreme deleterious effects on the U.S. Bubble economy.  As the governor of monetary stability, the Fed remains hopelessly lost in a quagmire nurturing disastrous Credit and speculative excess. There is no mystery surrounding dollar weakness and ongoing vulnerability.  The Fed obstinately refuses to admit its mistakes or cut its losses, and I fully expect the sinking dollar to incite unpredictable inflationary manifestations. The bursting of the technology and stock market Bubbles (nurtured by the Fed’s acquiescence of extreme financial excess as well as reckless New Paradigm blather) should have been the first leg of the requisite extensive financial and economic post-Bubble adjustment process.  Regrettably, the Fed’s aggressive “activist” response to the bursting of the equity Bubble was a derelict accommodation (patronage) of the greater Bubbles engulfing the entire Credit system.  The 525 basis point rate cuts and resulting extreme speculative and mortgage lending excesses, while exacerbating financial fragility and economic vulnerability, have done little more than suspend the imbalanced U.S. Bubble economy at tepid growth rates.  We may be in a post-stock market/technology Bubble environment, but we are firmly in the midst of a much grander and problematic financial fiasco.  Nowadays, the Fed has about run out of interest rate bullets and is increasingly desperate.  The risks, both financial and economic, are myriad and great.  Manifestly, the imbalanced U.S. Bubble economy is sustained only with unrelenting Credit excess.  Yet such financial and economic Bubbles are acutely susceptible to rising rates – a traditional market response to aggressive “reliquefication,” surging demand for borrowings, and a plunging dollar.  So the Fed and Wall Street have cleverly concocted the Deflation Bogeyman, that terrible scourge (recall the Great Depression!) that must be fought and conquered at all cost.  Never mind that excessive money supply expansion has been for years unrelenting, that households are taking on new debt at a record pace (double-digit mortgage growth!), that Credit availability is today ultra-easy for most borrowers (consumer, government and, increasingly, businesses), that government deficits are exploding, that our current account deficit is at an alarming 5% of GDP and growing, that import prices are up about 7% y-o-y, that the CRB commodity index is up 19% in twelve months, that gold is up 13%, that energy prices have been surging along with insurance, healthcare, tuition, and housing, and that general consumer price inflation is on an unmistakable rise.  Don’t be fooled.  This issue in the U.S. today is anything but “deflationary” pressures that would succumb to the sword of additional monetary stimuli.  The Fed has boxed itself into the corner of the above noted Bubbles.  It’s inflate or die, postpone the day of reckoning at all costs, and hope for a miracle.  It’s also negligent central banking of historic proportions.  Ironically, Alan Greenspan made the following comments in a speech yesterday on corporate governance and derivatives:  “It is hard to overstate the importance of reputation in a market economy.  To be sure, a market economy requires a structure of formal rules – a law of contracts, bankruptcy statures, a code of shareholder rights – to name but a few.  But rules cannot substitute for character.” Well, we agree wholeheartedly.  Yet there is absolutely no doubt that our central bank is in the process of destroying its reputation as a sound and prudent monetary system manager.  Today’s expedient focus on deflation risk – while disregarding the momentous dangers associated with runaway asset and financial Bubbles – is an act of despicable character.  There will be a huge price for all of us to pay. Surely not coincidently, the day following the Fed’s pronouncement the European Central Bankers made some strong statements related to deflation and sound central banking. The ECB’s views are worthy of our attention.  Reading and listening to recordings of their comments, I was again struck by the Stark Contrast to the economic drivel expounded by Chairman Greenspan and many of our central bankers.  The ECB today is notably informed, astute, focused and disciplined.  As central bankers should be, they remain cautious and conservative. But I also sense an air of confidence becoming of an institution that has achieved the status as the world's premier central bank.  And to appreciate the grounded nature of their monetary analysis and discourse is to recognize that the ECB is clearly winning the battle to manage the world’s premier currency.   Contrarily, the soundness and purchasing power of our currency has been severely and irreparably damaged.  The Greenspan Fed is contemptible.     To illuminate The Stark Contrasts Between Competing Central Banks, I thought it worthwhile to include some pertinent comments made yesterday by ECB officials. ECB President Wim Duisenberg:  “The reasons for not cutting rates were manifold. We need more information about whether recent developments – in particular the exchange rate – will continue or peter out or reverse.  We have to know more.” Wim Duisenberg:  “Since the end of the war in Iraq, financial market volatility has declined significantly, with a notable increase in stock prices. Nevertheless, there continue to be downside risks. First, there are the risks originating from the past accumulation of macroeconomic imbalances outside the euro area, and lately concerns have arisen with regard to the SARS virus.” Wim Duisenberg: “We explicitly do not have an activist short-term oriented policy.  We do not want it.” My comment:  It is the nature of successful central bankers to remain cautious and conservative, with a focus more directed toward monetary stability than economic expansion.  Goals are always long-term and policy is necessarily gradual, incremental, and non-experimental.  The ECB would simply not attempt “activist” policies to manipulate long-term interest rates or to stimulate short-term output growth.  Their overriding focus is on systemic, broad-based monetary and price stability.  The Fed, on the other hand, has for too long acquiesced/accommodated acute monetary instability in hasty pursuit of short-term economic growth catalysts.  This is a losing game and anathema to prudent central banking.  It is also interesting to note the ECB comment, “There are risks originating from the past accumulation of macroeconomic imbalances outside the euro area.”  As consummate central bankers, the ECB likely has a sound grasp of the nature and vulnerability of the U.S. Bubbles.  They would, furthermore, not expect such “accumulated imbalances” to be rectified by continued loose monetary policy from the Federal Reserve.  They want to have their house in order for the inevitable…    European Central Bank board member Eugenio Domingo Solans:  “The situation we analyze today has factors in both directions. On the one hand it’s clear the euro has strengthened and the price of oil has fallen. In this sense, the outlook for inflation is better. On the other hand, the situation of liquidity, of M3 and other variables we also consider, reflect an abundance of liquidity.”  My comment: Recognizing the nature of contemporary, securities-based Credit systems, central bankers must carefully consider the impact of financial market liquidity and Credit availability.  Excessive liquidity must be monitored carefully no matter what the underlying price trend in consumer prices.  Indeed, Credit creation, and the resulting liquidity effects, must be the locus of monetary analysis and management.  Problematic financial and economic imbalances, as we have witnessed repeatedly, emanate directly from Credit and liquidity excess.  The enormous financial and economic risks in the U.S. today are much more associated with the consequences of continued Credit, liquidity, and speculative excess than they are with general deflationary pressures.    ECB President Wim Duisenberg (quoted by Dow Jones – Charlene Lee):  “We also read our newspapers, and we see that here and there the word ‘deflation’ re-emerges.  We do not share this fear for the euro area as a whole. Wim Duisenberg: “To maintain price stability is defined as a rate of inflation of below two percent.  There were views who pleaded for any even tighter interpretation.  There were views who pleaded for a looser interpretation.  In the end, we all agreed that we would have a big credibility problem and create our own credibility problem if we were to even change the definition.  So there was quickly consensus that there was no need - that it would even be dangerous to change the definition.” My comment:  In Stark Contrast to the Federal Reserve, the ECB is absolutely determined to cultivate and safeguard credibility.  As part of the Fed’s “activist” policy approach, our central bank has for too long nurtured and pandered to the leveraged speculating community.  Yes, it remains an incredibly swift (although increasingly ineffective and destabilizing) policy mechanism (encouraging speculative purchases of U.S. Credit market instruments, immediately augmenting Credit availability).  But the very nature of this mechanism nurtures asset Bubbles and resulting distortions – dysfunctional Monetary Processes.  Moreover, it has placed the Fed in the dangerous position of being held hostage to the speculators, capricious financial markets, and destabilizing asset Bubbles.  Importantly, this is precisely the slippery slope of central bank credibility destruction.  And while the leveraged speculators remain to this day a captive audience to Fed pronouncements and policies, there is no doubt that the Fed’s status is in freefall with true (especially foreign) investors.  There will come a day when the manipulative Fed will no longer so easily hold sway over market perceptions (when real investors supplant the speculators as the driving force within the marketplace), and we will all dearly suffer from our central bank’s (and currency’s and markets’) tarnished reputation.  This line of analysis recalls that a key attribute of the classical gold standard was that it was self-adjusting/correcting.  Interestingly, in such a monetary regime speculators – placing bets that excesses and imbalances would be of a short-term nature and rectified either automatically or by determined monetary authorities – would actually be a stabilizing force.  Contrast this to the current environment where the speculators are quite confident in the perpetuation of Federal Reserve monetary mismanagement.  In this circumstance, they will place bets in the direction of continued excesses and imbalances, with speculation working decisively to further destabilize the system.  Again, Stark Contrasts… Otmar Issing: “There’s not the least evidence of deflation in the euro region at the moment.”  Wim Duisenberg:  “In the sixteen years that I was governor of the central bank of the Netherlands there were two years that we had deflation of minus one-half, and I publicly declared that I had lived in the central bankers’ paradise.” Question:  “How do you solve the problem of (the weak) sectors that can go into deflation?” Response from the ECB’s Chief Economist Otmar Issing:  “The concept of deflation is not a question of sectors and countries; it’s a question of the (entire) monetary area.  In all large monetary areas in the world there are regions that are slow and even sometimes negative developments in prices, and others which are higher.  So this is not specific for the euro area, but has nothing to do with deflation.  Deflation is a concept related to monetary policy for the whole entity - for the average of monetary area.  Sector price developments, this is a question of relative prices.  And it’s quite normal.  For example, in the computer sector you’re at extreme declines.  Telecommunications, this is daily lives and even strong declines in prices.  This is a question of relative prices of a market economy.  This is totally different from the concept of deflation…” My comment:  Dr. Issing’s analysis is, as expected, both quite astute and most pertinent.  The problem in the U.S. today can be succinctly explained as – in contrast to a nebulous risk of deflation - a dilemma of keenly divergent “relative prices.”  Goods prices have been under moderate downward global pricing pressure, while U.S. homes, land, bonds, mortgages, sports franchises, and many “services” prices have been inflating rapidly.  While expedient, any narrow focus by the Fed and Wall Street on “core CPI” patently misses the nature of diverse and aberrant Credit inflation that dominates contemporary monetary affairs. Further, the nature of divergent pricing pressures is easily explained by the peculiarity of the deranged U.S. financial system (Monetary Processes).  The Credit mechanism (bankers, investors, Wall Street, and the speculator community) has come to favor the inexhaustible volume and perceived (boom-time) safety of asset-based lending.  So the grossest excesses mount in asset classes such as residential real estate and securities (agency bonds, mortgage-backs, etc.).  We could drop money from legions of cargo helicopters, but it will quickly find its way into real estate, the bond market, and imported goods.  The enormous amount of created purchasing power (money and Credit) required to trickle down to spur the real economy would only further destabilize (inflate Bubbles) asset markets and trade deficits.  Today, in the aggregate, rampant money and Credit inflation runs unabated, although this monetary expansion could not be more uneven or destabilizing. But “this is totally different from the concept of deflation.”  I would add that a market economy will not function effectively over the long-term with an uncontrolled Credit system and unrestrained speculation.   Regarding the current environment, “reliquefication” runs unabated.  Yet resulting Credit excess continues to be overwhelming dominated by the mortgage arena, acting to restrict the dispersion of liquidity evenly throughout the imbalanced U.S. Bubble economy.  While it is understandable that we “bearish” analysts highlight the apparent ineffectiveness of the “reliquefication” to thus far stimulate business investment and employment gains, we need to tread carefully along this line of reasoning.  Perhaps the more salient point to garner is that the extraordinary nature of recent lopsided Credit growth (and speculative excess) is perceived quite positively in the Credit market – that the current strain of financial escapades has the potential to run to unusual excess without consequences that would tempt the Fed to take the punch bowl away anytime soon.  After all, if the enormous quantities of new Credit were instead being spread evenly throughout the real economy, there would certainly be heightened trepidation in the interest-rate markets.  Players would need to discount the probability that economic recovery could take hold, that general pricing pressures could mount, and that the Credit market (and its bevy of speculators) would need to begin contemplating the end to the halcyon days of extreme Fed accommodation.  Well, these are anything but normal times, and this is a most atypical market environment.  So there is today apparently no need for market nervousness.  The Credit system and economy are so distorted and imbalanced that a general recovery is not yet in the cards.  Thankfully, for the aggressive leveraged players, the general economy will most certainly struggle.  And, at least for now, the Fed and Wall Street can point to the weak goods sector, restrained “core” consumer inflation, and ramble on about the risk of deflation; and they can do it all with a straight face.  Meanwhile, the Great Credit Bubble runs out of control and the value of our currency and perceived financial wealth is quietly inflated away.  This is no way to run a monetary system, financial markets or an economy. The Ultimate Moral Hazard Card Being Played?

04/24/2003 Reliquefication *

I am out of the office today (Friday) but rushed a few things together yesterday.  My apologies…  Depending on tomorrow’s markets, economic data (GDP, New and Existing Home Sales!), and news, I may add additional comments by Monday morning.   Stocks generally ended the week higher with the S&P 500 and Nasdaq gaining 0.6%, the smaller cap Russell 2000 up 1.3% and the Dow lower by 0.4%. Tech stocks had a mixed week with the Nasdaq 100 losing 0.3%, the Morgan Stanley High Tech index gaining 0.3%, TheStreet.com Internet index up 0.3%, the SOX down 2.4%, software stocks off 0.2%, and the Nasdaq Telecommunications index up 1.4%. Financials were also mixed with banks losing less than a percent and broker dealers adding less than a percent. Cyclical stocks were among the best performing groups with the Morgan Stanley Cyclical index gaining 1.6% while consumer stocks added 0.8%. Biotech stocks jumped 8.3% while oil stocks slid 1.7%. Year to date, tech groups are the clear winners with the SOX ahead 12.3%, the Nasdaq Telecommunications index up 14.8%, TheStreet.com Internet index up 15% and the Nasdaq 100 up 10%. In contrast, gold stocks have lost 14.6% this year as measured by the Gold Bug index. Treasury yields fell with the 10-year closing out the week at 3.89% vs. 3.95% a week ago. The short end of the curve fell sharply with the 2-year closing at 1.57% vs. 1.67% the prior week. The CRB index ended the week about unchanged. Spot gold prices moved higher to $334.04 vs. $325.95 a week ago, but gold stocks fell 2.4% nonetheless. The dollar index weakened to 98.36 vs. 99.28 the prior week. April 23 – Dow Jones (Henry J. Pulizzi):  “Ford Motor Credit Co. tapped the European corporate bond market Wednesday, just a week after strong first quarter earnings helped ease concerns about weak profitability, pension liabilities and downward pricing pressure. The financing arm of Ford Motor Co. sold EUR1.5 billion in 5.5% three-year bonds, taking advantage of a recent sharp tightening in credit spreads.  Though fears over the company’s condition linger, the Ford deal met heavy demand from European investors desperate for higher-yielding assets. The transaction, EUR500 million larger than expected, was put together quickly over the course of the day and garnered more than EUR3.5 billion of orders.” April 22 – Dow Jones:  “BMW Financial Services Tuesday sold its $1.6 billion securitization of retail auto receivables at levels that are believed to be the tightest ever for an auto-backed issue, according to syndicate sources.  The asset-backed offering is the first this year from the BMW Vehicle Owner Trust securitization vehicle… Sources familiar with the offering said that the various tranches were two-three times oversubscribed ahead of the pricing.” April 23 – Bloomberg:  “The U.S. is trying to push the dollar lower against the euro to narrow its trade deficit and retaliate against Germany and France for their opposition to the Iraq war, German magazine Der Spiegel said.  ‘This will be Europe's invisible contribution to our Iraq costs,’ an unidentified U.S. official told European policy makers in Brussels, according to the magazine. The U.S. has given up its strong dollar policy, the official said.” Interestingly, dollar weakness seems to broaden by the week.  The euro again traded above 110, with the dollar nearing a record low against the European currency.  Year-to-date, we see that the Brazil real has gained 19% against the dollar, the Argentine peso 18%, South African rand 18%, Australian dollar 10%, and Canadian dollar 8%.  This week, British pound trades to a five-week high against the dollar; the Swedish krona trades to a three-year high; the South African rand to a 2 ½ year high; the Israeli shekel to a 15-month high.  Mexican peso trades to the highest level against the dollar since early January and the Brazilian real to the highest level since August.  (Argentine stocks traded to five-year highs this week.) April 22 – Wall Street Journal (Ray A. Smith):  “AS INSURANCE COSTS continue to rise, property owners are looking everywhere they can to help rein in the costs. Among their tactics: bulking up deductibles, using disposable cameras to document damage and having get-togethers with insurers… Property-insurance costs for building owners have been rising since 2001, though 2003 policies show the rate of increase has begun to slow. After going up as much as 90% on average in 2002, premiums rose 10% on average for policies signed covering 2003, says New York insurance broker Marsh Inc…” April 22 – Rocky Mountain news:  “The apartment vacancy rate in Colorado outside of Denver shot up to 11.6%, compared to 8.3% a year earlier… Despite the rising vacancy rates, the overall average monthly rental rate has barely budged, down only 1 percent.” April 22 – BusinessWire:  “The Nehemiah Corporation of California, the nation’s leading nonprofit provider of down payment assistance, today announced a series of new hires in key markets to strengthen the Company’s strategic national and local outreach program. As Nehemiah’s new Area Managers, these individuals will be responsible for engaging current and potential industry partners in participating in Nehemiah’s down payment assistance program… To date, Nehemiah has provided more than $500 million in down payment assistance gifts, resulting in over $15 billion in real estate transactions and has helped nearly 150,000 families and individuals achieve their dream of homeownership.” Economic data remain mixed and inconclusive.  This week’s ABC News/Money Magazine reading on consumer confidence jumped to a seven-month high.  Bankruptcy filings increased to 34,793, up 12% y-o-y.  Mortgage applications dipped again, with Refis down 8% and Purchase applications declining 4.3% for the week.  Yet these are declines from very strong levels, with year-over-year increases of 287% and 2.4% respectively.  Both the Bank of Tokyo-Mitsubishi (BTM) and Redbook weekly retail sales indices posted strong gains.  BTM had y-o-y sales up 4.4%, with Redbook up 2.2%.  But these comparisons may have been impacted by this year’s late Easter.  March’s 2.0% gain in Durable Goods Orders compares to the forecast of a 0.5% decline.  Impressively, gains were surprisingly broad based.  Capital Goods orders were up a noteworthy 3.2% (reversing February’s 2.5% decline).  Machine orders were strong, as were orders for computers and electronic products.  Orders for Defense goods surged 16%. At this time, there is mounting evidence that we are in the midst of major “reliquefication” in some ways similar to the post-Russia/LTCM collapse episode back in the autumn of 1998.  The financial sector is expanding aggressively, with extraordinary Credit growth, Credit market speculation, and consequent financial system over-liquidity.  The 1998/99 “reliquefication” deluge provided the necessary fuel to propel the technology and stock markets – “sectors” with already strong inflationary biases – into the precarious “blow-off” stage of terminal excess.  And, importantly, these extraordinary inflationary manifestations were magnets for global speculative finance, inciting a self-reinforcing “blow-off” melt-up for the dollar as well (much at the expense of other markets and economies, especially Latin America).  We then ask ourselves today:  If this “reliquefication” is sustained, what will be the nature of prospective inflationary manifestations?  First of all, unlike 1998, we don’t see an inflationary/speculative bias in the technology, stock market, or dollar arenas.  In fact, the dollar is an especially weak asset destined to suffer from ongoing runway U.S. Credit Bubble excess.  So, then, what are the “sectors” likely to be over-stimulated by dangerous (Credit) inflationary manifestations?  This is where things get interesting.  Certainly, there is a strong inflationary bias in the government sector and throughout healthcare and energy, which I expect to continue.  The housing sector has been enjoying in an enormous boom for several years now, but its prospects are much less clear.  There is certainly evidence supporting the view that the expansion is quite long in the tooth: home ownership is at record levels, the inventory of unsold homes is expanding; there are rising foreclosures and delinquencies nationally; and there are clear signs of problems in some markets (Denver and Dallas).  And with stagnant job growth, there is reason to question the strength of future housing demand.  Some even go so far as to claim that “deflation” is already impacting the housing sector.  Yet, it would have to be a very strange stain of “deflation,” as lending records are being shattered and the S&P Homebuilder index is up 22% year-to-date. The bottom line is that unprecedented mortgage Credit growth runs unabated, with it likely that the first quarter will post another period of double-digit household debt growth (on top of the 50% expansion over five years).  There remain millions of renters who would love to be homebuyers, and millions of owners that would enjoy nothing more than to move up to that larger dream home.  The household sector has fully discovered the “wealth creating” power (“homes for the long-term”) of aggressive mortgage borrowing.  Correspondingly, virtually the entire U.S. financial sector has recognized that there is one special sector that affords easy profit growth (and minimal “risk”!).  There are “nonprofit” groups springing up all over to provide down payment assistance to those with no savings, while lending standards could not be easier for those wishing to use inflated home equity to trade up.  Frankin Raines endeavors to grow Fannie Mae by more than double-digits.  And, importantly, the expanding national homebuilders have unlimited access to cheap finance, in one more extraordinary development that we can credit to contemporary structured finance.  In short, these are exceedingly powerful forces, with the mortgage finance arena retaining an extraordinarily strong inflationary bias.  Inflationary psychology could not be more ingrained throughout mortgage finance.  With this in mind, as we continue to analyze unfolding developments, we will look to mortgage finance as the “epicenter” for Credit growth, as well as a sector quite susceptible to inflationary forces.   April 24 – American Banker (Hannah Karp):  “Healthy mortgage lending was the highlight of a generally lackluster economy in March and early April, according to the Federal Reserve (beige book) report… Mortgage lending remained strong in most districts…” I thought it worthwhile to extract relevant residential real estate comments from the various District reports (Philadelphia did not address real estate). Boston – “Residential real estate markets in New England remain very strong. After substantial increases in 2002, prices have either leveled off or have increased at a moderate rate this year… Most respondents continue to complain about lack of inventory.  The shortage of supply is especially severe in the lower-to midprice range.  In most areas, such houses sell as soon as they are listed and often at or even slightly above their asking prices… Sales remain robust throughout the region, limited only by lack of inventory.” Chicago - “Realtors said that existing home sales were still strong but may have leveled off in recent months, while builders suggested that sales and construction of new homes slowed somewhat in March.” Atlanta - “Low mortgage rates continued to propel District housing markets in January and February.  The strongest reports in the District were from Florida…” New York - “Residential real estate markets appear to have slowed since the last report.  Home construction activity, as measured by housing permits, fell noticeably in the first quarter, hampered by heavy snow accumulations across much of the District.  New Jersey homebuilders report that demand for moderately priced homes has remained fairly sturdy…” St. Louis - “Home sales are still doing well in most of the District.  The Memphis area saw an increase in total home sales of about 13 percent in February 2003 compared to February 2002. Similarly, northern Kentucky saw an increase of 26 percent.  Contacts in St. Louis and northwest Arkansas reported that home sales were still strong in January.” Minneapolis - “Residential building and real estate activity continued to show signs of strength.  Housing units authorized in District states were up 15 percent for the three-month period ending in February compared with a year ago.” Dallas - “Single family activity remains soft, with numerous foreclosures, particularly in the Dallas-Fort Worth area.  Although activity is still moderately strong in the market’s low end, several contacts mentioned a lack of “urgency” among buyers.  Builders report an increase in incentives and downward pressure on home prices.” San Francisco - “…Contacts indicated that residential housing markets across much of the District remained robust in January and early February.  Sales of low-to-median priced homes remained high in most of the District, especially in Southern California and Hawaii, although the pace of sales and of price appreciation has moderated in some areas. Throughout the District, contacts noted that markets for high-end homes had cooled off.  Respondents attributed continued strength in overall home sales primarily to low mortgage interest rates.” Kansas City - “Residential real estate activity in the District continued to show strength in March and early April… Single-family housing starts increased further in most District cities, with builders reporting little effect from the onset of war.  Much of the increase continued to be for lower-priced homes, although several contacts mentioned some pickup in higher-end homebuilding as well… Many realtors reported good buyer traffic in recent weeks and expect solid sales to persist into the summer months.  Mortgage demand continued to be quite strong…” Cleveland - “District homebuilders continued to report steady sales, at levels roughly 3 percent to 5 percent higher than a year ago.  Although severe weather resulted in some slowing in sales and customer traffic in January and February, contacts reported that March sales and traffic were significantly higher, and quarterly sales were above most firms’ projections.” Richmond - “Residential real estate agents reported stronger growth in home sales since our last report.  A Richmond realtor said that sales were ‘great,” noting that his office posted record sales in March.  A realtor in Fredericksburg, Virginia, said that home sales over the last two months had been exceptionally strong: in her words the brisk activity was ‘wonderful,” but ‘exhausting.’” April 23 – Financial Times (Goldman’s Bill Dudley and Pimco’s Paul McCulley):  “The Federal Reserve has won its long war against inflation. And, with victory, go the spoils - evident in President George W. Bush’s decision to reappoint Alan Greenspan for another term as chairman. But to ensure an enduring legacy, Mr. Greenspan now needs to solve a different problem: inflation is too low, rather than too high.  How so? The economy needs a buffer of inflation above price stability to ensure that monetary policy has room to work effectively in the event of shocks to aggregate demand. The inflation rate should be high enough to allow the economy to take a shock without falling into deflation. …the Fed should commit to keeping its federal funds rate at or below the current 1¼ per cent until core inflation climbs back to, say, 2 per cent or higher on a year-on-year basis. The current reading of about 1½ per cent (on Mr. Greenspan’s preferred measure, the core PCE deflator) is right in the middle of the 1-2 per cent range that Ben Bernanke, Fed governor, recently suggested as the working definition of price stability.” Well, any hope that the inflationists’ might tone it down a little has apparently been lost.  The financial world has changed a lot since those dark days last October, but that terrible evil “deflation” apparently still lurks around every corner.  And while a deranged Credit system runs completely out of control, it is suggested that the Fed’s primary responsibility is to fight some phantom “deflation” risk and soundly beat it like they are said to have whipped inflation.  Though it may sound reasonable, it strikes me as disingenuous.    In the midst of rampant Credit excess, a faltering dollar, rising energy and import prices, surging insurance and healthcare costs and, even, generally rising consumer prices - rising interest rates would today be expected to pose heightened risk to Wall Street.  Yet rising rates would immediately place the leveraged speculators and Wall Street’s momentous Credit market speculative (and derivative) Bubble in serious jeopardy.  Remember 1994? (Yet the Bubble was so comparably tiny back then) So, propaganda and disinformation will be the order of the day.  We should expect to read a lot about the nebulous deflation risk from Wall Street and listen to increased chatter from the Fed about how they could move to “peg” long-term interest rates if necessary.  And I guess Credit and speculative excess can run absolutely wild, with additional deleterious effects on the real economy.  Mortgage Finance and housing markets can go to even greater levels of excess.  Financial sector expansion can become even more extreme and dangerous, and our trade and fiscal deficits can balloon forever.  That is, they tell us, as long as the core PCE deflator stays below a few percent.  The whole thing gets more ridiculous by the week.           From Dudley and McCulley:  “Expectations are what drive markets. By shaping expectations - and anchoring inflation expectations in positive territory with a buffer against deflation - the Fed could get the more exuberant economic recovery it desires, with less risk of deflation.”  Yes, stoking inflationary expectations may sustain the Credit system and economic Bubbles.  But at what cost?  And how does one ever plan on reigning in the Credit and speculative excesses and coming to grips with disastrous asset Bubbles, financial fragility, economic impairment and a dollar problem?  It’s a losing game with very high stakes.