07/24/2003 Struggling Team Greenspan-Bernanke *

It appears wild volatility has likely returned to the stock market. On the back of generally favorable earnings reports, the Dow gained 1% and the S&P 500 less than 1%. 3M, Alcoa, and AT&T were this week’s leading Dow gainers. The Transports enjoyed a solid week, adding 1.5%, while the Utilities were unchanged. The Morgan Stanley Cyclicals gained 2.9%, while the Morgan Stanley Consumer index was slightly positive. The broader market was generally firm, with the small-cap Russell 2000 gaining almost 1%. The S&P 400 Midcap index was down slightly. The tech-heavy Nasdaq100 added better than 1%, increasing y-t-d gains to 30%. High tech strength continued, as the Morgan Stanley High Tech index rose by 2.3% (up 35% y-t-d). The Semiconductors added 1.8% on the week, increasing 2003 gains to 35%. The Street.com Internet index gained 2.4% (up 46% y-t-d), and the Nasdaq Telecom Index returned 0.7% (up 40% y-t-d). The Biotechs gave back 1% this week. Financial stocks enjoyed gains, with the Broker/Dealers and Banks up 1%. With bullion up $15.50, the HUI gold index surged 16%. The bond market remains extraordinarily volatile. For the week, two-year Treasury yields added 1 basis point 1.50%, while 5-year Treasury yields added 12 basis points to 2.98%. Ten-year yields closed the week at 4.18%, up a noteworthy 18 basis points. The long bond also saw its yield jump 18 basis points to 5.12%, the highest yield since early January. The yield on benchmark Fannie Mae mortgage-backs jumped 16 basis points, while the implied yield on agency futures surged 22 basis points (up 87 basis points from June lows!). The spread on Freddie’s 4 ½% 2013 note widened 5 to 43, and the spread on Fannie’s 4 3/8% 2013 note widened 4 to 43. The benchmark 10-year dollar swap spread increased 2.75 to 41.5, the widest since mid-April. Interestingly, corporate debt outperformed, with investment grade spreads narrowing modestly and speculative grade spreads impressively. The dollar rally came to an abrupt halt, with the dollar index declining almost 2% this week. In a fascinating development not indicative of marketplace adulation for Fed policies, the yield curve is becoming unusually steep. The spread between 2 and 10-year Treasuries closed today at 267 basis points, 16 wider for the week, 30 wider for two weeks, and almost 50 wider over four weeks. According to Bloomberg, this is “the widest gap in more than a decade.” All the same, it was another week of solid debt issuance. In the investment grade market, Wachovia issued $1.25 billion, American Express $1 billion, Lehman Brothers $1 billion, First Data $1 billion, Fifth Third Bancorp $500 million, Marsh & McLennan $300 million, IBM $250 million, Vectren Utility $200 million, Old Dominion Electric $250 million, Union Electric $200 million, Con Edison $200 million, National City Bank $250 million, and Dominion Resources $510 million. It was another big week in the junk area. Nextel priced $1 billion, ACC Escrow Corp. $900 million, Rural Cellular $325 million, Delphi Automotive $500 million, HCA $500 million, Westlake Chemical $380 million, Mandalay Resort $250 million, Kinetic Concepts $205 million, Payless Shoesource $200 million, and Westinghouse Air $150 million. And there were a handful of converts priced. Health Management Association sold $500 million, Chiron $450 million, Quantum Corp. $160 million and America West $75 million. Broad money supply (M3) declined $3.1 billion last week, this following the $125 billion surge over the previous two weeks. Demand and Checkable Deposits dipped $1 billion, while Savings Deposits added $2.7 billion. Small Denominated Deposits declined $2.1 billion, and Retail Money Fund deposits dropped $7.9 billion. Institutional Money Fund deposits declined $1.0 billion. Large Denominated Deposits added $600 million after last week’s $62.5 billion surge. Repurchase Agreements declined $2.2 billion, while Eurodollars increased $7.8 billion. Elsewhere, Total Bank Assets declined $19.5 billion during the week of July 16th. Securities positions sank $62.7 billion. Loans and Leases rose $28.7 billion, with Security loans up $24.6 billion. Commercial and Industrial loans added $1.2 billion and Consumer loans gained $3.1 billion, while Real Estate loans dipped $6.2 billion. Foreign “custody” holdings of U.S. debt instruments declined $4.5 billion. There were 31,408 bankruptcy filings last week. Year-to-date filings are up 9.9% (according to J.P. Morgan Equity Research). RockyMountain News (John Rebchook): “In the first six months of the year, there were 4,340 foreclosures in the seven-county (Denver) area…a 38.5 percent increase. (Quoting a local real estate professional) ‘Most of them are dealing with a loss of jobs and not being able to get a job paying the same salary. Another problem is these 125 percent loans. People refinanced and were listening to lenders who were able to get appraisals for unrealistic amounts.’” Freddie Mac posted 30-year fixed mortgage rates surged 27 basis points this week to 5.94%. One year adjustable-rate mortgage yields rose 9 basis points to 3.67%. Thirty-year rates are now up 73 basis points in five weeks. June New Homes Sales were reported at a stronger-than-expected and record pace of 1.16 million units. New Home Sales have surged 24% since February’s low and are now on pace to shatter last year’s record by more than 10%. To put this number into perspective, the trough during the early nineties recession was put in during January 1991 at 401,500 annualized units. The high during the three years 1990 through 1992 was 676,000 units. June sales were up 21% y-o-y, with average (mean) prices up 8.1% to $243,500. Annualized Calculated Transaction Value (CTV) surged 30.8% y-o-y to $282.5 billion. CTV is up 50% over two years (volume up 30% and prices up 15%) and 80% over three years (volume 46% and prices 23%). The inventory of New Homes increased another 4,000 during the month to 345,000, the highest level since July 1996. It is also worth noting that 26,000 New Homes were sold for $300,000 and over. This compares to 15,000 sold in this category during June 2002. Existing Home Sales were reported at a very strong rate of 5.83 million units (double the trough level of 2.90 million units from December 1990), with sales remaining above last year's record pace. The Average Price came in up $12,000 to a record $224,900. The Average Price was up $13,000 in the West to a record $292,200, $8,400 in the Northeast to $238,200, $8,600 in the Midwest to $182,000, and a noteworthy $15,500 in the South to $209,400. Inarguably, broad-based housing inflation runs unabated. And with y-o-y Average Prices up 6.6% and Volume up 8.6%, CTV is up 15.8% to $1.31 Trillion. Existing Home Sales CTV is up 29% over two years (prices 10% and volume 18%), 42% over three years (prices 13% and volume 26%) and 102% over six years (prices 38% and volume 46%). The number of homes available for sale increased 400,000 to 2.50 million, the highest level since September 1991. And there is little indication that higher mortgage rates have tempered overheated housing markets. Despite the mortgage refi application index dropping back to almost 6,000 from May’s record spike to 10,000, purchase applications remain quite strong. Purchase application volume last week was up 26.6% from a year earlier, with dollar volume up a notable 36.9%. From the Los Angeles Times (Elizabeth Kelly): “Overall, last month was the strongest June in the region (Southern California) since 1989… Experts attribute the record prices to a basic rule of economics: Demand is high but the supply of homes is small. ‘The low interest rates spur the buying frenzy,’ said Frank Almeida, a real estate agent based in Riverside. ‘But there is not enough inventory.’ …Prices (y-o-y) rose 16.4% to $313,000 in Los Angeles County, 15.3% to $414,000 in Orange County, 23.8% to $255,000 in Riverside County, 22.6% to $195,000 in San Bernardino County, 20.7% to $390,000 in San Diego County and 18.2% to $396,000 in Ventura County.” According to DataQuick, June Los Angeles County condominium prices were up 20.5% y-o-y, the largest ever price gain. It’s quite a Bubble our Federal Reserve has nurtured out in the Golden State and elsewhere. Today from the California Realtors Association (C.A.R.): “The median price of an existing, single-family detached home in California during June 2003 was $376,260, a 15.9 percent increase over the revised $324,640 median for June 2002…C.A.R’s Unsold Inventory Index for existing, single-family detached homes in June 2003 was 2.3 months…” Amazingly, the average home price in California is up $51,620 over the past twelve months. And while Southern California is white hot, the North is not doing too shabby. Year-over-year prices are up 15.5% in Northern California, 22% in Sacramento, 15.2% in Santa Barbara County and 13.8% in San Luis Obispo. With earnings reporting season, we again enjoy the opportunity to examine the doings of our major financial institutions. Are they increasingly financing investment, or are they sticking with their fixation on asset and consumption-based lending? “An economy is as its financial system lends.” Credit insurer Ambac enjoyed y-o-y EPS growth of 36%. Adjusted Gross Premiums Written surged 65% y-o-y, with Public Finance up 65%, Structured Finance 41%, and International up 123%. The company increased Net Financial Claims in Force (NFCF) by $19.4 billion during the quarter (13.5% annualized growth rate) to $594.8 billion. NFCF (insurance written) was up 18% y-o-y and up 33% in two years. The company ended the second quarter with Statutory Capital of $4.1 billion. Credit card behemoth MBNA Financial expanded Total Managed Loans at a 17% annualized rate during the quarter to $110.5 billion. Total Assets expanded at a 19% rate to $57.2 billion and were up 21% y-o-y. This was up from the first quarter’s 13% growth rate, and the strongest asset expansion since last year’s third quarter. The Managed Loan Delinquency rate dropped 28 basis points during the quarter to 4.46% and was down 34 basis point y-o-y. The Managed Loan Credit Loss rate of 5.35% was down 12 basis points during the quarter, but remains 26 basis points above the year ago level. From Citigroup: “Once again, our consumer business delivered exceptional income growth of 18%, led by 63% growth in Retail Banking…” Total Retail Revenues were up 24% y-o-y. Global Corporate and Investment Bank income was up 2% y-o-y on 7% revenue growth. In North America, Consumer Net income jumped 17% y-o-y, while Corporate Net Income declined 8%. Total Assets expanded at an 18% rate during the second quarter, acceleration from the first quarter’s 15% rate. Examining first-half asset growth, we see that Total Loans were down 2% to $438.6 billion. Meanwhile, Federal Funds Sold and Securities Borrowed or Purchased Under Agreements to Resell surged 20% to $167.3 billion. Trading Account Assets were up 12% to $174.3 billion, and Brokerage Receivables were up 73% to $44.0 billion. Investments were up 11% to $189.0 billion. JPMorganChase: Trading Revenues were up 20% from the first quarter and 102% from last year’s comparable quarter. The Total Credit Portfolio expanded at an 11.8% annualized rate during the quarter and was up 6.2% from the year earlier. Year-over-year, Managed Consumer Loans were up 26% to $176 billion while Commercial Loans were down 13% to $91.0 billion. Curiously, Derivative Receivables were up 34% y-o-y to $93.6 billion, surpassing Total Commercial Loans for the first time during the second quarter. Bank of America reported record Net Income of $2.74 billion, up 23% y-o-y. The company posted record mortgage originations ($40 billion), while “mortgage banking income increased 305 percent to $559 million. Card income increased 23% to $762 million... Credit and debit card purchase volumes increased 9 and 19 percent…” Total Assets surged $89.4 billion during the quarter, or 53% annualized, to $769.2 billion. Total Assets were up 20% y-o-y. During the quarter, Available-for-sale Securities jumped $38.7 billion to $114.3 billion. Total Loans and Leases expanded at a 20% annualized rate during the period, up from the first quarter’s 1% and the fourth quarter’s 2%. Examining Average Loans, Total Commercial Loans contracted at an 11% rate during the quarter and were down 10% y-o-y to $139.1 billion. Total Consumer Loans expanded at a 16% annualized rate and were up 17% y-o-y to $211.2 billion. Residential Mortgages expanded at a 25% rate during the quarter to $120.8 billion, and were up 27% from the year earlier. The company repurchased 30 million shares during the second quarter, while “29 million shares were issued in the second quarter of 2003, mostly due to stock incentive plans.” From Wells Fargo: “The double-digit loan growth was generated primarily by the continued strong consumer demand for residential first mortgage and home equity loans and other revolving credit and installment loans… On a combined basis, average consumer loans and real estate first mortgage loans increased almost $29 billion, or 33 percent, from the same period last year. The Company also had strong loan growth in other key consumer areas, including personal loans and lines of credit, which saw funded balance growth of 46 percent in second quarter 2003, compared with second quarter 2002.” Quarter-over-quarter, “Real Estate 1-4 family first mortgage” loans expanded at a 34% annualized rate (up 42% y-o-y), with home equity loans growing at a 42% annualized rate (up 30.4% y-o-y). Commercial Loans declined at a 4.7% rate during the second quarter. Year-over-year, Total Loans were up $30.4 billion (16.4%), with Commercial Loans increasing $164 million (0.3%). From Washington Mutual: Highlights include “record loan volume of $120.32 billion, up 108 percent from the second quarter of 2002 and 13% higher than the first quarter… Home equity loans and lines of credit and multi-family loan volume increased by 30 percent from the first quarter of 2003 to $9.46 billion and 80 percent from the second quarter of 2002’s $5.27 billion.” Total assets increased at a 9% rate to $283.2 billion. Countrywide enjoyed a phenomenal quarter. “Total fundings were $130 billion for the second quarter, advancing 209% over last year.” From CEO Angelo Mozilo: “Mortgage banking results have been exceptional. Year-to-date fundings were $233 billion, which compares favorably to $252 billion in fundings for all of calendar 2002…” Countrywide’s Total Assets expanded a record $18.2 billion, or 99% annualized. Year-over-year, Total Assets were up 119%. “Bank total assets are now at $13 billion, up from $5 billion at December 31, 2002. The regulator-approved business plan has a goal of $17 billion in total assets by December 31, 2003.” Total Assets are up 480% over the past ten quarters. And with the recent back-up in rates, it is worth noting that the company ended the quarter with $35.7 billion of “mortgage loans and mortgage-backed securities held for sale” and another $10 billion of “trading securities.” New Century Financial (the king of variable-rate non-prime mortgages) saw originations jump 24% from the first quarter to $5.8 billion (up 120% from the year earlier quarter). FastQual, the company’s online product, accounted for $3.3 billion of originations, double the first quarter and compared to $424 million during Q2 2002. “Use FastQual, the fastest automated underwriting system in the non-prime market. Don’t wait all day for loan answers! Just submit loans online at www.NewCentury.com with FastQual, and we’ll give you loan approval answers in just 12 seconds!” “80/20 Combo - Loan amounts to $700,000K fico 580+” Total Assets expanded by $1 billion during the quarter, or almost 150% annualized, to $3.8 billion. Total assets were up 150% y-o-y. June highlights from Fannie Mae: “Total business volume was a record $142 billion, up from $129 billion in May. Fannie Mae’s book of business grew at an extremely strong compound annual rate of 33.1 percent, up from 18.1 percent in May.” For the second quarter, Fannie saw its Book of Business (mortgages retained and guaranteed) surge by a record $126.4 billion, or 26% annualized, to $2.05 Trillion. For comparison, Fannie’s Book of Business expanded $58.1 billion during last year’s comparable quarter. The company’s Book of Business has now ballooned $613 billion, or 43%, over the past 24 months, and has doubled since surpassing $1 Trillion for the first time during September 1998. Year-to-date, Fannie’s Book of Business has surged $230 billion, or at a 25% growth rate. Outstanding Mortgage-backed Securities have expanded at a 40% growth rate to $1.24 Trillion. There are few places where one can find a 40% growth rate on a base of a trillion dollars. From Alan Greenspan’s prepared comments last week before the House Committee on Financial Services: “The prospects for a resumption of strong economic growth have been enhanced by steps taken in the private sector over the past couple of years to restructure and strengthen balance sheets… Nowhere has this process of balance sheet adjustment been more evident than in the household sector. On the asset side of the balance sheet, the decline in longer-term interest rates and diminished perceptions of credit risk in recent months have provided a substantial lift to the market value of nearly all major categories of household assets. Most notably, historically low mortgage interest rates have helped to propel a solid advance in the value of the owner-occupied housing stock… On the liability side of the balance sheet, despite the significant increase in debt encouraged by higher asset values, lower interest rates have facilitated a restructuring of existing debt.” Our Fed chairman continues to propound dubious analysis; financial historians will not be kind. For one, he confuses cause and effect. Household sector asset prices - real estate in particular - are inflating specifically because of incessant household sector borrowing excesses and aggressive financial sector expansion. Keep in mind that household sector debt increased by more than $3 Trillion to $8.6 Trillion since the end of 1997, or 55% in just over five years. To claim that household balance sheets have been “strengthened” is simply one more ridiculous statement by our top central banker. Curiously, during the late nineties, when equities were the inflating asset of choice, the Fed at least paid lip service to the important issue of asset Bubbles. Today, with much more dangerous (and conspicuous) asset inflation running rampant, the Greenspan Fed has conveniently abandoned the issue. The above quarterly results from some of our major financial institutions indicate it is quite likely that second-quarter household mortgage borrowings will be even stronger than the first quarter’s 12% annualized pace. As we are again witnessing, asset Bubbles are incredibly seductive specifically because everything – including ballooning balance sheets – appears just marvelous; that is as long as additional Credit excess is forthcoming. But just as the telecom sector experienced post-Bubble, things can sour quickly when Credit Availability falters, asset values reverse, and bloated liabilities wreak increasing havoc on stressed balance sheets. If it were not silly enough to trumpet that (asset inflation-induced) “net worth of households is estimated to have risen 4 ½ percent” during the first half, Mr. Greenspan further pushed the envelope of acceptable central banking with the following: “Is it important for an economy to have manufacturing? There is a big dispute on this issue. What is important is that economies create value, and whether value is created by taking raw materials and fabricating them into something consumers want, or value is created by various different services which consumers want, presumably should not make any significant difference so far as standards of living are concerned because the income, the capability to purchase goods is there. If there is no concern about access to foreign producers of manufactured goods, then I think you can argue it does not really matter whether or not you produce them or not.” Again, future financial historians will not be impressed. This returns us to the critical issue of the “Quality of Output.” And it is similar to how companies can inflate earnings (“quality of earnings”) for quite some time seemingly without consequences, until the inevitable day arrives when it is discovered that assets have been overvalued. If assets are worth less than liabilities, crisis is then unavoidable. I have argued that a service sector economy is in reality a monetary economy. And, yes, as long as money and Credit are fabricated in great abundance, we do command the wherewithal to provide “services” to one another, seemingly without a hitch. We can treat each other to massage, consulting and legal services, brokerage inflating home and security transactions, and prepare each other’s meals. There is also nothing stopping us from gleefully boasting of our “economic output” and miraculous "productivity." But, at the end of the day, there’s a balance sheet problem: there’s no getting around the reality that we are creating (inflating) financial claims with little true economic value supporting the market value of this debt. We are simply playing an illusion with imputed market values detached from true wealth creation. Mr. Greenspan is dead wrong on this most important issue. It matters tremendously that our economy continues to lose its capacity to create sufficient manufactured goods. First, we are no longer self-sufficient, and are vulnerable to price inflation and availability issues for energy and an increasing array of products. Second, we have lost the capability for mutually beneficial trade and balanced global growth – sustainable trade of goods for goods. Instead, we trade new financial claims for goods, building up a mountain of foreign liabilities, while fearing the day our creditors question the financial integrity of their holdings. There is the crucial issue of financial fragility: as an economy we are massively inflating financial claims without the backing of tangible assets or the capacity to produce true economic wealth. Moreover, the longer the Credit Bubble is allowed to inflate, the greater the economy’s shift away from (profit constrained) manufacturing to (currently more profitable asset-inflation based) services. And the longer this inflation is fostered, the more the rising domestic cost structure impedes our global competitiveness. It is simply unbelievable that Mr. Greenspan does not appreciate these critical dynamics. Yet it does help to explain why there is little concern with our financial system’s fixation on asset and consumption-based lending, as opposed to financing business and capital investment. Apparently, the quality of financial assets matters about as much as the quality of economic “output.” Well, the nature of output is vitally important when its creation is being financed by new financial claims. And the quality of financial assets matters tremendously when they are being accumulated by foreign creditors. Fed Governor Ben Bernanke’s speech Wednesday was similarly unimpressive and dishearteningly detached from today’s critical issues. His opening sentence: “Achieving and maintaining price stability is the bedrock principle of a sound monetary policy.” If Mr. Bernanke focused on broad price stability, including real and financial asset prices, then we might begin by sharing some common ground. But for his definition of “price stability” he is content with an ultra-narrow focus on “Core CPI.” Especially considering the dynamics of contemporary market-based financial systems and asset inflation-centric economies, it is simply flawed central banking to fixate on such an inconsiderable component of total prices within an economic system. Instead, “the bedrock principle of sound monetary policy” should today be financial stability and balanced economic growth. Dr. Bernanke, a long-time proponent of inflation targeting, also made interesting comments regarding the Fed’s May 6th policy statement: “A crucial element of the statement was an implicit commitment about future monetary policy; namely, a strong indication that, so long as a substantial fall in inflation remains a risk, monetary policy will maintain an easy stance. Particularly at very low inflation rates, a central bank’s ability to make clear and credible commitments about future policy actions--broadly, how it plans to adjust the short-term interest rate as economic conditions change--is crucial for influencing longer-term interest rates and other asset prices, which are themselves key transmission channels of monetary policy.” I am reminded of Hyman Minsky’s brilliant proposition that “stability is destabilizing”: A protracted period of economic and financial tranquility increasingly foments destabilizing behavior (borrowing, spending and speculating excess, for three). Following this line of reasoning, a policy that “makes clear and credible commitments about future policy actions” - for today’s speculative-rife financial markets - is a recipe for serious trouble. Indeed, Dr. Bernanke would like to implement a process (“inflation targeting”) whereby monetary policy becomes quantitative and mechanical, dictated by core CPI prices. But such certainty and predictability, as we have witnessed, only incites destabilizing excess (If we are confident that rates are going to stay low, why not take huge leveraged bond positions financed by cheap overnight funds?). “The main purpose of this quantification of price stability would be to provide some guidance to the public as they try to forecast FOMC behavior… the Fed could make use of this quantitative guidepost to signal its expectation that rates will be kept low for a protracted period…” Ironically, such a “guidepost” would only be a more formidable adversary to financial stability. The Fed would be advised to withdraw from the business of “influencing longer-term interest rates and other asset prices.” With an enterprising leveraged speculating community of unprecedented dimensions, Fed efforts to manipulate the marketplace are both destabilizing and increasingly dangerous. Yet I do recognize that the Fed is now fully immersed in desperate measures to perpetuate a (John Law-style) financial scheme/Bubble. This past October, with the corporate debt crisis spiraling out of control and threatening to engulf the vulnerable consumer debt sector, the Fed saw little alternative than to resort to desperate measures. They (again) incited a major “reliquefication,” while at the same time talking “deflation” and the possibility of adopting measures to push long-term rates lower. Well, this clever approach proved too “successful.” The speculator crowd all rushed to the other side of the boat. Financial markets then turned over-liquefied and long-term rates collapsed. The Mortgage Finance Bubble ran completely out of control, with borrowing rates collapsing in market dislocation. Mr. Greenspan was forced to take notice. So things are becoming more interesting. The bond Bubble has been pricked, which draws our keen attention as to the ramifications for the historic Mortgage Finance Bubble. Things become all the more fascinating with troubles brewing at the GSEs, as rumors (noted by the Financial Times) circulated this week, “that the European Central Bank had recommended central banks cut their holdings of so-called agency debt…” Well, well, well, just wait until the GSEs are faced with the specter of inevitable post-Bubble Credit losses. Noting that agency spreads have widened signficantly of late, we recall how telecom debt spreads began to widen back in mid-1999 (and a few marginal companies began to quietly falter). And while there was little on the surface to cause great concern back then – after all, the Bubble was raging out of control and manic behavior would be sustained for several more quarters – an important inflection point in market dynamics had passed. Borrowing costs began to rise for the marginal companies, while Credit Availability began to tighten on the fringes. The huge speculator community, having inundated the sector with liquidity, was finding it more difficult to achieve expected heady gains. Some began to suffer losses. Importantly, speculative flows began to slow, setting in train the failure of the next marginal company. Credit availability became more restrictive and speculative losses began to mount. Eventually a full-scale retreat of speculative finance from the sector ushered in spectacular collapse. There was one more facet to the technology boom worth contemplating. Many sophisticated players recognized clearly that the tech sector was a major speculative Bubble. They were, nonetheless, determined to play it for all it was worth - that’s what they do for “a living.” Yet they were fully expecting to front-run the crowd to the exit when things began to unravel (the greatest gains, after all, are achieved during the final speculative blow-off!). Many were run over, overstaying the game and miscalculating how quickly greed can be transformed to fear (and illiquidity). The point being that I believe many of the sophisticated global players keenly appreciate the nature of the U.S. agency/mortgage finance/dollar Bubbles. They will play it for all its worth – especially with the confidence that Team Greenspan/Bernanke will stop at nothing to perpetuate the Bubble – but they will have one eye on the exit. This week saw agency debt prices weaken significantly, with spreads increasing to the widest level in four months. Over the past two weeks, 10-year U.S. Treasury yields have gone from 20 basis points less than 10-year German yields to almost 20 basis points higher. And this week the dollar rally abruptly reversed, with gold enjoying its strongest weekly gain in 17 months. There are, as well, calls at home and abroad to devalue the dollar against the Chinese currency. Why do we sense this is playing with fire? And while there is understandable complacency regarding the ramifications of a weak dollar for today’s liquid stock market, there are a few things to keep in mind. First, with market perceptions seemingly of the view that the dollar has experienced the worst of its self-off, any serious return of dollar weakness could catch players (speculators, derivative players, and foreign investors) unprepared. Second, weak private demand has necessitated foreign central banks to acquire enormous dollar holdings over the past several months. Is this sustainable and have foreign central bankers been shaken by the unexpected backup in rates? Third, we don’t see Inflationist Team Greenspan/Bernanke instilling much market confidence, especially to our foreign creditors. Their deflation and “unconventional measures” intimations play much better when bond prices are rising. And finally, it is worth noting that dollar weakness over the past 18 months has run concurrently with a virtual melt-up in bond prices. Foreign holders of Treasury and agency securities have enjoyed huge capital gains to off-set currency losses. There was also the (reliquefication-induced) collapse in spreads helping to mitigate dollar weakness. We operate today in an extraordinarily unsettled financial environment dominated by leveraged speculation and U.S. foreign liabilities of unprecedented amounts. It is our sense that the “leveraged speculating community” has been rattled by wild equity, currency, and bond market volatility. With this in mind, we should be prepared for heightened volatility. We have always believed that systemic stress would be most aggravated in an environment where the dollar weakened, bond prices declined, and spreads widened. Such a scenario exposes the speculators, derivative players, and our foreign creditors to the greatest risk of abrupt and significant losses (and resulting acute financial fragility). Such a scenario is, all of the sudden, not a low probability event. Dr. Bernanke may trumpet the death of core CPI inflation, but acute financial instability is alive and extraordinarily vibrant.

07/10/2003 North Atlantic Tides *

The rally continues, as stocks were led higher by (surprise) the highflying Biotech, Semiconductor and Technology sectors.  For the week, the Dow gained 0.5% and the S&P added 1.3%.  Altria and Coke were hit hard but it was otherwise a good week for the Dow components.  The Transports were very strong on the week, rising 5.4% while the Utilities were pared back 3.3%.  The Morgan Stanley Cyclicals added 2.6% with the Morgan Stanley Consumer index flat.  The broader market showed continued strength.  The Small-cap Russell gained almost 4% and the S&P 400 Midcap added about 2%.  The Nasdaq100 rose a full 4% this past week, increasing year-to-date gains to above 30%.  High Tech showed no signs of abating, as the Morgan Stanley High Tech index rose by 3.7% (up 36% y-t-d).  The Semiconductors posted a 6% surge on the week, upping 2003 gains to 35%.  The Street.com Internet index gained 3.2% percent (up 51% y-t-d) and the Nasdaq Telecom index returned 4.7% (45% y-t-d).  The speculative Biotechs added 5.7% this past week, increasing 2003 y-t-d gains to 38%.  Financial stocks were strong as well.  The Broker/Dealers added 3.6% and the Banks gained 3%.  With bullion sinking $6.20, the HUI gold index declined 1.7%. The Credit market took the global stock market rally in stride.  Two-year Treasury yields declined 3 basis points to 1.28% and five-year yields fell 4 basis points to 2.45%.  Ten-year Treasury yields closed the week at 3.63%, down 2 basis points, while the long bond saw yield was about unchanged at 4.68%.   The spread on Freddie’s 4 ½% 2013 note widened six to 38, and the spread on Fannie’s 4 3/8% 2013 note widened 5 to 39.  The benchmark 10-year dollar swap spread increased almost 2 to 37.  Corporate spreads generally narrowed, with junk performing well.  The dollar rally continues, with the dollar index gaining better than 1%.  The CRB index was about unchanged, with crude oil trading to the highest prices since March. Although issuance has now lagged somewhat for two weeks, nearly $10 billion of corporate debt was sold this week.  Goldman Sachs issued $2 billion of bonds, SLM Corp $1 billion, Ohio Power $450 million, Buckeye Partners $300 million, Hartford Financial $320 million, Wells Fargo $200 million, John Deere $200 million, Fairfax Financial $150 million, and Entergy Gulf States $200 million.  The junk area was quieter, although energy operator Calpine’s $2.55 billion offering was the largest in the junk market since 1999.  Strong demand caused the company to double the original size of the deal.  Other junk issuers included Western Wireless selling $600 million, Rockwood Specialties Group $375 million, CMS Energy $300 million.  The convert market remains on record pace.  Medimmune issued $500 million of converts, TXU Energy $475 million, CMS Energy $150 million, Jetblue Airways $150 million, and Protein Design Labs $250 million.  Broad money supply surged an eye-opening $63.1 billion (to $8.83 Trillion), the strongest weekly gain since the Fed’s post 9/11 liquidity operations.  M3 has now expanded $255.4 billion over the past 11 weeks, a 14% annualized growth rate, with y-o-y growth at 7.9%.  M3 is up $3.6 Trillion, or 70%, in six years.  For the week, Demand and Checkable Deposits gained $12.0 billion.  Savings deposits rose $8.4 billion (up $63.8 billion in five weeks).  Small Denominated Deposits declined $3.8 billion, while Retail Money Fund deposits gained $5.5 billion.  Curiously, Institutional Money Fund jumped $52.6 billion, with three-week gains of $67.6 billion.  Large Denominated Deposits declined $8.5 billion.  Repurchase Agreements dipped $1.2 billion and Eurodollars declined $1.5 billion.  Fed “custody” holdings increased $2.3 billion.  Total Bank Assets added $7.4 billion, while Bank Credit surged $48.1 billion.  Securities holdings rose $8.5 billion, with “Other” non-Treasury positions up $14.3 billion.  Loans and Leases surged $39.7 billion.  Real Estate loans jumped $27.5 billion, while Commercial and Industrial loans expanded $5.1 billion.  “Other Loans” jumped $29.9 billion.  Elsewhere, Commercial Paper increased $15.1 billion last week, with two-week gains of $36.2 billion.  CP has now increased to the highest level since September.  Financial sector CP jumped $13.9 billion to $1.367 Trillion, its highest level since June 2001.  Financial CP is now up $80 billion from March lows, while expanding at a 10% rate thus far during 2003.  Conversely, Non-financial CP has dropped $19 billion y-t-d to $136 billion, declining at a 19% rate. Consumer debt increased by a stronger-than-expected $7.3 billion (5.0% annualized) during May.  It remains puzzling that revolving and other non-mortgage consumer debt continues to expand despite record mortgage refinancings.  But, once again, the most interesting aspect of this release was the “Terms of Credit – New Car Loans” data. The average Amount Financed increased another $380 during the month to $27,920 (up from March’s $25,152).  This compares to third-quarter 2002’s average $25,959.  The average loan maturity increased 0.6 months to 60.7 months, up from the third-quarter’s 58.9.  Average Loan-to-value was unchanged for the month at 97%, up from the third quarter’s 96%.  The average Interest Rate declined 11 basis points during May to 2.40%, down from the third-quarter’s 2.68%.  It strikes me as notably non-deflationary that the average auto loan is approaching $28,000 and the average new home these days is going for about $243,000. According to Moody’s Credit Card Index report, the charge-off rate rose another 5 basis points during May to 7.05%, up from the year earlier 6.46%.  Yet the market is supposedly discounting a much improved environment going forward.  From JPMorgan research:  “Our market-weighted index of monoline credit card issuers rose 45.8% in the second quarter of 2003, significantly outperforming the S&P500’s 14.9% gain by 30.9%... Since bottoming on March 11, our monoline issuer index has appreciated 79%, outperforming a 22% return in the S&P500 by 57%.” Holiday-week distortions led to a significant decline in weekly mortgage applications.  However, examining year-over-year comparisons, Refi applications were up 196% and Purchase applications were up almost 17%.  In dollar terms, Purchase applications were up about 24%.  Freddie Mac’s reported 30-year mortgage rate jumped 12 basis points to 5.52%, up 18 basis points in two weeks to the highest level since early May.  One-year adjustable rates rose 6 basis points to 3.55%, with a two-week increase of 10 basis points. It was another amazing month for Countrywide:  “Average daily applications reached an all-time record of $3.2 billion, up 203 percent over last year.  Loan fundings reached an all-time high of $48 billion in June, an increase of 23 percent over last month.  Total loan fundings for the second quarter reached a new milestone of $130 billion, up 27 percent over the prior quarter’s record of $102 billion, and up 209 percent over the second quarter of 2002.  Monthly purchase fundings hit a record high of $13 billion, advancing 29 percent over last month’s record.  For the second quarter, purchase fundings were $33 billion, up 38 percent from the first quarter of 2003… The mortgage loan pipeline closed at a record high of $82 billion, up 11 percent over last month’s.”  This compares to a loan pipeline of $23.4 billion to end June 2002.  Year-over-year, June purchase fundings were up 77% y-o-y.  Non-purchase (refi) fundings were up 408%.  Home equity fundings were up 52% y-o-y, and Subprime funds were up 132%.  From company COO Stanford Kurland:  “Fundings for the first half of 2003 reached $233 billion, fast approaching the $252 billion originated for the full year of 2002.  In just six months, purchase fundings totaled $57 billion, 8 percent more than the purchase volume for the entire 2001 calendar year.”  It is also worth noting that “Total assets at Countrywide Bank…rose 11 percent over last month to $13.1 billion.”  Pretty good month… The May Trade Deficit, up 19% y-o-y to $41.8 billion, remained at a near record level.  Year-over-year Exports were up 1% to $57.6 billion, while Imports increased 7% to $104.4 billion.  Imports were 81% greater than Exports during May, compared to 72% one year ago.  Year-to-date by largest trading partner, Imports from Canada were up 7.3%, Mexico 3.3%, China 27.9%, Japan 0.0%, and Germany 14.1%.  Others of note include Saudi Arabia up 71.1%, Brazil 22.8%, India 15.1%, and Russia 56.8%.  June Import Prices jumped a stronger-than-expected 0.8%, the biggest gain since the prewar February price surge and noteworthy for its broadness.  Import Prices were up 2.0% y-o-y, although the detail is more interesting.  Food & Beverage prices were up 5.8% y-o-y.  Industrial Supplies were up 8.8%, with Fuels & Lubricants up 15.5%.  Paper & Stocks prices were up 8.5% y-o-y.  On the downside, Capital Goods prices declined 1.6% y-o-y.  Autos were up 0.7%, while Consumer Goods ex-auto was unchanged y-o-y.  June Producer Prices were reported this morning up a stronger-than-expected 0.5%, the strongest rise since March.  For perspective, there was only one month during 2001 when PPI was up more than 0.5%.  Year-over-year, PPI was up 2.9%.  Consumer Goods prices were up 3.9% y-o-y (residential gas up 35.5%!), and Capital Equipment was unchanged.  Intermediate Material prices were up 4.5% y-o-y, with Manufacturing up 2.9%, Processed Fuels up 15.7%, Construction up 1.1%, and Supplies up 1.9%.  Crude Material prices were up 29.4% y-o-y, with Food & Feedstuffs up 13.6%, and Crude Fuel up 80.7%. Insightful analysis from our most-capable summer intern, Indiana Hoosier Ryan Bend:  “General Electric announced their second quarter earnings today, and most market watchers usually find their results to be a decent barometer of economic trends.  GE reported quarterly earnings of $0.38, a decline of $0.06 or 14% over 2Q 2002.  CEO Jeff Immelt painted the picture of a slow growth economy where industrial manufacturers have little pricing power and are faced with rising raw material costs.  Excess capacity remains an issue as capacity utilization is stagnant at about 74%.  Consumer spending is chugging along, as we have seen in the recent retail numbers.  SARS worries are lifting and advertising spending is trending upward.  On the surface it appears that the economy is picking up steam and slowly working its way out of the doldrums.  But we caution investors to jump to this conclusion.  This is not a typical recovery.  Yes the Dow, S&P and Nasdaq have all had nice runs this first half.  Unfortunately, economic data paints a different portrait.  Job growth has been non-existent.  There is little evidence of pricing power.  And reports like the one from GE today help confirm what is happening in today’s Fed-fueled economy.  A significantly greater proportion of GE’s earnings came from financial services and insurance than last year.  Managing credit card receivables appears to be a  better business these days than manufacturing gas turbines, aircraft engines, or  plastics.  As inflation manifests itself in housing, health care, and financial services, industrial producers face continued problems.  Raw materials costs are increasing and sales are slow because companies do not want to invest.  The GE’s and Ford's of the world turn to their suppliers and say prices have to go down.  And someone gets squeezed.” (I’m trying not to “brainwash” Ryan!) Admittedly, most eyes will instinctively glaze over the minutia of various economic and earnings releases.  Yet, it is especially important these days to carefully analyze trade, pricing and profit data.  A key tenet of Credit Bubble analysis is that our contemporary, mutant financial system is hopelessly incapable of disseminating liquidity evenly or effectively throughout an increasingly maladjusted (domestic and global) real economy.  I believe we receive decisive support for this hypothesis weekly.  Even today’s gap between June PPI and “core” Producer Prices (up 0.5% vs. down 0.1%) is further confirmation of unusual Inflationary Manifestations and atypical, especially uneven pricing pressures.  And this morning’s huge Trade Deficit indicates clearly that rampant domestic Credit Inflation persistently manifests into ballooning foreign liabilities with minimal benefit to domestic goods-producing industries.  We also know that today’s wild mortgage finance excesses are stimulating consumption and housing inflation; yet these financial flows (Monetary Processes) are abnormally unbalanced and unsustainable. We have learned that the Fed still holds sway over the liquidity spigot; but we are as well witnessing that, these days, when they crank it wide open some quite unusual things develop.  For the equity market, to this point it has clearly been a case of a rising (powerful North Atlantic) Tide lifting all ships.  There’s been a major short-squeeze that has hoisted countless rickety old boats.  Moreover, the newfound wide-open Credit market has given new hope to many an ugly balance sheet (and the energy and telecom industries!).  And then there’s the issue of the proliferation of derivatives, where investors, fund managers, and speculators can easily take positions in indexes from the S&P100 to the small cap Russell 2000.  Placing a bet on a single index can nowadays provide buying power for up to a couple thousand stocks.  As such, we are of the view that market dynamics have been much more responsible for the impressive stock market breadth over the past months than underlying fundamentals.  And while there is no way we will dismiss this most powerful liquidity backstop, the bulls should be unusually cautious when it comes to the veracity of today’s marketplace as a discounting mechanism.  Importantly, today’s extraordinary divergences in relative prices, along with the confluence of unmistakable domestic cost pressures and a savage global goods pricing environment, does not lay the groundwork for a traditional cyclical earnings recovery.  In fact, we expect something at significant variance to what the bulls confidently believe is being forecasted by the stock market:  we are increasingly of the view that the same (unbalanced inflationary) dynamics that are wreaking havoc with California and state budget deficits (rising costs and sticky revenues) and holding back job growth for most industries will also play the role of Inevitable Profits Spoiler.  Sure, ultra-low interest rates -- along with the recent liquidity and market surge and relatively strong, Credit-induced spending -- could prove constructive for a few decent quarters of earnings gains.  But today’s dysfunctional Credit system and maladjusted economy absolutely do not create a positive long-term earnings story.  It is worth noting that Asia equity markets nicely outperformed this week.  Despite today’s decline, the Nikkei advanced another 1% this week.  The Hong Kong Hang Seng was up 3%, China Shanghai A shares 2%, Taiwan 2%, the Korea Composite index 2%, India’s Mumbai index 1.5%, Indonesia’s Jakarta 4%, Singapore 4%, and the Philippines Composite 1%.  Major U.S. indices lagged.  We note this as potential early confirmation that market players globally and here at home are beginning to appreciate that the unfolding (especially unbalanced) environment will favor some economies, industries and companies over others.  Some ships will for now sail smoothly over rough seas, while many other unsound boats will struggle in what will prove a less than hospitable environment. Watching “Kudlie and Cramie” the other night, Mr. Cramer posed the (rhetorical) question, “Is the current rally like 1991 or 1998.”  Of course, Messrs. Kudlow and Cramer, along with the bullish contingent, are increasingly confident that the feisty bear has been put to rest and a new nineties-style bull market has been launched.  They will be disappointed.    We’ve all read and discussed the concept that recession and bear markets are the requisite adjustment periods to cleanse the system of unsound boom-time excesses.  On a basic level this is little more than common sense.  But the real analytical “meat” is not so readily discernable.  When examining the complexities of contemporary economies and financial systems, there is much that remains nebulous and difficult to conceptualize.       Delving into Mr. Cramer’s question provides us an additional opportunity to refine our analysis.  It is rather straightforward that recessions are traditionally a period where bloated inventories are thinned, while excessive consumer and corporate debt loads are reduced to more manageable levels.  Uneconomic enterprises are liquidated, improving profitability for the survivors.  Unsustainable macro imbalances, such as outsized trade deficits, are brought back into balance.  The concomitant financial bear market is an opportunity for an impaired system to rid itself of the individuals, institutions, and mechanisms that were misallocating resources (financial and real), inciting unsound excesses (economic and financial), and fostering economic vulnerability and financial fragility.  We experienced somewhat of a healthy purging process during the early nineties recession, with the downfall of Michael Milken, Drexel Burnham, the S&Ls, the Bank of New England, and such.  Curiously, the economic consensus (focused only on the conspicuous) effectively developed the view that -- with inventories having become such a small factor in the contemporary U.S. economy -- the business cycle had basically become an archaic concept.  And after its great early-nineties “success,” the Greenspan Fed apparently convinced itself that boom-time financial imbalances were no longer especially problematic.  After all, banking system (boom-turned-bust) losses could be easily rectified by the magic of artificially low short-term rates and a steep yield curve.  Central bankers now enjoyed the power to recapitalize troubled institutions or an entire system simply by bestowing the capacity to borrow cheap short-term and lend dear long-term.  Along the way, the entire notion of the value/necessity of purging the system of excesses (both real and financial) was deemed antiquated and rather senseless.  Basically, it has been the ambition of the Greenspan Fed to abrogate the requisite adjustment process: A Not So Grand Experiment.  This has, most importantly, created a profoundly different environment today when compared to 1991 (or any post-adjustment period).  Previously overheated and distorted systems (financial and real economy) emerged from the early-nineties adjustment with a “clean slate.”  Sectors that had demonstrated strong inflationary biases and unsustainable booms were severely restrained, breaking (speculative) inflation psychology and arresting outsized (profligate, uneconomic and destabilizing) liquidity flows.  Dysfunctional Monetary Processes (fraudulent S&Ls and junk bond operators, over-zealous real estate finance, and destabilizing financial speculation) were broken.  This provided the backdrop for balanced financial flows to stimulate a measured and broad-based economic recovery.  And with speculative impulses having been harshly punished during a wrenching bear market, emerging heightened liquidity flows were much more driven by true economic profits than they were induced by speculative “profits”.  Today is not 1991.  Yesterday’s Financial Times featured an interesting piece, “Hustling for the Hedge Funds’ Dollar:  Why Booming Prime Brokerage May Become the Next Target for Regulators.”  A couple of charts get right to a heart of the matter.  Estimated Global Hedge Fund Assets ended 1991 in the range of $55 billion, with the number of funds around 600.  Estimated assets (a fraction of total positions) ended 2002 north of $600 billion, with the number of funds above 5,000.  Greenspan’s Not So Grand Experiment -- while thus far mollifying economic adjustment -- has acted significantly to exacerbate financial and speculative excess.  And while it is almost reasonable to trumpet the wonders of contemporary finance and central banking, the reality of the situation is anything but wondrous. Today is a lot like 1998.  After the Russia/LTCM collapse – and the “seizing up” of the Credit market – the Fed aggressively cut rates and reliquefied the system.  The GSEs led the charge.  The Fed and GSE’s maneuver more than nullified what would have been a fortuitous purging of speculative impulses throughout the leveraged speculating community.  Rather, Fed operations only emboldened the speculators with lavishly easy gains.  The speculative (inflationary) bias throughout the Credit system was intensified, with the resulting liquidity deluge swamping the stock market and telecom debt arenas (poised for blow-off excess).  This speculation-induced liquidity torrent hit a real economy with a strong expansionary bias, especially throughout the booming technology sector.  The consequences were a devastating stock market Bubble, with historic excess running rampant throughout NASDAQ, the Internet, and technology generally.  The corporate debt Bubble went to near catastrophic excess, while the real economy suffered extreme maladjustments.  And with the Credit system and monetary environment out of control, acute structural imbalances were imparted throughout.  The inflationary seeds for today’s California budget fiasco were planted by the Fed back in the fall of 1998. The key difference between 1991 and 1998 can be found with the latter’s strong inflationary biases.  The Fed commanded great power in October 1998 to incite speculation, foster liquidity creation and fuel economic expansion.  But underlying inflationary biases throughout the increasingly distorted financial system (Dysfunctional Monetary Processes) and maladjusted real economy guaranteed only the exacerbation of unfolding Bubbles.  Conversely, with excesses purged and dangerous inflationary biases having been wrung out of the system back in 1991, the Fed-induced expansion demonstrated patently divergent dynamics.  For one, there was little in way of a “leveraged speculating community” aggressively reacting to Fed largess.  Hence, speculative financial profits played no significant role in commanding liquidity creation or its dissemination.  There was certainly no destabilizing speculation-induced “liquidity deluge.”   Importantly, financial flows were dictated much more by economic profits than financial “profits”.  This crucial attribute was engendered by the character of both the financial system and the real economy.  The Credit and financial systems were devoid of powerful speculative impulses, with players guilty of previous misdeeds and financial excesses confined financially and/or otherwise.  At the same time, the real economy was bereft of sectors exhibiting strong inflationary biases that would attract disproportionate (and destabilizing) liquidity flows.  And, importantly, large numbers of uneconomic enterprises throughout the economy had disappeared.  While not appreciated at the time, the prospect for strong, balanced, and sustainable earnings growth had been created through the (real and financial) purging process.  A difficult adjustment process was, throughout 1991, setting the stage for a new bull market. There are today strong (1998-style) inflationary biases that forestall the commencement of a sustainable economic expansion, an enduring broad-based profits recovery, and an attendant new bull market.  Moreover, these problematic inflationary biases are deeply ingrained in both the financial sphere and real U.S. and global economies, eradicated only through a quite formidable adjustment process.  The powerful GSEs and Wall Street firms remain the masters of liquidity management, as if their operations were not largely responsible for previous booms-turned-bust.  A mortgage finance Bubble larger and much more dangerous than the equity market/technology Bubble runs completely out of control.  And with a massive and enterprising leveraged speculating community – with Fed policies acting generally through the manipulation of financial profits – the pursuit of speculative gains today overwhelmingly dictates financial flows (“Financial Arbitrage Capitalism”).  Within the real economy, strong inflationary biases throughout the expansive real estate, healthcare, and financial services sectors ensure that little of the massive liquidity creation flows to sound business and capital investment.  This has none of the characteristics of 1991. Real economic profits nowadays play an abysmally insignificant role toward dictating financial flows, investment, or economic expansion.  And while deep structural maladjustments ironically foster only greater financial and speculative excess, the resulting liquidity cataclysm is destined to foster only more spectacular booms and unavoidable busts.  Any expansion (financial or economic) fueled by speculative gains as opposed to economic profits is unsustainable and destined to end in tears.  Today, a broad-based and sustainable profits recovery is more a chimerical impossibility than even a remote possibility.  But we will be the first to admit that things are going to look seductively encouraging as long as liquidity remains so cheap and over-abundant.  In this most speculative of environments, liquidity begets speculation that begets only more destabilizing inflationary liquidity excess.  Yet we do have the sense that we are approaching a period where the market will begin to be a bit more discriminating.  This has “1998 boom and bust” written all over it.

07/03/2003 It's Going to be a Fascinating Second Half *

With the bond market in a fuss over the caliber of its gift from the Fed, equities gave back some of their recent gains.  For the week, poor performance from Disney, GM, and Honeywell pushed the Dow 2.3% lower.  The S&P 500 followed suit, giving back 2%.  The Transports fell 1% and the Utilities were pared back by 2%.  The Morgan Stanley Cyclicals dropped 2.5% and the Consumer index lost 1.8%.  However, the broad market was less volatile and more resilient than the major averages.  The small-cap Russell 2000 was unchanged, while the S&P 400 Midcap dipped only 0.5%.   The tech-heavy Nasdaq100 declined 1.5% this past week.  The Morgan Stanley High Tech index fell 2.1% and the ever-volatile Semiconductors declined 3.3%.  The Street.com Internet index was about unchanged, while the Nasdaq Telecom index declined less than 1%.  The Biotechs sold off 2.5%.  Sinking bond prices weighed on the financial stocks.  The Broker/Dealers were hit for 2.4% and the Banks shed 1.5%. The HUI Gold Bug index had a rough week, losing 4.4% of its value, as bullion sank $11.20.

The Treasury market was pounded, now having suffered the largest two-week decline since October.  For the week, two-year Treasury yields added 19 basis points to 1.35%, while five-year yields rose 18 basis points to 2.45%.  The ten-year Treasury note closed the week at a yield of 3.54%, up 23 basis points.  The long-bond saw its yield jump 25 basis points to close the week at 4.58%.  Benchmark mortgage-backed securities gained some relative performance, with yields increasing 15 basis points.  Implied yields on agency futures rose 11 basis points.  The spread on Freddie’s 4 ½ % 2013 note narrowed about 1.5 to 35, while the spread on Fannie’s 4 3/8% 2013 note narrowed less than one to 35.  The 10-year dollar swap spread narrowed 2.5 to 34.5.  Thus far, tumultuous trading in the Treasury market has caused little grief in the corporate market.  Spreads generally narrowed moderately this week, with junk bonds outperforming.  The dollar index gained better than 1%, while the CRB index declined over 1%.

Long-term rates shot higher globally.  Japanese benchmark 10-year yields increased 13 basis points to 0.725% (up 28 basis points in two weeks!).  Australian 10-year yields jumped 22 basis points to 5.03%, while New Zealand yields gained 17 basis points to 5.37%.  European yields generally increased 11 to 15 basis points.  Hungarian bonds saw yields jump 20 basis points, with Russian Eurobond yields up 15 basis points.  Yields were up moderately in Brazil and noticeably in Argentina.

General Motors this week completed the largest ever debt offering by a U.S. company.  With bids surpassing $30 billion, GM raised the size of its issuance by about a third to $17.6 billion.  The three-year GMAC $ tranche was priced at 290 basis points over Treasuries, the GM $ 10-year tranche plus 375 basis points, the GM $ 20-year plus 383 basis points, and the GM $ 30-year plus 400 basis points.  Issuance also included GM EUR 2.5 billion, GM GBP 600 million, and GMAC EUR 3.0 billion.  GM also raised the size of its convertible offering to $4 billion.  Spreads narrowed after the sale, with the 10-year US$ bonds contracting 20 basis points to 355 and the 30-year US$ bond spread narrowing 14 basis points to 386.

June 26 - Reuters:  “This is a wonderful example of the success the Fed can point to in bringing liquidity back in the corporate bond market,” said Mitchell Stapley, chief fixed-income officer at Fifth Third Investment Advisors.  “It’s a sign of less restrictive financial conditions in the economy.”  “The order books for the various euro tranches of the deal were between 2.5 and four times oversubscribed, said an official at one of the lead managers.”

Debt issuance remained quite strong, with the higher the yield the better.  HSBC Capital Funding raised $1.25 billion, EDS $1.1 billion, Sealed Air $850 million, Caterpillar Financial Services $350 million, Entergy Gulf States $240 million, Fiserv $100 million, and Cytec $200 million.  The list of junk issuers seems to lengthen by the week:  Reliant Resources $1.1 billion, PG&E $600 million, FPL Energy $380million, Gerdau Ameristeel $405 million, Arrow Electric $350 million, LNR Property $350 million, Worldspan $280 million, Vought Aircraft, Bally Fitness $200 million, GulfTerra Energy $250 million, Merisant $225 million, New World Restaurants $160 million, Mortons Steakhouse $105 million, Huntsman Advanced Material $100 million, Availl $200 million, Digitalnet $125 million, Danka $175 million, Alaris Medical $175 million, Avondale Mills $150 million, and Mobile Mini $150 million.  And the list of convertible issuers includes Halliburton at $1 billion, EDS $690 million, Sealed Air $300 million, RF Micro Devices $200 million, Meristar Hospitality $155 million, IMC Global $125 million, McMoRan $100 million, and Nektar Therapeutics $100 million.  

June 25 - Dow Jones:  “Global bond issuance reached record levels in the first half of this year as borrowers locked in low interest rates and investors flocked to fixed-income assets.  International debt capital market volume rose 16% in the first six months of 2003 to a record $2.5 trillion, according to preliminary figures compiled by Dealogic… The rising bond issuance included a 50% rise in global corporate junk bonds to $71.7 billion, the sector’s largest volume in five years. Investment-grade bond issuance posted a more subdued 10% gain in the first half to $693.1 billion.   Dealogic said the volume of mortgage-backed securities rose 12% to $476.4 billion in the first half of the year.”

June 23 - Dow Jones:  “U.S. dollar-denominated bond issuance in Asia, excluding Japan, could rise almost 20% from 2002 as issuers move to take advantage of favorable market conditions, Lehman Brothers said Monday.  New supply picked up after the war in Iraq, with an estimated $6 billion of issuance in May and June, taking the gross amount in the first half of 2003 to roughly $11 billion.   For the whole of 2003, Lehman predicted gross issuance to reach $21 billion, near 1996 levels, and up from $18.2 billion last year, driven by record low rates, tight spreads and declining external risk… Minus redemptions, net issuance is expected to nearly double to $14 billion, from $7.8 billion.”      

June 24 – Bloomberg:  “Romania raised 700 million euros ($810 million) in a sale of Eurobonds as investors build stakes in countries preparing to join the European Union in 2007. The former communist country priced the seven-year bonds to yield 5.975 percent, or 2.6 percentage points more than the mid-swap rate, a benchmark for international borrowing. That compares with 10.63 percent when the government sold debt of the same maturity two years ago. Investors who profited from soaring Polish, Hungarian and Czech bond prices as EU membership was confirmed for 2004 are seeking the same returns in Romania, Bulgaria and Croatia, which are bidding to be among the next wave of member nations… Romania last year received more than 2 billion euros of orders for a sale of 700 million euros of bonds due 2012. The bonds have risen since then, with the yield dropping to 6 percent from 8.8 percent at issue. The yield on Poland’s 2012 euro-denominated bonds has dropped to 3.9 percent from 6.3 percent a year ago.”

June 26 – Bloomberg (David Evans):  “On April 3, J.P. Morgan Chase & Co. held a conference in Manhattan, drawing about a thousand people to discuss one of the fastest-growing and least understandable financial markets in the world: credit derivatives.  ‘We outgrew the Waldorf and had to go to the Sheraton Towers,’ says Andy Brindle, global head of credit derivatives at J.P. Morgan. ‘Next year, we’ll have to go to Madison Square Garden, I think.’  …The global credit derivatives market, which wasn’t even tracked until 1997, has ballooned to $2 trillion based on the so-called notional value of the debts that underlie the contracts, according to Fitch…That market, Fitch predicts, will grow to $4.8 trillion by next year.  The entire derivatives market -- including transactions based on stocks, bonds, loans, commodities, currencies and mortgages -- has a notional value of about $100 trillion, according to the International Swaps and Derivatives Association. Those numbers are only guesses. Nobody knows how much money is actually at risk. Banks don’t have to report the details of their exposure, which leaves regulators in the dark. ‘This market is completely unregulated,’ says Randall Dodd, director of the Derivatives Study Center, a nonprofit research organization in Washington, and a former economist at the Commodity Futures Trading Commission.  ‘No reporting requirements, no collateral requirements, no licensing of traders,’ Dodd says. ‘There’s no supervision of this activity. Even if you’re a regulator and you want to see what’s happening, you can’t.’”

The Federal Reserve, of course, cut short-term rates to the lowest level since 1958.  It happened to coincide with the announcement of an all-time monthly record for New Home Sales, and the same week that saw the largest ever U.S. corporate debt issuance.  For those that missed it, I’ll share some of the commentary provided on CNBC from one of our list of outspoken inflationists.

Larry Kudlow:  “I don’t think the Fed sets interest rates.  I think the market will set those rates.  But the Fed can purchase two-years, five-years, ten-years.  In fact, when you take a look, year-to-date they have actually bought $10 billion of notes…  I just want them to add cash.  I don’t want them to control interest rates.  Just add excess reserves to the economy and the banking system and let this recovery really develop.”

CNBC’s Bill Griffith: “And when the Fed goes out and buys Treasury securities that way, that is what they are doing:  they are putting cash into the system.

Kudlow:  “That is correct.  They buy them and they pay for them literally with reserves that they create out of thin air.  And it’s kind of a cool system.  Too bad you and I can’t do it.”

Kudlow:  “To me I was hoping for more of a shock and awe statement from the Fed.  Something that would have suggested they’re determined to keep pushing liquidity in.  They’re determined to move to an excess reserve position.  They’re determined to finance the economy and the tax cuts that are going to raise demand for liquidity.  And they are determined to keep this position for a good long time.  To me, they should have been thinking outside the box.  This was very much inside the old box and therefore quite boring… What we really got…was a silent prayer. What the Fed really needed was a Hail Mary...”

Central bankers may not (yet) directly set long-term interest rates, but I would strongly argue that leveraged speculators keying off of Fed policy have evolved as the market’s price-setters.  The critical issue is not creating “an excess reserve position,” but the Fed’s capacity to engender adequate and balanced system liquidity.  Yet our system has for some time suffered specifically from excessive, speculative, and wildly unbalanced liquidity.  Mr. Kudlow, the Fed several years ago began throwing Hail Marys.  They now mindlessly just keep lobbing them, having discarded the tried and true game plan for a hope and a prayer.  (And it’s working as effectively as it would on the gridiron)

While unimpressive, the economic data seems to demonstrate gradual improvement by the week.  Initial jobless claims dropped 22,000 last week (44,000 in three weeks) to 404,000.  This was the lowest reading in 13 weeks.  Weekly bankruptcy filings were at 31,461, only slightly ahead of the year ago level.  Year-to-date filings are up 9.3%.  University of Michigan Consumer Confidence increased a stronger-than-expected 2.6 points to 89.7.  Current Economic Conditions added 2.7 points to 94.7, the strongest reading since April.

May Personal Income was reported up 0.3%.  Year-over-year, Personal Income has gained 2.9%, with Wage and Salary up 2.0%.  Manufacturing wages were down 2.0% y-o-y, while Service wages gained 3.1%.  Government wages jumped 4.7% from a year earlier and Transfer Payments gained 6.4%.  With a declining tax burden, Disposable Income was up 3.7% y-o-y.  Personal Spending increased 0.1% during May.  The unbalanced nature of the economy is again illuminated.  Spending on Durables declined 0.7%, while spending on Services increased 0.5%.  Year-over-year, Personal Spending was up a respectable 4.6%, with Durables up 5.2% (to $889 billion), Non-durables up 4.3% (to $2.19 Trillion) and Services up 4.6% (to $4.5 Trillion).  Personal Spending has surged almost 39% since May 1997.

Broad money supply (M3) rose $19.9 billion last week, with nine-week gains of $168.2 billion (11.4% annualized).  Demand and Checkable Deposits jumped $16.0 billion and Savings Deposits gained $15.2 billion.  Savings Deposits were up $498 billion, or 20%, to $3.0 Trillion over the past 52 weeks.  Last week, Small Denominated Deposits dipped $1.7 billion and Large Denominated Deposits declined $15.5 billion.  Retail Money Fund deposits dipped $6.0 billion, while Institutional Money Fund deposits added $5.3 billion.  Repurchase Agreements added $8.2 billion, while Eurodollars declined $1.2 billion.  Elsewhere, Total Bank Assets declined $52.6 billion, reversing the previous week’s $56.6 billion increase.  Securities holdings declined by $11.9 billion, while Loans and Leases added $5.1 billion (up $30.4 billion in three weeks).  Consumer loans rose $7.6 billion, and Commercial and Industrial loans added $500 million.  Atypically, Real Estate loans declined $9.2 billion.

Mortgage insurer PMI Group announced this week that they would not meet Wall Street earnings estimates.  The company now believes Expected Claims Payments will be approximately 20% above earlier estimates at a range of $210-$220 million.  Also, “The company continues to evaluate the carrying value of its investment in Fairbanks Capital Holding Corporation, which totals approximately $140 million.”

From Goldman Sachs’ quarterly earnings report:  “Fixed Income, Currency and Commodities (FICC) produced net revenues of $1.59 billion, its second best quarter ever…  Net revenues in Trading and Principal Investments were $2.01 billion compared to $1.44 billion for the second quarter of 2002 and $2.15 billion for the first quarter of 2003.  FICC revenues of $1.59 billion increased 39% compared to the same 2002 period, reflecting higher net revenues across nearly all businesses, particularly credit products, interest rate products, currencies and mortgages.  FICC continued to operate in a favorable environment, characterized by tightening credit spreads, declining interest rates, a steep yield curve, volatile currency markets and strong customer demand.”

New Home Sales surged 13% during May to a record 1.157 million pace.  This was 11% above the consensus estimate.  The average price jumped $7,500 to a record $242,500 (up $11,400 over two months).  And with New Home volume up 17.9% y-o-y and the average price up 7.1% y-o-y, New Homes “Calculated Transaction Volume” (CTV) was up an eye-opening 26.3% y-o-y.  For two years, volume was up 31%, prices up 15%, and CTV up 50%.  The average price is up 42% from the May 1997’s $170,700.  And while the Months Supply of New Home inventory sank to a record low 3.5, the dollar value of this inventory is up 30% in twenty four months (volume up 14% and prices up 15%).

Existing Home Sales were also impressive.  Sales were up 7% over two months to a near record level, with the average price up $8,700.  Year-over-year, May sales were up 4.4%, with y-t-d sales running 2% above last year’s record pace.  And with prices up 7.1% y-o-y, Calculated Transaction Volume was up 11.8% y-o-y to an annualized $1.255 Trillion.  CTV is up 28% over two years, 38% over three years, and a noteworthy 95% from May 1997.  The Midwest saw average prices surge $10,800 over two months (up 14.9% y-o-y), as sales volume jumped almost 11% to a new record.  Average (mean) Prices were up (y-o-y) 10.7% in the Northeast, 4.3% in the South, and 3.0% in the West.  The Months Supply of Existing Home inventory declined from April’s 5.1 to 4.7 months.

While backing off moderately, the Mortgage Bankers Association application index remains at historic levels.  The Refi index dipped 10% last week, although it was up 180% from a strong year ago level.  Purchase Applications declined 2.8%, but were up 4.6% from the year earlier.  In dollar terms, Purchase Applications were up 10.7% from a year ago.  The average fixed-rate mortgage loan was made at $170,600 last week, with the average adjustable rate mortgage at $322,300.
 
The Florida Association of Realtors reported May sales up 6% y-o-y, with median prices up 8% to $149,900.  “In May 1998, the statewide median sales price was $99,800, resulting in a 51.5% increase…”  Year-over-year price gains included Daytona Beach’s 20%, Panama City’s 21%, Miami’s 15%, and West Palm Beach-Boca Raton’s 14%.

From the Illinois Association of Realtors:  “Buyers continued to boost Illinois home sales to new heights in May… The statewide median cost of a resale home in May rose 8.7 percent to reach $172,290; it was $158,500 in May 2002… This May was the strongest May on record since the association began reporting statistics in 1990, and the current pace continues to amaze even the veteran sales agents...  The median existing single-family home price in the Chicagoland last month was $225,800, up 9.5 percent from $206,200 in May 2002.”

According to the California Association of Realtors, “The median price of an existing, single-family detached home in California during May 2003 was $369,290, a 15.6 percent increase over the revised $319,590 median for may 2002 (up $5,330 for the month and $49,700 y-o-y!).”  “But with the median price…posting double-digit increases in 22 out of the past 24 months, affordability concerns are increasing for many families in California”  “While we don’t anticipate sales to top last year’s record level, 2003 looks to be the second best year for residential real estate on record.”  A Long Beach real estate agent summed it up:  “The problem is, is that there’s just nothing to sell.  Supply and demand is killing us.”  The most notable price gains continue at the “lower end.”  Los Angeles enjoyed 19.8% y-o-y price inflation, Central Valley 19.4%, Riverside/San Bernardino 19.4%, Sacramento 17.7% and High Desert 16.9%.  Other notable y-o-y gains include Ventura’s 25.6%, North Santa Barbara County’s 26.5%, and Northern California’s 16.1%.  The statewide inventory of unsold homes is at 2.3 months, less than half the national average.

The Nelson A. Rockefeller Institute of Government (Nicholas W. Jenny) this week issued its June 2003 report, “State Tax Revenue – Slowing Again”.  First quarter state revenues increased 1.4% sequentially, an unimpressive gain after 2002’s third quarter rise of 2.5% and fourth quarter gain of 1.9%  (2002’s third quarter gain ended four straight quarters of sequential revenue declines).  This year’s first-quarter rise of 1.4% compares to the year earlier 7.8% decline.  By category, personal income taxes declined 3.1% y-o-y, a notable improvement from first quarter 2002’s 14.3% drop.  Corporate income taxes were up 10.3% during the first quarter, versus the 16.1% decline the year earlier.  Sales tax receipts were up 1.9% during the first quarter, compared to a 1.0% decline during 2002’s first quarter.   State revenues suffered an average quarterly decline of 3.5% during 2002, with only a 0.5% gain during 2001.  This is quite a turnaround from the 6.1% average revenue gain posted during 1996 and 1997.  Revenues surged an average 7.6% during 1998, before dipping slightly to 1999’s 5.8%.  Average quarterly annualized growth surged to 8.1% during the climax of stock market-related revenue gains enjoyed during year-2000 .

The consequences of Credit excess-induced boom-turned-bust are nowhere more problematic than in the tarnished Golden State.

During the five-year period (fiscal years 1995/96 to 1999/00), California revenues surged 68% ($29 billion) to $71.9 billion (according to state data).  This financial flow melee culminated with fiscal 1999/00’s historic one-year 22.7% surge.  On the expenditure side, state politicians (and rapidly rising costs) could hardly keep pace.  During the five-year period, total expenditures jumped 58% ($24.5 billion) to $66.5 billion.  The number of workers on the state payroll increased by about 20% in four years.  Overall spending rose 8.2% during ‘95/96, 8.1% during ‘96/97, 7.7% during ‘97/98, and 9.4% during ‘98/99.  With the torrent of tax receipts and the seduction of New Era banter, expenditures surged 15% during ‘99/00.  Yet the fiscal year ended with a large budget surplus and giddy politicians.  And then came fiscal 2000/01.  State spending surged 17.4%, but the bull market-induced revenue spigot ran dry.  Receipts actually declined almost 1% for the fiscal year - prospective surpluses as far as the eye could see instantly morphing into a deficits black hole.  Boom had turned bust, although various makeshift financing mechanism papered over the expanding hole for a couple of years.

Now, with a budget crater of somewhere between $29 billion and $38 billion, state coffers nearly depleted of cash, and lenders increasingly apprehensive, the Golden State is finally approaching The Wall.  Yet because the state has been in financial quagmire for some time and has repeatedly averted financial crisis, there is understandable complacency in the media and markets.  I would advise against complacency, although the state does appear to have resources to operate through much of the summer.  Last week the state’s finance director stated, “California is broke.  We are operating as of today completely on borrowed money, and we have no collateral left for additional borrowing capacity.”

For the past two years, the state has used myriad financial gimmicks (including selling tobacco settlement bonds) to postpone the day of reckoning.  But the much anticipated recovery in revenues failed to materialize, while several years of hoping allowed the state’s fiscal position to spiral completely out of control (analogous to an unemployed individual that risks ballooning Credit card balances to sustain his lifestyle).  Earlier this month (June12), the state issued (with bank support and extra fees) $11 billion of warrants to meet short-term cash requirements.  This was the largest-ever issue of such warrants.  California now receives the lowest S&P Credit rating of any state, with yields about 40 basis points wider than bonds issued by fiscally challenged New York and Texas.  Last week the state sold 30-year bonds at 5.0% (8.4% tax-adjusted yield), about 64 basis points wider than AAA state credits.  This spread was up 14 basis points from April, as virtually every other spread narrowed sharply.  A Fitch spokesperson was quoted by Bloomberg:  “California can’t go on forever living on borrowed money.  At some point, the market is going to change its mind” about lending.

June 12 - Sacramento Bee (Alexa H. Bluth):  “‘We are perilously close to losing the trust of the market,’ (state finance director) Peace said. ‘This was a sale that was clearly against the credit rating of the banks, not the credit rating of the state.’  The warnings came as divisions intensified between Democratic and Republican lawmakers and as a new statewide poll showed little public support for sweeping tax increases. Republican lawmakers - whose votes are needed to meet the two-thirds requirement to approve a budget - said they will not budge from their position against tax hikes…  The Democratic governor’s budget plan calls for a temporary half-penny sales tax increase to pay off $10.7 billion in proposed deficit bonds, as well as increases to cigarette taxes and income taxes for top earners…  Davis defended his budget blueprint, despite the lackluster showing in the poll for many of its components.  ‘If I have to choose between maintaining our progress in public education, continuing to provide health insurance for children, and continuing to protect you against both crime and terror or raising taxes, I am going to raise taxes,’ Davis said.”

The governor is now under serious recall risk, while Republican lawmakers are resolute in their pledge to not allow tax increases.  The democrats are equally resolved to avoid the draconian program cuts that would be required to get the state’s fiscal house in any semblance of order.  A recent attempt at a bi-partisan solution collapsed with virtually no support.  From Bloomberg:  “The plan…would cut 23,000 state jobs (the state has 295,000 workers), raise $6 billion in taxes, and slash $20 billion from state programs.”  The only Republican that has announced publicly that he would support a tax increase was quoted:  “Without bipartisan cooperation, we’re heading for a fiscal train wreck.   Sadly, there is little hope for change.”

Los Angeles Times (Evan Halper and Erika Hayasaki):  “During budget crises in previous years - last year’s budget was not signed until Sept. 5 - the state has not had to cut off as much money, but this year is different. A California Supreme Court ruling in May gives Westly very little flexibility.  That decision came in response to Howard Jarvis Taxpayers Assn. lawsuit to force lawmakers to take the budget deadline seriously. The court said the state has no legal authority to make many payments if no spending plan is in place.  The court also ruled that state workers can be paid no more than federal minimum wage until a budget is passed. The ruling gives state finance officials some time to reprogram their payroll system to make that possible. Westly said the computers will be updated by early September and, if no budget is in place by then, all state workers’ pay will be cut.  ‘A no-budget situation is not just academic,’ Westly said. ‘It will create real problems and hardships. This is going to be real hurtful for the state of California.’ Trial courts, child development programs, some mental health services and mandated payments to local governments cannot legally be paid after July 1 until a budget is in place, Westly said. Once the budget is passed, however, all payments will be made retroactively.”

More yesterday from the Los Angeles Times:  “On Wednesday, State Controller Steve Westly warned that California’s cash reserves are drawing down, and banks are refusing to lend the government any more money until it straightens out its budget mess.”  “Roughly $1.5 billion in state money will stop flowing to schools, colleges, transportation projects and medical providers.”

June 26 - Sacramento Bee (Alexa H. Bluth):  “If there is no budget after Tuesday, (state Controller) Westly said:  California will not make monthly payments beginning in July that total more than $200 million for K-12 schools and $200 million for community colleges.  State employees face drastic pay cuts as soon as late August.  Vendors will not receive payments for services rendered to the state after July 1.  Westly will continue a tradition of withholding pay from elected officials…  Westly said he is limited by a recent California Supreme Court ruling that dictates most state workers be paid the federal minimum wage - $5.15 per hour – when the state is running without a budget.”  Quoting the Chancellor of California Community Colleges:  “We’re talking about massive shutdowns in access and services that will begin to occur as early as August.”  Westly was quoted:  “This will create enormous hardships for literally thousands of vendors around the state who are absolutely innocent to the gyration of the budget battles of Sacramento.”

On the revenue side, car registration fees have been raised sharply.  From Bloomberg:  “Owners of the 26 million registered automobiles in the state will begin to pay on average $158 more a year starting October 1…”  Yet, quoting a Republican lawmaker:  “This tax increase is not only a bad idea, it clearly violates the California constitution.  I’m convinced that the courts will ultimately force the governor to give all the money back.”  And so goes the battle…

Los Angeles Times (Dan Weikel):  “In a hearing room filled to capacity, customers of Orange County’s largest sewer agency Wednesday both praised and criticized a proposal to double their rates over the next five years to help finance a $2.36-billion capital-improvement program…  ‘Our vehicle license fees have just tripled,’ said Paul Durazo of Westminster, who said he has been unemployed for 11 months. ‘It seems like everyone is screaming for more money. Why do we keep getting saddled with the bills?’”

It may prove to be months away, but there is an accident unfolding out in California.  And while the Golden State is faced with the largest and most pressing fiscal dilemma, it should be clear at this point that the root of the problem is systemic and structural.

Today from the Washington Post (Dale Russakoff):  “State governments’ financial health, which hit the lowest point since World War II last year, has worsened in the past six months, all but ensuring continuing cuts in priority programs such as education, Medicaid and aid to towns and cities, according to a survey released yesterday by the National Governors Association.  Budget cuts and layoffs this year produced the deepest state spending reductions in dollar terms since the governors began their fiscal survey in 1977… Still, with revenue declining more steeply and longer than in the previous two recessions -- and with Medicaid costs rising sharply -- many governors are likely to follow the lead of Maryland’s Robert L. Ehrlich Jr., who on Wednesday ordered a spending cut of as much as 10 percent...  Medicaid spending - which takes up 20 percent of state budgets - grew 13 percent in 2002, (and) 8 percent this year… ‘Medicaid is becoming the Pac-Man of state government, eating up each additional dollar generated in revenue,’ (executive director of the governors association) Scheppach said.”

The great late-nineties inflation imparted severe distortions.  As politicians are bound to do, inflated receipts were immediately spent and extrapolated far into the future. (One of the many reasons it is the crucial role of a prudent, independent central bank to contain excesses!)  It is instructive to note that the financial health of our states has actually worsened over the past six months, this despite the Fed’s “reflation” “successes”.  But this should be no surprise.  After all, the nature and manifestations of Credit inflation are characteristically altered over time, leaving the Fed powerless to regenerate the “favorable” old buoyant (stock market and option-induced) flow to state coffers.  Out in California, ultra-easy system-wide Credit conditions are having minimal impact on state revenues.  They are, however, severely inflating the price of housing, with generally rising costs for insurance, medical care, tuition, energy and other utilities.  Such inflationary manifestations are anything but conducive to either fiscal balance or economic health.

And while the budget quagmire garners some attention, there is a more momentous development unfolding insidiously: the cost of doing business in the Golden State - for businesses as well as state and local government - continues to rise.  This is one hell of an intractable structural problem, only aggravated by current monetary policies and dysfunctional Monetary Processes.  And there is absolutely no way for the Fed to now even out inflationary effects, with continued rampant Credit inflation only exacerbating terribly distorted price structures and economic maladjustments.  

 In this regard, California is surely more than a mere microcosm of the general maladjusted U.S. economy, where inflated cost structures find it only more difficult for business to compete globally. With respect to boom and bust dynamics and the great risk of flawed monetary policies, California will prove an historic case study.  And while I am no fan of juxtaposing our economy’s predicaments with those of Japan (altogether different economic structure and culture), there is one major similarity:  conventional inflation measures completely failed to capture the profound increase in the “cost of doing business.”  And as Japan has learned, this is a key structural problem impervious to even the most extreme monetary and fiscal policy measures.  It is also a most important issue disregarded by Mr. Greenspan in his serpentine plan to fight a collapsing stock market Bubble with only greater monetary accommodation.  This conundrum of an inflated “cost structure” and substandard growth also provides a good example of why learned European central bankers often expound that monetary policy is an ineffective mechanism for rectify structural problems, although it is quite prone to exacerbate them.

As analysts, we’ll follow the goings on in California with keen interest.  The state was at the very heart of the late-nineties Bubble, and we are today provided with a case study of how implausible it is to readily (as opposed to requisite arduous adjustment periods) abrogate past inflationary distortions with further inflation.  Furthermore, the Golden State remains at the very epicenter of the Fed’s continued failed monetary experiment – with only more desperate measures attempting to sustain an unsustainable Bubble.  After all, the Great California Real Estate Bubble has about the strongest inflationary bias today of any asset class.  And as difficult as things are today, the very serious trouble arrives when this historic Bubble finally succumbs.

I am convinced that a tottering California housing market was one of the key early-nineties factors that incited a panicked Fed to collapse interest rates (setting in motion the Great Credit Bubble).  Ironically, and quite ominously, when the gargantuan Golden State real estate market inevitably falters the Greenspan Federal Reserve will have already frittered away its ammo.  The Fed will lack even the sufficient arm strength to dump a little screen pass, let alone muster a last-second Hail Mary from deep in its own endzone.