09/11/2003 One for the Time Capsule *

It was one more unsettled week for global financial markets, as equities, bonds, currencies, and commodities all seemingly traded with dizzying volatility.  Our stock market was choppy, but ended the week little changed.  The Dow, S&P500, Transports and Morgan Stanley Cyclical indices posted fractional declines.  The Utilities added 1% and the Morgan Stanley Consumer index enjoyed a slight gain.  The broader market was largely unchanged, with the small cap Russell 2000 slightly positive and the S&P400 Mid-cap index slightly negative.  The NASDAQ100 was flat for the week.  The highflying technology sector generally underperformed.  The Morgan Stanley High Tech index declined 1% and the Semiconductors dipped 2%.  The Street.com Internet index lost 1%, while the NASDAQ Telecommunications index was unchanged.  The Biotechs posted a 2% rise this week, increasing 2003 gains to 42%.  The financial stocks were mixed, with the Broker/Dealers up 1% (y-t-d up 42%) and the Banks down 1%.  Today’s $4.90 drop left gold with a $2.90 decline for the week.  The HUI gold index was largely unchanged this week.  The Credit market rally continued this week, albeit with stunning intraday moves.  Two-year Treasury yields declined 9 basis points this week to 1.62%, with yields sinking 41 basis points over 8 sessions.  Five-year yields dropped 16 basis points to 3.11%, with yields down 50 basis points in 8 sessions.  The 10-year Treasury note saw its yield decline 10 basis points to 4.25, with yields down 45 basis points over 8 sessions.  Long bond yields dipped 3 basis points to 5.16%, although yields were down only 18 basis points over eight sessions.  Benchmark Fannie Mae mortgage-backed yields sank 15 basis points, with yields down a notable 50 basis points in eight sessions.  The spread on Fannie’s 4 3/8 2013 note narrowed 4 to 42, while the spread on Freddie’s 4 ½ 2013 note narrowed 6 to 42.  The 10-year dollar swap spread narrowed 3 to 43.5.  Corporate spreads were generally slightly narrower, with junk bonds increasingly volatile but thus far continuing to perform well. The dollar index declined better than 1% this week.  During the second half of August, the Euro dropped from 113 to about 108 during just seven sessions.  Over the past seven trading days, the Euro has now rallied back from 108 to 113.  Some kind of volatility…  With summer holiday season quickly winding down, the issuance boom has returned to the U.S. Credit market.  This week saw GE Capital issue $2.5 billion, Wells Fargo $1.5 billion, Liberty Media $1.35 billion, HBOS $750 million, Met Life $300 million, Johnson Diversey $406 million, Anheuser Busch $300 million, Carolina P&L $600 million, Public Service of New Mexico $300 million, Energy East Corp $200 million, Public Service of Oklahoma $150 million, Interstate P&L $150 million, Harsco $150 million, Georgia Power $100 million, and Rochester G&E $75 million.  After two weeks of strong inflows, junk bond funds saw moderate outflows of $486 million (from AMG).  Nonetheless, Dobson Communications issued $650 million, Quintiles $450 million, Tom Brown $225 million, and MGM Grand $600 million.  Primus Telecom sold $110 million of converts.  Venezuela sold $700 million of 10-year bonds (12.4% yield) today, its first issuance in two years.    September 11 - Dow Jones (Sonja Ryst):  “As hungry buyers continue bidding up the prices on government and corporate debt from emerging markets, three big-name issuers came to market on Thursday, kicking off what’s expected to be a busy few weeks of issuance… ‘The markets are poised to have issuance from everywhere in the next couple weeks,’ said Mike Conelius, a portfolio manager at T. Rowe Price… J.P. Morgan said in a recent report that $11 billion in emerging market debt issuance remains to be completed this year and that $32 billion had been placed so far… Debtors haven’t been able to raise international bond funding at such low cost in years. The J.P. Morgan Emerging Markets Bond Index Plus, or EMBI+, is trading at around 475 basis points over comparable U.S. Treasurys. The last time the EMBI+ went below 480 basis points was on May 5, 1998.” Today from Bloomberg’s hardworking William Pesek:  “Speculators, that international cast of financiers who helped fuel the Asian crisis, are again at Thailand’s gate. Barbarians to some, savvy market punters to others, speculators have rediscovered the Thai currency. Only this time, instead of driving the baht lower, as they did in 1997, speculators are driving it up.”  (It is today worth reminding readers that speculators generally don’t drive markets down when they are coming in, but rather when they are keen to exit)   Commodity Watch: September 12 – Market News International:  “Core raw materials prices soared in August by the most since 1979, boosted by scrap metals and leather…” Today’s better than 1% drop left the CRB commodities index with a slight decline for the week.  A poor crop in China and the U.S. drought were used as explanations, with Cotton trading to an almost three-year high this week.  Soybeans jumped to a 3-month high.  According to the U.S. Mint, American Eagle gold coins are selling at the strongest rate since 1999.  Global Reflation Watch: September 11 – Bloomberg:  “China’s money supply grew at a record pace in August, which may prompt the central bank to take additional action to curb bank lending in coming months. M2, the broadest measure of money supply rose 21.6 percent from a year earlier to 21 trillion yuan ($2.5 trillion), after climbing 20.7 percent in July… That exceeds the bank’s 18 percent growth target… Banks are eager to lend as they are awash with cash.  Household savings rose 18 percent to a record 10.7 trillion yuan in the year ended August 31…” September 10 – Bloomberg:  “China’s factory production rose in August at its fastest pace in five months and exports surged…  Production grew 17.1 percent from a year earlier to 350 billion yuan ($42 billion), after rising 16.5 percent in July…” September 10 – Bloomberg:  “China’s exports grew by more than a quarter in August as companies such as Broadcom Corp. and Wal- Mart Stores Inc. bought more Chinese-made semiconductors, clothes and toys.  Exports grew 27 percent to $37.4 billion after climbing 31 percent in July… ‘We’re growing very fast in China,’ said Yuan Yi, China country manager of Broadcom Corp., the world’s largest maker of cable-modem chips….    Wal-Mart Stores Inc., the world’s biggest retailer, said it plans to raise its purchases from China by a quarter to $15 billion this year.” September 8 – Bloomberg:  “Thailand’s exports in August probably rose 10 percent  (exports actually jumped 13%, up from July’s 4.5%) to a record $6.9 billion because of a surge in demand for electronics and other products, Commerce Minister Adisai Bodharamik said, citing preliminary data...  Rising exports prompted the finance ministry last month to raise its economic growth forecast by one percentage point to 7.1 percent. Exports have, on average, risen 18 percent this year because of a surge in shipments to China and other Asian nations…” September 11 – Bloomberg:  “Thailand’s new vehicle sales rose 18.7 percent in August from a year earlier to 42,453 units… For the first eight months of the year, automobile sales rose 33 percent to 334,422 units…” September 12  - Bloomberg:  “Indian industrial production grew faster than expected in July as lower taxes and interest rates led consumers to buy more cars and heavier monsoon rains lifted the confidence of farmers… Industrial production, which accounts for a quarter of Asia’s No. 3 economy, rose 6.5 percent… The cheapest borrowing costs in three decades and lower taxes are encouraging consumers to spend.”  (The Indian Rupee traded to a three-year high this week.) September 9 – Bloomberg:  “A measure of Australian companies’ sales, profit and hiring rose to its highest in almost nine years in August, signaling the economy is likely to recover from its slowest quarterly growth in 2 1/2 years, National Australia Bank Ltd. said.”  Yesterday it was reported that Australia’s unemployment rate dropped to the lowest level since 1990. September 12 – The Australian:  “Australian mining corporations are increasing their investment to supply the growing market in China.  Rio Tinto and BHP Billiton are making new investments to increase their production of iron ore.  It is predicted that China will increase its steel making capacity by between 40 per cent and 50 per cent in the seven years from 2003.” Russian industrial production jumped 6.6% during the first eight months of 2003.  Domestic Reflation Watch: Broad money supply (M3) declined $5 billion last week.  Demand and Checkable Deposits dipped $5.2 billion, while Savings Deposits jumped $18.3 billion.  Small Denominated Deposits declined $2.2 billion and Retail Money Fund deposits dipped $3.3 billion.  Large Denominated Deposits declined $2.8 billion and Institutional Money Fund deposits dropped $9.0 billion.  Repurchase Agreements added $4.9 billion and Eurodollars declined $5.7 billion.  Total Bank Assets jumped $36 billion.  Securities holdings increased $7.1 billion, while Loans and Leases added $15.1 billion.  Commercial and Industrial loans declined $3.4 billion, with a 6-week decline of $10.7 billion.  Meanwhile, Real Estate loans surged $24.5 billion last week, with a 6-week gain of $73.6 billion.  Elsewhere, outstanding Commercial Paper increased $5.9 billion.  Financial CP added $5.6 billion, while Non-financial gained $0.3 billion.  Year-to-date Asset-Backed Security issuance of $289 billion is running 16% ahead of last year’s record.  At $134 billion, home equity ABS issuance is running up 26%. August Producer Prices jumped 0.4%, with y-o-y gains of 3.4%.  August 2002 had y-o-y Producer prices down 1.5%.  Year-to-date, Producer prices have increased at a 4.4% annual rate.  It was reported this week that health insurance premiums jumped 14% this year, the strongest rise since 1990. Freddie Mac posted 30-year mortgage rates dropped 28 basis points to 6.16%, the lowest borrowing cost in six weeks.  One-year adjustable rates dropped 11 basis points to 3.87%, down from the year ago 4.32% and only 42 basis points higher than the lows established in late June.  Adjustable rate mortgages accounted for 21.6% of the total last week.  The Mortgage Bankers Association application index was distorted by the Labor Day holiday, so we’ll return to application data next week.  Countrywide Financial reported a significant drop in mortgage financings from July’s record.  August Total Fundings declined 21% from July to about $41 billion.  This was, however, up 93% from August 2002.  Refi fundings dropped 26% during the month, while Purchase fundings were down only 6%.  Purchase fundings were up 51% y-o-y.  Interestingly, Home Equity fundings actually rose 4% during the month to $1.77 billion and were up 72% y-o-y.  Subprime fundings declined only 4% during August to $1.65 billion and were up 133% y-o-y.  “Total assets at Countrywide Bank…rose to $15 billion, an increase of 7 percent from last month and nearly 300 percent more than August 2002.” Throughout the mortgage-dependent U.S. financial system, players are now forced to adjust to significantly fewer originations and an abruptly competitive environment.  This week Washington Mutual reported that mortgage origination volume had dropped 40% and that competitive market conditions would reduce gains recognized on new mortgages.  National City also cut its earnings forecast.  Mortgage real estate investment trust (REIT) Annaly Mortgage announced that it would cut its dividend by at least half.  Management blamed the previous refi boom and heavy prepayments of higher-yielding mortgages.  Over the past four quarters, Annaly ballooned its balance sheet 30% to $14.7 billion.  The company has shareholders equity of $1.16 billion.  The Mortgage Bankers Association released second-quarter delinquency and foreclosure data Wednesday.  Total, 1-4 Units delinquencies increased 10 basis points to 4.62% (down 15 basis points from Q2 2002).  Conventional Prime mortgage delinquencies dipped 2 basis points to 2.60%.  However, there is clear evidence of previous poor lending.  Conventional Subprime delinquencies jumped 59 basis points to 12.99%, although it is down from the year ago 15.67% (ratios surely benefiting from enormous Subprime lending growth).  Yet the most notable deterioration was evident with FHA mortgages.  FHA delinquencies surged 94 basis points to 12.59%, which is most likely related to the proliferation of down-payment “gift” programs.  FHA delinquencies were up 78 basis points from Q2 2002.  Overall, delinquency and foreclosure data are quite unimpressive considering current unprecedented lending excesses. A Labor Day holiday-shortened week saw 26,953 bankruptcy filings.  Year-to-date filings are running up 8.4%. The July Trade Deficit was reported at $40.3 billion.  Year-over-year, Goods Imports were up 8% to $105.8 billion, while Goods Exports increased 3% to $60.5 billion.  July Goods Imports were 75% greater than Goods Exports.  Year-over-year, Crude Oil imports were up 31.4%, Pharmaceuticals 20.3%, Apparel 12.3%, Food & Beverage 8.6%, and Services 8.3%.  Capital Goods imports were up 2.5%.  Examining Goods Imports y-o-y by region, Western Europe was up 3.9%, Eastern Europe 48.9%, Latin America 12.5%, Pacific Rim 6.2% and OPEC 24.2%.  Y-t-d by largest trading partner, imports from Canada were up 7.2%, China 24%, Mexico 2.2%, Japan down 0.6%, and Germany up 13.7%.  Other countries of note include y-t-d imports from Saudi Arabia up 68.4%, Brazil up 19.3%, Russia up 55.7%, and India up 13.9%.  This is an extraordinary, fascinating, historic period for Credit Bubble analysis.  And if there were doubts that the Credit Bubble had entered the precarious “blow-off” stage, the Federal Reserve’s second quarter Z1 “flow of funds” report certainly provides ample evidence.  It’s One for the Time Capsule. To begin, it is worth mentioning that in the 21 quarters prior to the second quarter (since the beginning of 1998) total Credit Market Borrowings (Non-financial and Financial) surged 51% - or $10.9 Trillion – to $32.1 Trillion.  After such an extended period of historic excess, Credit growth has now gone “parabolic.”  During the second quarter, Total Credit Market Borrowings expanded at an (seasonally-adjusted) annualized rate of $3.35 Trillion (10.4%).  This was a pace 27% greater than the previous record posted during 2002’s fourth quarter.  Led by record federal and household borrowings, Non-financial debt expanded at a 12% rate, double the first quarter.  One has to go all the way back to 1985 to find a year with stronger Non-financial debt expansion.  The federal government increased borrowings at a 24.3% annual pace. Total Non-financial Credit increased an unprecedented $631 billion during the quarter to $21.6 Trillion.  Since the beginning of 1998, Total Non-financial Credit has jumped $6.40 Trillion, or 42%.  Over this same period, GDP increased $2.54 Trillion, or 31%.  Thus, over the past 22 quarters, Total Non-financial Credit has increased from 184% of GDP to 200%.  Non-financial Credit was about 140% of GDP back in 1980.  Since the beginning of 1998, Financial Sector Credit Market Borrowings have surged $5.30 Trillion, or 97%, to $10.76 Trillion.  Financial borrowings as a percentage of GDP have jumped from 66% to 100%.  Total Credit Market borrowings (Non-financial and Financial) surged $11.7 Trillion, or 57% over 22 quarters.  As a percentage of GDP, Total Credit has increased from 250% of GDP to 300%. And while Federal debt issuance was extraordinary during the quarter, borrowing excesses were anything but confined to our nation’s capitol.  From the text released with the Fed’s Z1: “The pickup in debt growth in the second quarter was distributed broadly across all of the major sectors in the United States…”  The Household Sector increased borrowings by an unprecedented $1.0 Trillion annualized, or 11.5%.  One has to again go back to 1985 to find a year with a greater rate of debt expansion.  To put the $1 Trillion pace of borrowings into perspective, the Household Sector increased borrowings by $330.8 billion during 1997, $450.8 billion during 1998, $498.6 billion during 1999, $558.8 billion during 2000, $614.6 billion during 2001, and $771.8 during 2002.  Elsewhere, State and Local Governments increased borrowings at a 12% annualized rate.  Non-financial Corporate bonds were issued at an annualized pace of $309.6 billion, the strongest growth since Q2 2001.  Corporate debt expanded at 6.3% annualized.  This was more than double the first quarter’s rate and compares to 2002’s growth of 1.2%.  Total Mortgage Credit (home and commercial) expanded at an unprecedented $1.14 Trillion annualized (14.3%).  This was 30% greater than 2002’s record annual debt growth.  During the first half, Total Mortgage Credit expanded at a rate of $1.01 Trillion (12%).  This compares to 2002’s $879.6 billion, 2001’s $700.4 billion, 2000’s $570.1 billion, 1999’s $568.5 billion, 1998’s $510.6 billion and 1997’s (pre-Bubble) $337.3 billion.  During the second quarter, Home Mortgage Credit expanded at an amount almost 370% of the debt growth from (pre-Bubble) 1997.  For the second quarter, Home Mortgage Borrowings expanded at an unprecedented $951.4 billion, or 14.3% annualized.  This compares to 2002’s $721.2 billion, 2001’s $532.7 billion, 2000’s $418.2 billion, 1999’s $424.4 billion, 1998’s $384.6 billion, and 1997’s $258.3 billion.   It is also worth noting that Home Equity Loans (included in Home Mortgage Borrowings) expanded at an unprecedented $174.8 billion annualized, or 20% rate.  This compares to 2002’s record growth of $129.8 billion.  Home Equity debt expanded $68.8 billion during 2001, $97.8 billion during 2000, $56.0 billion during 1999, and $60.6 billion during 1998. Since the beginning of 1998, Total Mortgage Debt has expanded $3.71 Trillion, or 70.5%, to $8.96 Trillion.  Over these 22 quarters, Home Mortgage Debt surged $2.99 Trillion, or 72%, to $6.88 Trillion.  During this period, Total Mortgage Debt jumped from 62% to 84% of GDP, while Home Mortgage Debt increased from 47% of GDP to 64%.   The Financial Sector continues to expand aggressively.  Commercial Banking had Net Acquisition of Financial Assets of $819.1 billion annualized (11.0%), a pace 72% greater than 2002’s record Commercial Banking expansion of $476.4 billion.  Since the beginning of 1998, Commercial Banking assets have jumped 47% to $7.62 Trillion.  And while corporate bank loans declined at an annualized pace of $74.3 billion during the quarter, Mortgages increased at a $355.4 billion rate (16.9%).  Holdings of Agency debt increased at an unprecedented pace of $283.9 billion, or 29.5% annualized.  Combined, Mortgage and Agency debt holdings expanded $639.3 billion annualized (20.9%), compared to 2002’s $409 billion, 2001’s $185.4 billion, and 2000’s $186.9 billion.  Over the past 22 quarter, Commercial Banking holdings of Agency debt has surged 80.7% (to $1.03 Trillion) and holdings of Mortgages 76% (to $2.19 Trillion). Financial sector expansion was all-encompassing.  Credit Unions increased assets at a 16.7% rate during the quarter (up 12.3% y-o-y).  Finance Companies increased assets at a 17% rate (up 8.8% y-o-y).  Real Estate Investment Trusts (REITS) expanded at a blistering 34.7% rate during the quarter to $101.0 billion, with 12-month gains of 18.7%.  The Fed expanded its assets by 11% annualized to $769, with first-half growth at almost 12% annualized.  Curiously, Foreign Banking Offices in the U.S. decreased Net Acquisition of Financial Assets at an annualized $116.6 billion. GSE asset holdings expanded at a 9.3% rate during the quarter to $2.66 Trillion, with y-o-y gains of 11.5%.  GSE assets are up $1.56 Trillion, or 142%, since the beginning of 1998 (22 quarters).  Mortgage-backed Securities (not retained by GSEs) expanded at a 7.8% rate during the quarter to $3.29 Trillion, with y-o-y gains of 8.1% (up $1.46 Trillion, or 80.1% over 22 months).  Asset-backed Securities (ABS) expanded at a 12.1% annualized rate during the quarter to $2.51 Trillion, with a 12-month rise of 11.9%.  ABS have surged $1.524 Trillion, or 154.3%, since the beginning of 1998.  Combined “Structured Finance” (GSE, MBS, & ABS) expanded at a 9.5% rate during the quarter to $8.46 Trillion.  During the past year, “Structured Finance” liabilities increased $789.3 billion, or 10.3%.  Over 22 months they inflated an amazing $4.55 Trillion, or 116.2%.   It is also worth noting that Mortgages accounted for 82% of new ABS assets during the second quarter, compared to 39% during 2000, 47% during 2001, and 49% during 2002. The “flow of funds” report includes a Credit category “Federal Funds and Repurchase Agreements,” combining two key security financing mechanisms used throughout the Credit system (for leveraged securities speculation).  Recalling the “melt-up” that enthralled the Credit market during the second quarter, we would expect to see evidence of extreme use of financial sector borrowings to finance speculation.  Such is the case and it’s conspicuous.  For the quarter, Federal Funds and Repurchase Agreements expanded an unprecedented $564.3 billion annualized, a growth rate of 43%.  For perspective, Fed Funds and Security Repurchase Agreements expanded $105.0 billion during 2002, $22.3 billion during 2001, $113.2 during 2000, $169.8 billion during 1999 and $91.3 billion during 1998.  (One would assume that the financial sector used this funding source aggressively to partially finance the unprecedented Treasury debt issuance boom and the continued enormous quantity of Agency debt issued.)  Total Security Credit expanded an unprecedented $160.8 billion ($643.2 billion annualized!) to $957.4 billion.  Total Security Credit was up 28.4% y-o-y, and has more than doubled since the beginning of 1998.  As always happens, the speculators loaded up at the top of the market. Further confirmation of the extraordinary degree of second-quarter leveraged speculating is found by examining the asset expansion at the Wall Street firms.  Security Brokers and Dealers increased financial asset holdings at an eye-opening $530.9 billion pace, or 38.3% annualized.  For the quarter, the Broker/Dealer’s asset “Security Credit” expanded at an unprecedented $86.8 billion ($347 billion annualized!) to end the quarter at $246.3 billion.  These are client loans to purchase securities, most likely Credit market instruments (junk bonds, corporates, agencies, Treasuries, etc.)  Miscellaneous Assets expanded $61.9 billion (21% annualized) to $785.1 billion.  Over the past 22 historic Credit Bubble quarters, Security Broker Dealer assets have surged 92% to $1.5 Trillion. And with the U.S. Credit Bubble in the midst of blow-off excess, the world is being inundated with dollar liquidity.  Yet there is little international interest in real economic investment in the high-cost U.S. economy.  By default, our foreign trading partners (much through their central banks) are accumulating holdings of U.S. financial assets like never before.  From the Z1, the second quarter saw Rest of World Net Acquisition of US Financial Assets of $959.6 billion annualized, or 14.6%.  The composition of these purchases is notable.  Holdings of Credit Market Instruments increased $1.06 Trillion annualized, almost double the previous record established during Q4 2001.  Holdings of US Government Securities (Treasuries and Agencies) increased at an unprecedented $688.7 billion pace, or 35.9% annualized.  For comparison, Rest of World increased holdings of US Government Securities by $362.7 billion last year, $234.6 billion during 2001, and $129.5 billion during 2000.  Conversely, Foreign Direct Investment (FDI) increased $53 billion annualized (3.4%) during the second quarter, a fraction of 2000’s $321.3 billion increase in FDI.  Since the beginning of 1998, Rest of World holdings of U.S. financial assets have surged $2.98 Trillion, or 64%.  Foreign holdings have jumped from 57% of GDP to begin 1998 to 71% by the end of the second quarter.  Supported by extraordinary Credit-induced inflation, total Household (including Non-profits) asset values jumped an eye-opening $2.0 Trillion during the quarter (17% annualized) to a record $50.54 Trillion.  Since the beginning of 1998, Household asset values have surged $10.9 Trillion, or 28%.  Over the past 12 months, the total value of Household assets is up $2.2 Trillion (real estate almost $1 Trillion to $14.1 Trillion, financial assets almost $1 Trillion to $32.0 Trillion, and Other about $200 billion to $4.4 Trillion).  And despite a surge in Household borrowings (expanding 15% annualized to $9.3 Trillion), Household Net Worth jumped $1.7 Trillion during the quarter, or almost 17% annualized, to $41.4 Trillion.  There remains little mystery as to why consumer borrowing and spending remains so resilient:  Asset Inflation.     Today the Office of the Comptroller of the Currency released its second quarter Bank Derivatives Report.  “Uncertainty in financial markets continues to drive banks and their customers to seek risk mitigation opportunities through the use of derivatives…”  Well, I would argue that the continued explosion in derivative positions is a peculiarity of contemporary finance and its out of control Credit Bubble.  For the quarter, total derivative positions held by the major U.S. banks jumped $4.4 Trillion, or 27% annualized, to $65.8 Trillion.  By category, Interest Rate derivatives were up 24% annualized to $56.9 Trillion, Foreign Exchange 48% annualized to $7.1 Trillion, Credit derivatives 46% annualized to $802 billion, and Other declined 4% annualized to $1.0 Trillion.  By product, Futures & Forwards jumped 24% annualized to $12.7 Trillion, Swaps 25% annualized to $38.1 Trillion, and Options 34% annualized to $14.3 Trillion.  JPMorgan Chase derivative positions increased to $32.7 Trillion (25% growth rate), Bank of America $13.8 Trillion (23% rate), and Citibank $11.0 Trillion (33% rate).    Milton Friedman interviewed this week on CNBC:  “I don’t believe there is any New Economy at all in that sense (unique surge in productivity).  There was the same talk in the 1920’s.  The 1920s were a period very much like the 1990s in which we had a tremendous surge of productivity in the United States during that ten year period.  This time the big difference is in the way in which the Federal Reserve handled the monetary reaction.  And as a result, you had a very mild recession and there was nothing to cut productivity down drastically.” It is certainly no coincidence that so-called productivity “miracles” were trumpeted during respective 1920s and 1990s Credit Bubbles.  Simplistically, Credit and speculative excess, along with resulting asset inflation, stoked abnormal spending (business and consumer) and “output” (including “upscale” and luxury goods and services).  And, especially after examining recent Credit data, it is not the least bit surprising that talk of the Productivity miracle has gone “parabolic.”  This is, after all, consistent with the blow-off stage of the Great Credit Bubble.  Everything seems to lose its bearings. Dr. Friedman’s calamitous error (which is perfectly consistent with his flawed analysis of the causes of the Great Depression) is to believe that the Fed has “handled” the situation adeptly and successfully.  Dr. Freidman, along with so many others, is analyzing the situation incorrectly.  The reality of the situation is that the Fed has not “handled” anything other than prolonging an increasingly dangerous Bubble.  Any serious analyst - operating from a sound analytical framework - delving into the Fed’s “flow of funds” data can come to some important conclusions.  First, there is no mystery surrounding the economic pickup; it’s conspicuously induced by unprecedented Credit excess.  The “mystery” is why the economy is not much stronger.  Second, with Credit expanding dramatically in excess of investment or even economic (distorted as it is) “output,” rising asset prices (stocks and real estate, in particular) also do not constitute an enigma.  There is today unprecedented liquidity fueling destabilizing asset inflation.  Third, Credit and speculative excesses have reached unprecedented extremes.  Total Credit Market Borrowings (in excess of $32 Trillion, or three times GDP) are now expanding at a rate close to 10%, with Non-financial debt growing at low double-digits.  Textbook Blow-off.    What is admittedly not clear is the duration of this fateful blow-off phase.  There are clearly powerful forces at work sustaining this historic Bubble.  But uncertainty does not mean this “Cassandra” will back down.  For too many years we’ve witnessed the unstable U.S. and global financial systems nurture repeated “miracle” booms and subsequent devastating busts.  We watched repeated blow-offs, and their manic existence was measured in quarters and not years.  Today, we’re just witnessing The Big One.   And there is simply no way around the very harsh reality that current extraordinary Credit and speculative excesses are setting the stage for financial and economic instability unlike anything experienced in a very long time.  Rampant asset inflation and lurching economies are seductively un-enduring inflationary manifestations.

08/28/2003 Two Runaway Bubbles and Global Reflation *

The stock market seemed to enjoy itself. For the week, the Dow added almost 1% and the S&P500 gained about 2%. The Transports and Morgan Stanley Consumer index added 2%, while the Utilities advanced 1%. The Morgan Stanley Cyclical index added another 2%, increasing year-to-date gains to 26%. The broader market continues to outperform the major averages. The small cap Russell 2000 gained 2.5% this week, with 2003 gains reaching 30%. The S&P400 Mid-cap index added 2% (y-t-d gains 21%). The NASDAQ100 gained 3%, increasing y-t-d gains to 36%. The Morgan Stanley High Tech index added 3.5%, as 2003 gains reached 46%. The Semiconductors jumped 4% (y-t-d up 58%) and The Street.com Internet index gained 2% (y-t-d up 54%). The NASDAQ Telecom index jumped 4%, increasing y-t-d gains to 44%. The Biotechs added 2% (up 34% y-t-d). The Broker/Dealers (up 38% y-t-d) and the Banks (up 17% y-t-d) added 1%. With bullion surging $12.50, the HUI Gold index gained 7%. The Credit market remains extraordinarily unsettled, although rates ended the week little changed. The 2-year Treasury yield declined 2 basis points this week to 1.90%, while the 5-year yield was unchanged at 3.46%. The 10-year Treasury note saw its yield decline 1 basis point to 4.46%, with the long-bond yield down 4 basis points to 5.22%. Mortgage-backs and agency debt continue to under perform. Benchmark mortgage-backed yields were up less than 1 basis point. The spread on Fannie 4 3/8% 2013 note widened 5 basis points to 53, as the spread on Freddie’s 4 ½% 2013 note widened 4 to 53. The 10-year dollar swap spread added 1.5 to 50.5. Measures of bond market option volatility remain unusually high. Corporate bonds continue to outperform, with investment grade spreads narrowing slightly and junk spreads narrowing meaningfully. Junk bond spreads declined this week to levels last seen in June 2002. It was the second-slowest issuance week of the year for the corporate bond market. Citigroup issued $2 billion and Toll Brothers $250 million. ICI reported that investors pulled $10.8 billion from bond funds during July, ending 18 months of inflows. “Investors poured a net $249.4 billion into taxable bond funds the past three years as the stock market declined…(from Bloomberg).” After 5 weeks of outflows, junk bond funds saw record inflows of $3.26 billion this past week (from AMG). The quest for yield is very much alive, from households to the leveraged speculating community. Japanese government yields rose almost 5 basis points this week to 1.45%. With the economy demonstrating encouraging signs (and Japanese central bankers seemingly less enthusiastic about supporting the greenback), the yen today rose to a three-month high against the dollar. And with regional growth in Asia set to excel, Latin American currencies are under increasing pressure. Mexican and Argentine pesos this week traded to 5-month lows against the dollar. Emerging market debt, however, continues to perform well. Commodity Watch: The CRB index today traded to the highest level since March 12th. Soybeans enjoyed the strongest one-month price gains since June 1998 (according to Bloomberg). Prices surged 16%, with y-o-y gains of about 10%. Retail gasoline prices jumped 15% this month to a record high ($1.747 nationally), with y-o-y gains of 25%. Gold rose today to a six-month high. Copper enjoyed its best one-day jump “because of increasing demand from China, the world’s biggest consumer of the metal… Demand for the metal in China rose 24% from a year earlier…” August 27 – Bloomberg: “Cattle futures in Chicago surged to a 10-year high because of strong demand for beef at a time of reduced supplies of slaughter-ready animals. Wholesale beef prices have climbed almost 10 percent since July 1…” August 28 – USAToday: “‘Refining is a feast or famine business, and it’s a festive orgy right now,’ says Tom Kloza, chief oil analyst at Oil Price Information Service. Last week, refiners in some markets could buy oil for about $30 a barrel, refine it all into gasoline and sell the gas for $69. That’s a $39 profit vs. $4 to $10 normally. ‘Some are looking at their bottom lines and saying, ‘A few more days of this and we’ve made our year.’” Global Reflation Watch: August 28 – Bloomberg: “The New York Mercantile Exchange said a member seat to trade metals on its Comex division sold for a record $220,000, almost double the price for the last sale, which was in June.” Yesterday from Interfax: “With the severe gasoline and diesel shortages on domestic markets showing no sign of relief after several weeks, top refineries in China will begin another major output hike starting from September, and might see high demand continue into the fourth quarter, one refinery official predicted… As another way of relieving the domestic supply shortages, PetroChina has decided to reduce its September gasoline export volume by 14%...” August 29 – Bloomberg: “Japan, the world’s largest consumer of crude oil after the U.S., said oil imports rose 8.8 percent in July from a year earlier, the 11th straight month of year-on-year gains.” Bloomberg: “Mexican retail sales rose in June at their fastest rate in four months.” Market News Int.: “German real plant and equipment orders rose a strong 10% in July from their level of a year earlier.” Bloomberg: “Japanese machine tool orders rose a revised 25.4 percent in July from a year earlier…” “S. Korean Consumer Prices Rise First Time in 5 Months,” up 3.0% y-o-y. August 28 – Bloomberg: “Canadian existing home sales and prices rose to record highs in July as purchasers took advantage of the lowest mortgage rates in half a century. Sales rose 11 percent to a seasonally adjusted 41,886 in July, surpassing the prior record of 41,193 in January 2002… The average price was C$207,615 ($148,550), 12 percent greater than a year earlier and the sixth straight month of record prices.” August 28 – Market News International: “The value of new (UK) mortgage loans approved rose to its highest level on record in July, while the number of loans approved topped 100,000, the highest since May last year… These latest figures add to evidence which suggests the strength in the housing market is showing few signs of abating.” August 29 – Market News International: “UK house prices once again shattered expectations of a slowdown, rising 1.1% on the month in August… The survey showed the year-on-year growth rate slowed to 16.6% from 17.9% in July…” Eurozone M3 money supply growth expanded at an 8.5% annualized rate during July. This was up from June’s 8.3% rate of growth, with growth not stronger since last September. Total Credit growth expanded at a 5.3% annualized rate, up from June’s 4.8% to the strongest rate of growth since January 2002. Canadian broad money supply (M3) has expanded at a 10.2% annualized rate from year end through July, with 14.8% annualized growth over the past five months. UK’s lending (M4) expanded at a 10.1% pace over the past three months and is up 10.3% over 12 months. August 26 – Bloomberg: “Malaysia’s broadest measure of money supply rose at the fastest pace in four years in July because an interest rate cut boosted demand for loans from factory owners, contractors and consumers. M3, the most closely watched measure of money in circulation, rose 8.7 percent from a year earlier…” August 27 – Bloomberg: “Malaysia’s economy grew at a faster-than-expected pace in the second quarter, after Kuala Lumpur Kepong Bhd. and other planters shipped more palm oil and Petroliam Nasional Bhd. sold more liquefied natural gas and oil. Gross domestic product expanded 4.4 percent in the three months to June 30… Malaysia, Southeast Asia’s third largest economy after Indonesia and Thailand, is being helped by rising demand for commodities and higher prices…” August 27 – Bloomberg: “Thailand raised its economic growth forecast for 2003 by a full percentage point because of rising exports to China and other parts of Asia, and an increase in local consumption and investments. The Finance Ministry yesterday raised the forecast to 6.1 percent from its previous estimate of 5.1 percent… Exports have on average risen 18 percent this year because of a surge in shipments to China and other Asian nations, even as the U.S., Thailand’s single biggest buyer of Thai exports, has ordered fewer Thai goods. Exports to countries in the Association of Southeast Asian Nations grouping rose 16 percent in the second quarter to $4 billion, while sales to China surged 73 percent.” August 27 – Bloomberg: “India’s economy may grow at its fastest pace in five years in the 12 months that began April 1 as heavier than normal monsoon rains boost farm production and spending on goods and services, the central bank said. Asia’s third-largest economy may grow ‘significantly’ more than the 6 percent the Reserve Bank of India forecast in April, the central bank said… Lower rates are encouraging consumers to borrow to buy cars and homes. The central bank expects banks to lend 16 percent more in the year through March in the fiscal ending March 31.” August 28 – Bloomberg: “Airbus SAS, the world’s second largest aircraft maker, said demand for new planes is rising, especially from Asian carriers as passenger traffic increases following the containment of the deadly severe acute respiratory syndrome. Several Asian airlines that earlier had asked Airbus to push back deliveries next year because of SARS are now asking if they can have the planes on the originally scheduled dates, said John Leahy, Airbus’s chief commercial officer. ‘SARS now appears not only to be over, but there’s some pent-up demand we’re seeing as some of the traffic is even higher now than at this time last year,’ said Leahy…” August 27 – AP: “Tennessee Valley Authority directors voted Wednesday to raise electric rates for the first time since 1997. The nation’s largest public utility which serves customers in seven southeastern states said the estimated $365 million rate boost was needed to pay for $3.6 billion in required pollution controls for its coal-fired power plants by decade’s end. Homes and businesses will see a 7.4 percent rate jump beginning Oct. 1... The rate hike was only the second in 16 years for TVA.” U.S. Bubble Watch: Broad money supply (M3) was about unchanged last week. Currency was up $1.0 billion and Demand and Checkable Deposits surged $26.4 billion. Savings Deposits jumped $22.9 billion and Small Denominated Deposits declined $2.6 billion. Retail Money Fund deposits and Institutional Money Fund deposits each dropped $4.1 billion. Large Denominated Deposits dropped $12.6 billion and Eurodollar deposits dipped $1.7 billion. Curiously, Repurchase Agreements sank $25.3 billion. Foreign (Fed “custody”) Holdings of U.S. Debt increased $2.6 billion, with 4-week gains of $17 billion. Total Bank Assets dropped $49.8 billion. Securities holdings added $6.2 billion, while Loans and Leases dropped $36.7 billion. Commercial and Industrial loans dipped $1.3 billion and Real Estate loans declined $$4.3 billion. Securities loans sank $31.2 billion. Other Assets declined $18.1 billion. Elsewhere, Commercial Paper outstanding dipped $1.8 billion last week. Financial CP added $0.5 billion, while Non-financial CP declined $2.3 billion. For the first time since early 2001, Durable Goods Orders posted back-to-back monthly gains. Ex-transports, it was the strongest gain in six months. Durable Goods Shipments were the strongest in twelve months. The Chicago Manufacturing index rose for the fourth straight month to the highest level since May 2002. August’s reading of 58.9 compares to April’s 47.6 and March 2001’s 35.5. Prices Paid jumped 4.5 points to 52.4. Production added 3.2 points to the highest level since February. New Orders declined slightly but remained at a strong 61.6. Today’s Personal Income and Personal Spending data again illuminate an imbalanced economy. Personal Income was up 0.2%, with y-o-y gains of 3.3%. Benefiting from a lower tax bill, Disposable Income jumped 1.5% during July, with y-o-y gains of a noteworthy 5.2%. By category, Personal Income from Services was up 3.9% y-o-y and from Government was up 4.4% (Transfer Payments up 6.3% y-o-y). Meanwhile, Personal Income from the Goods Producing sector was up 0.2% y-o-y, with Manufacturing down 1.3% y-o-y. Personal Spending jumped 0.8% during July, the strongest gain in four months. Personal Consumption was up 4.6% y-o-y, with spending on Durables up 6.1%. J.D. Power and Associates is projecting August vehicle sales to jump to a booming 18.2 million unit pace, which would be the strongest reading since December. Goldman Sachs is forecasting sales at an 18.8 million unit rate. June sales were at a 16.4 million unit rate and July sales were at 17.3 million. Having over the past several months watched Credit excess go to extraordinary extremes – with unprecedented excesses throughout mortgage finance - we should not today be surprised by the jump in economic “output.” This week’s upward revision of second-quarter GDP to 3.1% (fueled by stronger household, corporate and government spending) now sets the stage for significant growth through the end of the year. Lehman Brothers this week raised their estimate for third-quarter growth to 5%. ISI is also saying 5% growth is “likely.” Former Fed governor Laurence Meyer is forecasting third-quarter growth of 5.25%. August 26 – San Francisco Chronicle (Kelly Zito): “Mortgage giant Fannie Mae today will announce the infusion of $35 billion into affordable housing programs in the Bay Area -- more than double the amount earmarked for such initiatives four years ago. The firm said the increase is due in part to the higher cost of housing in the Bay Area. ‘It takes more money to fill the affordability gap here,’ said Sheila Burks, director of Fannie Mae’s Bay Area Partnership office. ‘The size of the deals is bigger, the land is more expensive, and so we have to account for that.’” (“Inflation begets greater inflation”) August 24 – Akron Beacon Journal (Gloria Irwin): “Each month, hundreds of Ohioans get a free house down payment, thanks to the marketing efforts of Tom Brubaker. Brubaker is one of 70 independent representatives nationwide for AmeriDream Charity, a nonprofit organization headquartered in Maryland that helps people without significant savings get Federal Housing Administration loans. The program and others like it across the nation work because FHA rules allow borrowers to use a gift down payment. The ‘gift’ comes from the home seller, who agrees to kick back 3.75 percent of the sale price to the buyer to be used as a down payment. Brubaker is a strong advocate of such programs, which are generating 17,000 home sales a month nationally, according to one trade association. People who have worked hard and have decent credit should be able to buy homes, even if they haven’t managed to save money for a down payment, said (Brubaker)… ‘Everybody deserves to own a home,’ Brubaker said… Now, however, the federal government is studying whether these programs are also putting taxpayers on the hook for riskier loans. The inspector general at the U.S. Department of Housing and Urban Development studied 2,261 mortgages in four cities where California’s similar Nehemiah program provided the down payment. The report, released last September, found that 19.39 percent of them were in default… The findings were disputed by Nehemiah Corp., which pioneered the down payment gift program in 1997. The sample size wasn’t large enough to draw specific conclusions, Nehemiah officials said. In response, HUD is in the midst of a comprehensive internal study… In the meantime, AmeriDream and similar programs are growing in popularity. In some situations, builders of new homes also are using the program…The program isn’t perfect, though. ‘My concern with it is that the buyer has no money in the transaction,’ (mortgage company executive Mary) Schoenfeld said. Even worse, ‘99.9 percent of the time, the buyer has no money in savings at all…’ Despite the criticisms, Brubaker maintains AmeriDream's advantages outweigh its disadvantages… Even if borrowers are more likely to default, ‘is it not worth it for those people who didn’t default?’ and became homeowners, he said.” (“Hats off” to Ms. Schoenfeld!) Existing Home Sales surged to a record high in July, with sales up almost 14% from July 2002. Average Prices (mean) were up 12% over four months and 13.8% y-o-y. Average Prices were up 20% over two years, 29% over three years, and 49% since (pre-Bubble) July 1997. With July Average Prices up 13.8% and Sales Volume up 10.3%, Calculated Annualized Transaction Value (CTV) surged 25.4% to $1.40 Trillion. CTV was up 39% over two years, 61% over three years, and 109% over six years. By region, Northeast Average Prices were up 10.9% ($23,600) y-o-y, with three-year gains of 30.7% ($56,300). Midwest Average Prices were up 4.2% ($7,400) y-o-y, with three-year prices up 21.2% ($31,900). Average Prices in the South were up 16.1% ($31,000) y-o-y, and 39.5% ($63,300) since July 2000. The West saw Average Prices increase 8.1% ($21,600) over the past year, with three-year gains of 22.7% ($53,100). August 26 - American Banker: “The median existing-home price was $182,100, up 12.1% from a year earlier, the (National Association of) Realtors said. ‘That’s the strongest national price increase since November 1980, a reflection of tight inventories in a record market,’ David Lereah, the trade group’s chief economist, said… Because home prices are still rising, the ‘cost to wait,’ as Pinnacle (Financial’s) Mr. Long put it, will be higher than any savings on interest costs that would result from rates coming back down. Homebuyers should keep in mind that the effects of higher rates will not offset the costs of remaining on the sidelines while homes appreciate, Mr. Long said. ‘You always have the opportunity of bringing down your interest rate when it comes back down,’ he said.” (Shame on Mr. Long) New Home Sales were similarly “impressive.” July’s annualized volume of 1.165 million units was slightly below June’s (revised higher) record. Sales volume was up 21% y-o-y and up 32% from July 2001. Average Prices surged almost $20,000 during the month to $256,000. Average Prices were up 17.5% ($38,200) y-o-y, with six-year gains of 46%. Calculated Annualized Transaction Volume was up a notable 42.5% y-o-y to $298 billion. CTV was up 62% over two years and 111% over six years. The inventory of new homes declined 2,000 last month to 338,000, or 3.5 months supply. Freddie Mac 30-year mortgage rates increased 4 basis points lasts week to 6.32%, with 1-year adjustable rates adding 4 basis points to 3.88%. The (now widely followed) Mortgage Bankers Association refi application index sank 21% the past week to the lowest level since mid-June 2002. Purchase Applications dipped 5.7% for the third straight week of decline. Yet Purchase Applications were up 9.5% from one year ago, with dollar application volume up 18.2%. Purchase Applications were up 27% from the comparable week two years ago. August 25 – California Association of Realtors (C.A.R): “The median price of an existing, single-family detached home in California during July 2003 was $383,320, a 19.1 percent increase over the revised $321,900 median for July 2002, C.A.R. reported. The July 2003 median price increased 2.1 percent compared to a revised June 2003 $375,610 median price.” Sales were up 10% from July 2002, while the inventory of unsold homes dropped to 2.4 months from the year ago 2.6 months. Notable year-over-year price inflation included Los Angeles County up 25.4%, Riverside/San Bernardino up 27.7%, Central Valley up 20.0%, High Desert up 19.6%, Northern California up 21.5% and Santa Barbara County up 23.6%. It is worth noting that the median California home price inflated $7,710 during July and $61,420 over the past year. August 25 – Florida Association of Realtors: “It’s a bird, it’s a plane, it’s Florida’s red-hot housing resale market, soaring 16 percent in July… Statewide, a total of 19,724 existing single-family homes sold last month compared to 16,939 homes in July 2002. At the same time, the statewide median sales price also rose 13 percent to $164,000; a year ago, it was $144,700. In July 1998, the statewide median sales price for existing single-family homes was $103,800, representing a 57.9 percent increase over the five-year period…” There is a strong consensus that the mortgage boom is over and that home prices will now quietly plateau. While convenient, such an outcome would be quite unBubble-like. It is the nature of entrenched speculative Bubbles that they run increasingly out of control - that is until prices eventually reverse and hammer the speculators. Today, the American homeowner has never felt as wealthy or as infatuated with housing as the ultimate investment. It has become a full-fledged mania, with spectacular price gains only reinforcing inflationary psychology. Many key markets are very short of inventory, with virtual buyers’ panic dynamics now in play. Enjoying the fruits of rampant asset inflation and ultra-easy equity extraction, the consumer is borrowing and spending aggressively. Refinancings have slowed markedly. However, the household sector has accumulated enormous liquidity over the past year. Additionally, inflated values have again set the stage for significant equity extraction (increasingly through home equity loans as opposed to refis). There is little in today’s rate or Credit availability environment that would lead me to believe retrenchment is imminent. As Mr. Greenspan stated today, “A mild calibration of monetary policy to address asset bubbles does not and cannot work.” Well, how about 1% Fed funds with California (and other) home prices rising at an almost 20% clip? Major inflationary psychology (“blow-off”) has taken hold in housing markets from coast-to-coast. As such, Bubble dynamics would lead us to believe that surprises (Credit growth, resulting inflation and spending) will continue to be largely on the upside. Financial fragility remains the prominent wildcard. China Bubble Watch: I am also increasingly of the view that “upside surprises” are likely in store for the second historic Bubble now running on full throttle in China. Similar to the mortgage finance Bubble, I don’t believe analysts or policymakers really appreciate what has been developing. Many, in fact, have been quite dismissive of the Chinese economy, a view increasingly difficult to justify. And, again paralleling U.S. mortgage finance, when excesses reach the manic stage things have a way of becoming quite unstable and prone to running completely out of control. August 26 – Australian Financial Review: “China’s economy appears to have overcome the effects of the severe acute respiratory syndrome crisis. Retail sales, industrial production and foreign direct investment rose sharply in July 2003… China’s demand for industrial raw materials is particularly strong, and analysts expect the country’s imports of such products to continue to rise. There was strong growth in China’s consumption of key commodities such as alumina, copper, zinc, nickel and stainless steel in 2002, as more multinationals elected to use China as a major manufacturing base.” August 29 – Dow Jones: “During the next 17 years, China plans to build 30 nuclear plants with capacity totaling 32 million-40 million kilowatts, state media reported Friday. Based on China’s gross domestic product target of $4 trillion by 2020, the National Development & Reform Commission forecast China will need power generation capacity of 800 million-850 million KW by that year, compared with the current 350 million kilowatts, reported the government-run newspaper People’s Daily.” This past weekend The Peoples Bank of China announced that it would raise bank deposit reserve ratios from 6% to 7%. Bloomberg’s William Pesek wrote a good article with the poor title (I know, “Those who live in glass houses…”), “China’s Central Bank Takes Away Punchbowl.” Another economic commentator averred, “China’s actions…indicate that they will not allow the bubble to build further. This is bad news for global growth.” And another: “This is a smart move by the Chinese authorities, who are going to take a soft economic landing now instead of a hard economic landing later.” Well, let’s not get all carried away by an inconsequential reserve adjustment. And we definitely cannot disregard Bubble dynamics that, over years, have developed powerful inflationary and speculative momentum. It is worth recalling that Japanese authorities raised the discount rate from 2.50% in mid-1989 to 6% by late 1990. And even with the 1990 equities collapse, the Japanese economy posted 5.9% growth during the first quarter of 1991. It was not until the third quarter of 1993 that GDP posted a 0.1% decline. And here at home, despite a collapsing NASDAQ and Fed funds at 6.50%, the booming economy did not post negative growth until the Q1 2001’s 0.6% decline (with only mild contraction over three quarters). This week’s move by Chinese authorities will surely have little impact whatsoever on what is increasingly an unwieldy boom. If anything, it is evidence that the Chinese government is nervous, though understandably unwilling to take the risky measures that would be necessary to cool a clearly overheated economy. Contemporary central bankers – operating with global fiat currencies and unmanageable Credit systems - are notoriously soft. “Soft landings,” for the most part, are an urban myth. The bottom line is that Chinese are in the throes of one heck of a boom, a circumstance that becomes much more significant for a lot of things (global growth, commodity prices, interest rates, financial stability, etc.) as the U.S. Post-boom Boom takes hold. China’s financial institutions are said “to have made loans at the fastest pace since 1996 in July” (Austin American-Statesman). From the People’s Daily: “New bank loans grew by 1.9 trillion yuan ($230 billion) in the first six months, almost equaling the total for the whole of last year, leading banking experts to predict that the loan growth will surpass 30 percent this year.” Money supply is running up almost 21% y-o-y, compared to about 15% one year ago and 14% two years ago. “Overall national fixed income investment hit 1.93 trillion yuan ($233 billion) in the first half of this year, up an annualized 31.1 percent, the highest growth rate in ten years.” “During the first six months of this year, production and investment in steel and iron sectors grew by 21 percent and 130 percent respectively…” “In June, new construction of housing projects increased by 27.9 percent, but sales jumped by 36.4 percent…” Automobile sales are up 30% y-o-y. Think for a moment about the role that the island of Japan came to play in the global economy. Then ponder the size of China and the number of hard-working, enterprising Chinese. The SARS scare reduced economic growth from the first quarter’s 9.9% rate to 6.7% during the second quarter. But the Chinese economy (and the entire region) is now quickly bouncing back, with inflationary pressures building (as one would expect during the advanced stage of a protracted Credit boom). There are major housing Bubbles in key markets, and consumption is surging. July imports were up 35.3% y-o-y, compared to 28.9% during July 2002 and 7.5% during July 2001. As I have written in the past, the nature of inflationary manifestations changes over the course of a Credit boom. Going forward, I would expect much less talk of China “exporting” global deflation. This week, Intel announced that it would invest $375 million to build its second manufacturing facility in China, joining scores of companies (large and small) rushing to participate in the boom. Direct foreign investment was up 34% during the first seven months of the year. There are now more than 400,000 foreign companies set up to do business in China. Increasingly, there is an historic “gold rush” dynamic to the China boom that will certainly not be squelched by tinkering with reserve requirements. And demonstrating the self-reinforcing nature inherent to Credit booms, there is an interesting and significant dynamic at play regarding speculative financial flows: The greater the production boom and the larger its trade surpluses, the greater the expectation that the Chinese currency will eventually be revalued higher. This is leading to enormous speculative flows that only exacerbate the boom. Official reserves are expanding by $10 billion per month and have reached $350 billion. China’s “embarrassment of riches” leaves it with an enormous treasure trove of purchasing power. The Chinese appear increasingly willing to spend. It is worth noting that Japanese July exports were up 5% y-o-y. And while exports to the U.S. were down 6%, exports to other Asian nations were up 13% y-o-y. Leading the pack, sales to China were up 28%. Chinese imports are now stoking Asian exports, fueling impressive regional growth that has real potential to help pull even Japan out of its morass. It’s been awhile since the world has concurrently experienced Two Runaway Bubbles. And to have these companion booms now simultaneously lurching forward - fueled by unprecedented global monetary accommodation, Credit expansion, and speculative excess - is something truly extraordinary. Since the Japanese bust in the early nineties, recurring booms and busts and resulting global deflationary pressures provided, ironically, a quite auspicious environment for the blossoming U.S. Credit Bubble. Things are different these days: there are Two major unwieldy Bubbles increasingly inflating other economies. Moreover, there is presently a dearth of collapsing Bubbles working to offset inflationary pressures for the global system as a whole. These Changing Times would appear to provide a near ideal environment for energy prices, gold, commodities, and other “hard” assets. At the same time, it is difficult to envisage how the unfolding global Reflation could be anywhere near as accommodating to U.S. financial assets. It is a backdrop that looks certain to test the mettle of the leveraged and speculation-rife U.S. Credit system.

08/21/2003 Way Behind the Curve *

It was another week of “adventure” for unsettled global financial markets. The dollar enjoyed its largest gain in 2 ½ years, Semiconductor stocks surged 11%, unleaded gasoline jumped almost 10%, and the two-year Treasury yield traded this week to the highest level since December. As for the stock market, equities continued their upward momentum, led by episodes of buyers’ panic (semiconductor and tech stocks). The Dow Jones Industrial Average gained 0.3% for the week, and the S&P 500 added 0.2%. The Transports added 0.7% and the Utilities dropped 0.5%. Economically sensitive issues outperformed, with the Morgan Stanley Cyclicals gaining 1.2% (up 23% y-t-d). The Morgan Stanley Consumer index gave back 1.3%. The broader market was much stronger, as the Russell advanced 2.9% (up 27% y-t-d) and the S&P 400 Midcap rose 2.1% on the week. The tech-heavy Nasdaq100 surged, with its 4% rise increasing 2003 gains to 33%. The Morgan Stanley High Tech index added 6.2%, increasing y-t-d gains to 41%. The Semiconductors enjoyed another excellent week, up 11.4% (up 52% y-t-d). The Street.com Internet index added 6.6% (up 51% y-t-d) and the Nasdaq Telecom index gained 1.3% (up 38% y-t-d). The Biotechs moved upward by 1.9% this past week. Financial stocks were unimpressive, with the Broker/Dealers down slightly. Banks continued their recent underperformance, dropping 2.1%. In the face of a surging dollar, gold was notably resilient. With bullion up 70 cents, the HUI Gold index was down less than 1%. It was another wild ride for the Credit market. On the week, 2-year Treasury yields increased 11 basis points to 1.91%, with 5-year yields adding 3 basis points to 3.44%. Ten-year yields declined 7 basis points to 4.46% and the long-bond yield dipped 14 basis points to 5.26%. While volatile, the spread on Fannie’s 4 3/8% note narrowed almost 2 to 48, while the spread on Freddie’s 4 ½% note was about unchanged at 49. The 10-year dollar swap spread narrowed 0.5 to 49. Benchmark mortgage-backed spreads widened 1 basis point. Corporate spreads narrowed somewhat, with junk bonds outperforming. The yield on December 2004 3-month Eurodollars rose 9.5 basis points to 2.89%. This week marked the slowest week of debt issuance this year, with sales of $1.9 billion below this year’s daily average of $2.7 billion (from Bloomberg). Boeing Capital issued $500 million, Commonwealth Edison $250 million, Consumer Energy $400 million, and Oil Insurance LTD $300 million. Junk issuance slowed to a trickle, with NVL Financial selling $200 million, and Monitronics International issuing $160 million. Oxford Automotive postponed its planned $240 million junk debt sale. The convert market saw STM Micro issue $1.4 billion (boosted size 15%) and Alkermes $100 million. Japanese government bond (JGB) yields jumped 25 basis points this week to 1.35%, with 2-week gains of 48 basis points. Yields have now tripled since June 11th. Commodity prices are on the move. The CRB index traded above 240 for the first time since May, with y-o-y gains of almost 12%. Gasoline (NY futures) prices surged almost 10% yesterday, “the largest gain in more than 12 years” (according to Bloomberg). National gas reserves declined for a fifth consecutive week to a nine-month low (down 15% y-o-y). Natural gas traded to a six-week high this week. From Bloomberg: “Gas for delivery during the five-month North American heating season averaged $5.662 today, up 5.2 percent from last Friday and 47 percent higher than a year ago…” Platinum prices traded near 23-year highs. Soybeans are up 15% this month. Pork bellies futures were up the trading limit today on a report of depleting inventories, with prices up 40% y-o-y. Headlines from foreign economies: Yesterday from Interfax: “Russia’s GDP went up 6.9% in January-July 2003 against the same period last year…” Yesterday from Bloomberg: “Taiwan’s export orders rose in July at their fastest pace in six months to an all-time high as spending on notebook computers, cell phones and other goods picks up in China and other key overseas markets. Orders – indicative of shipments in one to three months – rose 15 percent from a year earlier…” Also from Bloomberg: “South Korea’s exports rose 19 percent from a year ago to $8.4 billion in the first 20 days of this month…” Global growth is accelerating, but it is as unbalanced as the domestic U.S. economy. The Philadelphia (“Philly”) Fed index surged a much stronger-than-expected 13.8 points to 22.1, the highest reading since June 1998. The index traded at a low of negative 33.6 during January 2001. The index is up strongly from April’s reading of negative 8.8. New orders gained 4.2 points to the strongest reading since January. Prices paid surged a noteworthy 22.5 points to 16, the highest reading since April. Market News International (Steven K. Beckner): “Federal Reserve Governor Mark Olson said he has no specific timetable in mind for when the Fed should begin to move away from its very low interest rate stance but said he would like to see some evidence of increased business pricing power and employment growth before the Fed does so. Olson, in a Wednesday interview with Market News International, was upbeat about the economic outlook and said the threat of deflation is steadily diminishing but doubted the country is ‘out of the woods’ on further ‘disinflation.’ Asked what circumstances would justify a move away from negative real interest rates, Olson replied, ‘One would have to see evidence of pricing power... We have not seen evidence of pricing power in the market yet.’ Also, Olson said he would want to see increased employment as a prerequisite. ‘When the employment rate starts moving up, at that point it will start to feel more like a full recovery,’ he added. Olson had no specific numerical goal or timetable for returning to full employment, but said, ‘I would like to see the overall economy growing at a rate that exceeds the rate of productivity so we create more jobs, but I don’t have a time frame.’” (New Age central banking) There were 29,356 bankruptcy filings last week, up 2.8% y-o-y. Year-to-date filings were up 7.6%. The federal government ran a $54 billion deficit during July, compared to the year ago $29 billion deficit. For the month, revenues were down 8.1% and spending was up 8.7%, with Defense spending surging 17.4%. After 10 months, the fiscal year-to-date deficit has climbed to $324 billion. This compares to the year earlier $178 billion. Year-to-date revenues were down 3.9%, while spending was up 7.1%. Year-to-date Individual Tax Receipts declined 6.4%, and Corporate Income Tax Receipts were down 14.8%. Social Insurance Receipts were up 2.0%. The spending side is a rather amazing story. Defense expenditures are up 16.5% year-over-year to $318 billion. Health & Human Resources spending was up 8.6% to $420 billion, while Social Security disbursements were up 4% to $423 billion. Labor department spending jumped 9.7% to $58 billion, and federal Education spending was up 24.6% to $47 billion. Treasury interest expense was down 3.5% to $289 billion. Fiscal y-t-d spending on Veterans was up 12.5% ($47 billion) and Agriculture was up 3.9% ($62 billion). The Ports of Los Angeles and Long Beach reported a surge of activity during July. For the month, combined container Imports jumped 10% from June (558,000), while Exports increased 11% (to 178,000). Year-over-year, inbound containers were up 9% and outbound containers were up 16%. The number of containers leaving the two ports empty was up 10% y-o-y to 310,000, fully 56% of inbound containers. August 20 – Bloomberg: “As U.S. consumers squeeze a growing amount of cash out of their homes in the form of home equity loans, securities backed by the loans have surged, creating a bonanza for the banks that underwrite them. In the first half of 2003, sales of home-equity-loan-backed bonds grew 39 percent from a year earlier to $90 billion, according to Bloomberg data… Overall, home-equity-loan-backed bonds generated $224.5 million in fees for underwriters in the first half -- more than the fees from debt backed by loans on autos and credit cards combined… Industrywide, bonds that repackage subprime second mortgages accounted for 83 percent of all home-equity-loan-backed bonds sold in the first half, up from 75 percent in 2000, according to Moody’s. ‘It’s an area of lending that’s really gone mainstream,’ says Engelken. Home-equity-loan-backed bonds appeal to investors stung by credit rating downgrades on other ABSs, says Anthony Thompson, head of U.S. ABS research at Deutsche Bank Securities Inc.” August 20 - Dow Jones (Christine Richard): “Capitol Commerce Mortgage, a California-based wholesale mortgage lender with operations in eight states, isn’t talking about why it shut down its operations Friday. But mortgage industry observers say the company ran into problems hedging its exposure to sharply rising interest rates. And that’s raising concerns that other financial intermediaries in the mortgages market could be facing similar problems. ‘There are many more mortgage companies out there that are taking nasty hits,’ said Bob Walters, chief economist for Quicken Loans… ‘This is the first really significant player to fall,’ he added. Capitol Commerce is estimated to have had around $6 billion in mortgages in its pipeline and was one of the top mortgage wholesalers in its home state of California, according to a person familiar with the mortgage industry there.” August 20 – Dow Jones (Dawn Kopecki): “The entire financial marketplace would feel the impact of a rating downgrade on the debt of either Fannie Mae or Freddie Mac, Rep. Richard Baker, R-La., says in an upcoming issue of Money magazine… ‘If a GSE had its credit rating downgraded, it would have a dramatic, instantaneous impact on the entire financial marketplace because of the implications to capital held at (federally insured banks)…’ GSE debt made up 95% of all bank capital held by federally insured commercial banks at the end of 2002. At the same time, he admitted that efforts to pass legislation moving Fannie and Freddie’s regulator from the Department of Housing and Urban Development to the Treasury Department are not politically popular. ‘It’s not something many homeowners or taxpayers are even aware of, so if you make the change and provide for adequate safeguards, that’s not something you can go home and run a 30-second ad about,’ Baker said. ‘It’s a difficult policy question with only political downside.’ Even federal investigators looking into Freddie’s accounting scandal are treading very carefully, Baker said. ‘There’s a concern by many that if an inappropriate regulatory action is taken, it could hurt one of the strongest legs of the economy, which has been the real estate boom,’ Baker said when asked about the Department of Justice and Securities and Exchange Commission, which are both investigating numerous accounting problems at Freddie. ‘If it could be alleged that any regulator took an action which in some fashion damaged the secondary mortgage market and slowed down the sales of homes, that would be a very bad political thing to do.’” Freddie Mac posted 30-year fixed mortgage rates rose 4 basis points to 6.28% last week, a 107 basis point increase from mid-June. One-year adjustable mortgage rates jumped 9 basis points to 3.84%, up only 30 basis points since June. The Mortgage Bankers refi application index dropped another 15% last week to the lowest level since July 2002. Purchase applications declined 6.5% to a level only 5% above one year ago. The dollar value of purchase applications, however, was up about 14% y-o-y. Last week, variable rate mortgages accounted for 23.3% of total new mortgages, up from 13.4% during the final week of June. Last week’s variable rate ratio was the highest since May 2000. The National Association of Home Builder’s activity index jumped 6 points this month to 71. This was up from April’s 52, to the strongest reading since January 2000. The homebuyers’ panic runs unabated in Southern California. August 21 – Los Angeles Times (Bonnie Harris): “The Southern California housing market delivered another strong performance last month, setting an all-time record for sales in the Inland Empire and the 30th consecutive month of double-digit price increases for the entire six-county region… The median price for homes sold in the Southland hit a new record of $328,000 in July - up 21% from a year earlier… In addition, a total of 33,561 new and existing homes were sold, which was the highest monthly sales count in nearly 15 years. Riverside and San Bernardino counties easily led the region in sales of new homes, with year-over-year increases of 35% and 36%, respectively. Median home prices rose from a year ago in all six counties, with Orange County again fetching top dollar at $428,000. In July, the median price for new houses and condominiums in Orange County was $549,000, for existing houses it was $465,000 and for existing condominiums, $300,000. Only Ventura County topped Orange County’s median price in any category, with a $619,000 median price for new homes in July. That was a year-over-year increase of 48%. ‘It is absolutely crazy,’ said Veronica Sheffield, a Pacific West Realtors agent in Ventura. ‘Two months ago, I couldn’t imagine [prices] going any higher, and now this. How much more can we honestly expect to see?’” The Mortgage Bankers Association reported that new commercial mortgages jumped to $29.5 billion during the second quarter, up almost 29% y-o-y. August 22 – National Mortgage news: “Thrift originations rose 22% in the second quarter to nearly $200 billion as refinancings pushed production to a new industry record.” August 18 - GMAC: “Residential Funding Corporation (GMAC-RFC) today announced that its total mortgage-backed securities (MBS) and mortgage related asset-backed securities (ABS) issuance reached a record $25.3 billion during the first half of 2003 in the U.S.” GMAC-RFC securitized a record $34.5 billion of mortgage-backs during all of 2002, which was up 31% from 2001. As was widely reported, July Housing Starts jumped to the highest level since August 1986. Single-family starts have not been as strong since November 1978, with Starts on pace for the strongest year since 1986. Compared to July 2002, single-family Starts were up 13.1%, with multi-family starts up 5.5%. By region, single-family Starts were up 31.5% in the Northeast, 7.7% in the Midwest, 17.1% in the South, and 5.3% in the West. Single-family building permits held at near record levels. Broad money supply (M3) added $15.3 billion last week. Demand Deposits declined $22.5 billion, while Savings Deposits surged $36.6 billion. Savings Deposits have increased $305 billion since early March (over 23 weeks), or 24% annualized. Last week, Small Denominated Deposits declined $2.6 billion, while Retail Money Fund deposits added $1.1 billion. Institutional Money Funds declined $7.2 billion, with Large Denominated Deposits increasing $7.5 billion. Repurchase Agreements gained $2.2 billion and Eurodollar deposits dipped $1.1 billion. Foreign (Fed “custody”) holdings of U.S. Debt” added $6.4 billion, with three-week gains of $14.4 billion. “Custody” holdings were up $141 billion, or 17.5%, from one year earlier. Commercial Paper outstanding declined $5.0 billion. Non-financial CP increased $2.6 billion, while financial CP declined $7.5 billion. Following a three-week surge, Total Bank Assets declined $14.4 billion. Securities positions dropped $36.4 billion (down $56.6 billion over two weeks), with Treasury and Agency positions down $44.1 billion. Loans and Leases expanded $17.4 billion (up $44.1 billion over two weeks). Commercial and Industrial loans declined $2.1 billion and Real Estate loans dipped $3.6 billion. Securities loans jumped $15.3 billion and Consumer loans added $4.4 billion. News this week from Intel, the “Philly” Fed, and various sources confirm that our unsound Bubble economy is lurching forward. An economist quoted by Bloomberg captured the growing euphoria: “We have all the classic signs of a burgeoning recovery.” The stock market certainly believes so. I would, however, argue that we are instead witnessing classic signs of commencing a dangerous stage of an ill-advised (out of control) Credit Boom. This is neither a rant nor an issue of semantics. A normal cyclical recovery would experience burgeoning demand throughout the interest rate sensitive sectors, particularly housing and autos. Pent-up demand (especially for durables) would hold the key to accelerating growth. Additionally, a surge in capital spending would be expected to play an instrumental role in propelling the fledgling expansion. And, importantly, unfolding recovery would be stoked by easing Credit conditions, with lenders loosening Credit availability after an extended period of caution. Logical and historically relevant yes, but all of this has virtually nothing to do with today’s financial and economic landscape. Indeed, there’s little normal about the current environment. It’s categorically abnormal and it’s surely not a “recovery.” Rate sensitive sectors have enjoyed booming demand for several years now – powering into overdrive since the Fed began cutting rates aggressively back in late 2000. Capital spending is playing a trivial at best role in the current expansion, as we continue to gut our nation’s manufacturing base. And instead of a cyclical easing of Credit conditions and a resulting up-tick in borrowings, we are witnessing a blow-off surge after years of unprecedented excess. Rather than a typical cyclical housing recovery, we are witnessing very late stage parabolic excess and (financial and economic) distortion. There are two fundamental aspects of Credit-induced booms that are today very much in play. First, for the real economy, Credit excess begets only greater excess. The more Credit excesses stoke spending and economic “output,” the greater will be the demand for additional borrowings. Credit inflation begets self-reinforcing inflation of varying manifestations. This is the very essence of Credit booms, and once heated up they become only increasingly unwieldy. Ours has turned white-hot. Conspicuously, the monetary/services U.S. (maladjusted) economy is being driven by extreme Credit excess (household, federal, financial, and state and local borrowings). And while some hold the view that today’s “recovery” is weak and unsustainable, Credit Bubble analysis would approach this debate differently: as long as financial market liquidity and the current ultra-easy Credit environment are sustained, the economy is likely to surprise on the upside. In the process things become only more “unwieldy,” as we have been witnessing of late. This is why I incessantly argue that a stable and manageable Credit system should be central bankers’ top priority. The Fed ignores the issue completely. The second fundamental aspect of Credit booms is the critical role played by self-reinforcing asset inflation. Credit excess begets rising asset prices that beget additional borrowing demands and higher asset prices. Overheated Credit systems and rising asset prices create their own liquidity, fomenting seductive Bubble market dynamics. This is why contemporary central bankers must recognize and guard against asset Bubbles (also a top priority). The Fed ignores the issue completely. Inarguably, the contemporary U.S. Bubble economy is married to inflating real estate prices and inflating securities values (expanding quantities, as well as rising prices) like never before. The “good” news is that a strong inflationary bias is maintained throughout mortgage finance, the Credit system generally, and the "services" real economy. Current inflationary momentum likely dictates that there is some time remaining for the overheated national housing market, as well as a bit more life left for many dangerous housing Bubbles, including California. But we are in the dangerous, very late stages of an historic housing boom and mortgage finance Bubble. One percent Fed funds is grossly inappropriate for this stage of the Credit cycle. Importantly, there is today The Great Misinterpretation: Most see Promising Nascent Recovery when the reality is Precarious Late Stage Credit Boom. And while I may concur with the optimists regarding near-term GDP acceleration, that’s the extent of our “meeting of the minds.” They relish in the perceived opportunities afforded by cyclical upturns, giddy with the belief that we’ve seen the worst (and it really wasn’t half bad). We see a very different world: the perpetuation of Bubble excess, inducing a compounding of serious mistakes that occur at the manic final stage of the cycle. First of all, considering the fundamental backdrop, current stock market sentiment is truly extraordinary. (Over) Liquidity has worked its seductive magic, with investor optimism having returned to extreme levels. The hedge funds have been forced to reduce short positions, derivative players have unwound bearish trades, and money is again aggressively chasing performance. All of this sets the stage for yet another round of disappointment. And, as always, the “news” follows the general direction of stock prices. Good news is today accentuated (i.e. Intel’s announcement), while negative developments are downplayed or completely ignored. When stock prices commence their decline, we will be hearing and reading much more about the unfolding quagmire in Iraq (as well as Afghanistan and the faltering Mid-East peace process) and the festering energy crisis. There are some serious unfolding problems that are today being whitewashed. And when it comes to Late Cycle Errors, the Fed is absolutely making a mockery out of sound central banking. The economy is quickly heading toward 4% growth, there’s double-digit mortgage debt expansion and a buyers’ panic in some key housing markets, energy (and other) prices are surging, general Credit conditions could not be easier, and our trade deficits are out of control. Meanwhile, this week saw a parade of central bankers assuring the markets that they would keep rates at 1% for “a considerable time”. As such, the Fed is committing (one more) huge mistake. They are playing this as Accommodating Nascent Recovery, when they should be Clamping Down on Late Stage Unruly Credit Boom. In the process, our central bank is bringing new meaning to the term “Behind the Curve.” The Credit market has much reason to worry. Curiously, amid this week’s stock market euphoria, the financial stocks quietly traded unimpressively. Apparently our central bankers believe they are doing the bond market another favor by promising not to raise rates. Yet, so aggressively accommodating Post-boom Boom is doing only further disservice to financial stability. If this were Nascent Recovery fueled by capital investment and pent-up demand for durables, moderate Fed accommodation would be appropriate. To maintain unprecedented accommodation in today’s Late Stage Bubble Environment is reckless. Today’s dilemma – our system’s Achilles heel – is that the financial sector has no alternative than to aggressively expand holdings of risky assets (securities and mortgages). The Fed is on a futile crusade to sustain an unsustainable Bubble that must be financed by a ballooning financial system. There is simply no way around this fact of life. This brings us to the issue of Fed credibility. To read and listen to what our central bankers are thinking these days is not comforting (ok, it’s disturbing). They simply could not be more lost in flawed analysis and oblivious to critical issues. It certainly appears to me that the Greenspan Fed is today the proverbial deer caught in the headlights. I would expect this to be a seething issue for the vulnerable bond market over the coming weeks. As always, the risk of being Behind the Curve is that, after waiting too long, more drastic measures are necessary to get things under control. While comfortable that they have the Fed in their back pocket, the Credit market will nonetheless be haunted by nightmares of an unchecked Credit boom and an endless flood of risky loans and securities.