Saturday, August 30, 2014

08/24/2000 The Law of Diminishing 'Reliquefications' *

The speculative juices were certainly flowing in the equity market this week, as the AMEX Biotech index surged 13% and The Internet index jumped 6%. The year-to-date gain for the AMEX Biotech index has now reached 92%. For the week, the NASDAQ100 added greater than 3%. The Morgan Stanley High Tech index also added 3%, increasing its year-2000 gain to 19%. This week, the small cap Russell 2000 advanced 2%. The Semiconductors added 1%, increasing year-to-date gains to 62%, while the NASDAQ Telecommunications increased slightly for the week. For the bluechips, the Dow and S&P500 gained 1%. The Morgan Stanley Cyclical index declined about 1%, while the Transports, Utilities, and Morgan Stanley Consumer indices all declined nearly 2%. The financial stocks were generally mixed, with the S&P Bank index adding about 1%, while the Bloomberg Wall Street index declined almost 1%.

With this week’s continued rally, long-bond yields are now near 15-month lows. For the week, 2-year yields dropped 4 basis points, 5-year yields 8 basis points, and 10-year Treasury yields sank 5 basis points to 5.72%. Spreads generally narrowed this week, with the benchmark 10-year dollar swap declining 4 basis points to 125. The benchmark Fannie Mae mortgage-back saw its yield decline 4 basis points to 7.68%. The implied yield on the 10-year agency futures contract dropped 7 basis points to 6.81%. It appears that corporate debt is dramatically under performing, with the spread on AA investment grade corporates widening about 3 basis points to a near record 172. Spreads on junk debt also widened several basis points this week to levels approaching 1998 extremes. With oil prices rising, a faltering euro, and yesterday’s report of the strongest German producer price gains in 9 years, pressure is mounting on the ECB to raise rates. European note yields are now near 5-year highs.

Despite all the talk of economic slowdown, there is certainly little sign of moderation in recent money and credit data. Either the economy is not slowing as presumed, or pricing pressures are considerably stronger than perceived. While we continue to suspect that demand remains quite resilient throughout the economy, we also recognize that rising inflation fuels money and credit growth. During the past 14 weeks, broad money supply (M3) has expanded $173 billion, or at an annualized rate of almost 10%. This continues a period of rampant money excess that has seen broad money supply expand $600 billion (almost 10%) during the past year. Looking at recent bank data, we actually see acceleration in bank credit growth, with total bank credit expanding by $127 billion, or at an annualized rate of almost 13% over the past 10 weeks. Total bank loans and leases have expanded at a rate of almost 16% during this period. Year-to-date, total bank credit has expanded at a rate of 9.4%, with loans and leases expanding at a rate of 11%. Interestingly, so far this year commercial and industrial loans have expanded by $75 billion (11.1% rate), while real estate loans have surged $134 billion (13.7% rate). During the past year, total bank credit has expanded by 11% ($500 billion), with total loans and leases increasing 13% ($435 billion). Looking at the two largest categories, commercial and industrial loans increased 11% ($111 billion), and real estate loans expanded 16% ($226 billion). Looking back over what has been an historic 24 months of money and credit excess, we see that total bank credit has expanded 19% ($807 billion), with commercial and industrial loans growing 20% ($182 billion) and real estate loans increasing 26.5% ($336 billion.)

After several months of stagnation, we see that money market fund assets are again expanding rapidly. During the past seven weeks, money market fund assets have increased $73 billion, or at an annualized rate of 33%. Over this period, institutional money funds have increased $40 billion, or at a rate of about 45%. During the past two years, money market fund assets have surged almost $500 billion, or near 40%.

We also see that Fannie Mae has returned to aggressive credit creation. During July, Fannie Mae made gross purchases of $15 billion of mortgages, the most since last September. For the month, Fannie Mae expanded its mortgage portfolio at an annualized rate of 18.6%, its strongest growth since November. After expanding its mortgage portfolio at an 8% rate during the first four months of the year, this rate has since doubled to 16% during the past three months.

With the Federal Home Loan Bank System (FHLB) recently reporting financial results, we now also know that this powerful GSE once again played a major role in “reliquefying,” or perpetuating the great U.S. Credit Bubble. During the second-quarter, the FHLB expanded “advances” (loans) to member institutions by an eye-opening $32.3 billion, or at an annualized rate of 32%. During the past four quarters, FHLB advances have expanded $108 billion, or 33%, to $437 billion. Over this same period, total assets have increased $135 billion to $621 billion, while FHLB short-term debt has increased 67% to $155 billion.

For the “Big Three GSEs” – The FHLB along with Fannie Mae and Freddie Mac - total assets increased $58 billion during the second quarter. For the past four quarters, “Big Three” assets increased $289 billion, or 21%. During the past eight quarters, total “Big Three” assets surged an incredible $612 billion, or 59%. Wow… With such egregious credit excess, there is no mystery surrounding the U.S. bubble. “Big Three” assets now total $1.642 trillion, after ending 1992 at $396 billion. For comparison, during the past two years, total assets of the Federal Reserve have expanded by about $70 billion, or 14%.

With the continuation of truly astonishing money and credit growth, there should be little surprise that the economic boom endures, nor should there be any wonder as to the source for increasingly problematic distortions affecting the U.S. economy. All the same, our central bankers continue to ignore money and credit excess. Most regrettably, they have chosen instead to trumpet productivity improvements and the “New Economy” as responsible for this the longest ever expansion. We would consider this silly analysis, if it were not so perilous. All the same, we have no doubt whatsoever that it is the unprecedented credit explosion that is behind the U.S. boom, not productivity enhancements or improved technologies.

As we have discussed previously, our highly leveraged and vulnerable credit system again came to the brink of a liquidity crisis during this year’s first quarter. As soon as the extreme pre-Y2K money and credit expansion moderated in January, spreads widened abruptly, credit market liquidity began evaporating, and the stock market began faltering. As such, it is critical to recognize and appreciate that for a system involved in credit bubble dynamics, enormous money and credit expansion fodder - additional leveraging – is required to keep a highly leveraged system viable. In the case of the U.S. credit bubble, the focal point of this leveraging is within the financial sector. And, importantly, it is probably most accurate to view the U.S. credit system as being in a state of extraordinary stress since the crisis in the summer and fall of 1998 – a protracted crisis interrupted only by periods of extreme leveraging/money and credit creation (“reliquefication”).

Remembering back to 1998, the key 10-year dollar swap spread widened from 55 to almost 100 as the crisis took hold between August and mid-October. Then, however, unprecedented money and credit growth “reliquefied” the credit system over the next 7 months, with the 10-year dollar swap spread narrowing all the way back to 65. Yet, this massive “reliquefication” ran its course and spreads again widened sharply over the summer of 1999, actually rising all the way to 110 in August and early September. Credit market liquidity was again faltering, stress was building in the fragile interest-rate derivative area, and then the gold derivatives market dislocated spectacularly. But with fears associated with the quickly approaching Y2K, the Greenspan Fed was more than willing to accommodate another round of extreme money and credit growth – “reliquefication” -going into year-end. Over the following five months, truly unprecedented money and credit growth fueled an 80% surge in NASDAQ, with historic speculation especially in the Internet sector. The Internet index surged almost 300% in seven months. As liquidity returned to the credit market, the 10-year dollar swap narrowed from 110 in September to 70 by late January.

When the historic Y2K “reliquefication” subsequently ran its course, systemic stress returned to the fragile U.S. financial system with a vengeance. The heedless Internet bubble was pierced, and the historic NASDAQ speculative bubble was at the brink of a dangerous implosion. The 10-year dollar swap spread widened from 70 in January to an unprecedented 140 during April, while access to the capital market closed for many companies. However, with a return to crisis, it quickly became time for another bout of financial sector “reliquefication.” Here, we definitely believe it became Greenspan’s intention to ward off a major stock market decline, choosing instead to “let the air out” of the U.S. bubble slowly and gradually. The mechanism to “manage” such a major undertaking was to ensure financial market liquidity while accommodating only more money and credit excess. In essence, it became one momentous policy error to add to a lengthening list of major blunders. The consequence has been that since the end of February, broad money supply has expanded by nearly $300 billion, a rate of nearly 10%. This surge in new money creation provided the necessary mutual fund inflows to fuel a significant recovery in NASDAQ, a now nearly 20% year-to-date gain in the Morgan Stanley High Tech index, and a wild speculative run for the AMEX Biotech index that has now posted a 92% year-2000 advance. So much for “letting the air out.” And much to the delight of Wall Street, the IPO market was revived, with speculative demand leading to a flurry of new deals. Liquidity also returned to the debt market, much to the relief of a very long list of cash-strapped companies.

However, there is no cure for the credit bubble disease, and certainly the Fed accommodating additional money and credit excess is anything but a panacea. In fact, we very much believe that there are dynamics in play that can be aptly described as “The Law of Diminishing Reliquefications.” Indeed, we have argued for months that this round of “reliquefication” would be less effective for the markets and, importantly, much more problematic than previous episodes (and inevitable future “reliquefications” even more so!) for the real economy. For one, with the U.S. economy desperately overheated and imbalanced, another big shot of credit-induced liquidity was precisely what was not needed. Our view has been that with the economy running white-hot and capacity constrained, creating additional spending power would lead to bottlenecks, rising wages, rising home prices, general inflationary pressures, and surging imports. Clearly, some unmistakable bottlenecks have developed, with the California energy market, gasoline production, and summer airline travel quickly coming to mind. In past commentaries, we have also highlighted both rising wage pressures and a national real estate bubble that is absolutely out of control in California. These are the enormous costs directly associated with “reliquefications” and continued monetary excess.

And while distortions and inflationary manifestations are generally difficult to quantify, imports are much less so. Monthly imports have now surged more than $11 billion (10%!) during just the past six months. Year-over-year, imports have increased an alarming 19%. Further, the unprecedented money and credit bonanza transpiring during the past two years has stoked a staggering 31% increase in imports – credit inflation manifestations in true form! Right here - with an unprecedented surge in imports - we see the factor most directly raising our country’s standard of living and fueling a protracted period of prosperity. Yet, the Federal Reserve ignores reality, choosing to trumpet what is sold as a miraculous productivity story and a “New Economy.” With June imports totaling $120 billion - almost one-third larger than June of 1998 - it is simply ridiculous to espouse surging productivity as the source of current prosperity. It is also clear that we are increasingly “exporting” our credit inflation. The surge in global oil prices is but only the most obvious of what is surely heightened distortions and imbalances for the global economy. Clearly, US money and credit excesses have come to play a profound role for the global economy, a development that only creates greater fragility for the already vulnerable global financial system and economy.

On another front, it is also interesting (an we would certainly argue quite noteworthy) to see how this most recent “reliquefication” has engendered only a minor pullback in credit spreads. The 10-year dollar swap spread trades today at 126 (versus an average of 84 for all of 1999), while junk bond and corporate spreads remain near record highs. The benchmark Fannie Mae mortgage-back spread to the 10-year Treasury trades today not far off all-time highs at 195, this compared to 122 during January. Agency spreads also trade today at about 114, up considerably from 55 in January. The financial sector may create enormous additional quantities of money and credit, but this liquidity demonstrates increasing preference towards Treasuries and relative safety, at the expense of corporate debt securities and companies that need funding. It is our view that the relative poor performance of U.S. junk and corporate debt issues provides clear and ominous portents for the coming cycle downturn.

And while this most recent bout of “reliquefication” has had a much-diminished impact on the financial system (financial asset prices), it has and continues to be our view that it carries significantly more punch for general inflation and other distortions. One way to look at this situation is to say that while past monetary excess largely fueled NASDAQ and stock prices generally, recent money and credit creation demonstrates considerable “leakage” into wage pressures, imports, and surging crude, gasoline, natural gas and heating oil prices specifically. In this regard, it is our view that we have crossed an important inflection point. The days where monetary excess would conveniently flow into stock market and home price inflation without overt negative consequences are a thing of the past. Going forward, the distorting consequences of money and credit excess will be much more easily discerned, and we don’t see how such newfound “transparency” will be bullish.

In conclusion, it is our belief that the Greenspan Fed has set course for an attempt to “let the air out” of the U.S. stock market bubble slowly and gently (and the nonsense that profound productivity improvements is responsible for minimizing economic imbalances is simply justification for not acting appropriately against bubble excess). And while such a strategy may seem reasonable on the surface, it terribly flawed. With the U.S. in the midst of an historic credit bubble, anything that prolongs this dangerous period of excess will only create a greater disaster for the future. In fact, after so many years of credit and speculative excess, we are now at the point where truly immense money and credit creation is required to keep highly overvalued U.S. equities levitated. At the same time, the degree of monetary excess necessary to perpetuate the U.S. financial and economic bubbles is gargantuan. After all, this credit bubble should have been pierced in 1998, if not sooner. Unprecedented excesses since 1998 have only extended the period of dangerous end-of-cycle extremes we refer to as “the terminal phase of credit excess.” It should be obvious that it is an absolute disaster for the Federal Reserve to accommodate the continuation of this exceedingly long and reckless party. Hopefully (but we are not holding our breath) the surge in oil prices and the appearance of many other distortions and imbalances is aiding the Fed’s appreciation for its failed approach. If not, perhaps global central bankers, increasingly nervous of rising oil prices and heightened risk of inflation, as well as other distortions and imbalances, will finally draw the line and demand that the Federal Reserve rein in this bubble. It is certainly our view that the major rally in energy prices over the past few weeks should have significantly raised the awareness of the danger of the present course in U.S. monetary policy. It is also our perception that the most recent “reliquefication,” as diminished as it was, is about to have run its course. Things could get interesting…