Monday, September 8, 2014

04/01/2005 That Kind-Hearted Kate Welling *

While most of the major indices were about unchanged for the week, equities felt worse than that. For the week, the Dow was slightly negative and the S&P500 was slightly positive. The Transports were hit for 1.5%, while the Utilities recovered 2%. The Morgan Stanley Consumer index was slightly negative, and the Morgan Stanley Cyclical index declined 1%.   The small cap Russell 2000 declined 0.6%, while the S&P400 Mid-cap index was barely positive. Technology stocks were mixed. The NASDAQ100 was unchanged, and the Morgan Stanley High Tech index slightly negative. The Semiconductors declined 1%, while The Internet Index was up 1%. The NASDAQ Telecommunications index was unchanged. The Biotechs were hit for almost 4%. Financial stocks were mixed but unimpressive. The Broker/Dealers were unchanged, while the banks gained 0.6%. With bullion up $1.40, the HUI index rallied 2%.

The bond bear took a respite. Two-year Treasury yields declined 12 basis points this week to 3.73%. Five-year Treasury yields dropped 17 basis to 4.12%, and ten-year Treasury yields sank 15 basis points to 4.45%. The long-bond saw its yield drop 12 basis points to 4.72%. The spread between 2 and 30-year government yields was unchanged at 99bps. Benchmark Fannie Mae MBS yields declined 17 basis points for the week, a decent showing. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note widened 2 basis points to 37, while the spread on Freddie’s 5% 2014 note widened 2 basis points to 34. The 10-year dollar swap spread increased another 1.5 to 46.25. The corporate bond market remains unsettled, with junk spreads widening again this week. The implied yield on 3-month December Eurodollars dropped 15 basis points to 4.165%.

April 1 – Bloomberg (David Russell): “General Electric Capital Corp. and Berkshire Hathaway Inc. led companies that issued $167.4 billion of debt last quarter, 10 percent less than a year earlier… GE Capital…sold $9.4 billion of debt, and…Berkshire Hathaway…issued $3.75 billion of notes and bonds in its first sale since July. Companies were selling bonds at a faster pace than a year ago until GM, the world’s largest automaker, on March 16 said it would have its largest quarterly loss since 1992. Investors then demanded more in yield to own company debt relative to risk-free Treasuries, causing Masonite International Corp., Navarre Corp. and other issuers to delay plans to sell bonds. ‘For the first time in over a year, we started to see signs of volatility creep into the credit market,’ said James Esposito, head of the investment-grade syndicate desk at Goldman Sachs… ‘Issuance has slowed a bit because of recent volatility, not necessarily because interest rates are higher.’   …Convertible bond issuance was down 61 percent to $6.6 billion.”

March 31 – Bloomberg (Walden Siew): “General Motors Corp. led the worst month for automotive company bonds in at least eight years as lower sales and record-high oil prices made it harder for the manufacturers and parts suppliers to meet debt payments. A Merrill Lynch & Co. index showed that auto sector bonds have given investors a 5 percent loss during March through yesterday, including reinvested interest, compared with a 1.3 percent loss overall for investment-grade debt. GM's 7.75 percent note due in 2036 dropped 23.5 percent… Merrill Lynch’s index of investment-grade debt fell 1.34 percent this month, and is down 1.18 percent for the quarter.”

April 1 - Dow Jones (Simona Covel): “Shaken by higher interest rates and the seemingly imminent prospect of giant General Motors Corp.’s arrival in the speculative grade market, U.S. high-yield bonds lost more value in March than in any month since July 2002. The junk bond market shed about 2 1/2% in March, the greatest monthly loss since the market plummeted almost 4% in the wake of the WorldCom Inc. accounting scandal nearly three years ago…”

April 1 – Bloomberg (Joe Mysak): “If you thought the pace of municipal bond issuance would slow in response to higher interest rates, think again. More bonds were sold during the first quarter of 2005 than in any other first three months of a year. The estimated $96 billion (the figures are massaged for some time after the quarter ends) sold so far this year eclipses the previous record, which was the $87 billion sold in 2004. In 2003, the market’s record year, when $384 billion in municipal bonds were sold, the first quarter amounted to $85 billion… The second quarter of 2003 holds the record for a quarter, at $120 billion. The fourth quarter of 1985, when issuers rushed to market to avoid tax law prohibitions scheduled to go into effect in 1986, saw $110 billion in municipal bonds sold. The fourth quarter of 2002, at $105 billion, the second quarter of 2004, at $104 billion, and the second quarter of 2002, at $98 billion, round out the top five.”

April 1 – Bloomberg (Adrian Cox): “U.S. companies sold more shares in initial public offerings in the first quarter than in any similar period for the past five years, as economic growth fueled stock sales and reduced demand for convertible bonds and agency debt. The value of IPOs sold in the first three months of 2005 rose 47 percent to $10.1 billion from a year earlier, the highest amount since a record $18 billion was sold in the first quarter of 2000, data compiled by Bloomberg show. Convertible bond issuance dropped 61 percent to $6.6 billion, a fifth of 2002’s level. U.S. agency debt sales fell 40 percent to $177 billion from last year’s peak.”

Corporate issuance came to a near standstill during the final week of the quarter. Investment grade issuers included Keyspan $300 million, American Standard $200 million, and First Citizens $75 million.

At $1.1 billion, junk bond fund outflows were heavy for the second straight week. Issuers included Sunstate Equipment $125 million.

Foreign dollar debt issuers included National Australia $500 million.  

Japanese 10-year JGB yields dropped 4 basis points to 1.33%. Emerging debt markets generally regained their composure, at least for this week. Brazilian benchmark dollar bond yields dropped 44 basis points to 8.66%. Mexican govt. yields ended the week down 18 basis points to 6.07%. Russian 10-year dollar Eurobond yields declined 4 basis points to 6.36%.

Freddie Mac posted 30-year fixed mortgage rates increased 3 basis points to 6.04% (up 47bps in 7 weeks). Fifteen-year fixed mortgage rates added 2 basis points to 5.58%. One-year adjustable rates jumped 9 basis points to 4.33%. The Mortgage Bankers Association Purchase Applications Index rose 5.5% this past week. Purchase applications were up 6% from one year ago, with dollar volume up almost 19%. Refi applications declined 2%. The average new Purchase mortgage jumped to $245,600. The average ARM increased to $336,600. The percentage of ARMs jumped to a record 36.6% of total applications.  

Broad money supply (M3) rose $17.9 billion to $9.51 Trillion (week of March 21). Year-to-date, M3 has expanded at a 2.0% rate, with M3-less Money Funds growing at a 5.8% pace. For the week, Currency added $1.3 billion. Demand & Checkable Deposits surged $25.9 billion, while Savings Deposits dipped $3.1 billion. Small Denominated Deposits gained $4.1 billion, and Retail Money Fund deposits gained $2.1 billion. Institutional Money Fund deposits declined $6.4 billion. Large Denominated Deposits dropped $7.2 billion. Repurchase Agreements added $1.6 billion, while Eurodollar deposits dipped $0.3 billion.              

Bank Credit has expanded a remarkable $301.8 billion during the first 12 weeks of the year (19.4% annualized). Securities Credit is up $119.4 billion, or 27% annualized year-to-date. For the week of March 23, Bank Credit increased $4.2 billion to a record $7.048 Trillion.   Securities Holdings added $0.5. Loans & Leases gained $3.7 billion, expanding at a 16% rate year-to-date. Commercial & Industrial (C&I) loans dipped $0.6 billion. Real Estate loans jumped $9.3 billion. Real Estate loans have expanded at a 17% rate during the first 12 weeks of 2005 to $2.642 Trillion. Real Estate loans are up $347 billion, or 15.1%, over the past 52 weeks. For the week, consumer loans added $0.9 billion, while Securities loans declined $3.8 billion. Other loans dipped $2.2 billion.  

Total Commercial Paper dropped $20.2 billion last week to $1.429 Trillion. Total CP has expanded at a 4.4% rate y-t-d (up 8.4% over the past 52 weeks). Financial CP declined $10.9 billion last week to $1.293 Trillion. Non-financial CP dropped $9.3 billion to $136.4 billion.    

Fed Foreign Holdings of Treasury, Agency Debt rose $3.0 billion to $1.392 Trillion for the week ended March 30. “Custody” holdings are up $55.9 billion, or 16.7% annualized, year-to-date (up $232.4bn, or 20%, over 52 weeks). Federal Reserve Credit declined $1.1 billion for the week to $782.3 billion, down 4.2% y-t-d (up $44.6bn, or 6.0%, over 52 weeks).

ABS issuance slowed to $6 billion (from JPMorgan). First quarter issuance of $149 billion was about unchanged from comparable 2004. At $93 billion, y-t-d home equity ABS issuance was 6% above year ago levels.  

Currency Watch:

The currencies were quite volatile this week, as the dollar index mustered about a 0.5% gain. On the upside, the Brazilian real gained 2.5%, the Iceland krona 2.0%, the South African rand 2.0%, the Colombian peso 1.3%, and the Mexican peso 1.25%. On the downside, the Swedish krona dipped 0.6%, the Philippines peso 0.5%, and the Singapore dollar 0.4%.

Commodities Watch:

April 1 – Bloomberg (Claudia Carpenter): “Commodities prices had their second-biggest quarterly gain since 1988 as oil jumped to a record $57.60 a barrel, copper touched a 16-year high and coffee, soybeans and cotton rose 15 percent or more. Surging demand for raw materials in China and accelerating economic growth in the U.S. helped send the Reuters-CRB Index of 17 commodities up 10.5 percent, the most since an 11.2 percent gain in the 2004 first quarter. The index rose to a 24-year high on March 16 and may reach a record because investors are buying commodities as alternatives to U.S. stocks and bonds. ‘We’re continuing to see, even with the highs reached in commodities, just a mushrooming in how many institutional investors are allocating new money,’ said Robert Leary, 44, a managing director at Wilton, Connecticut-based AIG Financial Products Corp….”

April 1 – Bloomberg (Koh Chin Ling): “China, the world’s largest cotton consumer, will probably have a bigger shortfall next year because 2005 cotton acreage may fall about 11.5 percent, the National Development and Reform Commission said… Prices of the fiber are expected to rise this year because global production may drop 9 percent while consumption may rise 2 percent, the commission said…citing international forecasts.”

May crude oil jumped $2.43 to $57.27. For the week, the CRB index rose 1.6%, increasing y-t-d gains to 9.8%. The Goldman Sachs Commodities index surged 4.5% to a record high, pushing 2005 gains to an impressive 26.2%.

Global Financial Stress Watch:

March 29 – Dow Jones (Arden Dale): “Investors in emerging-market mutual funds and hedge funds reversed course dramatically in recent days, staging a big pullout due to worries about inflation.   A major rout in emerging-market stocks and bonds that began earlier this month is the impetus behind the move, according to analysts. Last week, shareholders in emerging-market stock funds yanked out more money than they have since last May, according to fund tracker Emerging Portfolio Fund Research. Emerging-market bond funds also were hit hard, EPFR said. For the first time this year, investors took more money out of the bond funds during the week than they put in.”

China Watch:

March 30 – Bloomberg (Rob Delaney): “China’s rising property prices pose a threat to the stability of Asia’s second-largest economy and local officials who fail to take measures to rein in growth will be held to account, the country’s highest ruling body said. The State Council, China’s cabinet, ordered the clampdown in a six-page document…that was circulated to city governments and state media… ‘Excessive growth in housing prices has directly undermined the ability of city residents to improve their living standards, affected financial and social stability, and even influenced the health of the national economy,’ the document said.”

March 28 – AFX: “China’s economy will show growth of 8.8 pct year-on-year in the first quarter of this year, down 0.7 percentage points from the fourth quarter of last year, a government think tank research report said. A slowing agricultural sector and decreased investment are the main factors behind the less robust gross domestic product growth…”

March 29 – Bloomberg (Wing-Gar Cheng): “China’s consumption of oil this year may rise 10 percent to 354 million metric tons because of surging demand for fuels, the China Petroleum & Chemical Industry Association said. China’s reliance on imported oil will increase as local production isn’t meeting the country’s needs, Tan Zhuzhou, the association’s president, said….”

March 29 – Bloomberg (Koh Chin Ling): “China’s exports of textiles and garments rose 31 percent in the first two months, more than double the rate analysts say might prevent competitors in the U.S. and European Union from requesting trade limits. Overseas sales of clothing and fabrics rose to $12.5 billion in January-February from $9.6 billion a year earlier…”

March 27 – AFX: “China’s electricity consumption is expected to reach 2.42 trln kilowatt hours (kWh) this year, up 12 pct from last year, the Economic Daily reported, citing the chairman of the State Electricity Regulatory Commission. Chai Songyue also said that China’s electricity demand this year will increase by 12 pct and that the country’s power supply is expected to remain tight due to insufficient coal supply, overloaded power generators and transmission lines.”

Asia Inflationary Boom Watch:

April 1 – Bloomberg (Heejin Koo and Young-Sam Cho): “South Korean exports rose faster than economists expected to a record in March, led by European sales of cars made by Hyundai Motor Co. and Kia Motors Corp. Exports gained 14.2 percent from a year earlier to $24.2 billion, accelerating from February’s revised 6.7 percent growth… The pickup in exports may help Asia’s third-largest economy meet the government’s growth target of 5 percent for 2005.”

March 30 – Bloomberg (Anuchit Nguyen): “Thailand’s economic growth will exceed 5 percent this year as revenue from tourism revives after the Dec. 26 tsunami that killed more than 5,300 people in the Southeast Asian nation, central bank Governor Devakula said. ‘Economic growth will remain strong because tourism is good. Economic growth will certainly exceed 5 percent.’”

March 28 – Bloomberg (Stephanie Phang): “Malaysia’s broadest measure of money in circulation expanded more than 12 percent for the third straight month in February, the central bank said today. M3, the most closely watched measure of money supply, rose 12.4 percent in February from a year earlier…”

April 1 – Bloomberg (Shanthy Nambiar and Soraya Permatasari): “Indonesia’s inflation accelerated to its fastest pace in at least 26 months in March after the government raised fuel prices, increasing pressure on the central bank to raise interest rates. Consumer prices rose 8.8 percent from a year earlier compared with a 7.2 percent gain in February, led by a surge in transportation costs… Accelerating inflation may drive up interest rates, slowing Indonesia’s economy, Southeast Asia’s largest, after its biggest expansion in eight years in 2004.

April 1 – Bloomberg (Jason Folkmanis): “Vietnam’s economic growth accelerated in the first quarter, boosted by services that make up two-fifths of the $40 billion economy. Gross domestic product expanded 7.2 percent from a year earlier, according to preliminary estimates released by the General Statistics Office… That compares with 7 percent growth in the first quarter of 2004. Services expanded 7 percent compared with 6.6 percent growth a year earlier as easy credit fueled business investment. ‘You see investment everywhere, renovation of businesses, new buildings going up,’ Susan Adams, the International Monetary Fund’s senior resident representative in Vietnam. ‘People are increasing the quality and variety of the goods that they consume.’”

Global Reflation Watch:

March 30 – AFX: “Average year-end bonuses paid by Japanese companies with five or more employees rose 2.7 pct to 430,278 yen last year, the first increase in eight years, the government reported. Bonuses rose from 1.2 pct to 19.6 pct in seven industries, including the manufacturing, construction, real estate, electricity/gas and mining industries, according to a survey released by the Ministry of Health, Labor and Welfare. Year-end bonuses fell in only two industries -- the wholesale/retail and financial services/insurance sectors.”

March 29 – Bloomberg (Harumi Ichikura): “Honda Motor Co., Japan’s third-largest automaker, said global production of its cars and light trucks rose 10.5 percent in February compared with the same month last year… Toyota Motor Corp., Japan’s biggest automaker, said global production of its cars and light trucks rose 11.6 percent in February from a year earlier… Nissan Motor Co., Japan’s second-largest automaker, said global production of its cars and light trucks rose 10.8 percent in February compared with the same month last year.”

March 31 – Bloomberg (Alexandre Deslongchamps): “Prices for existing Canadian homes rose to a record in February, buoyed by rising employment and mortgage rates near 50-year lows. The average price for a house or condominium rose 8.3 percent to C$238,778 ($197,326) as sales climbed 2.4 percent to C$9.16 billion, the most ever, according to the Canadian Real Estate Association in Ottawa. The number of units sold rose 3.5 percent to 38,215, the most since September 2004. ‘The continuation of low interest rates is keeping housing demand strong, it’s that simple,’ said Gregory Klump, the association’s senior economist. ‘Continued job growth has helped sales to continue momentum.’”

March 30 – Bloomberg (Christian Baumgaertel and Brian Swint): “Money supply growth in the 12 countries sharing the euro unexpectedly slowed in February, easing pressure on the ECB to raise borrowing costs. M3 increased 6.4 percent from a year earlier after expanding 6.6 percent in January, the ECB said in Frankfurt today… The bank says a rate above 4.5 percent risks fueling inflation…   Credit to households and companies grew 7.3 percent, the same pace as the month before, when the rate was the highest in more than three years. ‘The fuel is here to support the housing market for a long time,’ said Lorenzo Codogno, co-head of European economics at Bank of American in London. ‘The excess liquidity floating around can push asset prices’ higher than they otherwise would be.”

March 28 – AFX: “Pay settlements in the UK continue to edge higher and are rising at their fastest rate in six years, a survey found today. Pay analysts Industrial Relations Services, part of the LexisNexis Butterworths online information group, found its headline measure of pay awards across the whole economy standing at 3.3 pct for the three months to February…”

March 30 – Market News: “Home construction in France remained buoyant in February, with the launch of nearly 33,000 units -- a rise of more than 13% from February 2004, according to non-seasonally adjusted data released Wednesday by the Construction Ministry. The three-month annual comparison highlighted by the ministry showed a gain of 13.4% for December-February over the previous-year period.”

March 28 – Bloomberg (Jeffrey T. Lewis): “Prices of goods leaving Spanish factories, farms and mines rose  0.7 percent in February from the previous month, as an increase in the cost of oil boosted the price of gasoline and other energy products. Producer prices rose 4.9 percent from a year earlier…”

April 1 – Bloomberg (Bradley Cook): “Russia’s manufacturing activity in March accelerated at the fastest pace in seven months as factories increased output to meet swelling demand, an index of purchasing managers showed... The survey of 300 purchasing managers ‘signals further improvements in Russia's industrial dynamics, with the headline index reaching a seven-month high…’”

Dollar Consternation Watch:

March 30 – AFX: “The US dollar is facing an imminent collapse and a standard gold currency is the best alternative for international trade, the Star quoted former prime minister Mahathir Mohamad as saying. The dollar is retaining some value because of fears of a global economic catastrophe if it is rejected, Mahathir told a conference of some 650 chief executives from 30 countries at a conference in Kota Kinabalu on Borneo island yesterday, the report said. ‘But the catastrophe will come one day because even the most powerful country in the world cannot repay loans amounting to seven trillion dollars,’ Mahathir said.”

Bubble Economy Watch:

March 31 – Bloomberg (Martin Z. Braun): “New York state lawmakers approved a $106.6 billion spending plan, the first on-time budget in 21 years. The plan leaves open to negotiation $1.6 billion in additional spending for welfare, the state’s voting system and construction projects for public and private colleges. In the past five years, New York State’s budget has grown 37 percent from $77.5 billion in fiscal 2001.”

March 29 – The Wall Street Journal (Paul Glader): “Keith Busse added three Corvettes this year to his stash of 51. They’re housed in his Corvette Classics Museum, an 18,000-square-foot showroom open to the public. The 61-year-old Mr. Busse lives in a 7,000-square-foot mansion when he’s not spending time at one of his two lakefront retreats or shooting 18 holes at a golf course he spent $1.2 million to help build. Last year his compensation totaled $9.4 million and his net worth rose 30% to about $50 million. A boom in steel, coal and iron ore is bringing wealth commonly associated with Wall Street and Silicon Valley to an unlikely place: America’s industrial heartland.”

Financial Bubble Watch:

April 1 – Bloomberg (Kathleen M. Howley): “Manhattan apartment prices surged 23 percent to a record $1.21 million during the first three months of the year as the city’s economy expanded and Wall Street bonuses fueled purchases in New York’s priciest borough. The average price rose from $987,257 in the fourth quarter of 2004, according to a report published today by Miller Samuel Inc., the borough’s largest appraiser, and real estate brokerage Prudential Douglas Elliman. It was the second-biggest price gain ever, following a 23.5 percent jump in 2001’s first quarter… New Yorkers flush with bonuses bid up prices, rushing to beat rising mortgage rates, after the city’s economy expanded at the fastest pace in four years. Wall Street firms such as JPMorgan Chase & Co. and Merrill Lynch & Co. awarded $15.9 billion at the end of the year, an average of $100,400 per employee, New York state Comptroller Alan Hevesi has said. ‘There’s a lot of Wall Street bonus money in these numbers,’ Miller, 44, said. ‘New Yorkers had money to spend, and they wanted to get their mortgages before interest rates went up.’ Compared with the first quarter of 2004, the average price for an apartment gained 26 percent from $966,292, the report said.”

That Kind-hearted Kate Welling:

I was traveling at the end of the week and had limited time to put together this week’s Bulletin. I am indebted to that Kind-hearted Kate Welling for graciously allowing me to use one of her recent interviews from her outstanding Welling@Weeden publication. The interviewee seemed a little odd to me, but he may have made a couple of ok points. My take is that the interviewer makes him come across smarter than he is.

This following is a reprint of an interview with Doug by Kate Welling recently published in welling@weeden. Copyright, welling@weeden, 2005, All Rights Reserved. Reprinted with permission. For further information, call 203 861-7643.
“Gimme Credit—Not!” was the headline I put over my last full scale interview with my old friend Doug Noland, in these pages, back in December of 1999. If Doug, who writes The Credit Bubble Bulletin every week for David Tice & Associates at, was extremely worried by the economic climate back then, he’s beside himself now. And he’s still very much worth listening to. I called him last week, after he took the Fed’s latest Z.1 apart in print, piece by piece.

Kate Welling: You’re like a kid in a candy store, Doug, every time the Fed releases a fresh Z.1—a macabre kid in Harry Potter’s candy store, that is.
Doug Noland: Oh geez, you’re not going to harp about all that gloom and doom stuff, are you?

That’s your role. I really try to avoid it; it’s just too darn depressing. But I have to admit, the dimensions of the credit expansion are mind-boggling. Even though the Fannie and Freddie, which you were so fixated on a few years back, have been largely taken out of the picture.
That’s the power of the bubble. Once you create a bubble, it will sustain itself one way or the other. Once you get it revved up, everybody is waiting for an opportunity. So someone dropping out just becomes an opportunity for the others. That’s why you can’t let the bubbles get this heated.

You wrote that banks have been only too eager to pick up the slack from the GSEs?
Yes, banks can grow their balance sheets as much as they would like today. And they are. For 2004, the pace of domestic financial sector debt growth actually declined to 7.2% from 10.4%— chiefly because of the abrupt slowdown in GSE asset growth and their attendant credit market borrowings. That slowdown, however, was more than compensated for by the ballooning in bank deposits and other financial sector claims. Total GSE assets increased only $109 billion last year, or 3.9%, to $2.9 trillion, and were essentially flat in the fourth quarter. Quite a comedown from their double-digit growth rates from 1998-2002, and even from 2003’s 9%. Meanwhile GSE mortgage-backs grew by only $54 billion last year, to $3.54 trillion. The action in structured finance has switched into asset-backed securities, where outstandings surged a record $331 billion, or more than 13%, to $2.82 trillion. In fact, ABS is up $600 billion, or 27% in just two years. Yet even if structured finance provided the financial genesis of the credit bubble, its the banks and brokers and their clients who are keeping it aloft today. Banks are extending a lot of mortgage credit, generating lots of fee income that flows into earnings.

Surely you don’t have a problem with that? Mortgage lending is as American as apple pie.
Apparently. Let me put it this way: The Z.1 is this beautiful document because it shows clearly where the credit excesses are—and those excesses explain so much of the strange behavior of the economy. This one quarterly statistical release provides lots of answers.

Only if you can navigate a mind-numbing avalanche of numbers.

It is packed with a lot of them that are worth noting. Like the fact that bank credit expanded 9.2% last year, or by a record $569 billion, while bank loans grew by 9.1% or $403 billion, also a record. Or that bank mortgage exploded to $2.6 trillion last year, a gain of 15% or $339 billion—and at better than twice the pace it had grown, on average, during the preceding 8 years. On the banks’ liability side, total deposits last year climbed a record $510 billion, or 11.3%, to $5.03 trillion. And anyone who takes some time to study the statistics in the Z.1 can also see, for example, that these dopes running around talking about a “shortage of bonds” because “corporations are so flush” are just that—dopes.

 I don’t know about “anyone” but the preternaturally perceptive Andrew Smithers did a neat job in a recent report (published by his Smithers & Co.) of using the Z.1 to show that U.S. companies are anything but flush with cash. His contention, in fact, is that they’re currently paying out more, in (paltry) dividends and share buybacks, than they’re earning in profits—a situation that clearly can’t go on forever, and has obvious negative implications for the stock market.

I haven’t seen that research. But I was thinking in even more macro terms. Greenspan was recently asked about all those projections a few years ago of federal surpluses “as far as the eye could see.” His response was basically, “Well, we were all wrong. Everybody thought there would be surpluses.” That’s just so outrageous. I mean, it was just so clear, if you looked at the Z.1 and if you really understood the flow of finance back in the late ’90s, you had to see the huge capital gains tax bonus pouring into the federal government. And you had to know it was unsustainable. Today’s situation is very similar. We have huge federal borrowings and mortgage credit that have created just a huge tailwind of finance blowing across corporate America. But it’s not sustainable. You can’t continue to create almost $1.2 trillion in mortgage credit every year—because then you’d continue to have these massive current account deficits and all of the distortions that go with them. Everyone wants to extrapolate the “positive” bubble effects. We don’t learn.

Come on, Doug. Housing values aren’t going to pop like the internuts back in 2000.
Unfortunately—the key right now is that the trillion dollars plus of total mortgage credit created last year is directly linked to the current account deficit.

What? There can’t possibly be that many hedgies buying houses in the Cayman Islands—
No. The linkage I see is that when people borrow against their homes and when you have this inflation of asset values, it leads to over-consumption. I think you can draw that link clearly. The issue is global now. How long will the world continue to buy these dollar balances? Obviously, recently, we’ve been hearing from the South Koreans, the Japanese. Everybody is saying, “Oh, my gosh, no mas, please!”

Already, the only foreign interests actually buying our paper are the central banks. Private investors aren’t interested.

The official flows are just amazing. What’s called Rest of World (ROW) holdings of U.S. assets last year increased by better than 13% to $9.29 trillion. Official holdings, soared by $290 billion, or 25.3%, to $1.44 trillion last year, making the two-year increase in official holdings an unprecedented $537 billion, or 60%. In fact, official holdings lately have been rising more in one quarter than they did in each year, on average, between 1998 and 2002. But a clear preference, among foreign investors, for holdings of U.S. credit market instruments, as opposed to direct investments of any kind is also visible in the numbers. Thus, foreign direct investments climbed only 10.5% last year, to $1.72 trillion, while ROW holdings of U.S. credit market instruments surged 21% to $4.7 trillion.

You’re saying foreign investors would rather buy Treasuries and ABS than make direct investments in this country. Okay, but so what?

What that points to is that the “love affair” you hear some people talking about between foreign investors and U.S. assets is really more a case of foreign central bankers doing what they have to support their currencies by recycling dollars. And if they do the same thing for the next year, do we have $80 oil? Today you can clearly see the price effects on global commodities prices. The CRB Index has just been on the fly. So if the central banks want to continue this recycling, we’ll see what happens with global commodities, with the Asian boom and the emerging market boom. We’re finally at the point where the inflationary bias globally is pretty intense. If we continue to feed that animal, there are going to be consequences.

Isn’t that precisely what you see Greenspan and company trying to do? Asset inflation is surely more palatable than deflation.

Oh, sure. But I’m not certain that they appreciate the dynamics of mortgage credit—how it will continue to expand. I have never really sensed that there is an appreciation of that.

What’s wrong with mortgage credit growing?

Well, take California, where home prices climbed 20% over the past year. That means that this year, mortgage credit there has an inflationary bias: More credit will be created simply because of the prices of the homes have gone up. Even if the number of transactions is flat this year with last, 15%-20% more credit will be created. And home prices have risen across the whole nation, which will feed more speculative excess, more transactions and more credit creation. Even Freddie Mac, which has been moaning about falling originations and fewer refinancings, estimates total mortgage credit growth of 11.9% this year (vs. a record $1.19 trillion, or 12.8% increase, in 2004). That is the dynamic that I’m not sure the Fed fully appreciates. Yet it is a key dynamic because all of this new mortgage credit is creating distorted spending patterns, and, especially, over-consumption. Yet the Fed doesn’t seem to have a problem with it. From what I’m reading, they seem to be expecting a natural slowdown in the growth of mortgage credit this year. But that’s just not the way that bubbles work. It won’t gently slow just because rates have risen a little bit. Inching rates up in baby steps isn’t going to curb mortgage borrowing, no way. Speculative psychology is so strong in housing, they’re really going to have to ratchet rates up.

And deliberately pop another bubble? No way.

Look, whether you do macro credit analysis, or just old school inflationary analysis, if you look at the Z.1, you can see why my thesis is that this thing is a runaway train heading for a financial accident.

There you go with the gloom and doom again.

I know, but when I do the analysis, that’s where I come out. I just don’t see anything to slow down this impending train wreck. What I mean is, it would take exorbitantly higher rates to slow this down, but those sorts of rates, in and of themselves, would probably produce the accident. So to me, this is a runaway train at this point. Everyone can get all bullish because they see liquidity everywhere, but that is kind of textbook, too; that’s the way credit bubbles suck everyone in at the end.

You don’t agree, as a great lady once said, that too much of a good thing is just about right?
Absolutely not. Too much liquidity is a sign of the problem. Why did NASDAQ spike up like it did? Because of wild liquidity excesses. You always have wild liquidity excesses when you have this kind of monetary disorder. So why did NASDAQ collapse? NASDAQ collapsed because it went into a melt-up mode. When you create all this liquidity and prices spike up, eventually they reach a tipping point and reverse—and then liquidity collapses. Right now, wherever you look, you see liquidity. But you are also seeing global asset inflation and speculation. Which means that this thing is going to require continuous injections of liquidity now, to keep this thing levitated. But that’s the danger. Right now, the system can, and does, create enough liquidity to keep everything up. But how long can this go on? It’s already at the point now, where huge amounts of liquidity have to be created, because asset inflation has gone global; market bubbles have gone global.

 As long as the governments of the world keep running their printing presses, what’s wrong with a using a little inflation to keep things moving along?

There are consequences—and they are not all benign. Look at the price of oil, look at copper. These are distortions. What are the consequences, if this liquidity continues for another year? And what are the consequences if all of a sudden something impedes the flow? Either case is troubling.

Which would be worse is the question. Clearly, the Fed is working to insure that there’s no end to the flood of liquidity. Your friend at the German central bank is about the only one who wants to take away the punch bowl.

Otmar Issing? He’s chief economist of the ECB now. But what he’s saying is nothing more than any other traditional central banker should be saying. When I went to Australia to study, I spent a lot of time in the library reading the history of central banking. The sort of language Otmar uses—that’s traditionally the way central bankers are supposed to talk. The sort of talk we’ve heard recently from Alan Greenspan and Ben Bernanke is unbelievable to me. This is New Age central banking; there has never been anything like it. They’ve both effectively thrown up their hands and said they can’t deal with these excesses.

Traditional central bankers didn’t have a wonderful track record in dealing with bubbles, either.
It’s not perfect.

I’ll say. History is full of booms and busts—and their painful consequences.

No argument. But I have been reading the biography of one of Greenspan’s illustrious predecessors, William McChesney Martin. Even 3% inflation drove him crazy in the 1950s and 1960s. He didn’t want to see any speculation. He had been president of the New York Stock Exchange when he was younger. He just understood the markets. He didn’t want to see a market get all revved up, because once one gets revved up, it’s very hard to control the excesses. Today, no one will even address all this speculation. And we’ve come to the point where the Fed uses the speculating community as a “tool” of reflationary monetary policy.

 He must be spinning in his grave. Speculation is what passes for investment these days.
It dominates the financial markets.

Fundamentals are irrelevant when long-term is this afternoon. And especially when the majority of transactions are in derivatives. There’s a huge disconnect today between traditional business economics and the machinations of today’s financial markets.

That’s very well said. That is my point when I talk about “financial arbitrage capitalism.” I mean, you are what you eat. The economy is how the financial sector lends. So if everything is a spread trade and no one cares about the underlying credit or the underlying economic return, how could you expect that to work well for the structure of the economy? It can’t, yet that’s what we see today. The system just wants to buy mortgage backs, or some derivative or some mortgage credit. So that’s what the system lends to. What are the consequences? We have asset inflation and over-consumption and huge trade deficits.

That’s very well said, too. But the “beauty” of the whole thing is that nobody is responsible. Everyone is just doing what he has to do to earn a return.

Absolutely. Hats off to them. That’s why this all boils down to the Fed. Only the Fed can possibly control the direction in which the financial sector evolves. But they’ve just thrown up their hands and said, “We trust the markets to do what is best.”

The ascendancy of unfettered market capitalism has been evolving for over 20 years.
The mid-1980s is a great starting point for it. Henry Kaufman had it right there in his 1984 book: “Securitizations are the future. Forget bank loan officers. Now we can just package up loans and sell them. Finance is changing.”

It was incredibly liberating to shake off the shackles of Regulation Q; to march to the beat of the market, instead of fusty old regulators. But somewhere along the line, the rewards got separated from the risk-tasking.

What frustrates me is that no one ever asks, what’s the end game? There is this whole Keynesian idea that the Fed will allow 3% inflation every year to keep the wheels moving. That’s fine, but only for a while. It reminds me of telling a child he can grow 5% every year. That’s fine until he reaches 18 or 19, but then you have to change the rules. If he continues to grow at that rate, he’ll kill himself. The nature of the system changes. At some time, you have to make the difficult decision to recognize that. Today, we just ignore the way the system has changed. But we can’t just sit back and let the markets do whatever they want, accept a 3% CPI and ignore asset inflation, as contemporary economics would have us do. It’s just not sensible to ignore the tremendous changes in the financial sector and the economy that have occurred in the last 20 years, much less since Keynes was around.

Clearly, there’s no rolling back the clock. Just as clearly, the financial system has grown like topsy. You’re implying that there’ll be some kind of day of reckoning, but that assumes an assumption of responsibility. And that just doesn’t happen these days, at least unless Eliot Spitzer gets involved. To otherwise adopt old-time fiduciary religion is career suicide.

Exactly, It’s so clear in my mind—in the category of often wrong, never in doubt—that in the whole focus on the market pricing mechanism, you have to separate the sphere of the real economy from the financial sphere. It’s popular to quote Adam Smith these days. But even Adam Smith said the whole basis of free-market capitalism is sound finance, though that is not what he called it. Back then, it was gold-backed money. But the point is, if the financial sphere is out of control, there is no way the market pricing mechanism can function properly in the economic sphere. They are not all one. The financial sphere—credit—has to be restrained. Financial excesses have to be restrained. If they are not, you lose control of the pricing mechanism and so the whole system breaks down. That is what you are observing right now. Nobody has any incentive to slow down this runaway train. Everybody has every incentive to play this game as hard as they can, and it is a self-reinforcing mechanism. I repeat: If the central bank doesn’t have the financial sphere under control one way or the other, it will lose control in a big way, and the system will not self-correct. The market pricing mechanism cannot self-correct in an era of uncontrolled finance.

A much older and wiser market pro put it to me somewhat differently, the other day, observing that the ultimate irony is that Karl Marx, in some sense, was right: Capitalism is destroying itself because it has succeeded in utterly divorcing financial markets from their basic economic raison d’etre.
Finance has got to be restrained, I can’t over-emphasize this point, by the real economy. If it is, over-investment in the real economy causes returns to drop, and the market pricing mechanism tends to restrain the amount of new finance going into that area.

And if it’s not, there’s virtually no limit to how much can be poured into a rat hole like the internuts or credit default swaps.

Yet even a Bill Gross has been quoted saying something as nonsensical as we have more savings than we do investment opportunities, or something to that effect.

He’s a pretty smart cookie.

Yes, but that is not it at all. I mean, if you are going to pour all this finance into asset prices, real estate or securities, the system will create huge excess liquidity, above what can be used in the real economy—by definition. That is part of the whole distortion of market pricing mechanism. You don’t want all this speculative finance going into the asset markets because it starts to overwhelm the amount of finance needed for real investment. That is how you create bubbles. So sure, now we have a huge surplus of dollar IOUs arising from borrowings against homes and securities. But don’t call that “savings.” Bernanke saying that our current account deficit arises from not having enough savings for the amount of investment we do—What kind of craziness is that?

That’s pretty strong language.

He’s too intelligent to actually believe it. Here’s the quote: “Over the past decade, a combination of diverse forces has created a significant increase in the global supply of saving—a global saving glut—which helps explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today.” How do you avoid talking about consumption when you’re talking about the current account deficit? You don’t avoid it accidentally! Bernanke’s statement just was not credible coming from someone in his position. Especially at the same time that Japan’s prime minister and central bankers throughout Asia are getting a little tired of absorbing these dollar balances. I just think that today our financial officials at least need to demonstrate that we understand there is a problem.


They could start by admitting there are excesses in mortgage finance and beginning to rein it it.

Are you kidding? What a firestorm that would set off.

If they don’t address mortgage finance excesses and over-consumption, they’ll never address the current account deficit, which is directly linked to them. We’re in a liquidity boom now, the banks and the hedge funds have stepped into the roles Fannie and Freddie used to play. But what happens when the market get over-leveraged a little bit and we do not have the GSEs to provide the “backstop” bid? It is going to be so interesting to watch how this works, the next time the hedge funds decide to sell their mortgage-backeds. Who is going to buy them? Obviously, the Fed doesn’t want rates to go up to a point that will force the hedge funds to liquidate that paper. But if rates don’t go up, we’ll add another $1.3 trillion in mortgage credit this year, and add some $750 billion to the current account deficit. Again, what is the end game?

Well, how high can rates go before we hit that tipping point?

No idea. But probably higher than most people think because of financial innovation. If folks don’t like the 30-year fixed mortgage rate, they will take the ARM. They just want to get into the home. And that is something, again, that you can see quite clearly in the Z.1.


In the Household balance sheet, even though it includes “non-profits.” During 2004, household assets surged by over 9%, or by $5.07 trillion—meaning that households’ assets have grown more in the last two years (by $10.9 trillion) than they did even at the 1998-’99 peak of the tech bubble, when they climbed by $9.4 trillion. And a large chunk of that appreciation took place in the real estate sector. Household real estate holdings climbed by a record $2.21 trillion last year or 12.9% to $18.65 trillion. Household real estate asset values were up 24% in two years and 92% in seven years. Meanwhile, on the liability side of the household ledger, obligations increased 11.7% , or by $1.12 trillion in 2004, and by a stunning $336 billion in the fourth quarter alone, which almost equals the sector’s annual average increase in liabilities all through the decade of the 1990s.

So what is the end game?

That has always been the issue with asset inflations throughout history. Back in the 1920s, in my view, the key was the speculative finance that generated excess liquidity. It was mainly leverage created by borrowing to finance securities purchases back then. Mainly stocks. But on the margin it became liquidity for the economy. Then, of course, the asset inflation led to distortions in spending and investing, domestically and globally. When the speculators got hammered and liquidity collapsed, the economy was so distorted that it couldn’t function without that speculative liquidity. Today, you can see the spending distortions. You can see also how this speculative liquidity has gone global. A real question is whether today’s spending patterns are sustainable domestically. Can we continue to have all this home price inflation to stimulate luxury consumption and everything else? Is consumption sustainable globally? Are all these factories that have been built to send goods to Americans sustainable? If we have problems in mortgage finance and all of a sudden that trillion dollars of mortgage credit drops by half—wow! It would change spending decisions dramatically if home prices started to decline. The system can so easily go from what appears to be just endless amounts of credit and liquidity and spending power to a place where the whole economy is primed for all sorts of spending that just doesn’t develop. That’s what all the fuss in the tech sector was about. It was all primed for endless liquidity. Because it seemed to have endless liquidity. All the speculative finance was going into technology. Until it reversed. Then technology just collapsed, because everyone had extrapolated the boom times endlessly. Well, now the same dynamic is working globally, through the current account deficit. It will keep working amazingly well, but only as long as the liquidity keeps flowing. And it’s not sustainable. That’s what isn’t generally appreciated about the end of the 1920s and the Depression. Bernanke and Milton Friedman and that whole monetarist crew believes it got out of hand because there was a $4 billion hole in the banking system. They say that the Fed should have just cut a check for $4 billion, recapitalized the banks, and everything would have been wonderful. But it wasn’t a $4 billion problem. The asset markets and the whole economy had become so distorted that the Fed could have cut a check for $25 billion every six months back then, and it wouldn’t have been enough. It would have taken endless and continuous infusions of huge amounts of liquidity and credit. That’s where we are today. It took $1.2 trillion in mortgage credit last year. It will take $1.3 trillion this year. The economy looks like a miracle, but you had better be prepared, because it’s not sustainable. That’s more than four times the average annual growth in mortgage credit in the 1990s. It’s a huge number.

I’m getting the impression you don’t think we can just keep adding zeros.

Clearly, the Asian central banks are growing nervous. Maybe they do realize that they had better keep buying dollar assets, because they are going to be buying for a long time. Until the current account deficit declines dramatically, they are going to have to keep buying them. They are going to have to act as buyers of last resort, and buy our paper. But they are becoming nervous about this, and that is an important development.

Why do you say that?

I would argue that for the past 18 months, one of the reasons the dollar decline has been orderly has obviously been that the central banks have acted as the buyers of first and last resort. Everybody knows they will buy. Which is a circumstance that provides a huge advantage for interest rate derivatives players.

How so?

Let’s say that a corporation, or a hedge fund, or anyone, goes to JP Morgan and buys dollar protection. What JP Morgan knows is that if they need to short the dollar, they can easily call an Asian central bank and sell them dollars. The whole currency derivatives market has worked seductively well because of its liquidity backstop from Asian central banks. But now there are indications that Asian central banks are not too happy with this arrangement now. At some point, foreign politicians—if not central bankers—will be forced to confront the dollar dilemma. That’s one important development that could shake the complacency that has defined this market.

What are some others?

The similar situation in the interest rate market. The GSEs, since 1994, have provided the liquidity backdrop, but the situation is clearly different now. Not only are rates rising and MBS spreads widening, the once high and mighty GSEs are no longer going to be providing the backstop bid. And now we have $50-$60 oil. We have other commodity prices going nuts. We have interest rates that are way too low to rein in these mortgage credit excesses that are becoming very destabilizing because of the current account deficit and over-consumption. So we have all kinds of factors putting pressure on the Fed. The U.S. economy is very strong, and there is a strong inflationary bias, and yet there’s been lots and lots of complacency. It could be a very volatile mix. But there is one thing I am sure of, what Dr. Bernanke recently called that “global glut of saving” is actually an historic excess of dollar IOUs. And that these IOUs are predominantly backed by non-productive assets could be a huge problem. That a lot of these IOUs are owned by foreigners only will compound any problems that develop. Worse, an evidently large but unknown portion of these IOUs are held—or hedged—by highly leveraged speculators, which potentially creates what Hyman Minsky called “acute financial fragility.”

You see some risks rising. But you said yourself that investors have been very complacent.

They had been lulled to sleep, because of the Fed’s interest rate stance, and the enormous backdrop of liquidity. It has seemed that there is free money to be made in things like derivatives. I use the old flood insurance analogy. There has essentially been free money available to write insurance. Nobody has experienced any significant losses in quite some time, so everyone has been willing to write lots of flood insurance. So lots of “insurance” has been written in equities, in currencies, interest rates, especially in the credit default area. After all, writing this insurance produces “free” money. So of course the hedge funds have been very active. Why wouldn’t they want to write it and take 20% of the premium every year—until the tail kicks their ass? All of these individual decisions have been very rational. But the whole system has too many players, ensuring that the bubble will continue, until it pops.

And your point is that a lot of individually rational economic acts are adding up to what looks to be a dangerous situation in the market?

We have to say the individual decision is rational, and that’s important. This is not a mania in which everyone is running around doing silly things. It’s not that. This isn’t playing out like other market bubbles we have read about in history books. These decisions are very rational. It is rational for the person out in California to buy a home and to take the adjustable rate mortgage. It’s rational for the hedge funds to do what they’re doing. It’s rational for the businessmen to what they are doing– these are all rational decisions. This credit bubble has nothing to do with rationality. It has to do with the market’s pricing mechanism getting distorted. You have such monetary disorder that even though people are making rational decisions, individually, for the system as a whole, those decisions create huge dislocations. I am going to rant forever to make this point. People aren’t crazy. The system itself tempts people to do things that are individually very rational, but that, as a whole, can be very dangerous for the system. Very destabilizing. It’s all too rational to borrow to buy assets today. It’s all too rational to borrow to speculate.

And asset inflation troubles you deeply, even though standard inflation measures aren’t even up enough [until recently] to rouse the Fed?

It’s everywhere in the world. That’s what this is about. It’s gone global. It’s endemic. It’s commodities, home prices, bond prices, stock prices, foreign real estate, emerging bond markets, emerging equity markets, Chinese real estate, for gosh sakes. That’s what makes it so inflationary now. You have an environment of rising asset prices and unlimited amounts of cheap liquidity. I mean, good luck! Why would anyone expect the U.S. economy—or the global economy—to slow today with that backdrop? That’s the unfolding story. Would a 6% Fed funds rate be crazy? Not that many years ago, we had 6% Fed funds. Certainly inflation is higher today than it was back in 2000. There is an inflation problem. People can deny it all they want. But we’re not talking about goods pricing. The pricing of everything made in China or India. We’re talking about basically everything else. Medical, housing, energy, college tuition, movie tickets or popcorn, my Milk Duds at the movies on Saturday night. And the problem is global. Even European central bankers are faced with this now. They look at home prices and see that their rates are too low. But they keep them low because of the dollar. It is as if the weak dollar has central bankers all over the world just frozen. They have to keep their rates artificially low, but those low rates, combined with all the excess dollar liquidity is a very potent recipe for asset inflation. That’s why I insist that whole problem goes back to credit creation.

And you don’t see the air being let out of this massive bubble gently?

It can’t happen.

So you’ve become a cave dweller, or what?

The perennial question. I’ve argued all along that one thing you don’t do is let it go worse. Yet that is exactly what we’ve done. Just look at what they’ve allowed to happen out in California, where average home prices are to the moon and all the mortgages are adjustable or interest-only. I believe that there’s a case to be made that the fallout from California alone could severely impair the U.S. financial sector.

Wouldn’t be the first time.

We should have never allowed mortgage credit to double in seven years. Never. Now we will see annual increases of 12% a year, 13% a year, until the thing blows. As I said, it will take huge amounts of liquidity to sustain these asset markets—whether they trade real estate, bonds, or stocks. So how will the financial sector create that liquidity? Only by continuing to offer interest-only teaser loan rates. We have to lend to the marginal guy who shouldn’t be buying a house; to the guy paying double what a reasonable person would pay for a home in San Diego. So we are still sustaining it, but there is going to be a price to be paid.

Well, the Fed has been raising the price of the credit and is about to [did, on Tuesday] raise the price again.

But the Fed isn’t controlling or creating the credit. What it is doing is providing the backdrop, in guarantees and promises, that allows people to be comfortable and complacent. But the Fed isn’t creating the credit. It is that financial sector that is creating the credit.

There you go again, with your economic heresy.

I can’t help that it’s not conventional dogma. The analysis works. It is speculative financial activities, in particular, that are creating most of the credit. And that’s the danger of it. The Fed doesn’t control it. The Fed can control it, when it wants everybody to continue to leverage and to continue to expand credit, as it so effectively encouraged everyone to do in 2002. Trouble is, now speculative finance has gotten so big that it is starting to be destabilizing, and the Fed won’t be able to put the genie back in the bottle. At this juncture, the interests of the Fed and the interests of speculators are no longer the same.

As falling long rates, in the face of the Fed’s increases in short rates, have been demonstrating?

Sure. Why wouldn’t that happen? If you tell everyone exactly what you are going to do, they are going to devise ways to generate speculative gains from that rainbow. You can’t tell the speculative marketplace what you’re going to do. You’re just asking for trouble.

Transparency is not always and everywhere wonderful?

The system does not function well when you have out of control speculative access. In a normal climate, they can and should be transparent. But not today. Speculators need to be punished today so that they don’t go out and continue to do the things that are destabilizing for the system. But the Fed obviously can’t do that today because the whole system has been rendered fragile by its reliance on hugely leveraged underpinnings. Which means, in effect, that the Fed has lost its power to control speculative finance. Its baby steps are ridiculous. They are not going to do anything.

Except, maybe, change psychology slowly?

Again, the speculation has gone global. Today, the money wants to go everywhere—or, rather, the finance wants to go everywhere. It will play Brazil, China, India, emerging market. It is taking enormous amounts of liquidity to keep these markets all levitated. Now, the system can create enough credit, but these amounts are so huge that this is going to be much more destabilizing than what most would expect. That’s why we could easily see $60-$70-$80 oil. Things can get crazy now because liquidity has just taken on a life of its own.

Has oil taken gold’s place as a store of value?

Not really. But gold still has the issue of the central banks’ inventories of gold, and how much they are selling. So there are still supply issues in gold. But clearly, financial players around the world are now saying, “I will trade some of my dollar balances for crude because I need the crude.” The Chinese are clearly going to buy oil and any commodity they can trade their dollar balances for, without causing too big of a crisis. Why wouldn’t they? These are smart people. They don’t need the dollar balances. They buy them because someone has to buy them. At any opportunity to trade them for copper or zinc or anything, they will trade. Everyone wants to act as if the global environment never changes. The reality is that it has changed profoundly, in just a few years. What I am contending today is that the period of “disinflation” has ended—ironically, just when some have been trumpeting that the Fed has won the battle against inflation. We have very highly liquid competitors now. And we are bidding against them for whatever we want or need. Meanwhile, the foreign credit systems that used to be highly constrained by the strong dollar—by the fear that if they did anything risky, speculative financial flows would desert them for the safety of the U.S.—have been utterly unleashed. Now, it’s like everyone has a checkbook backed with U.S. dollars and can do whatever they want. There is no restraint on any credit system now. Be it China, India, or Brazil, these countries can create all this credit and finance domestic booms without having to worry about a run on their currencies. They can inflate for awhile, and that will ease their transitions into a flexible currency system. Again, in the weak dollar now—the dollar’s vulnerability—gives credit systems around the world almost a hall pass to do things that they weren’t able to do five years ago or even three years ago. They’re no longer worried about a currency collapse throughout Asia. They are worried about the currencies melting up. This is an inflationary bias that many analysts have missed. And you see it in Latin America today, too. These are very, very important developments. Maybe financial speculation will keep all these markets levitated. I’m not saying that can’t happen. But if it does, we’re going to see wild price movements, shortages of all sorts of things, and things will get very strange.

You see no other alternatives?

Well, baby steps by the Fed in this environment are not going to cut it. But if something occurs to make the spread traders and the leverage players reevaluate how high market rates can go, that could produce a major market event. I don’t know what that could be, given this liquidity backdrop. However, if liquidity starts to go the other way and bond yields rise and all of a sudden everyone wakes up and smells inflation, there could be a very profound change in market psychology.

And Nirvana for bears?

I can dream, can’t I?

Postscript: Post Tuesday’s Rate Hike

The markets initial reactions say the Fed has caught someone’s attention this time, Doug—

So it would seem. The bond market, in particular, has been gliding along on the assumption that the carry trade, et al, were safe because of the latest version of the Greenspan put: It’s his last year, in office, so the great one isn’t going to let anything happen. He understands how leveraged the system is, understands all the fragilities. It’s as if they’ve been singing, “Don’t Rock The Boat, Baby” to him, and he’s been dancing along.

But now, suddenly, it looks like he might?

The thing is, if someone steps back and considers it dispassionately, the Greenspan Fed has been anything but infallible. They appear in hindsight to have been totally oblivious to LTCM, they totally misplayed Y2K—I could go on and on. So maybe some bond market players have started to realize they’ve been giving the Fed too much credit. Maybe they’ve started wondering, finally, if the Fed does really look at the world conventionally and so may have decided that rates need to go to 5% or even higher. If so, we may be seeing the beginning of a market reality check. “Maybe we don’t have the Fed in our back pocket and maybe they're really worried about inflation.” If so, this is a very dangerous change in perceptions in the bond market, because it was well beyond the point where fundamentals didn’t matter. Anytime you get a market where fundamentals don't matter, you're heading down a slippery slope. And it could be that the bond market is starting to pay a price for that now.

How high could rates go?

Well, the difference between 1994 and 2004, was that in 1994 the market didn't know how high the Fed could go, while last year, speculators were sure they knew exactly how much rates would rise. Now, in 2005, my observation is that it’s like 1994 all over again, albeit in a very changed world. So who knows? All of a sudden the speculators have losses and they don't know how high rates could go, so it's a different ballgame. We’re back to greed and fear. And fear is on the rise. We’ve got GM’s woes throwing a monkey wrench into the booming credit default swap market—and no one knows how that plays out, because the whole thing is so new. We have monkey wrenches in credit derivatives, currencies and commodities have turned wild—you know the litany. Put it this way: We have all the makings now for some companies or institutions to have been hurt enough to start a domino effect. Things can happen very quickly. Back in 1998, we had a couple of small mortgage companies file for bankruptcy without ever missing a Wall Street earnings estimate. Meanwhile, the stocks in the financial sector just aren’t acting well. People forget, too, that Fannie and Freddie still have enormous derivatives portfolios that could well become systemic issues in a rising rate environment.

On that happy note, let’s sign off again. Thanks.