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November 11, 2006

Monetary Developments vs. Monetary Aggregates
by Doug Noland

The Dow gained 1%, increasing y-t-d gains to 13.0%, and the S&P500 rose 1.2%, raising 2006 gains to 10.6%. Economically-sensitive issues performed well, with the Transports up 2.6% (up 12.8% y-t-d), and the Morgan Stanley Cyclical Index up 2.3% (up 10.0% y-t-d). The Utilities added 0.8% (up 13.1% y-t-d), and the Morgan Stanley Consumer index gained 0.6% (up 13.2% y-t-d). The broader market was strong. The small cap Russell 2000 rose 2.2% and the S&P400 Mid-Cap index 2.1%. Technology was also strong. The NASDAQ100 surged 2.8%, and the Morgan Stanley High Tech index was up 2.9%. The Semiconductors rose 2.7%, and The Street.com Internet Index gained 3.2%. On the back of strong Cisco earnings, the NASDAQ Telecommunications index surged 5.7%, increasing y-t-d gains to 23.1%. The Biotechs added 0.9%, increasing 2006 gains to 12.1%. The Broker/Dealers rose 1.8% (up 19.5% y-t-d), and the Banks gained 1.5% (up 9.7% y-t-d). Trading at an all-time high this week, the NYSE Financial index rose 1.6% to increase y-t-d gains to 15.6%. With bullion gaining $1.80, the HUI Gold index rose 1.6% this week.

For the week, two-year Treasury yields declined 8.5 bps to 4.73%. Five-year yields fell 12 bps, ending the week at 4.57%, and bellwether 10-year yields dropped 13 bps to 4.59%. Long-bond yields declined 11.5 bps to 4.695%. The 2yr/10yr spread ended the week inverted 14 bps. The implied yield on 3-month December '07 Eurodollars fell 15.5 bps to 4.775%. Benchmark Fannie Mae MBS yields sank 17 bps to 5.75%, this week outperforming Treasuries as MBS yields dropped to the lowest level since February. The spread on Fannie's 5 1/4% 2016 note ended the week at 36, and the spread on Freddie's 5 1/2% 2016 note at 35. The 10-year dollar swap spread declined 0.8 to 53.0. Despite continued enormous issuance, corporate bonds generally traded in line with Treasuries. Junk spreads widened slightly this week.

Investment grade issuers included HCA $5.7 billion, Time Warner $5.0 billion, Goldman Sachs $2.0 billion, HBOS $2.0 billion, GE Credit $825 million, Dominion Resources $650 million, American Express $600 million, Talisman Energy $600 million, Genworth Financial $600 million, Prologis $550 million, Pitney Bowes $500 million, Joy Global $400 million, Indiana Michigan Power $400 million, Cigna $250 million, Jetblue Airlines $125 million, million and Atlantic Marine $90 million.

November 11 - Wall Street Journal (Cynthia Koons and Michael Aneiro): "Global issuance of risky 'high yield,' or junk bonds -- which Wednesday surpassed the previous record for a single year -- surged further into uncharted territory following yesterday's blockbuster sale of $5.7 billion in new debt by hospital operator HCA Inc. ...Global high-yield issuance surged past the $210.8 billion mark set in 2004 to a record., according to Dealogic. By yesterday...total global junk issuance stood at $217.4 billion, with a month and a half to go until year end.. October set a single-month record with $30.5 billion in new issuance.... And a report issued this week by J.P. Morgan forecasts that this month could see as much as $25 billion in new issuance, which would be a record for November... Despite the surge in issuance, junk-bond yields have dropped to a 5½-month low of 8.15%..."

November 9 - Bloomberg (Caroline Salas): "HCA Inc., the biggest U.S. hospital operator, sold $5.7 billion of debt to fund its leveraged buyout in the biggest issue of speculative-grade bonds in 17 years. Today's sale, which offered yields as high as 9.625 percent, is exceeded only by the $8.5 billion issued to finance Kohlberg Kravis Roberts & Co.'s $31.3 billion purchase of RJR Nabisco Inc. in 1989."

November 9 - Bloomberg (Robert Burgess): "Time Warner Inc., the world's largest media company, sold $5 billion of bonds in its first sale since 2002 to refinance debt and buy back stock... Those securities were priced to yield 23 basis points over the London interbank offered rate."

Junk bond funds reported inflows of $39.2 million this week. Junk issuers included NRG Energy $1.1 billion, Sally Holdings $710 million, Griffin Coal $400 million, NCO Group $365 million, Conexant Systems $275 million, Foundation RE $250 million, Continental Airlines $200 million, and Britannia $185 million.

Convert issuers included General Cable $315 million, Arris Group $240 million, Millennium Pharmaceutical $225 million, Hornbeck Offshore $220 million, and Inland Real Estate $170 million.

International dollar debt issuers included Turkey $2.25 billion, Brazil $1.5 billion, Xstrata Finance $2.25 billion, L-Bank Foerderbank $1.0 billion, Lloyds Group $1.0 billion, IFFIM $1.0 billion, Yypothekenbk $1.25 billion, Glitner Banki $500 million, Bombardier $385 million, Marfrig Overseas $375 million, Bertin LTDA $350 million, and Industrias Unidas $200 million.

Japanese 10-year "JGB" yields declined 3 bps this week to 1.68%. The Nikkei 225 index declined 1.5% (y-t-d up 0.006%). German 10-year bund yields decline 6 bps to 3.71%. Emerging markets remain impressive. Brazil's benchmark dollar bond yields dipped one basis point to 6.14%. Brazil's Bovespa equities index increased 0.7% this week (up 21.7% y-t-d). The Mexican Bolsa jumped 3.4%, increasing 2006 gains to 34.5%. Mexico's 10-year $ yields fell 7 bps to 5.62%. The Russian RTS equities index surged 4.8% (up 51.6% y-t-d). India's Sensex equities index gained 1.2%, increasing 2006 gains to 41.3%. China's Shanghai Composite index added 0.9%, increasing y-t-d gains to 62.2%.

This week, Freddie Mac posted 30-year fixed mortgage rates added 2 bps to 6.33%, down 3 bps from one year ago. Fifteen-year fixed mortgage rates also rose 2 bps, to 6.4% (up 15 bps y-o-y). And one-year adjustable rates increased 2 bps to 5.55% (up 43 bps y-o-y). The Mortgage Bankers Association Purchase Applications Index rose 7.1% this week. Purchase Applications were down 12.5% from one year ago, with dollar volume 11.9% lower. Refi applications surged 11%, confirming an upsurge in refinancings that began in July. The average new Purchase mortgage increased to $228,500, while the average ARM jumped to $378,300.

The Fed did not release bank Credit data this afternoon.

M2 (narrow) "money" supply added $3.0 billion to $6.951 TN (week of 10/30). Year-to-date, narrow "money" has expanded $265 billion, or 4.7% annualized. Over 52 weeks, M2 has inflated $321 billion, or 4.8%. For the week, Currency added $1.3 billion, and Demand & Checkable Deposits gained $6.9 billion. Savings Deposits fell $11.2 billion, while Small Denominated Deposits rose $4.4 billion. Retail Money Fund assets increased $1.6 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, increased $7.6 billion last week to $2.273 Trillion. Money Fund Assets have increased $216 billion y-t-d, or 12.1% annualized, with a one-year gain of $290 billion (14.6%).

Total Commercial Paper added $0.7 billion last week to $1.90 Trillion. Total CP is up $260 billion y-t-d, or 18.3% annualized, while having expanded $252 billion over the past 52 weeks (15.3%).

Asset-backed Securities (ABS) issuance this week increased to a still relatively slow $9 billion. Year-to-date total ABS issuance of $622 billion (tallied by JPMorgan) is running about 7% below 2005's record pace, with 2006 Home Equity Loan ABS sales of $423 billion about 3% under comparable 2005. Also reported by JPMorgan, y-t-d US CDO (collateralized debt obligation) Issuance of $288 billion is running 81% ahead of 2005.

November 10 - Bloomberg (John Glover): "Sales of so-called collateralized debt obligations have surged about 50 percent to almost $700 billion this year, according to Barclays Capital. Investment banks create the obligations by taking pools of bonds and credit derivatives and slicing them into chunks bearing different levels of risk with ratings from the top AAA to the riskiest so-called equity portion, which isn't rated. The popularity of the instruments is holding down yield premiums as banks buy debt to put into the securities..."

Fed Foreign Holdings of Treasury, Agency Debt increased $2.1 billion during the week to $1.696 Trillion (week of 11/8). "Custody" holdings were up $177 billion y-t-d, or 13.5% annualized, and $218 billion (14.8%) over the past 52 weeks. Federal Reserve Credit expanded $1.8 billion to $835.2 billion. Fed Credit is up $8.8 billion (1.2% annualized) y-t-d, while having expanded 4.5% ($35.9bn) over the past year.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $655 billion y-t-d (18.7% annualized) and $695 billion (17.4%) in the past year to a record $4.701 Trillion.

November 6 - Bloomberg (Eugene Tang): "China's foreign currency reserves have exceeded $1 trillion to become the world's largest held by any country, China Central Television reported, citing the country's currency administrator... China's reserves are growing at a rate of almost $30 million an hour, mostly fueled by a gap between exports and imports that tripled to $102 billion last year."

November 9 - Bloomberg (Svenja O'Donnell): "Russia's foreign currency and gold reserves, the world's third largest...surged $5.1 billion to $274.2 billion in the week ended Nov. 3... The Bank of Russia's reserves have swelled 57 percent this year, and surged from $12 billion in 1998..."

Currency Watch:

November 7 - Bloomberg (Rainer Buergin): "China wants to add U.S. dollar-denominated assets to its foreign exchange reserves that offer higher yields than U.S. government bonds... China is considering buying U.S. corporate bonds or bonds sold by quasi-governmental institutions such as Fannie Mae and Freddie Mac..."

The dollar index fell 0.8% to 84.88. On the upside, the South African rand gained 2.3%, the Norwegian krone 1.7%, the Swedish krona 1.6%, and the Polish zloty 1.4%. On the downside, the Sri Lankan rupee declined 0.9%, the Mexican peso 0.8%, the Brazilian real 0.5%, and the Philippines peso 0.4%.

Commodities Watch:

November 8 - Bloomberg (Debarati Roy): "Prices for zinc, used to rust-proof steel, may rise 11 percent to trade above $5,000 a metric ton by the end of the year because of rising demand from China and supply disruptions, Macquarie Bank Ltd. said. 'Zinc looks as though it's running out,' said Adam Rowley, London-based analyst...'When a commodity runs the price can go anywhere as we have seen in copper and nickel.'"

Gold added 0.3% to $629, and Silver gained 3.0% to $13.115. Copper fell 7%, reducing y-t-d gains to 60%. December crude rose 43 cents to end the week at $59.57. December Unleaded Gasoline gained 3.5%, while December Natural Gas declined 1%. For the week, the CRB index added 0.3% (down 6.4% y-t-d), and The Goldman Sachs Commodities Index (GSCI) rose 1.7% (up 2.3% y-t-d).

Japan Watch:

November 10 - Bloomberg (Lily Nonomiya): "Japanese machinery orders unexpectedly slumped, signaling economic growth may stall and prevent the central bank from raising interest rates, already the lowest among major economies."

China Watch:

November 10 - Bloomberg (Lee Spears): "China's exports are expected to rise to $960 billion this year, the official Xinhua News Agency reported...boosting the country's trade surplus to $150 billion."

November 9 - Bloomberg (Warren Giles): "China will probably overtake Germany to become the world's second-biggest trader next year after the U.S. as the Asian nation's economy expands and its trade surplus balloons, the World Trade Organization said."

November 8 - Bloomberg (Nerys Avery): "China's trade surplus surged to a record $23.8 billion in October as imports grew at the slowest pace in 15 months... The gap widened from September's $15.3 billion... Exports jumped 29.6 percent and imports rose 14.7 percent."

November 8 - Bloomberg (Nerys Avery): "China's exports of machinery and electronics surged 29.7 percent through October from a year earlier to $439.7 billion, the customs bureau said, topping last year's total."

November 9 - Bloomberg (Wing-Gar Cheng and Ying Lou): "Natural gas demand in China, the world's biggest energy user after the U.S., may increase by more than 15 percent annually for the next 20 years, a government official said."

India Watch:

November 10 - Bloomberg (Cherian Thomas): "India's industrial production grew a faster-than-expected 11.4 percent in September, sustaining the fastest streak in a decade, adding to evidence that interest rates may rise."

November 9 - Bloomberg (Cherian Thomas): "India's revenue from customs, excise and other indirect taxes rose 22.5 percent to 1.1 trillion rupees ($24 billion) in the six months ended Sept. 30..."

November 10 - Bloomberg (Sam Nagarajan): "Money supply growth in India slowed in the two weeks ended Oct. 27 from the previous two-week period... The M3 measure of money supply increased 18.6 percent in the two weeks through Oct. 27 from a year earlier..."

November 8 - Bloomberg (Sumit Sharma and Cherian Thomas): "ICICI Bank Ltd., India's biggest by market value, plans to lend to 25 million rural clients in five years to sustain record loan growth as the government curbs credit to customers in the cities."

Asia Boom Watch:

November 7 - Bloomberg (Theresa Tang): "Taiwan's exports increased in October at the slowest pace in 15 months as demand from China, Japan and the U.S. eased. Overseas sales increased 5.6 percent from a year earlier after climbing 18.1 percent in September..."

November 9 - Bloomberg (Kim Kyoungwha): "Gains in South Korean property prices are 'very worrisome' and one of the areas the Bank of Korea looks at in setting interest rates, Governor Lee Seong Tae said. 'The situation where apartment prices have risen fast is very worrisome and the Bank of Korea is closely monitoring the progress in the market."

Unbalanced Global Economy Watch:

November 8 - CNW: "Canadians have every intention of keeping up the feverish pace of mortgage borrowing...supporting a projected 10 per cent growth in mortgage credit are rising house prices, a booming economy in western Canada and continued high numbers of new housing completions."

November 8 - Bloomberg (Peter Woodifield): "The value of London's most expensive homes are rising at the fastest pace in 18 years as bankers, traders and hedge-fund managers anticipate record bonuses this year, a survey by Knight Frank LLC showed. The U.K. capital's prime properties climbed 2.1 percent in October, bringing the 12-month increase to almost 25 percent..."

November 9 - Bloomberg (Simone Meier): "Swiss consumer optimism rose to the highest level in more than five years as stronger economic growth prompted companies to boost hiring."

November 9 - Bloomberg (Jonas Bergman): "Swedish unemployment fell to a four-year low in October, declining for a third consecutive month, as accelerating economic growth fueled demand for workers... The non-seasonally adjusted jobless rate fell to 4 percent from 4.2 percent..."

November 8 - Bloomberg (Jonas Bergman): "Smaller Swedish companies are restrained by shortages of qualified workers as they seek to hire amid the most optimism in six years, a survey by Swedbank AB and the Federation of Private Enterprise showed."

November 6 - Bloomberg (Marta Srnic): "Russia's economy probably will grow at the same pace next year as in 2006 as high commodity prices spur consumption and investment, the International Monetary Fund said. The economy will sustain its 6.5 percent pace next year after expanding 6.4 percent in 2005 and 7.2 percent in 2004..."

Latin American Boom Watch:

November 9 - Bloomberg (Thomas Black): "Mexico's annual inflation rate rose to a 15-month high in October as the price of tomatoes, electricity, milk and onions surged. Inflation quickened to 4.3 percent in the 12 months through October from 4.1 percent in September..."

November 10 - Bloomberg (Telma Marotto): "Brazil's annual inflation rate fell to a seven-year low in October, adding to speculation that central bankers will cut the benchmark lending rate a half-percentage point this month to spur economic growth."

November 8 - Bloomberg (Daniel Helft): "Argentina's vehicle sales will rise to a seven-year high in 2006 as consumers' purchasing power grows amid a four-year economic expansion..."

Central Banker Watch:

November 8 - Bloomberg (Hans van Leeuwen and Gemma Daley): "Australia's central bank raised its benchmark interest rate to the highest in almost six years to curb inflation, risking an economic slowdown as households grapple with record debt. Reserve Bank of Australia Governor Glenn Stevens raised the overnight cash rate target a quarter percentage point to 6.25 percent..."

November 6 - Bloomberg (Simone Meier and Matthew Brockett): "European Central Bank council member Axel Weber said the inflation outlook is 'alarming' and policy makers need to stay 'vigilant'... Inflation will remain above the ECB's 2 percent limit 'clearly throughout 2007 and well into 2008,' Weber told reporters... That's 'alarming, especially when mirrored against strong monetary dynamics. It's too early to give the all clear on monetary policy. We have to stay vigilant.'"

November 9 - Bloomberg (Sheyam Ghieth and Gabi Thesing): "European Central Bank Executive Board member Lorenzo Bini Smaghi said the bank's key lending rate is 'too accommodating,' indicating further increases in borrowing costs are justified. 'Leaving it at this level would be a monetary policy that is too accommodating,' he said in a speech delivered in Milan today. The ECB, which kept its benchmark lending rate at 3.25 percent this month, must stay 'very vigilant' to head off inflation risks, according to Bini Smaghi...the third ECB policy maker this week to suggest that interest rates must rise further..."

November 8 - Bloomberg (Craig Torres and Anthony Massucci): "Inflation is a larger risk than an economic slowdown even as a slump in home construction drags down growth, Chicago Federal Reserve Bank President Michael Moskow said. 'My current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low... Some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability.'"

Bubble Economy Watch:

September's Trade Deficit declined from the previous month's record to $64.3 billion. Goods Exports were up 20% from a year ago to a record $88.6 billion. Goods Imports were up 10% from a year earlier to $157.8 billion.

November - Freddie Mac U.S. Economic Outlook: "Given the past increases in mortgage rates, refinance activity continues to be strong due to continued incentives to cash-out home equity and refinance ARMs scheduled to have a payment reset in the next several months. The refinance share of loan applications for the next two quarters is projected to average 44%. Mortgage debt will grow by a rate of 9.1% in the last quarter of this year and drop to 5.8% in early 2007.'"

November 9 - Bloomberg (Lindsay Pollock and Philip Boroff): "Christie's International sold $491.5 million of impressionist and modern art last night in New York, setting a record for a single auction and topping the previous high by $205 million."

Real Estate Bubble Watch:

November 11 - Dow Jones (Danielle Reed): "Foreclosure activity is up in the majority of the country's metro areas, real estate data firm RealtyTrac reported...that 318,355 properties in the U.S. entered some stage of foreclosure in the third quarter, a 17% increase over the prior quarter. Detroit, Fort Lauderdale, Fla., and the Denver-Aurora, Colo. metro areas saw the highest growth in foreclosure activities. One in every 80 Detroit households had a property enter some stage of foreclosure, while in Fort Lauderdale it was one in every 88 households and one in every 90 homes in Denver."

November 9 - Dow Jones (Janet Morrissey ): "Manhattan's commercial real estate market flourished in October as asking rents for class A office space surged to an all-time high... The study...found average asking rents hit $63.26 a square foot, exceeding the market's previous record high of $61.48 set in April 2001. The October rent level was up 4.8 percent from September, marking the biggest month-over-month spike since 1991, and up 24.7 percent from a year earlier, the report said."

November 9 - Bloomberg (Hui-yong Yu): "The U.S. office vacancy rate fell to 12.96 percent in the third quarter from 14.13 percent a year earlier...according to a survey by Colliers International. Rents nationwide increased, with asking prices for space in high-quality downtown office buildings rising 11.8 percent in the three months ended September..."

Financial Sphere Bubble Watch:

November 6 - Bloomberg (Christine Harper): "Never in the history of Wall Street have so many earned so much in so little time. Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. are about to reward their 173,000 employees with $36 billion of bonuses. That's a 30 percent increase from last year's record, and it doesn't include the billions more that will be paid by Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co., the three largest U.S. banks, as well as the hundreds of hedge funds and private-equity firms that constitute the financial industry."

November 8 - Dow Jones (Damian Paletta): "Fannie Mae Chief Executive Daniel Mudd said...that the company's announced $1.05 billion cost in 2006 related to restating its accounting errors and complying with regulatory oversight was 'dramatically' higher than earlier projections."

Energy Boom and Crude Liquidity Watch:

November 7 - Bloomberg (Stephen Voss): "The cost of satisfying the world's thirst for energy through 2030 has swollen by $3 trillion in a year because of higher industry costs, especially in oil and gas, the International Energy Agency said. Governments and companies need to spend $20 trillion in 25 years and there is 'no guarantee' it will succeed, the IEA said...in its annual 'World Energy Outlook.' More than half of the total will be needed in emerging countries, where both demand and supply are rising the fastest. China alone needs to spend $3.7 trillion on energy during 2005 to 2030."

November 6 - Bloomberg (Chan Tien Hin): "MMC Corp., a Malaysian builder whose shares have risen 69 percent this year, won rights to develop a $30 billion new city in Saudi Arabia with Saudi Binladin Group, tapping growth in the world's biggest crude oil producer."

Climate Watch:

November 9 - Associated Press: "A severe drought since late October in southern China has left more than 2.4 million people short of drinking water, state media reported... Rainfall levels in Guangxi province were down 65% in October from the previous year, including eight cities and counties that haven't seen rainfall in the past month... The volume of water in the province's reservoirs has fallen from 8 billion cubic meters to 4.7 billion cubic meters, and 46 reservoirs in the provincial capital of Nanning have dried up..."

Monetary Developments vs. Monetary Aggregates:

The European Central Bank this afternoon concluded its two-day conference, "The Role of Money: Money and Monetary Policy in the Twenty-First Century." Presenters included ECB President Jean-Claude Trichet, ECB Vice President Lucas Papademos, and Federal Reserve Chairman Bernanke.

The discussion of "money" is too often technical in nature and almost always insufficiently assessable to non-economists. This is unfortunate, and the scholarly presentations at this conference - at least the few I had the opportunity to read today - are typical in this regard. Nonetheless, I find the subject matter intellectually stimulating and the nuances intriguing. You see, the "old school" ECB remains firmly committed to Monetary Analysis. Meanwhile, the New Age Fed has abdicated the monetary aggregates and, in the process, carelessly tossed Monetary Analysis in the scrapheap.

Curiously, Mr. Trichet addresses "Monetary Developments," as opposed to quantifiable "money" supply: "...The relevance of the monetary pillar can anyway not be judged based on the simple bivariate correlation of policy rates with the growth rate of headline M3 (or any other single monetary indicator)." In stark contrast, chairman Bernake began his speech, "My topic today is the role of monetary aggregates in economic analysis and monetary policymaking at the Federal Reserve. I will take a historical perspective, which will set the stage for a brief discussion of recent practice..." "It would be fair to say that monetary and credit aggregates have not played a central role in the formulation of U.S. monetary policy since [1982], although policymakers continue to use monetary data as a source of information about the state of the economy."

Mr. Papademos strikes right at the heart of the issue in his opening comments: "...Is it really possible for a policy described as "monetary" to be formulated and implemented without money playing a central role in it? Indeed, the suggestion that monetary policy can be conducted without assigning a prominent role to money seems like an oxymoron - a statement containing apparently contradictory terms, if not worse: for the literal meaning of the Greek word "oxymoron" is "pointedly foolish". Yet in recent years, a large and influential body of academic work has disregarded or deemphasised the role of money as a determinant of inflation, even in the long run."

When it comes to "money," Dr. Bernanke's intellectual fixation remains with fashioning doctrine that ensures there will always be sufficient quantities of it - that there will never be a repeat of the post-Bubble Fed blunders that he believes unleashed deflation and the Great Depression: "The Federal Reserve's first fifteen years were a period of relative prosperity, but the crash of 1929 ushered in a decade of global financial instability and economic depression. Subsequent scholarship, notably the classic monetary history by Milton Friedman and Anna J. Schwartz (1963), argued that the Federal Reserve's failure to stabilize the money supply was an important cause of the Great Depression. That view today commands considerable support among economists, although I note that the sources of the Federal Reserve's policy errors during the Depression went much deeper than a failure to understand the role of money in the economy or the lack of reliable monetary statistics. Policymakers of the 1930s observed the correlates of the monetary contraction, such as deflation and bank failures. However, they questioned not only their own capacity to reverse those developments but also the desirability of doing so. Their hesitancy to act reflected the prevailing view that some purging of the excesses of the 1920s, painful though it might be, was both necessary and inevitable."

ECB analysis is forward-looking, focused on the complex role money and Credit play in fostering asset Bubbles, financial instability and future inflation. From Mr. Papademos: "...The ability of monetary developments to indicate imbalances in the financial system and the implied potential risks to long-run price stability has recently been stressed in particular by the BIS (Bank of International Settlements) and is confirmed by recent research at the ECB." The Fed basically eschews comprehensive and forward-looking Monetary Analysis, choosing instead a shallow emphasis on core consumer price indices.

As long-time readers know all too well, Monetary Analysis is near and dear to my analytical heart. Perilous developments in contemporary "money" and Credit today pose incredible risk to our future, yet they receive little attention. I applaud the ECB's efforts, am appalled by the Fed, and generally believe that conventional thinking on "money" is so flawed that it would not be disadvantageous to wipe the slate clean and start from scratch.

The traditional "quantity of money" approach to Monetary Analysis is an analytical dead end. The "transaction" role of "money" is today of minimal importance, while an ambiguous "store of value" attribute is absolutely paramount. No longer does the Federal Reserve even attempt to manage "money" and the Fed and banking system certainly no longer enjoy a monopoly on its creation. Greatly complicating the matter, the static monetary aggregates today have little relationship to the vagaries of marketable securities-based Credit "money." The phenomenon of "Money" is perception-based and, hence, non-quantifiable - which, by the way, creates one heck of a predicament for econometricians and contemporary (statistical models-based) economics generally. If you can't model it, ignore and dismiss it.

The mystique of "Moneyness" is achieved when the marketplace perceives a financial claim's superior liquidity and "store of notional value" attributes. "Moneyness" is special because it basically fosters insatiable demand - which ensures powerful forces will evolve to issue it in increasing excess. If "moneyness" is confined to the narrow monetary aggregates - say, government-issued currency and bank created deposits - that's one (generally manageable) issue. Conversely, if "moneyness" evolves right along with a runaway Credit boom to encompass the financial claims issued by an expansive Credit system financing speculation, asset and economic Bubbles - well, it becomes one hell of an unwieldy problem.

From Bernanke: "Even in those early years...financial innovation posed problems for monetary measurement, as banks introduced new types of accounts that blurred the distinction between transaction deposits and other types of deposits."

Well, forget about analytical tumult from the past associated with the introduction of new types of bank accounts. The explosion of GSE debt and guarantees, MBS, ABS, Wall Street and securities Credit, myriad financial guarantees, "structured finance," and mushrooming derivatives markets have thoroughly and radically altered Monetary Analysis. Today, in the euphoric late stage of historic Credit boom, the attribute of "The Moneyness of Credit" has created virtually insatiable demand for trillions of Credit instruments - top-rated and perceived highly liquid. And, as we're witnessing, the greater the degree of Credit excess, along with resulting asset inflation and economic booms, the further the "Moneyness" attribute gravitates out the risk spectrum - and the greater the gulf between the perception of safety and liquidity and the reality of highly risky Credits acutely vulnerable to a reversal in the Credit Cycle.

Hoping to transition from the theoretical to more practical market analysis, I would like readers to recall the 1999/early-2000 environment - the terminal blow-off phase of the technology Bubble. It was common back then for the major technology companies to write put options on their own stocks. Revenues were surging throughout the industry, and most tech companies were major buyers of their own shares. Writing/selling put options on their ever-rising share prices was pretty much found money and could be rationalized as a way to reduce the cost of buybacks. Treasury departments were happy to participate, turning themselves into profit centers extraordinaire. Come the bursting, many companies were burned by these put positions - although losses generally were embedded in the cost of share repurchases rather than flowing through to (rapidly shrinking) earnings.

I hold the view that this aggressive company put option activity was likely an integral aspect of what developed into a major derivatives market distortion - playing a meaningful yet unrecognized role in the NASDAQ Melt-Up Dislocation. I am delving into this issue tonight because I believe something similar has unfolded in the corporate debt risk markets.

Importantly, throughout the technology blow-off, the huge supply of put selling by the major technology companies worked to distort both market prices and perceptions. For one, technology stock "insurance" was readily available in the marketplace at relatively inexpensive prices (considering the actual, yet at the time unappreciated, risk of collapse). This nurtured a perception within the speculator community that the best strategy was to play the market run for all it was worth, while at the same time either holding puts or planning to use the derivatives market to hedge exposure at the first indication of a bursting Bubble.

Typically, a writer of an equity put option will short a portion of the underlying stock as a hedge. This position is then adjusted (dynamic trading) to ensure that the short position generates sufficient profits in the event the stock declines and the put "goes into the money." Thus, if a large number of market participants move to hedge their equities exposure (buying puts), the market would be expected to come under selling pressure as the writers of this protection short stock to establish their hedges.

But with companies selling puts options and writing other derivatives - on shares they expected to repurchase at some future date - the market did not bear the usual brunt of hedge-related selling pressure. Indeed, a key dynamic unfolded where the availability of inexpensive market insurance altered the market's perception of risk. It certainly emboldened the leveraged speculator community - in the process creating huge buying power to push the market higher and ensure the speculators and "insurance" sellers were aptly rewarded. Additionally, those that had shorted stocks (either as bearish trades or as hedges against "insurance" written) forced to cover - at any price. And the higher the market rose, the greater the incentive to speculate in stocks and call options, write market insurance (capture premiums) and cover shorts. Despite rapidly escalating risk, put protection remained readily available at significantly distorted prices.

Importantly, the speculation and derivative-related market dislocation created a backdrop that virtually ensured a collapse. A wildly distorted derivatives "insurance" marketplace had come to create a prevailing misconception that market risk could be easily and inexpensively mitigated. And it is a very dangerous facet of contemporary derivatives markets that a large segment of a market adopts a strategy that preordains an eventual attempt to offload market risk to "the market." In the end, the technology Bubble became so extended that when it eventually reversed, the crowd rushed to establish hedges and liquidity almost immediately evaporated. Put sellers and derivative speculators, including tech companies, completely backed away from selling new "insurance" and the price of protection skyrocketed. Selling stock essentially became the only mechanism to "offload" risk - and the market collapsed.

These days, the market distorting dislocation resides in Credit derivatives. The leveraged speculating community - having ballooned enormously since the days of the tech Bubble - has gravitated to and is making a big fortune in various endeavors (i.e. Credit default swaps, CDOs, constant proportion debt obligations/CPDOs, and myriad Credit derivatives) that is essentially writing Credit "insurance." The proliferation of speculators seeking to sell Credit protection has profoundly reduced its price and increased its availability. This has encouraged many to speculative in risky Credit and hedge in derivatives. Wall Street has certainly been emboldened to fashion sophisticated structures that pool risky loans and then go to the marketplace to buy insurance. Such an operation satisfies those clients wanting to borrow money, speculator clients wanting to write Credit protection, and other clients wanting to speculate on "top-quality" but higher-yielding debt instruments. The end result is the creation of coveted top-rated "money-like" securities that today enjoy almost insatiable demand - and with it as almost unlimited potential for issuance. Loans to pool and structure have been the limiting factor, but the corporate/M&A/ leveraged loan/junk/energy/resurgent telecom booms are quickly addressing this shortage.

To be sure, this dynamic has had a profound impact on general corporate Credit Availability, the cost and availability of Credit "insurance," Credit creation, marketplace liquidity and asset market prices. And the more Credit becomes available and the greater the Credit boom, the fewer corporate defaults and the more profits for those selling Credit protection - writing flood insurance during a drought. The greater returns from writing Credit insurance, the more players and finance that clamor for a piece of the action. This, then, incites a flurry of Wall Street innovation, crafting only more sophisticated (and leveraged) structures that somehow extract greater profits from shrinking "insurance" premiums. And reminiscent of the technology blow-off, those speculating on the end of the Credit cycle - speculating on widening Credit spreads - have been forced to run for cover. This has only fanned the mania.

One upshot to this incredible dynamic is an issuance explosion of securities and instruments fashioned with the attributes of "Moneyness," though backed by increasingly risky Credits. A second is the dangerous marketplace perception of limitless inexpensive Credit insurance. A third is the perception and extrapolation of endless liquidity, "money" to fuel permanent prosperity. The Credit, insurance, and liquidity booms stoke the economy and inflate corporate revenues and earnings. They also flood the spectacular M&A boom with cheap finance, emboldening players to extrapolate both earnings growth and today's backdrop of unlimited cheap finance. And inflating stock prices create their own self-reinforcing speculation and liquidity Bubbles, further deflating risk premiums and distorting market perceptions - creating only more intense speculative demand for corporate securities.

The explosion of Credit derivatives and top-rated corporate securities issuance is a monetary development of historic proportions. I have written about the "Moneyness of Credit" issue over the past few years, but never did I imagine it would come to this. Marketplace perceptions of safety and liquidity are today being grossly distorted on a scale - multi-trillions of securities from one end of the globe to the other - that so overshadows the technology Bubble - that overshadows anything previously experienced in the history of finance.

Following in the footsteps of the technology derivatives Bubble, the mania in Credit "insurance" ensures a collapse. It today feeds a self-reinforcing boom, but when this cycle inevitably reverses, the scope of Credit losses will quickly overwhelm the thinly capitalized speculators that have been more than happy to book premiums directly to profits. Undoubtedly, an unfolding bust would find this "insurance" market in complete disarray. Much of the marketplace today expects that they will, when things begin to turn sour, either obtain Credit "insurance" or hedge/"reinsure" protection already written. But when much of the marketplace moves to offload Credit risk there will simply be no one to take the other side of the trade. As losses mount, the market will then face the harsh reality that minimal "insurance" reserves are available to make good on all the protection written. This will have a profoundly negative impact on both Credit Availability and marketplace liquidity - ruining the plans for many expecting - and requiring - that "money" always flow so freely.

A major problem with the current monetary boom - the "Moneyness of Credit Bubble" - is the enormous and widening gulf between the markets perception of safety and liquidity and the acute vulnerability of the actual underlying Credits. Runaway booms invariably destroy the "money" - in whatever form it takes - whose inflationary expansion was responsible for fueling the Bubble. This lesson should have been learned from the late-twenties experience, or various other fiascos as far back as John Law. When current perceptions change - when trillions of instruments are reclassified and revalued as risky instruments as opposed to today's coveted "money" - Dr. Bernanke will learn why a central bank's monetary focus must be in restraining "money" and Credit excesses during the boom. And the longer this destabilizing period of transforming risky Credits into perceived "money" is allowed to run unchecked, the more impotent his little "mop-up" operations will appear in the face of widespread financial and economic dislocation - on a global scale.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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