All Dressed Up...

By: Doug Noland | Fri, Feb 23, 2001
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Global financial instability returned with a vengeance this week, with Turkey in the throes of financial collapse. Here at home, the Dow declined 3%, and the S&P500 dropped 4%. The Transports declined 2%, while the Morgan Stanley Cyclical and Morgan Stanley Consumer indices dropped 3%. The Utilities declined 1%, and the Biotechs added 1%. The broader market suffered, with the small cap Russell 2000 and the S&P400 Mid-Cap indices sinking 4%. The technology bust continues, with the NASDAQ100 declining 7%, the Morgan Stanley High Tech index 6%, and the Semiconductors 8%. The Street.com Internet index was hit for 10%, and the NASDAQ Telecommunications index lost 9%. Financial stocks were under pressure as well, with the S&P Bank index dropping 5% and the AMEX Securities Broker/Dealer index sinking 10%. Buyers surfaced for gold shares, with the HUI Gold index jumping 8% this week.

The credit market was also unsettled. With global financial crisis unfolding and expectations of more action by the Fed, short-dated Treasury securities performed well this week. Two-year Treasury yields dropped 12 basis points to 4.53%, and 5-year note yields declined 6 basis points. Interestingly, however, longer-dated instruments are under performing, quite likely in response to a deteriorating inflation outlook. The key 10-year Treasury yield declined only 1 basis point this week, while long-bond yields actually increased 3 basis points. Mortgage-back and agency yields generally added one or two basis points, under performance worth monitoring closely. The benchmark 10-year dollar swap spread widened 2 basis points to 96. Credit spreads generally widened across the board, with junk debt giving up some of recent gains. Gold jumped better than $2 dollars, while the dollar saw gains from earlier in the week turn to a small loss with today’s decline.

“As long as the economy suffers, if we are in a recession – which I think we are – then longer-term Treasuries and certainly shorter-term Treasuries will decline in yield and the prices will go up. Sue, (CNBC’s Sue Herera) let me give you an interesting take on the (stock) market today. This shows you how complicated these things can get and how, from an institutional standpoint, how we think, I suppose. Around 2:30 New York Time, Standard and Poor's came out and downgraded Japan from “Triple-A” to “Double-A”. At that very moment the stock market took off. And it took off, I believe, in anticipation that Japan’s central bank would have to ease further and liquefy their economy. Now we were just talking about the Federal Reserve here in the United States. If the Fed eases and lowers interest rates then that’s positive for the stock market. Well, if Japan or Europe does the same thing that’s also a positive. And when Japan was downgraded, basically institutional money managers hopped on that and said this is the signal that Japan may have to liquefy their economy – reliquefy the world to a certain extent, and that’s positive for stocks. So Japan was a big plus in terms of our market today.” Pimco’s Bill Gross, CNBC 2/22/01

“Oil has risen nearly non-stop since December 1998, housing prices have also done nothing but rise in the last few years, and nobody over this same time has left a job for a lower paying job, and the PPI jumps dramatically because of cigarette prices?” John Roque, Arnhold & S. Bleichroeder (quoted by Dow Jones Newswires)

I used the following quote from Schumpeter last week, but it is certainly worthy of another read:

“What nobody saw, though some people may have felt it, was that those fundamental data from which diagnoses and prognoses were made, were themselves in a state of flux and that they would be swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way.” Joseph A. Schumpeter, Business Cycles, 1939

The ground is threatening to give way. Here at home, the bursting of the historic technology bubble runs unabated, destroying perceived wealth and market liquidity like a giant wrecking ball. Globally, liquidity conditions throughout the emerging markets took a dramatic turn this week, with a spectacular currency collapse in Turkey. We believe that this week marks a critical inflection point for the U.S. and global financial system, and certainly accelerates what we had expected to be waning liquidity conditions at home and abroad. The Turkish government allowed the lira to float, and it immediately sank 40%, before ending the session down 28%. The lira lost 35% of its value in the past two sessions. Importantly, the unfolding crisis in Turkey has put an abrupt halt to a four-month liquidity-induced rally in emerging debt and equity markets. Global economic fundamentals are deteriorating rapidly, with slowing global economies and very fragile financial systems. The termination of the liquidity surge into emerging economies will only exacerbate the downturn as international lenders and speculators now move to cut exposure to these markets. How quickly will they move?

It appears that the leveraged speculating community has been caught once again. Acting for months with the confidence of knowing that it had an aggressive Fed and a wall of liquidity at its back, risky assets were back in vogue. Financial Nirvana, however, has been abruptly and harshly interrupted by dreadful U.S. inflation data and financial crisis for a major ally in the midst of an IMF bailout program. “Stagflation” has replaced “bailout” (Fed, IMF, Treasury) as the new buzzword on emerging market trading desks, and perhaps U.S. fixed income desks as well. This is a major “Big Picture” development, and it’s not bullish.

Wall Street, of course, will downplay the relevance of Turkey, and will likely even go so far as to argue that this is but one more reason for additional aggressive accommodation from the Fed and central bankers globally. We would urge that this is not the time for complacency or “rose colored” goggles. Turkey has been fighting financial crisis now for more than a year, although the most recent IMF bailout is only about three months old. As a close U.S. ally, there was a perception in the marketplace that Turkey would escape a major financial catastrophe on the back of an aggressive IMF bailout and other support if necessary. It was a test of a new “kinder and gentler” IMF approach focusing on a “crawling” pegged value for the lira and loans to allow time for inflation to drop and financial stability to return. But, political crisis and capital flight forced this plan to be thrown out the window. The end result is another spectacular IMF failure and understandable fears of contagion effects.

Interestingly, the IMF and new U.S. Treasury Secretary were even quick to support the major devaluation in the lira, while global bankers, speculators, and derivative players were left licking their wounds and pondering how the devil their interests quickly became so dispensable. The new administration made good on its “hands off” approach, and it has become immediately clear that “times they are a changin’.” Why do I imagine that the leveraged speculating community already yearns for the “good old days”? (“Where’s Bob Rubin?”)

Estimates place Turkey's foreign debt at $110 billion. It is believed that commercial debt comprises about 70% of total foreign debt. Of this amount, European banks lent $54 billion, while US banks are thought to have about $5 billion of loan exposure. The size of bets placed by the hedge fund community is unknown. Late this week Fitch downgraded a series of “structured finance” entities here in the U.S. that were conduits for Turkish financial institutions. All in all, this crisis entails a significant amount of new problem debt that can be grouped with what is very much a rising mountain of impaired credits. At what point problem credits weigh on the very foundations of the global financial system is today unknown, although it clearly came much closer this week. We would expect the major European financial institutions in particular (also with considerable exposure to credits in Latin America) to be increasingly risk-adverse. This is a significant development for U.S. financial assets.

Yesterday from Reuters: “Turkey crisis seen shutting out emerging bond issuers - Turkey's financial crisis and the ensuing currency devaluation has slammed shut the once wide-open door to emerging market issuance, and unless the global economic picture brightens, borrowing nations may face trouble raising money this year. ‘The short-term impact of Turkey's problems is an increase in risk aversion,’ said Graham Stock, head of sovereign debt strategy for Latin America at J.P. Morgan. ‘And then there is the broader global backdrop -- the prospect for stagflation in the United States is going to further reduce the appetite for risk and the ones most vulnerable are those with the greatest financing needs.’ Of all the Latin American borrowing nations, it is Argentina that needs to borrow the most money from the international capital market -- making the country that only two months ago secured a hefty IMF package the most vulnerable to contagion, analysts say.”

Financial markets have been shaken, from Eastern Europe, to SE Asia, to Latin America. The vulnerable market in Argentina should be monitored carefully. True, unlike 1997/98, there is not a string of pegged currency regimes in wait of domino collapse. Still, economies and financial systems throughout the emerging markets are today acutely fragile. And, importantly, the U.S. credit system is immensely more vulnerable today than it was in 1998. Not only is leverage greater throughout the system after several years of truly unprecedented credit excess, but we are now firmly in the early stages of a dramatic and problematic deterioration in general credit quality that was not a factor in 1998. Moreover, the whole risk profile of the U.S. financial system is greatly exacerbated by the historic collapse of the technology bubble. This is diametrically different than 1998.

However, the factor making the current situation particularly ominous (and a point that is not appreciated in the marketplace) is that the crisis in Turkey and the continuing technology collapse are occurring only weeks after the Fed’s dramatic 100 basis point move on interest-rates. Bullish strategists are now claiming – as was the case with Lehman Brother’s Jeffery Applegate this afternoon on CNBC - the market is reacting to the Fed being “increasingly behind the curve.” Nope, that’s poor analysis. In fact, and what is truly an extraordinary development, acute financial stress has unfolded in the face of extreme U.S. money supply expansion and general global central bank accommodation. U.S. Broad money supply expanded another $18 billion last week and has now surged $244 billion in just the past 13 weeks (14% annualized) and $388 billion (13% annualized) over 23 weeks. Further evidence of a financial system run amok was provided by data released yesterday from Strategic Insight: a record $140 billion flowed into funds during January, crushing the previous record of $87 billion during January of 1999. Of this amount, $33.5 billion flowed into equity funds, $8.6 billion into bond funds, and $4 billion into international funds. The vast majority of January’s record flows were accounted by the extraordinary expansion in money market fund assets. Not bad for a household sector with a negative savings rate – this is 100% unadulterated credit inflation.

There is little mystery as to origin of much of this “money.” January numbers are in from Freddie Mac, providing further evidence of the scope of the current mortgage-lending boom. Freddie expanded its mortgage portfolio at a 19% annualized rate, although its average interest-earning assets increased at a 27% annualized rate during January, to $456 billion. It is worth noting that Freddie Mac ended 1997 with total assets of $195 billion.

Interestingly, Craig Tolliver’s article (CBSMarketWatch) on January’s record fund flows quoted the director of research at Strategic Insight, a fund consultancy firm: “The extraordinary commitment of fund investors, reflected in their purchasing and retention patterns, is quite reassuring. This is especially comforting when you take into consideration the tumultuous fourth quarter and lingering uncertainty in 2001.” Well, we see it much differently – this is one big “dog that didn’t bark.” As discussed last week, the U.S. financial system has gone through an extraordinary Reliquefication. Today it should be recognized that this process has had little impact on the collapsing technology bubble and only a muted response for the stock market generally. This is certainly not what Wall Street anticipated. It is actually quite ominous, and the fact that confidence remains so high in the face of such dismal performance should be particularly disconcerting to the bulls.

One of the central themes of my analysis holds that it is the financial sector that largely creates the money and credit that provides liquidity to the financial markets and economy. Money and credit are created through lending, and the financial sector expands money and credit by increasing its liabilities - by taking on additional leverage. I take strong issue with the consensus view that the Federal Reserve is the master of contemporary money creation. And the way our financial system has developed over the years, traditional bank lending has given way to the GSEs, Wall Street firms, the securitization marketplace, and capital markets generally as the driving force behind money and credit growth. In particular, the notion that the Fed is the sole provider of liquidity is misguided, with significant ramifications for the markets currently. Of course, the Fed is clearly a key player, setting the price of short-term borrowings and providing both the general environment and expectations conducive to taking on additional leverage. While the Fed does today have some room to lower rates, it has largely spent all its bullets (and then some!) as far as creating an environment conducive to money and credit excess. Financial market liquidity is predominantly the output of the financial sector. And as I have said before, as goes the financial sector, so goes liquidity.

So we have today a most fascinating situation with Wall Street clamoring for additional rate cuts from the Fed, apparently with the expectation that this act alone creates liquidity. It does not, and boy will Larry Kudlow and the others be disappointed. What’s more, there is no admission, or perhaps even recognition, that over the past four months even unprecedented liquidity creation has proved insufficient to inflate stock prices, what is unmistakable evidence of the increasing impotence of Fed policy (harbinger of the inevitable and problematic “pushing on a string” dilemma). The issue today is not interest rates, but financial fragility. That lower rates and extreme liquidity creation cannot rectify the collapsing technology bubble or cure financial fragility comes as no surprise to those of us that recognize the historic nature and immense scope of the previous excesses created with this historic Bubble Economy.

All the same, for some time the leveraged speculating community has operated with a mindset of “heads I win, tails you lose.” It could play the great financial bubble knowing that the Greenspan Fed would be quick to react to any bubble trouble. “Sure, the tech bubble will burst one of these days, but then I will really print money on my leveraged positions in agency securities and my spread trades!” Having witnessed this routine many times before, and even having assurances “shouted from the rooftop” by Greenspan himself, “everyone” knew the cuts were coming; everyone had their favorite, often sophisticated, strategy to profit from the imminent rate reductions; and with everyone “fat and happy” from years of huge speculative gains, everyone was more than willing and able to place huge “bets.” They placed massive bets.

This immense wall of “hot money” stoked a spectacular rally in Treasuries, mortgage-backs, agencies, corporates, junk bonds, munies, emerging market debt, and so on, as well as sharply narrowing spreads, which conveniently worked wonders for the speculators in more than offsetting losses suffered in technology stocks. This wall of liquidity drove interest market interest-rates much lower, with pesky fundamentals like heightened inflationary pressures mowed over in the process. It was a game for anyone and everyone, from investors to the leveraged speculators to the “risk-averse” to the Bill Grosses of the world. It was wonderfully profitable fun and games – the easiest of money. OK, so now what? This, indeed, is at the heart of today’s great dilemma: the leveraged speculating community has so anticipated and so aggressively positioned for this “Reliquefication trade,” that enormous financial sector borrowings have been added to already unprecedented financial sector leverage, in the greatest “crowded trade” in history (surpassing even technology stocks!) – leverage on leverage, speculation on speculation. Extraordinary liquidity was in fact created, but emphasis on the “was.” It will prove one hell of an act to follow. This time around, rampant credit inflation even made its way to goods and services prices, as well as wages.

So, here we are today. We see the Wall Street proprietary trading desks and derivative operations, the legions of hedge funds, the money center banks, pension fund managers and other financial players, from near and far, All Dressed Up for one hell of a bash. But, dog gone it, they just haven’t yet figured out that it’s very late in the festivities and the party’s almost over. The speculators can plead to the Fed for one more spiked punchbowl to make everything right, but it’s been very much “BYOB” all along. Or, even better, the leveraged players can resort to ranting and raving that the Fed spoiled the party and is now derelict for not creating enough liquidity. Yet, such antics are not going to change the fact that they (the leveraged speculating community) have been The Party, and that they have been spiking the punch - the source of liquidity fueling this historic bubble. You can almost hear, “please God, if you allow just one more round of the “Chain Letter,” one more layer of the “Pyramid Scheme,” or just one more “Greater Fool,” I promise I won’t get myself in such a jam ever again…please…I promise…” I was informed that a popular bumper sticker here in Texas a few years back went something like this: “God, please give me one more oil boom and I promise I won’t piss it away.”

There’s one undeniable aspect of this extraordinary financial environment: everything is done to outrageous and reckless extremes, but it is somehow passed off for normalcy. Too much money, too much easy credit, and a booming industry in speculation have over the years come to feed and feed on excess. The whole system is out of control. The technology bubble was nurtured and allowed to go to dangerous extremes, and we are in the early stages of paying the price for such ridiculous waste and nonsense. The technology bubble a problem, how about real estate? Great danger has developed as the entire U.S. credit mechanism has been allowed (encouraged?) to stray way beyond soundness and reasonableness. We are left today to ponder how long this fragile system can be held together. With emerging debt and equity markets under pressure, faltering currencies, widening credit spreads, rising credit losses, derivative risks, faltering equity markets and huge losses in technology stocks and derivatives, we see little opportunity for the financial sector to avoid severe impairment. It wasn’t supposed to be this way, the financial players presumed, with the Fed as surefire backstop. But, things were just taken to absurd extremes and the Fed doesn’t possess the power many claim.

Today was another one of those ominous days, with sinking global equity markets, faltering U.S. financial stocks, widening spreads, and a sagging dollar creating a confluence of self-feeding negative forces. In the past, days like today often provided the signal that things were serious enough to garner a response from the Fed. And, sure enough, by days end expectations were for imminent rate cuts, with NASDAQ recovering to sport a gain for the day and financial stocks rallying from big losses almost back to break even. You’ve got to be impressed by Wall Street propaganda: faltering liquidity, blame the Fed and claim they’re way “behind the curve.” The Street is now calling loudly for more rates cuts, and Greenspan has never disappointed. And like Pavlov’s dogs, if the Fed does bow to Wall Street’s wishes next week, such news would likely be greeted with a rally. This does not, however, change the fact that this party is winding down. Wall Street may be All Dressed Up, but it’s quickly running out of time. The enormous leveraged speculating community is loaded, and there is no one left to take the other side of the trade. The problem with being heavily leveraged is that one loses flexibility and has little room for error. Furthermore, the Turkish lira provided another alarming example of a discontinuous market, a circumstance likely to be experienced one day in the U.S. derivatives marketplace. The way things are shaping up, the coming weeks will provide one major test for the U.S. financial sector, U.S. financial markets generally, and the dollar. The dollar certainly provided little in the way of a safe haven this week. We are witnessing financial fragility in its purest form. This is out of the Fed’s control.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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