Reality Check

By: Doug Noland | Thu, Apr 12, 2001
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Money Supply (M3)
Implied Yield on 10 Year Agency Bond Futures
10 Year Treasury Yield
2 Year German Note Yield

In a move that will certainly be welcomed by many, this is an abbreviated holiday version of the Credit Bubble Bulletin. I think the less time spent on stock market and economic analysis this holiday weekend, the better…

Stocks enjoyed their strongest rally since early last summer, with spectacular gains throughout the technology sector. For the week, the NASDAQ100 gained 18%, the Morgan Stanley High Tech index 15%, and the Semiconductors 23%. The Street.com Internet index jumped 25%, and the NASDAQ Telecommunications index 17%. The Biotech index surged 15%. The Broker/Dealer index jumped 18%. Blue-chips rallied sharply, with the Dow adding 3% and the S&P500 gaining 5%. The Transports increased 3%, and the Morgan Stanley Cyclical index and the Utilities rose 5%. The broader market enjoyed a solid performance, with the small cap Russell 2000 gaining 5% and the S&P400 Mid-Cap index jumping 6%. Banks stocks advanced about 6%. Gold stocks rallied at the end of the week, with the HUI index posting a 3% gain. The dollar weakened into today's close and appears vulnerable going into next week.

It was the worst week in three months for the U.S. credit market. For the week, 2-year Treasury yields jumped 18 basis points to 4.24%. The "middle of the curve" was hammered, with 5-year Treasury yields surging 29 basis points to 4.76% and the 10-year 28 basis points to 5.16%. Yields on benchmark Fannie Mae mortgage-backs rose 19 basis points and agency yields generally surged about 26 basis points. Spreads were relatively quiet, with the 10-year dollar swap spread about 1 basis point narrower to 89. After yesterday's key decision by the European Central Bank not to lower rates, European bonds suffered their worst two-day losses in five years. Importantly, global bond euphoria has been abruptly interrupted.

The historic U.S. monetary inflation runs unabated, with broad money supply (M3) surging another $45 billion last week. Institutional money fund assets increased $18 billion and large time deposits added $17 billion. Over the last two weeks, broad money supply has jumped $110 billion. M3 has increased a staggering $600 billion during the past 35 weeks, or at a simply ridiculous annualized growth rate of 13%. It is worth noting that commercial paper outstanding increased $17 billion last week, with financial sector borrowings up $20 billion. Total financial sector commercial paper borrowings ended the week at $1.153 trillion, while domestic non-financial companies have borrowed $254 billion. This is an acutely fragile credit system that continues to run out of control.

While investor and media attention are keenly focused on the powerful NASDAQ rally and rising equity prices generally, it appears the past week could prove a key inflection point for global credit markets. This is particularly the case for what we view as a very vulnerable market in the U.S. It has been our view, of course, that speculators have been placing aggressive bets on the assumption that global central bankers had commenced a process of concerted and forceful cuts. With global equity markets under intense pressure, and rhetoric seemingly espousing virtual global economic collapse and rapidly strengthening deflationary forces, market expectations had panic-stricken central bankers commencing a race to near Japanese-style zero interest-rates. The problem is that economies, while weak, are not collapsing and the evidence of general deflation is not all too convincing. And now the markets see reluctance by the European Central Bank to "play ball." This is not how the speculators were hoping this would develop. In the U.S., in particular, there appears significant market risk associated with a highly leveraged credit system in the face of extraordinary money supply expansion, extreme financial and economic maladjustments, and unrelenting and enormous borrowing demands.

On the international front, it is certainly worth highlighting the European Central Bank's open disregard for intense market pressure to lower rates. This could be viewed as a refreshing affront to the overly accommodating U.S. Federal Reserve. If nothing else, it does draw a clear distinction to the Federal Reserve's vice of responding impetuously to market pressures. From an article by Reuters' Tomasz Janowski: "Duisenberg made clear the young, fiercely independent central bank was determined to play its own game. Asked whether it mattered to the bank that people had been asking it to cut rates, he said: 'I am polite, so it does matter. You might say I hear but don't listen'…Duisenberg stressed that even though inflation in the 12-nation euro zone should return below the ECB's two percent ceiling in the second half of this year, price risks, albeit diminished, had not entirely disappeared. He said after-effects of a past surge in oil prices and the weakness of the euro could bring higher pay demands. 'Wage developments remain an upward risk to price stability which needs to be closely monitored,' Duisenberg said. Asked why the bank did not cut rates if it was confident inflation would fall below two percent in the medium-term, Duisenberg said it was not yet clear how pronounced the slowdown in inflation was going to be."

Again parting with the Fed, Duisenberg stated 'I specifically do not want to introduce a bias in our utterances or our statements. So you can keep on waiting and we'll keep on seeing." Spoken like a true central banker. And from Bloomberg: "Deutsche Bundesbank Vice President Juergen Stark Wednesday warned against 'hectic action' and 'loose policy' in light of the worldwide economic slowdown. In an interview with German daily Boersen-Zeitung, Stark refrained from commenting on the next two meetings of the European Central Bank. 'The ECB follows a price stability target and has a clear strategy, as opposed to other important central banks in the world,' he said. 'You can't just lump everything together and forget that interest rates in Europe are already at relatively low levels.'"

Hats off to the ECB. Perhaps there is hope for responsible central banking after all. Clearly, in a global environment rife with aggressive speculative trading, central bankers should err on the side of keeping the speculating community off balance, not pander to it like the Federal Reserve. Pandering only nurtures speculative bubbles. It is certainly not a central bank's role to "buddy up" with the investment community or the media, although both groups have come to believe otherwise. From today's Financial Times: "The surprise is not that the European Central Bank left short-term interest rates on hold. The confusing signals meant that almost anything was possible. The odd thing is that Wim Duisenberg, the ECB president, went out of his way to sound hawkish." This hawkish tone is consistent with comments from former Bundesbank President Hans Tietmeyer, including the remark "steady-hand policy can decisively help to stabilize market expectations." Mr. Tietmeyer also apparently made a fascinating comment to the effect that the Federal Reserve is "dangerously near to becoming a slave to the financial markets." Near?

And while the speculators may pout and throw little tantrums in the near-term, we certainly see recent developments consistent with the very arduous and fitful process that over the long-term is building credibility for the ECB and the euro. Meanwhile, the credibility of the Greenspan Fed is clearly on the wane. We'll be the first to admit, however, that in this "mixed up world" market participants much prefer U.S.-style aggressive "shoot from the hip and ask questions later" central bank accommodation to the caution and measured approach adopted by the ECB. This, like other dangerous financial market fads, will pass. If only the speculators could create a "spread trade" taking a short position in Fed credibility while going long ECB credibility, I think they would have a big winner. We certainly expect such dynamics to manifest in the currency market; it is just a matter of time.

This week provided further evidence of the significance of the mortgage-refinancings. Bloomberg quoted a Wall Street analyst: "March was the first full month where you could begin to see the magnitude and the power of the current refinancing boom. Even with no further (Fed) cuts, U.S. originations should be back at $1.5 trillion, the record we saw in 1998. If the Fed makes additional cuts, you could see lending volumes as high as $1.7 trillion.'" From CountryWide Credit: "'Countrywide seized the opportunity presented by the current refinance boom, achieving three new milestones,' said Stanford L. Kurland, chief operating officer. 'March was a landmark month for Countrywide, as we set new company records in fundings, average daily applications and pipeline.' Fundings were $9.6 billion in March, the highest monthly total in the company's 32-year history. The previous mark was $9.4 billion set in December 1998. Average daily applications reached $734 million, surpassing the record set last month by 10 percent. This enormous surge of applications pushed our pipeline of loans in process to $18.3 billion which is also a new record and a 104 percent increase over the same date last year." March fundings were up almost 90% year over year.

More from Bloomberg: "Investment banks are also benefiting as sales of mortgage-backed securities soared to the fastest pace in two years. Some $166 billion worth of mortgage bonds were sold in the first three months, the biggest quarterly volume since the first quarter of 1999, according to Bloomberg data. Sales of collateralized mortgage obligations reached $75 billion in the first quarter, almost half of the total $187 billion sold in 2000. 'Everyone is really busy,' said Thomas Marano, head of mortgage trading at Bear Stearns & Co., which sold about $11 billion in collateralized mortgage obligations in the first quarter. 'I don't see this letting up for at least a few months.'"

And closely related to the mortgage finance bubble, we see the GSEs hard at work as key players helping to recycle our massive trade deficits. From Dow Jones: "Freddie Mac's $5 billion (bond) reopening Tuesday drew the strongest international reception ever for a five-year reference note. Some 48% of the deal was purchased by investors outside the U.S., easily surpassing the previous record of 40% for a comparable Freddie Mac sale, said Louise Herrle, vice president and treasurer." Well, I guess foreigners have to buy something with all those dollars…

I am going to highlight an article written by Gary Rosenberger at Market News International (MNI) (www.marketnews.com). In their excellent weekly "Reality Check" columns, they go directly to business operators to see what's really happening below the surface of all the economic data and headlines. This week's piece was titled "US Apartment Rent Increases Aggressive: Brokers," with a long subheading "--Utility Increases Between 67% to 300% Major Cost-Push --With Economy Uncertain Many See Increased Demand For Rentals --Less Apartment Rent Inflation Where Tenants Pay Utilities."

"Apartment rents are soaring in response to skyrocketing utility bills and a growing predilection for rental space during this period of economic uncertainty, say brokers and management companies. That has emboldened landlords to stand firm on rent hikes after years of hesitancy that came on competition for a dwindling tenant population that had swarmed toward home ownership, they say. The latest increases may typically double the percentage increases of previous years - except in areas where tenants are responsible for their own utility bills and there is less of a burden on landlords, they add."

Quoting an executive from an apartment management company with properties in Ohio, Michigan and Florida: "Right now, landlords impose the most the market can bear. Due to our costs being at an all-time high, rent increases are aggressive. We've had horrific weather in our markets in Ohio and Michigan this winter, and in many of our buildings we've seen the cost of utilities go up anywhere from 67% to 300%." Further, the executive also stated "rent increases vary dramatically by market - but on average they've been anywhere from 5% to 10% this winter versus a norm of around 2% to 4% in recent years. She added that some of the increase 'reflects markets that have been underpriced and where we can no longer live with it.' Insurance, real-estate taxes, labor and maintenance costs are up as well -- and even with the heftier rent increases and cost-cutting measures 'we barely keep pace.' 'For years we haven't been able to raise rents to the same degree that our costs went up. We're now playing a little bit of catch-up.' She added she sees no evidence of an economic slowdown in terms of an increase in the number of evictions from people who can no longer pay rents…"

"The St. Louis market has also seen rents rise amid a slower economy," from an industry executive in Missouri. 'In our market, there is a shortage of needed housing. At the same time, there's been a strong seasonal surge in demand for apartment space this spring.' The combination of the two factors have forced rents about 7% to 10% higher, compared to a normal rent increase of around 5%." She also associates the very strong market for rentals to the local housing market. "…the local real-estate market has since become so inflated that the latest round of interest rate declines have had no appreciable impact on the rental market. Interest rates are down, but it's still a seller's market. There are no bargains in this market."

"In Minneapolis rent increases are in the 8% to 10% range." "In Minneapolis, the problem is a lack of new product and vacancy rates that are between 1% and 2%…We haven't seen much development in the last four or five years -- property tax rates of 20 cents on the dollar for rentals kept developers out. In fact, local rent increases have been in that range for the last three years. And rents could still go higher when landlords start to pass on the higher cost of utilities. It's still too soon. I haven't seen them pass it on yet, but it may still happen, " according to an apartment search firm.

"A Los Angeles apartment locator, who asked that his name not be used, said local rents 'are through the roof' -- stating that the local energy problems had a hand in forcing the increases."

It just doesn't look like deflation to me, anything but. Instead, there should be enough signs of rising prices to keep an increasingly nervous bond market on edge. Actually, this is disturbingly reminiscent of the Japanese bubble economy from the late 1980s. While measures of consumer price inflation remained subdued, the true cost of living rose significantly. We follow these details closely because credit market investors have had a very strong predilection of looking only to data that supports their view of Federal Reserve rate cuts "as far as the eye can see," while ignoring considerable anecdotal evidence of heightened inflationary pressures. Hence, the marketplace is today extraordinarily vulnerable to an abrupt change in perceptions. One of these days there may be a Reality Check. And perhaps the ECB "sees the writing on the wall," no longer wants to "play the game," and is instead preparing for inevitable trouble. We think so. One thing is for sure, if U.S. rates continue to move higher there will be a significant decrease in mortgage-refinancings, with negative implications for financial system liquidity, consumer spending and the Great U.S. Credit Bubble.

Have a relaxing and enjoyable Easter holiday weekend!


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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