Inflationist Watch

By: Doug Noland | Fri, Jan 21, 2005
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HIGHLY UNEDITED!

Sellers were out in force again, with last year's favorites leading on the downside. For the week, the Dow and S&P500 declined 1.4% and 1.6%, respectively. The Transports and Morgan Stanley Cyclical indices were hit for 2.8%. Meanwhile, the Utilities were about unchanged, and the Morgan Stanley Consumer index was down only 0.3%. The broader market was under moderate selling pressure. The small cap Russell 2000 and S&P400 Mid-cap indices dipped 1%. Technology selling was more aggressive, with the NASDAQ100 declining 3.8%. The Morgan Stanley High tech index declined 4% and the Semiconductors 3.5%. The Street.com Internet index was down 2%, while the NASDAQ Telecommunications index was hit for 4.5%. The Biotechs declined almost 2%. The Broker/Dealers fell 1%, while the Banks were about unchanged. With bullion recovering $4.20, the HUI gold index rose 3.7%.

The Treasury market performed well. For the week, two-year Treasury yields dropped 8 basis points to 3.15%. Five-year Treasury yields declined 7 basis points to 3.64%. Ten-year Treasury yields sank 8 basis points to 4.14%. Long-bond yields also declined 8 basis points to 4.65%. The spread between 2 and 30-year government yields was unchanged at 150 basis points. Benchmark Fannie Mae MBS yields sank 13 basis points to the lowest level since last April. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note widened 2 basis points to 36, and the spread on Freddie's 5% 2014 note widened 2 basis points to 33. The 10-year dollar swap spread declined 1 to 38.25. Corporate bond spreads generally widened, with junk debt noticeably underperforming again this week. The implied yield on 3-month March Eurodollars declined 1.5 basis points to 2.955%.

January 19 - Bloomberg (Karen Brettell): "The U.S. two-year swap rate rose to its highest in 2 1/2 years as the prospect of further Federal Reserve benchmark rate increases spurred demand from investors to exchange interest payments to fixed rates from floating. The increase in the two-year rate narrowed the gap with the 10-year swap rate to about 92 basis points today, its lowest since March 2001..."

The holiday-shortened week saw about $9 billion of corporate bond sales. This week's investment grade issuers included JPMorganChase $2.75 billion, Allstate Life $500 million, Coventry Health $500 million, and Appalachian Power $200 million.

Junk bond fund outflows jumped to $445.6 million for the week ended Wednesday. Junk issuers included Rayovac $700 million, Vendanta Resources $600 million, CSN Islands $400 million, Mobile Telesystems $400 million, JB Poindexter $200 million, Del Laboratories $175 million, ALH Finance $150 million, Forest City Entertainment $150 million and Carriage Services $130 million.

January 21 - Bloomberg (Michael Rothschild): "Domino's Pizza Inc. Chief Financial Officer Harry Silverman turned to JPMorgan Chase & Co. to refinance a high-yield loan in November as companies took advantage of investor appetite for floating-rate assets with payments that are adjusted as interest rates change. Companies such as Domino's used high-yield loans in 2004 to lower interest payments and to pay for acquisitions, boosting the market to a record $564 billion worldwide. 'It seems like it's been much easier to procure financing than since the early 1990s,' says Silverman... JPMorgan... maintained its perennial lead as the biggest arranger of high-yield, high-risk loans in the U.S., where the market totaled $457.4 billion. In Europe, the market topped $100 billion for the first time..."

Convert issuers included Celanese $240 million and Alexion Pharmaceuticals $125 million.

Foreign dollar debt issuers included Austria $1.0 billion, Rentenbank $1.0 billion, Swedish Export Credit $1.0 billion, Royal Bank of Canada $750 million, Alrosa Finance $500 million, and Rabobank $100 million.

January 19 - The Wall Street Journal (Jeff D. Opdyke): "With the dollar in a four-year slide and commodity prices on the rise, investors are turning to foreign bonds that provide inflation protection. These bonds act much like the Treasury inflation-protected securities, orTIPS, that U.S. investors have been snapping up since 1997. Like TIPS, they are aimed at helping investors preserve the purchasing power of their money over time. But the foreign variety has the added benefit of generating higher returns if the dollar continues to fall. Now, an increasing number of countries are joining the mix by offering their own version of inflation-protection bonds."

Japanese 10-year JGB yields sank 5.5 basis points to 1.345%. Brazilian benchmark bond yields declined 6 basis points to 8.26%. Mexican govt. yields ended the week at 5.13%, dropping 7 basis points for the week. Russian 10-year dollar Eurobond yields rose 4 basis points to 5.96%.

Freddie Mac posted 30-year fixed mortgage rates declined 7 basis points this week to 5.67%, the lowest level in 12 weeks. Fifteen-year fixed mortgage rates fell 4 basis points to 5.15%, while one-year adjustable-rate mortgages inched up 1 basis point to 4.11%. The Mortgage Bankers Association Purchase applications jumped 14% for the week, recovering from recent weakness. Purchase applications were down 12% from one year ago, with dollar volume slipping almost 6%. Refi applications surged 19% during the week. The average new Purchase mortgage slipped to $228,200, and the average ARM was about unchanged at $309,200. ARMs were about unchanged at 32.8% of total applications

Broad money supply (M3) $ billion (week of January 10) declined $8.7 billion to $9.433 Trillion. For the week, Currency added $0.9 billion. Demand & Checkable Deposits sank $65.5 billion. Savings Deposits jumped $67.9 billion. Small Denominated Deposits added $2.2 billion. Retail Money Fund deposits declined $4.9 billion, and Institutional Money Fund deposits dropped $23.5 billion. Large Denominated Deposits surged $31.5 billion. Repurchase Agreements declined $15.5 billion, and Eurodollar deposits dipped $1.9 billion.

Bank Credit jumped $38.7 billion for the week of January 12 to $6.81 Trillion. For the week, Securities holdings rose $11.3 billion, and Loans & Leases jumped $18.3 billion (up $47.3 billion in three weeks). Commercial & Industrial loans rose $7.0 billion, with a 10 week gain of $16.8 billion. C&I loans have actually expanded at a 7.6% rate over the past half year. For the week, Real Estate loans jumped $21.8 billion (up $24.1bn over 2 weeks). Real Estate loans are up $333.4 billion, or 14.9%, over the past 52 weeks. For the week, consumer loans declined $4.6 billion, while Securities loans added $2.4. Other loans increased $6.3 billion. Elsewhere, Total Commercial Paper jumped a notable $14.9 billion to $1.409 Trillion (up 9.0% over 52 weeks). Financial CP rose $11.5 billion to $1.272 Trillion. Non-financial CP added $2.4 billion to $136.8 billion.

Fed Foreign Holdings of Treasury, Agency Debt declined $7.5 billion to $1.344 Trillion for the week ended January 19 (up $238bn, or 22% from a year earlier). Federal Reserve Credit added $2.6 billion for the week to $783.3 billion.

Continuing last year's strong momentum, this week's ABS issuance jumped to a strong $14 billion (from JPMorgan). About $7 billion home equity ABS were sold.

Currency Watch:

Today's sharp sell-off wiped out most the dollar index's gain for the week. For the week, the New Zealand dollar rose 2.5%, the Australian dollar 1.5%, and the British pound 1%. On the downside, the Romanian leu dropped 3%.

Commodities Watch:

January 18 - Bloomberg (Stephen Voss): "Oil prices may surge again this year unless global demand slows as the cost of crude increases, said the International Energy Agency, an oil policy adviser to 26 nations. Global demand for gasoline and other oil-based fuels rose 3.3 percent last year, the fastest since 1976, and 'failed to respond' to higher prices, which climbed 34 percent for the year as a whole... In 2005, world consumption is expected to rise 1.8 percent."

January 21 - Bloomberg (Wing-Gar Cheng): "China's crude oil imports rose 31 percent in December compared with a year earlier, the Beijing-based Customs General Administration of China said. Crude oil imports increased to 12.1 million metric tons... China's 2004 crude oil imports rose 35 percent to 122.7 million tons..."

January 21 - Bloomberg (Simon Casey): "Zinc futures rose to a seven-year high in London on concern production may fall further in China, the world's biggest producer of the metal used to rustproof steel, because of power shortages."

February Crude Oil was unchanged (and resilient) this week at $48.53. The Goldman Sachs Commodities index added 0.4%, with three-week gains of 6.9%. The CRB index rose 0.3%, turning the y-t-d change to slightly positive  

China Watch:

January 17 - Bloomberg (Nerys Avery): "China's investment in factories, homes and other fixed assets is growing too fast and the government needs to step up efforts to cool expansion and damp inflation, according to the nation's top planning body. 'We still need to enhance and improve the country's macroeconomic controls,' Cao Yushu, spokesman for the National Development and Reform Commission, said... 'The growth rate of investment is still too high and the structure of the investment is clearly still not rational.'"

January 17 - XFN: "China's Ministry of Commerce (MoC) said 82% of the world's leading firms will increase their investment in China in the next three years, attracted by the country's rapidly growing economy. The results were released by the Chinese Academy of International Trade and Economic Cooperation under the MoC, which conducted a survey of BusinessWeek's top 1,000 global firms..."

January 20 - Bloomberg (Wing-Gar Cheng): "Beijing is facing its worst natural gas shortage in 20 years this winter on increased demand and limited supply, China Daily said, citing Mayor Wang Qishan. The city may not be able to meet demand during the Lunar New Year holidays and the annual National People's Congress meetings in March should gas consumption remain high... The city is cutting gas supply to industries and replacing more than 1,300 gas-powered buses with those run on oil, the report said."

January 20 - Bloomberg (Theresa Tang): "Taiwan's corporate investments in China rose 47 percent in December, the Ministry of Economic Affairs' Investment Commission said... In 2004, Taiwan's approved investment in China rose 51 percent to $6.94 billion from the previous year."

January 18 - Bloomberg (Hector Forster and Loretta Ng): "China increased oil demand almost 16 percent to a record in November as refinery processing gained, signaling a possible return to the double-digit growth last seen in the first half of 2004, the International Energy Agency said."

January 17 - Bloomberg (Koh Chin Ling): "China's restaurants had sales of more than 80 billion yuan ($9.7 billion) in December, rising 18 percent from a year earlier to a level equivalent to that for the whole of 1993, the Ministry of Commerce said."

January 18 - Bloomberg (Philip Lagerkranser): "Hong Kong's unemployment rate fell to a three-year low in December as rising tourism and booming trade with China helped drive the fastest economic growth since 2000. The rate, which has dropped from a record 8.7 percent in July 2003, declined to 6.5 percent..."

Asia Inflationary Boom Watch:

January 19 - Bloomberg (In-soo Nam): "Export-Import Bank of Korea, a state-owned trade financer, said it will increase lending to small-sized companies by 17.3 percent this year and offer lower lending rates to assist exports. The bank will provide 3.68 trillion won ($3.6 billion) in loans and guarantees to small-sized exporters... Lending rates will be cut by 0.5 percentage points on average..."

January 19 - Bloomberg (Claire Leow and Shanthy Nambiar): "Indonesia's economy will expand 5.5 percent this year from 5 percent in 2004, boosted by consumer spending and investments, a government report said."

Global Reflation Watch:

January 19 - Bloomberg (Julie Ziegler): "Private investment in emerging market nations such as China, Russia and Mexico will reach $276 billion this year, riding a surge of equity and debt buying from the fourth quarter that was triggered by weakness in the U.S. dollar. Net private investments last year reached $279 billion, the highest since the 1997 Asian financial crisis, exceeding an October forecast by $53 billion, the Institute of International Finance said in a report assessing 29 emerging market nations."

January 20 - Bloomberg (Lily Nonomiya): "The number of corporate bankruptcies in Japan fell 16 percent in 2004 to their lowest level in 13 years, Tokyo Shoko Research Ltd. said."

January 21 - Bloomberg (Kathleen Chu): "Tokyo residential land prices increased in 2004 for the first time in 17 years, the Nihon Keizai newspaper said...citing a survey by Misawa-MRD Co. Residential prices in the capital rose an average of 0.1 percent, while prices in Tokyo combined with its suburbs fell 5.3... Greater Tokyo prices fell 6.4 percent in 2003. The survey also showed that average home land prices around Osaka had their first increase in 14 years..."

January 21 - Bloomberg (Sam Fleming): "U.K. gross mortgage lending fell last month to the lowest since February, adding to evidence of a slowdown in the property market, said the Council of Mortgage Lenders."

January 18 - Bloomberg (Brian Swint and John Fraher): "German exports rose to a record last year as foreign demand helped Europe's largest economy return to growth... Exports rose 10 percent to 731 billion euros ($953 billion) from a year earlier, the Federal Statistics Office (said)... The surge in sales abroad boosted Germany's trade surplus by a fifth, taking it to a record of 155.6 billion euros."

January 19 - Bloomberg (Rainer Buergin): "An increase in German sales-tax revenue in December has raised hopes that domestic demand will improve and help boost economic growth, the German Finance Ministry said... Revenue from sales tax rose 1.7 percent in December from a year earlier after declines in November and October... Revenue from corporate income tax increased 9.8 percent in December..."

January 19 - CNW: "Canada's import and export trade through the Port of Vancouver grew 11 per cent to 73.9 million tonnes in 2004, with shipments of sulphur, potash and containers reaching record levels. The port's 2004 performance is a key indicator for Western Canada's booming resource-based economy, which is being driven by surging demand from China and other Asian economies."

Latin America Reflation Watch:

January 20 - Bloomberg (Carlos Caminada): "Brazil, the world's biggest exporter of beef, soybeans and iron ore, had a record current account surplus of $11.7 billion last year boosted by record oversees sales of steel, agricultural machinery and other goods... For the year, foreign direct investment rose to $18.17 billion from $10.1 billion in 2003."

January 20 - Dow Jones: "Sales of new cars and light trucks in Chile rose 24.3% in 2004 to 119,526 units, the country's automotive association, ANAC said... This was the third highest sales figure on record."

January 20 - Bloomberg (Alex Emery): "Peruvian exports rose 37 percent to a record $12.36 billion last year, as China nearly doubled purchases of Peruvian goods, the government said. Sales abroad last year were topped by mining exports, which rose 44.4 percent to $6.77 billion..."

Dollar Consternation Watch:

January 21 - Market News: "French Finance Minister Herve Gaymard urged
Washington again Friday to end its policy of benign neglect of the dollar. 'It's true that this slide of the dollar is worrying,' the minister reiterated in a radio interview... The US Administration 'must definitely end its attitude of negligence,' Gaymard said... 'I read Mr. Bush's speech attentively. Unfortunately, he didn't talk much about this issue.'"

Bubble Economy Watch:

January 18 - Market News (Gary Rosenberger): "Factory shipments of major appliances soared in December, girded by a positive outlook for 2005 and ahead of wholesale price increases announced for January - but the heavy pre-buying virtually assures softer shipments to start off 2005, industry officials say. Retailers are looking forward to higher prices - estimated at 5% to 10%, if it all sticks - because they want to slow the treadmill that compels them to move ever-greater volumes just to keep revenues in line with prior years. The best-performing market segment continues to be the high end, spurred by home remodeling and luxury home sales that require better ranges, dishwashers, refrigerators and other products appropriate for luxury homes, they say."

January 20 - New York Times (Jennifer Steinhauer): "The Consumer Price Index for the New York region rose 3.8 percent as an overall average in 2004, the federal government said yesterday, as higher food prices and rising fuel costs drove the largest year-to-year increase in the index since 1990. The figures showed that New Yorkers spent more money last year whipping together salads and slicing bananas into their cereal than the rest of the United States, as local prices for food showed the largest annual increase in 14 years, according to the Bureau of Labor Statistics. Food prices, especially for products bought in grocery stores, rose more in the New York region than anywhere else in the country. Since December 2003, the price for food in grocery stores in the New York metropolitan region rose 5.5 percent..."

Mortgage Finance Bubble Watch:

January 21 - Dow Jones: "Top economists at Fannie Mae and Freddie Mac expect home sales to drop slightly in 2005 from last year's record-breaking performance as slower home price gains and modestly higher interest rates cool the red hot U.S. housing sector... 'Higher, but still modest mortgage rates means that the housing market should have another splendid year in 2005, said (Freddie's) Nothaft... he expects sales on new and existing homes to just eclipse the record set in 2004 - at 7.85 million units sold in 2005. (Fannie's) Berson...was more pessimistic, projecting a decline from 2004 in both categories to roughly 7.25 million units."

Fannie Mae posted a slow December. For the month, the company's Book of Business expanded at less than 1% annualized to $2.31 Trillion. Outstanding MBS grew at an 8.5% pace to $1.40 Trillion, while the company's Retained Portfolio contracted at a 10.1% rate to $904.6 billion. For the year, Fannie's Book of Business increased $108.7 billion, or 4.9%. The Retained Portfolio increased 0.7%, while Outstanding MBS expanded 7.9%.

January 20 - The Wall Street Journal (Ruth Simon): "Taking advantage of rising property values, record numbers of homeowners are turning to home-equity loans as a source of easy cash. Overall, home-equity originations climbed 35% last year to a record $431.3 billion, according to SMR Research Corp... Most of the growth has been in variable-rate lines of credit that are tied to the prime rate, currently 5.25%. Countrywide Financial Corp. originated $30.9 billion in home-equity loans last year, a 71% increase... As competition heats up -- and rising rates make refinancings less attractive -- lenders are looking for new ways to boost this market."

January 18 - Los Angeles Times (Annette Haddad): "Home prices in Los Angeles and Orange counties set records - yet again - in December, though the pace of sales slowed as the supply of available houses dwindled... The median price in Los Angeles County rose 21.2% to $418,000 from a year earlier but was essentially flat from the month before. In Orange County, the December median gained 18% to $551,000 and was up less than 2% from November... (From DataQuick). For the full year...both counties saw their median prices rise 24%, which was above the 20% rate of appreciation in 2003. As for sales in December, the number of transactions year over year slipped 7.4%...in Los Angeles County and dropped 10.2%...in Orange County... For 2004, sales for all types of homes decreased 3.3% in L.A. County and 11.5% in Orange County."

January 18 - San Diego U-T (Roger M. Showley): "San Diego County housing prices rose a record 21.1 percent in 2004, turning in a ninth straight year of gains with a December median price near $500,000, DataQuick Information Systems reported yesterday. Based on all transactions for the year, the overall median home price in the county stood at $459,000 on 60,886 sales, firmly placing the area among the nation's five most expensive housing markets."

At $4.73 billion, California ARM heavyweight Golden West Financial's December originations were the strongest since August, and were up 26% from December 2003. Total Assets expanded at a 26% rate during the month to $106.9 billion and were up 29% for all of 2004. Loans were up 31% for the year to $102.7 billion. On the liability side, FHLB borrowings increased at a 30% rate to $33.8 billion (up 54% for the year). Total Deposits expanded at a 12% rate during December to $53.0 billion (up 13% during 2004). The company originated a record $49.0 billion of mortgages during the year, up 36% from 2003. Adjustable-rate mortgages were 99% of total originations. CEO Marion Sandler stated, "This past year customers were particularly attracted ot the affordable payments and flexible terms offered by our primary product, the adjustable rate mortgage..."

Washington Mutual's Total Assets expanded $19.1 billion, or 26% annualized, to $307.9 billion during the fourth quarter, the strongest growth since the second quarter of 2002. "While fourth quarter fixed rate home loan volume declined 46 percent compared with the fourth quarter of 2003, adjustable rate home loan volume was up 27 percent, while home equity loan and lie of credit and multi-family volumes rose 17 percent and 36 percent, respectively... During the fourth quarter of 2004, ARMs represented 68 percent of the company's home loan volume, compared with... 48 percent in the fourth quarter of 2003." Average Home Equity loans expanded at a 39% rate during the quarter and were up 63% y-o-y. On the liability side, Total Deposits increased $4.96 billion, or 12% annualized, to $173.7 billion. Advances from the FHLB surged $10.3 billion, or 69% annualized, to $70.1 billion. For the year, Deposits were up 13%, while FHLB borrowings surged 45%.

Earnings Watch:

Highlights from Citigroup's fourth quarter: "In North America, average loans grew 20% in retail banking and 13% in consumer finance, while internationally, retail banking deposits increased 19% and cards opened more than 1 million new accounts. Smith Barney net client flows were the strongest in 11 quarters, at $10 billion, and private bank assets under management increased 24%. In transaction services, assets under custody rose 23%..." "International revenues and net income increased 14% and 25% respectively. Corporate and consumer franchises in Asia performed exceptionally well as increased customer balances, loans, card accounts and corporate customer activity resulted in revenue and net income growth of 36% and 63%, respectively." "International Cards revenue and income growth reflect a 32% increase in accounts and 22% growth in managed loans..." Capital Markets and Banking - fixed income markets revenues grew 12%... Equity markets revenues increased 28%... Investment banking revenues increased 18%." "Operating expenses increased 39%, reflecting increased compensation expense and the impact of recent acquisitions."

Citi Total Assets expanded at a 13% rate during the fourth quarter (up from the Q3's 11.6% rate) to $1.484 Trillion and were up 17.5% from a year earlier. For the quarter, Trading assets expanded at a 24% annualized pace to $280.2 billion, and Investments increased at a 14% rate to $213.2 billion. For the year, Trading assets were up 19% and Investments almost 17%. Examining Loans assets, Consumer loans expanded at a 26% rate to $435.2 billion and Corporate loans increased at a 4.6% rate to $113.6 billion. For the year, Consumer loans were up 14.6% and Corporate loans 15.8%. Brokerage assets expanded at a 13.5% rate to $39.3 billion, and were up 48% y-o-y. On the liability side, Total Deposits expanded at a 20.7% rate during the quarter and were up 18.7% for the year. Fed funds and "repo" liabilities were up 15.7% for the year to $209.6 billion. Short-term Borrowings dropped 15.5% for the year to $31.0, while long-term debt increased 27.8% to $207.9 billion.

JPMorganChase's fourth quarter results were unimpressive, with earnings disappointing for the second straight quarter. Total Assets expanded 7% annualized during the fourth quarter. Comparisons to year ago levels are difficult due to the merger of Bank One.

Highlights from Wells Fargo: "Average loans up 19 percent from prior year. Average commercial and commercial real estate loans up 10 percent..." Total Loans expanded at an 11.9% rate during the quarter. Home Equity loans expanded at a 21% rate during the quarter and Credit cards 35%. Notably, Commercial Loans expanded at a 30% rate during the quarter to $54.4 billion. From one year ago, Commercial loans were up 11.9%, while Total Consumer loans increased 36.5%. Home Equity loans were up 43% and Credit card 23%. Wells Fargo originated $298 billion of mortgages during 2004.

Highlights from Bank of America: "Fourth quarter net income rose 41 percent to $3.85 billion (year ago results do not include FleetBoston)... Securities gains for the year were $2,172 million... Securities gains for 2003 were $1,069 million (including FleetBoston) ... The company opened 5.59 million new consumer credit card accounts in 2004... Returned more than $8.8 billion to shareholders I 2004 through dividends and net share repurchases." Fourth quarter Average Total Assets increased 20% annualized to $1.15 Trillion, with strong gains in both Trading and "Fed funds sold and repos." Total Average Commercial loans expanded at a 1%, while Average Consumer loans increased at a 15% rate (up from the third quarter's 9% pace).

Credit card lender Capital One expanded Assets at a 14% rate during the quarter to $53.7 billion, with Total Assets up 16% y-o-y (up 44% over two years). MBNA assets declined slightly for the quarter to $61.7 billion (up 4% y-o-y).

Inflationist Watch:

Earnings season is our opportunity to glean insight with respect to how the financial sector is financing our economy and markets. "You are what you eat. An economy is how the financial sector lends." While there are scores financial companies left to report, I cannot at this time point to any significant change in recent trends. The Mortgage Finance Bubble continues to dominate the financial landscape. Originations have slowed markedly from the days of the refi boom, but debt growth remains rapid. Home equity borrowing is the fastest growing product. Commercial lending continues to pick up steadily if not impressively. The major banking institutions remain in an aggressive posture, with loose lending standards and aggressive expansion (including branch openings) ensuring earnings troubles in the future. Trading positions are being pared back, while loan portfolios expand robustly. For now, with artificially low deposit and liability rates, boom-time profitability remains ostensibly impressive for many.

Each month I anxiously anticipate a new article from my favorite "analytical nemesis," Paul McCulley. I appreciate his focus, insight and passion, but take strong exception to his analytical framework. He is a devout Keynsian and, in my parlance, a fervent "inflationist." As a devout non-ideologue and sound Credit guy, I find that his writings get under my analytical skin and rouse me. I wish I had the time to do his latest piece "justice."

From Mr. McCulley's January article, "Shades of Irrational Exuberance"

"For, you see, monetary policy works by inciting changes in financial asset prices, which in turn change the calculus of decision makers in the tangible asset world, sometimes known as the real world.

The Fed's ultimate objectives - full employment and price stability - are connected to the real world, but the Fed cannot target changes in the real world directly. The Fed can only directly and indirectly target changes in the financial world, through (1) changes in its Fed funds rate instrument, and even more important, (2) talk about prospective changes in its Fed funds rate instrument.

This really is what the Fed does: it pegs the Fed funds rate, which is the rate of return on overnight money - which always trades at par! - and thereby indirectly targets an array of asset prices - sometimes known as 'financial market conditions' - in an attempt to elicit outcomes consistent with its ultimate goals for the real economy...

Its objective (is) to promote financial market stability - to wit, non-bubble "financial market conditions" - and, more generally, its objectives as custodian of the global reserve currency, to promote non-bubble global financial market conditions, including most importantly their anchor: "spread markets" in the US of A.

In examining the FOMC's dilemma, let's start with the simple observation that in real time, monetary policy can only influence the demand side of the economy, not the supply side of the economy. Put more technically, the supply side of the economy is more or less fixed in real time, so what the Fed can do is influence demand versus that relatively fixed supply, generating changes in resource utilization and thereby, inducing changes in inflation.

Yep, this is how Fed policy works: it's a Keynesian, Phillips Curve world!"

The big problem I have is that we do not operate in a "keynesian, phillips curve world!" Rather, it is a Credit and Asset Bubble World. Years (decades?) of financial "evolution" (with related Credit and asset inflation) have the U.S. Credit system fully geared for lending to the asset markets, while the ballooning "investment" world is fixated on leveraged "spread trade" speculations ("Financial Arbitrage Capitalism"). Policy stimulus enjoys an extraordinarily captive audience, yet will foremost incite further Bubble excess. The notion that the Fed is promoting financial stability is mistaken, while hopes and dreams that further accommodation will rectify imbalances are foolhardy. Indeed, conventional central banking doctrine is both outdated and misguided. And while sophisticated, clever and highly seductive, today's inflationism is a more dangerous scourge than ever.

What sets Mr. McCulley apart from others - making him an especially imposing "nemesis" - is that he is such a keen and adept observer of the U.S. Credit system, "financial conditions," and the Fed. It is accurate that "monetary policy works by inciting changes in financial asset prices," as much as I believe this lies at the very heart of flawed monetary policy theory. And he is spot on when he avers that U.S. "spread markets" are today the "anchor." Speculative spread trades have evolved into the epicenter for system liquidity, and a semblance of stability is maintained only as long as the Fed accommodates endemic leveraging. And, interestingly, Mr. McCulley is unapologetic when it comes to the reality that asset inflation and Bubbles are an inevitable cost of policy stimulus: McCulley: "I have long believed that asset prices bubbles are not just a risk, but also a virtual certainty stemming from current global circumstances." But, Mr. McCulley, how does it all end - what is the endgame?

Under the heading "The Fed as Bartender," he writes: "In order for America to play the role of global aggregate demand partier of first and last resort, in the face of American monetary stimulus leaking out through the current account deficit into foreign job creation, American consumers need to feel good about themselves. And nothing makes the American consumer feel as good as elevating property prices. Nothing! House price inflation emboldens consumers to spend liberally out of current income, secure in the knowledge that the house is doing the heavy lifting of wealth building. And for the most animal-spirited of consumers, it allows them to turn their houses into ATM machines. Accordingly, there is nothing wrong with the Fed offering happy prices for property price tippling, if and when there is a whiff of deflation in the air, borne of irrational ennui. Such was the case in 2001..."

I cannot let such commentary go unanswered. From one "populist" to another, how can we ever morally or ethically condone the Federal Reserve policy of inciting massive household borrowings to mitigate previous policy blunders? As unjust and often arbitrary redistributors of wealth, risk, indulgence and hardship, Credit inflation and asset Bubbles are indeed crucial moral and ethical issues. Moreover, the focus of the Fed should be on domestic financial and economic stability - keeping our house in order - and not on "global aggregate demand." And from one student of markets to another, how can we not contemplate and factor into our analyses an eventual housing bust? Consciously inciting mortgage finance excesses will go down as one of history's greatest policy blunders

And "irrational ennui"? "Irrational" and "rational" are overused these days. The 2001 "ennui" was a perfectly reasonable post-tech Bubble environment, and it was "necessary adjustment" and not deflation "in the air." The unfolding recession and financial dislocation were an unfortunately necessary step toward recalibrating the highly distorted U.S. financial sector. And, let there be no doubt, only a rather painful period of financial upheaval would have initiated the required changes to borrowing, spending, investing and speculating patterns - the very serious structural adjustments necessary to return some semblance of balance and sustainability to the U.S. and global economies. But the Fed was determined to inflate.

"Which brings us to Macroeconomics 104, where we learn that private foreign net investment in America is putatively a good thing, while a large share of foreign official investment flows in America's capital surplus is ostensibly a bad thing. Why? Foreign private investors in America are theoretically profit-maximizers and are coming to America to make profits, which is a sign that investment in America must be more profitable than in other places.

In contrast, foreign official investors in America are not profit maximizers, and are lending America money as an act of mercantilist self interest, so as to keep their own currencies undervalued, thereby giving their exporters an "unfair" advantage against American producers. Accordingly, we also learn that the greater the official share of America's capital account surplus, the more unsustainable it is, and therefore, the more unsustainable America's current account (or trade) deficit is. Why? Since foreign official investors are not profit maximizers, there is no assurance they will continue to lend America dollars if and when their non-profit motives change, generating a disorderly decline in the dollar and dollar-denominated asset prices and, therefore, a dark winter for the American economy."

This line of analysis is extremely important, although I have issues with the premise. Foreign central bankers are not our problem; they've only kept us in the game. Mr. McCulley contrasts profit-maximizing "investors" to foreign central bankers, but fails to address the global pool of speculative finance that purchases a large share of U.S. securities and Credit instruments. I would argue that "official" investors will prove stronger hands than the speculators come difficult times. And I would argue that direct investment is beneficial to our economy, although there is woefully little of this today. Meanwhile, official, investor and speculator purchases of U.S. Treasury, agency, MBS, and ABS together sustain the U.S. Bubble and nurture further systemic fragility. But this is much more a product of dollar "recycling" and financial arbitrage than true profit-seeking investment. It is the nature of what is being financed (asset Bubbles and non-productive debt) that has set the stage for "a disorderly decline in the dollar" and "a dark winter for the American economy."

"I agreed with Mr. Greenspan's instinct that the equity market was in a [late nineties] bubble, even as he denied that was his instinct. But it was not a generalized bubble, I argued, but rather a bubble in technology stocks, commonly known as New Economy stocks. Indeed, valuations on Old Economy stocks were getting pummeled. Accordingly, my quarrel with him was that hikes in the Fed funds rate until tech stocks cried uncle was equivalent to 'trying to get the attention of gluttons by starving anorexics. It's bad macroeconomic policy, and it's also morally wrong.'"

I take exception with this analysis. I believe wholeheartedly that we were in a generalized Credit Bubble in the late nineties. Telecom and technology were simply the sectors demonstrating the strongest inflationary bias - thus receiving outsized quantities of superfluous speculative finance. Clearly, the bond market, leveraged speculation, and mortgage finance Bubbles were well advanced, and one can easily trace their roots back to the early nineties. Today's quagmire was not created because anyone was made to "cry uncle," and there were certainly no "starving anorexics." The Fed specifically stoked fledgling Bubbles to compensate for the bursting of the tech Bubble. This was "bad macroeconomic policy, and it's also morally wrong."

I also want to stress that "necessary adjustments" should not be thought of in terms of either a moral or ethical issue. Justice has absolutely nothing to do with it. We see these days that virtually the entire financial infrastructure - from real estate lending to financing securities and derivative trades - finds it more lucrative to direct finance to assets markets than to fund sound investment. And, importantly, with Credit and liquidity flowing in gross excess from the (speculative) asset markets to the real economy, the system's entire market pricing structure becomes only increasingly impaired over time In reality, the current Bubble environment makes it very difficult to determine what "sound investment" entails. I would strongly argue that it is today impossible for the market mechanism to effectively price risk or allocate capital. "Necessary adjustment" has everything to do with a maligned pricing and the misallocation of finance and real resources - everything to do with sustainability.

But the Greenspans, Bernankes, and McCulleys of the world will have no part of "necessary adjustments." Greenspan speaks sanguinely of market-based adjustments. Bernanke blames the Great Depression on "Bubble poppers." And from Mr. McCulley:

"Fed Governor Bernanke, in his very first speech as governor in October 2002, explicitly embraced the validity of using the microeconomic tools of regulation, rather than the macroeconomic tool of the Fed funds rate, in the event of suspected bubble tendencies in select markets ("to the extent that credit expansion is indicative of bubbles, I think that empirical linkage points to a better policy approach than attempts at bubble-popping by the central bank.")... I could not agree with Mr. Bernanke more! The Fed should not use the macro tool of the Fed funds rate to deal with the micro problem of potential bubbles ("excessive risk taking"!) in selected asset markets. That's why I was so troubled to see the FOMC - or at least "some" of its participants - talking openly in the December 14th minutes about a putative need to get the Fed funds rate up, so as to unwind whiffs of irrational exuberance, borne of a 'prolonged period of policy accommodation.'"

"What we do know is that Mr. Greenspan, unlike Mr. Bernanke, has no taste whatsoever for applying micro regulatory solutions to micro bubble problems. Or to return to an analogy I used last summer, if Mr. Greenspan were a bartender with one rowdy drunk: He would double the price of beer for all, in an effort to bankrupt the drunk more quickly, rather than simply cut off the drunk, letting the decent folk continue to act decently at an unchanged price."

Well, the situation today is certainly not one of "one rowdy drunk." It's a rowdy party and no one has the courage to remove the punchbowl. And this goes right to the heart of the flaw in Dr. Bernanke's analysis. The Credit Bubble issue is very much a macroeconomic issue. And if there were effective "micro" tools at the Fed's disposal, they would at best treat the symptoms and not the disease. The Fed funds rate is today so out of line with inflationary forces - asset and commodity inflation in particular. Speculation psychology has become endemic. We are in the midst of a mania in housing, a boom in commercial real estate, a hedge fund and leverage speculation craze, an emerging markets boom, and a boom in art and collectables. Gambling is all the rage. There is very much a general "exuberance, borne of a prolonged period of policy accommodation."

Watching the speculative U.S. stock market give up some ground, the bond market is breathing a sigh of relief. And perhaps faltering equities will entice the Fed to partake in the much anticipated pause. But I would argue that that lower market yields are destabilizing - more beer for the drunkards. They fuel the mortgage Credit and non-productive debt excesses that weigh on the dollar. And continued liquidity excesses and dollar weakness - in the context of strong inflationary biases in commodities and foreign markets - could easily incite a renewed stampede into things perceived as a better store of value than greenbacks. This could include oil, gold, precious and industrial metals and emerging bond and equity markets. Most classes of risk assets have performed well during the now two-plus years of "reflation." I now expect returns to diverge, and this change in trend will incite indecision, volatility and unstable flows. U.S. stocks could be in a lose-lose. Poor relative performance will entice anxious (performance chasing, trend following) flows to other asset classes, while gains will embolden the Fed "hawks." And a special thanks to Mr. McCulley for graciously granting me permission to quote from his article. I very much appreciate the "debate."


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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