The Great Dilemma

By: Doug Noland | Fri, Jan 28, 2005
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The Dow and S&P500 indices gained about one-third of a percent this week. The Transports and Utilities gained 2%. The Morgan Stanley Cyclical index was slightly positive, while the Morgan Stanley Consumer index gained 0.5%. The Russell 2000 posted a small gain, with the S&P400 Mid-cap index doing slightly better. Technology stocks were mixed. The NASDAQ100 was about unchanged, while the Morgan Stanley High Tech index posted a small decline. Semiconductors rallied 2.5%. The NASDAQ Telecommunications index declined 1%, and The Street.com Internet index was down marginally. The Biotechs were about unchanged. The financial stocks were also mixed. The Broker/Dealers rose 2%, while the banks posted a slight decline. Gold dipped 55 cents to $426.70, while the HUI Gold index dropped 4%.

The yield curve flattened more this week. Two-year Treasury yields rose 8 basis points to 3.24%. Five-year Treasury yields increased 3 basis points to 3.68%, while ten-year Treasury yields dipped 1 basis point to 4.13%. Long-bond yields declined 4 basis points to 4.60%. The spread between 2 and 30-year government yields narrowed 12 basis points to 136. Benchmark Fannie Mae MBS yields increased 7 basis points. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note widened one basis point to 37, and the spread on Freddie's 5% 2014 note widened one basis points to 34. The 10-year dollar swap spread was up 0.25 to 38.50. Corporate bonds generally traded in line with Treasuries. The implied yield on 3-month March Eurodollars rose 1.5 basis points to 2.97%.

Corporate debt issuance jumped to a strong $21.7 billion (from Bloomberg). This week's investment grade issuers included Wachovia $1.95 billion, CIT $2.5 billion, Bear Stearns $1.1 billion, GE Capital $750 million, IBM $750 million, Loews $700 million, Caterpillar Finance $600 million, Colonial Properties $275 million, Eaton Corp $150 million and Union Electric $85 million.

Junk bond fund outflows reached $759.5 million for the week, with two-week withdrawals above $1.2 billion. Junk issuers included Novelis $1.4 billion, Tenet Healthcare $800 million, Hanaro Telecom $500 million, Accuride $275 million, Knowledge Learning $260 million, Del Monte $250 million, AMR Holdco $250 million, Hexcel $225 million, Gregg Appliances $165 million, Eye Care Centers of America $150 million, Edgen Acquisition $105 million, and Quality Distribution $85 million.

Convert issuers included Rambus $300 million and Alexion Pharmaceutical $150 million.

Foreign dollar debt issuers included KFW $3.0 billion, Intelsat Bermuda $2.55 billion, Philippines $1.5 billion, Hungary $1.5 billion, Nationwide Building Society $1.5 billion, Telefonos Mexico $1.3 billion, Ontario Province $1.0 billion, Peru $900 million, Canada Mortgage & Housing $500 million and First Citizens $100 million.

January 27 - Bloomberg (Netty Ismail and Jun Ebias): "The Philippine government sold $1.5 billion in bonds, its biggest single debt offering, after increasing the size of the sale by 50 percent on investor optimism the nation's budget deficit can be reduced. The Philippines, the biggest overseas debt seller in Asia, priced the dollar-denominated 25-year bonds to yield 9.7 percent... Investors ordered five times more securities than available. The Philippines, which had its debt rating cut to three levels below investment grade last week..."

Japanese 10-year JGB yields declined 4 basis points to 1.305%, a 10-month low. Brazilian benchmark bond yields sank 21 basis points to 8.05%. Mexican govt. yields ended the week at 5.08%, down 5 basis points for the week. Russian 10-year dollar Eurobond yields dipped 2 basis points to 5.94%.

Freddie Mac posted 30-year fixed mortgage rates dipped one basis point this week to 5.66% (the lowest level in 13 weeks). Fifteen-year fixed mortgage rates also declined one basis point, to 5.14%. At the same time, one-year adjustable-rate mortgages jumped 7 basis points to 4.18% (highest in 4 weeks). The Mortgage Bankers Association Purchase applications dipped 2% for the week. Purchase applications were down 5% from one year ago, with dollar volume up about 2%. Refi applications declined 5.7%, giving back some of last week's jump. The average new Purchase mortgage increased to $230,600, and the average ARM jumped to $314,900. ARMs declined to 31.7% of total applications.

Broad money supply (M3) jumped $26.0 billion (week of January 17) to $9.460 Trillion. For the week, Currency added $0.9 billion. Demand & Checkable Deposits rose $14.4 billion. Savings Deposits increased $16.3 billion. Small Denominated Deposits added $2.9 billion. Retail Money Fund deposits dipped $3.6 billion, and Institutional Money Fund deposits sank $16.4 billion. Large Denominated Deposits gained $9.2 billion. Repurchase Agreements dipped $0.8 billion, while Eurodollar deposits added $3.2 billion.

Bank Credit jumped $33.2 billion for the week of January 19 to $6.840 Trillion. For the week, Securities holdings surged $29.7 billion, and Loans & Leases added $3.5 billion. Commercial & Industrial lending remains robust, with C&I loans up $4.1 billion during the week. Real Estate loans dipped $3.4 billion. Real Estate loans are up $321 billion, or 14.3%, over the past 52 weeks. For the week, consumer loans fell $2.0 billion, and Securities loans declined $4.3 billion. Other loans gained $9.0 billion. Elsewhere, Total Commercial Paper jumped $9.7 billion to $1.419 Trillion (up 9.1% over 52 weeks). Financial CP increased $5.0 billion to $1.277 Trillion. Non-financial CP rose $4.7 billion to $141.5 billion. Non-financial Commercial Paper expanded $12.0 billion during the first four weeks of the year and is up 21.6% from one year ago.

Fed Foreign Holdings of Treasury, Agency Debt added $3.8 billion to $1.347 Trillion for the week ended January 26 (up $235bn, or 21% from a year earlier). Federal Reserve Credit declined $2.8 billion for the week to $780.6 billion.

ABS issuance increased to $14 billion (from JPMorgan), including about $11 billion of home equity ABS.

Currency Watch:

January 24 - Bloomberg (Vivianne C. Rodrigues): "Foreign currency trading in London and North America averaged $917 billion a day in October, according to the first surveys conducted by the Bank of England and the Foreign Exchange Committee, a group sponsored by the Federal Reserve Bank of New York. The surveys, to be conducted twice a year by the BOE's Foreign Exchange Joint Standing Committee and the Foreign Exchange Committee, will compare trading in the world's two biggest currency markets."

For the week, the dollar index rose slightly. The Australian dollar gained 2%, the Brazilian real 1.6%, and the South Korean won 1.32%. On the downside, the Chilean peso declined 1.8%, the Canadian dollar 1.5%, and the Japanese yen 0.6%.

Commodities Watch:

January 25 - Bloomberg (Wing-Gar Cheng): "China's oil-product imports rose 34 percent to 37.9 million metric tons in 2004 as the economy grew at its fastest pace in eight years, the National Bureau of Statistics said... China exported 11.5 million tons of oil products in 2004... Crude oil imports rose 35 percent to 122.7 million tons..."

January 25 - Bloomberg (Wing-Gar Cheng and Koh Chin Ling): "China's sales of oil and petroleum products rose 46 percent by value last year as the economy expanded 9.5 percent, the National Bureau of Statistics said... 'The supply of coal and oil is still very tight and transportation capacity is still not sufficient,' Li Deshui, the bureau's commissioner said. 'The constraints on China's energy resources are still prominent.'"

February Crude Oil dropped $1.35 this week to $47.18. The Goldman Sachs Commodities index dipped 1.4%, reducing year-to-date gains to 5.3%. The CRB index was unchanged for the week and is basically flat for 2005.

China Watch:

January 25 - Bloomberg (Nerys Avery): "China's economic growth unexpectedly accelerated to 9.5 percent in the fourth quarter and the government said it will maintain restrictions on lending and investment in the world's fastest-growing major economy."

January 26 - Bloomberg (Lily Nonomiya): "Japan's combined trade with China and Hong Kong exceeded that of the U.S. in 2004 for the first time, the Ministry of Finance said, underscoring their increasing importance as a market for Japanese goods. Total exports and imports to and from China and Hong Kong last year totaled 22.2 trillion yen ($214 billion), accounting for 20.1 percent of total trade... Trade with the U.S. amounted to 20.5 trillion yen last year, making up 19 percent of Japan's total."

January 26 - Bloomberg (Jianguo Jiang): "The Shanghai branch of China's central bank asked lenders to be more vigilant about loans after new mortgages increased by 102.3 billion yuan ($12 billion) in the city last year, the Oriental Morning Post reported... The increase is higher than the 20.4 billion yuan of new mortgages recorded in 2003 in Shanghai, China's biggest commercial city with a population of 17 million people. New mortgages last year accounted for 76 percent of total new lending in the city..."

January 25 - Bloomberg (Helen Yuan): "China produced 274 million metric tons of crude steel last year, beating estimates by the nation's industry association, according to calculations based on figures released by the statistics bureau. China, the world's top producer of the alloy, made 23.2 percent more crude steel and 23.5 percent more steel products in 2004 than a year earlier..."

January 25 - Bloomberg (Nerys Avery and Philip Lagerkranser): "China's retail sales rose at the fastest pace in seven months in December as rising incomes enabled households to spend more. Retail sales surged 14.5 percent from a year earlier after climbing 13.9 percent in November..."

January 26 - Bloomberg (Koh Chin Ling): "China's grain shortage will extend into 2005 as reserves decline, the China Securities Journal reported, citing the Price Monitoring Center of the country's top planning agency. Costs of fertilizers may rise this year as demand increases... Fertilizers including urea and potash rose as much as 20 percent last year, the report said... Any increase in China's grain production this year may be limited because of the weather and constraints in increasing planting areas, the report said."

January 25 - Bloomberg (Koh Chin Ling): "China, the world's largest duck producer, slaughtered 1.8 billion of the birds in 2004, 8 percent more than in the previous year as rising incomes boosted meat demand, according to an Agriculture Ministry affiliate. China's duck production accounted for two-thirds of world output last year..."

Asia Inflationary Boom Watch:

January 24 - Bloomberg (Theresa Tang): "Taiwan's export orders grew more slowly in December and industrial production fell as an economic slowdown in China, the island's biggest overseas market, curbed demand for cell phones, flat-panel displays and computer chips. Orders -- indicative of shipments in one to three months -- rose 26 percent from a year earlier to $19.8 billion..."

January 25 - Bloomberg (James Peng): "Taiwan's money supply growth accelerated in December for the second straight month as borrowing and investment increased, the central bank said. M2, the broadest measure of the island's money supply, rose 7.3 percent from a year earlier after gaining 7 percent in November, the Central Bank of China said... That's the biggest gain in four months. M1A, which tracks net currency in circulation plus checking accounts and passbook deposits, expanded 14.8 percent last month..."

January 26 - Bloomberg (Seyoon Kim): "South Korean companies' overseas investment rose more than a third last year as manufacturers such as Hynix Semiconductor Inc. expanded in China. Foreign investment climbed 37 percent to $7.9 billion, the Ministry of Finance and Economy said... China received $3.6 billion of this, 32 percent more than in 2003, and the total number of overseas investments rose 27 percent to 3,904."

January 26 - Bloomberg (Amit Prakash): "Singapore's industrial production expanded 31.7 percent in December from a year earlier, an Economic Development Board spokeswoman said in a phone interview. Production expanded 13.9 percent in 2004."

January 28 - Bloomberg (Stephanie Phang): "Malaysia's broadest measure of money in circulation expanded at a faster pace in December as bank lending rose and consumers increased spending during the year-end festive season. M3, the most closely watched measure of money supply, rose 12.4 percent in December from a year earlier..."

January 25 - Bloomberg (Anuchit Nguyen): "Thailand last month posted its highest trade surplus in almost five years... The trade surplus in December widened to $922 million, the highest since March 2000... Exports last month rose 17 percent from a year earlier to $8.47 billion. Imports increased 2.9 percent to $7.55 billion."

January 24 - Bloomberg (Jun Ebias and Francisco Alcuaz Jr.): "The Philippine central bank expects inflation to accelerate to as much as 7 percent..."

January 26 - Bloomberg (Jason Folkmanis): "Vietnam's inflation rate accelerated in January for the first time since October, as the return of avian influenza and rising rice prices drove up overall costs for food in the Southeast Asian nation. Consumer prices rose 9.7 percent from a year earlier..."

Global Reflation Watch:

January 28 - Bloomberg (Brian Swint): "House prices in the 12 countries sharing the euro increased at the fastest rate since 1990 in the third quarter, fuelled by mortgage debt as the European Central Bank held borrowing costs at six-decade lows, Barclays Capital said. Property prices gained 8.7 percent in the three months to September from the same period a year earlier..."

January 28 - Bloomberg (Brian Swint): "Growth of the money supply in the 12 countries sharing the euro, the European Central Bank's barometer of future inflation, accelerated in December. M3 grew at an annual pace of 6.4 percent after expanding 6 percent in November, the ECB said in a conference call from Frankfurt today. Economists had expected 6.1 percent growth..."

January 26 - Bloomberg (Thomas Mulier): "The number of people visiting another country rose 10 percent in 2004, the fastest rate in 20 years, as tourism picked up in the wake of the war in Iraq and the containment of severe acute respiratory syndrome, the World Tourism Organization said. About 760 million people took a vacation in another country last year..."

January 26 - Bloomberg (Samantha Lafferty and Claire Shoesmith): "Mayfair, an area of London's West End that's home to Claridge's hotel, is the world's most expensive place to locate a business as hedge funds drive up rents. Annual rents in Mayfair, where investment firms such as Thames River Capital and Blackstone Group LP have offices, rose 23 percent last year to 1,571 euros ($2,036) per square meter, according to a survey published...(by) Cushman & Wakefield. Hedge funds 'aren't frightened of paying good rents,' said Tim Wadhams, an associate director at London-based real estate agent Savills Plc..."

January 25 - MarketNews: "Home construction in France remained buoyant in December, as 4Q housing starts posted a 14.7% rise on the year, while 4Q permits were up 21.3% on the year, according to non-seasonally adjusted data released Tuesday by the Construction Ministry."

January 25 - Bloomberg (Halia Pavliva): "Russia's exports increased 34.2 percent in the first eleven months of the year to $163.6 billion because of high prices for oil, Russia's major export commodity, the State Federal Statistics Service said. The country's imports increased slower than exports, by 25 percent during the January to November period..."

January 26 - Bloomberg (Halia Pavliva): "Russia's retail sales rose 12.1 percent in 2004, compared with 8.4 percent in 2003, as the expanding economy boosted consumer demand."

January 25 - Interfax: "Car production increased 9.7% in Russia in 2004, the country's Federal State Statistics Service (Rosstat) reported."

January 26 - Bloomberg (James Cordahi): "Saudi banks posted record profits last year, spurred by increased consumer lending and more fees from initial public offerings, the Arab News said... National Commercial Bank, Saudi Arabia's largest lender, posted the biggest profit of $933 million, an increase of 25 percent compared with 2003... Saudi British Bank...boosted net income 30 percent to $427 million, while Saudi Hollandi Bank...increased profit by 24 percent..."

Latin America Reflation Watch:

January 28 - Bloomberg (Guillermo Parra-Bernal and Carlos Caminada): "Brazil's annual budget deficit as a proportion of the gross domestic product narrowed last year to the lowest on record as tax collections jumped and the government paid less in interest. The annual budget deficit, or the excess of expenses over revenue at the federal and local governments and state-controlled companies, narrowed to 2.68 percent of GDP..."

January 25 - Dow Jones: "Mexican Economy Minister Fernando Canales said Monday that the country attracted about $16 billion in foreign direct investment last year. In a presentation before Mexican industrial business chamber Canacintra, Canales said the fresh capital 'represents the confidence and belief that investing in Mexico is good business.' The expenditures represent a 50% increase over the $10.7 billion that foreign investors spent in Mexico during 2003."

January 25 - MarketNewsInt: "The Mexican economy surged 6.0% year-over-year in November as activity posted sharp increases across all sectors, the National Statistics Institute said Tuesday. The...monthly GDP estimate, showed services jumped 6.4%, industry rose 5.4% and agriculture rose 4.1% in the month. Within industry, manufacturing gained 5.8%, construction jumped 6.5%, and utilities were up 1.9%."

January 25 - MarketNews: "Retail sales in Mexico posted another solid increase in November, rising 6.7% year-over-year, while wholesale sales rebounded from a relatively disappointing October, surging 10.8% after a disappointing 5.1% rise in the prior month, the National Statistics Institute reported..."

January 27 - Bloomberg (Andrew J. Barden and Eliana Raszewski): "Argentina's international reserves topped $20 billion for the first time in almost three years as an export-led economic expansion boosted the flow of dollars to the South American country. Foreign reserves climbed to $20.06 billion yesterday... That's the highest level since February 2002 and more than double the level of $8.24 billion reached in January 2003..."

January 27 - Dow Jones: "Argentine supermarket sales made a strong rebound in December, showing their largest month-on-month gain since the country's financial crisis...supermarket sales climbed 9.7% from a year earlier..."

January 28 - Bloomberg (Heather Walsh): "Chilean manufacturing production climbed in December at the fastest pace in three months, spurred by a jump in consumer demand as the economy accelerated. Output rose 10.2 percent from a year earlier, expanding for a 28th month..."

January 25 - Bloomberg (Alex Kennedy): "Venezuelan sales of construction materials soared last year as a recovering economy fueled a surge in building, El Universal reported. Cement sales rose 31 percent and rebar sales increased 48 percent last year... Jobs in the construction industry helped lower the unemployment rate to 10.9 percent in December from 14.6 percent in the same month a year earlier."

January 26 - Bloomberg (Alex Emery): "Peru's new vehicle sales rose 27.6 percent last year as Peruvians bought 15,919 cars and trucks, state news agency Andina reported. Bus and truck sales registered the highest growth, jumping 52 percent last year while sales of pick-ups and SUVs rose 41 percent..."

Dollar Consternation Watch:

January 27 - UPI: "A top Chinese economist says the U.S. dollar is not a stable currency, and China's first priority is to adopt a more flexible basket of currencies. Fan Gang, director of the National Economic Research Institute at the China Reform Foundation, was speaking...at the World Economic Forum in Davos... Fan said the yuan should be pegged to a more 'manageable' basket including euros, yen and dollars. 'The U.S. dollar is no longer -- in our opinion is no longer -- (seen) as a stable currency and is devaluating all the time, and that's putting troubles all the time,' Fan said... 'Now people understand the U.S. dollar will not stop devaluating'..."

January 28 - Bloomberg (James Hertling and Simon Clark): "Bill Gates, the world's richest person with a net worth of $46.6 billion, is betting against the U.S. dollar. 'I'm short the dollar,' Gates...told Charlie Rose in an interview in front of an audience of about 200 at the World Economic Forum in Davos, Switzerland. 'The ol' dollar, it's gonna go down.' Gates's comments reflect the same view as his friend Warren Buffett... 'It is a bit scary,' Gates said. 'We're in uncharted territory when the world's reserve currency has so much outstanding debt.'"

January 28 - Bloomberg (Christian Baumgaertel and Fergal O'Brien): "European Central Bank council member John Hurley said a 'disorderly unwinding' of the U.S. current account and budget deficits could lead to a 'sharp euro appreciation.' 'The biggest risk is a disorderly unwinding of global imbalances, especially the twin deficits in the U.S.,' Hurley, who is also the governor of the Irish central bank, said... 'If this were to occur, we could experience a rapid decline in the U.S. dollar and a sharp euro Appreciation.'"

January 26 - Bloomberg (Joshua Fellman): "Continuing U.S. budget deficits risk prompting a sharp decline in the dollar, a surge in interest rates and long-term erosion of consumer and investor confidence, former U.S. Treasury Secretary Robert Rubin said. It's going to be 'substantively difficult and politically very difficult,' to dig the U.S. out of the very deep fiscal hole it's now in, Rubin said at Citigroup Inc.'s Asia Pacific Fixed Income Investor Conference... 'There is great peril in refusing to face the problem.' ... 'Things that can't go on indefinitely tend to stop.' ...Increased antagonism toward the U.S. may make it more difficult to gain international cooperation in dealing with financial crises, Rubin said."

January 26 - MarketWatch: "Asian countries will not be able to maintain their inflexible currency regimes indefinitely, nor is the huge US current account deficit sustainable, Dutch Nation Bank President Nout Wellink, an ECB Governing Council member, said... 'The countries that for domestic reasons have decided to stabilize their exchange rate with respect to the dollar have had to buy enormous quantities of dollars to keep their currency from appreciating in dollar terms... As a result of this, they have built up unprecedentedly huge official reserves in dollars. This policy can and will not continue indefinitely.'"

January 26 - Bloomberg (Evalinde Eelens): "The record U.S. deficit causes dollar weakness and suggests the country is living beyond its means, European Central Bank policy maker Nout Wellink said. 'The dollar is weak because the U.S. has been living large,' Wellink, also the Dutch central bank president, said in a speech today in the Dutch town of Herten-Roermond. 'The average U.S. citizen and the government spends a lot and saves little,' Wellink said. The U.S. should adopt 'a little Calvinism.'"

Bubble Economy Watch:

January 25 - Bloomberg (Roger Runningen and Richard Keil): "The Bush administration predicted the federal budget deficit will reach $427 billion this fiscal year, bigger than the record shortfall of last year and almost $100 billion higher than the gap it anticipated six months ago."

January 26 - Dow Jones (Allison Bisbey Colter): "SLM Corp. expects origination of student loans through its own brands or affiliated brands to increase by 15% to 20% this year, in line with the 18% growth the company reported for 2004, President and Chief Operating Officer Tom Fitzpatrick said... Moreover SLM feels confident that students borrowing needs are growing faster than they have over much of the past decade as the cost of higher education accelerates."

January 27 - Bloomberg (Joe Richter): "U.S. durable goods orders rose in December, ending the best year in a decade for makers of appliances, autos and other long-lasting items. Orders increased 0.6 percent to $200.3 billion last month... Excluding transportation equipment, bookings rose a larger-than-forecast 2.1 percent after declining 0.9 percent in November. For the year, orders surged 10.9 percent."

Mortgage Finance Bubble Watch:

December Existing Home Sales were reported at a strong 6.69 million annualized rate, up 5% from one year earlier. The median price jumped to a record $242,800, up 8.2% from December 2003. Average Prices were up 19% over two years, 26% over three years, and 52% over six years. December Calculated Transaction Value was up 13.7% (volume up 5%, prices up 8.2%). Total 2004 Existing Home Sales were up 9.5% from record 2003 levels to 6.69 million. To put this number into perspective, it was more than double 1991 sales and 20% larger than 2002 (then a record). Last year's total sales were also 66% greater than annual sales during the nineties, and 78% greater than the average during the period 1990-1997. According to the National Association of Realtors, the median price for Existing Home Sales increased 8.3% during 2004 to $184,100. This was the biggest one-year increase since 1980.

January 26 - PRNewswire: "A new product feature from Wells Fargo Home Mortgage can help homebuyers looking to increase their short-term cash flow or who intend to move or refinance within a few years. The company is launching an interest-only feature that doesn't require principal payment for a period of 10 years. Wells Fargo Home Mortgage's interest-only product feature was previously available only on 5- and 7-year adjustable-rate mortgages (ARMs). Interest-only mortgages can be used for purchase or refinance transactions... After the interest-only period has ended, full principal and interest payments are required as the loan fully amortizes... Potential homebuyers who may be suited for the interest-only feature include: Those who do not intend to be in their homes for more than a few years. (And) people looking for lower monthly payments and a chance to redirect their cash flow to high-yield and tax-deferred savings or maximize retirement contributions."

From the California Association of Realtors: "Homebuyers concerned about future mortgage-rate increases flooded the market in December, driving the median price to an all-time high of $474,480. The median price increased by double-digits in every region of the state, with the High Desert, Riverside/San Bernardino, Sacramento, Santa Barbara and North Santa Barbara County regions posting increases of more than 30 percent." Median prices gained $72,760 (18.1%) during 2004 and were up $135,640 (40%) over two years. Median condo prices surged $12,880 to a record $391,050. Condo prices were $81,000 (26.1%) during 2004, with a two-year gain of $137,490 (54%). The "unsold inventory index" declined to 2.8 months from November 3.4 months (up from Dec. 2003's 1.9 months).

Freddie Mac posted a mixed December. The company's Book of Business expanded $8.96 billion (7.2% annualized) to $1.505 Trillion, the strongest expansion since July. Freddie' Retained Portfolio, however, contracted by $3.34 billion (6% ann.) to $653.6 billion. For the full year, the company's Book of Business expanded 6.5%, while the Retained Portfolio increased only 1.3%. Combined Freddie and Fannie Books of Business expanded $200 billion during 2004, or 5.5%. Combined Retained Portfolios increased $14.3 billion, or 0.9%, to $1.558 billion.

Earnings Watch:

American Express expanded Total Assets by $13.7 billion, or 31% annualized, to $193 billion during the fourth quarter. This was the strongest asset growth since the fourth quarter of 1999. Fourth quarter earnings were up 17% from the year earlier period to $896 million.

Student loan provider SLM Corp posted a record fourth quarter. Assets increased an unprecedented $13.1 billion (74% ann.) to $84.1 billion. Total Assets were up 30% for the year.

Mortgage REIT behemoth Thornburg Mortgage expanded assets during the fourth quarter at a 41% rate to $29.2 billion. Total Assets (chiefly ARM mortgages, and mostly "jumbos") were up 53% for the year, having increased from the $10.5 billion to begin 2003. On the liability side, the company ended 2004 with Reverse Repurchase Agreements of $14.2 billion, Asset-backed Commercial Paper of $4.9 billion, and Collateralized Debt Obligations ("CDO's) of $6.6 billion. Shareholder's Equity ended the year at $1.8 billion.

Highlights from IndyMac: "Record mortgage loan production of $11.2 billion, up 79% over the fourth quarter of 2003. Record total assets of $16.8 billion, up 27% compared with total assets at December 31, 2003. IndyMac's pipeline of mortgage loans in process totaled $6.3 billion at December 31, 2004, up 53%... "

Mortgage REIT American Home Mortgage Investment reported quarterly revenues up 76% from the fourth quarter of 2003 to $152 million. Assets expanded at a 23% rate during the quarter to $9.59 billion. On the liability side, Reverse Repurchase Agreements increased to $7.1 billion, up from $1.34 billion to begin 2004. The company ended 2004 with Stockholder's Equity of $867 million.

Americredit reported net income of $64.6 million for the quarter, up 39% from the $47.2 million earned during the same period a year earlier. Automobile loan purchases increased to $1.12 billion for the second quarter of fiscal year 2005, compared to $700.0 million in the December 2003 quarter. Loan purchases for the six months ended December 31, 2004, were $2.21 billion compared to $1.45 billion for the same period last year." Total Assets expanded at a 31% rate during the quarter to $9.51 billion, the strongest growth since the quarter ended June 30, 2001.

The Great Dilemma

It was another interesting week. The Administration released its estimate for a record $427 billion federal deficit. A leading Chinese economist was speaking publicly in Davos about losing confidence in a perpetually "devaluating" U.S. dollar. There was a disappointing two-year Treasury auction, with a notable decline in in-direct bidders - read Asian central banks. Yet ten-year Treasury yields actually declined a little, and the spread between 3-month Treasury bills and benchmark Fannie MBS narrowed 10 basis points to the lowest level since early 2001. Meanwhile, in response to a question about the risk higher home prices pose to the U.S. economy, Freddie Mac's CEO Richard Syron stated, "Is this a major economic question? No."

Well, U.S. home prices are a major economic "question," right along with the "price" of the dollar and the "price" of U.S. Treasuries and mortgage Credit. All are closely related and arguably problematic. Credit is too cheap and assets too dear, and the dear assets seem to make Credit only cheaper. And it is worth noting that the government's fiscal position is especially alarming when one considers that we are in a period characterized by the robust expansion of Credit, spending and asset inflation. One doesn't have to be a crazyman to envisage a scenario where a faltering dollar, rising inflation, significantly higher interest rates, a bursting Mortgage Finance Bubble, and a deep recession manifest into Trillion dollar deficits. I wouldn't bet against it.

Yet I do believe it is somewhat antiquated analysis to focus the blame for dollar woes on spendthrift Washington. In the "old days," the government "printing press" was the marginal creator of the excess purchasing power that would fuel over-consumption and an escalation in U.S. current account deficits. Stabilizing a lot of things - inflation and the dollar, for two - was largely a matter of reining in federal discretionary spending. The rising price of Credit would force the issue (remember "crowding out"?). But times have changed - the financial system and economy are quite different now.

First of all, The Great Mortgage Finance Bubble is today's creator of "marginal" purchasing power, as well as marginal global financial market liquidity. This has momentous ramifications that I think are only now just beginning to resonate in the marketplace. For one, the nature of ensuing Inflationary Manifestations is notably non-conducive to Federal government receipts. This is quite a contrast to the late-nineties equities boom and flood of capital gains taxes to federal and state coffers. Not only does home price inflation receive quite favorable tax treatment, (the Inflationary Manifestation) excess consumption of imported goods does a better job lining foreign government pockets than Uncle Sam's. And a strong case can also be made that the resulting faltering dollar - with rising energy and other costs, as well as stubborn unemployment - will tend to inflate government expenditures.

The wishful consensus view seems to hold that the dollar will recover when fiscal restraint belatedly returns to Washington. Such a view does a complex world injustice. I would argue that the financial markets now dictate the U.S. current account deficit. Here we find dysfunctional Bubble and Speculative Dynamics in full command. The U.S. Financial Complex lends and speculates aggressively - chiefly in mortgages and related instruments - and this purchasing power fuels massive and endemic current account deficits. These deficits are exacerbated by the reality that the financial sector prefers asset and consumption-based lending to financing goods-producing investment. The speculators likewise fancy liquid agency and mortgage securities, while the "industrialists" favor easy financial profits to slugging out in the goods markets.

Trade deficits have become a deep structural malady disguised as somewhat of an inconvenience, at worst. Global dollar over-liquidity is "recycled" right back into U.S. securities markets, and the tussle for limited quantities of coveted securities pressures market rates lower. The New Age Bond Market relegates the "permabears" to "permabeatenups." Pickled notions of permanently low rates and limitless liquidity stoke the Finance and Asset Mania.

It is the nature of Bubbles - not unlike bureaucracies - that dynamics evolve to ensure that they are bolstered and perpetuated. Left to their own devices (which they have been), they will prove powerfully self-reinforcing; Bubbles will inflate, propagate and disperse. And I have argued that the U.S. financial sector has turned dysfunctional and that financial crisis is unfortunately the likely catalyst to contain excess and redirect the flow of resources away from asset markets and to productive investment. Today, years of mortgage lending excess incite further Credit inflation, over-consumption, excess global liquidity, a weak dollar, more central bank purchases, enticing market rates, more borrowing and speculating, deeper economic distortions, and higher home and asset prices.

Interestingly, the GSEs have markedly slowed their expansion and attendant debt issuance. Banking system real estate lending, however, has more than filled the void. So we now have a strange dynamic where U.S. bank Credit expansion is a leading source of global liquidity that is then "recycled" directly back to U.S. securities markets. This bank Credit is created primarily through the issuance of short-term "monetary liabilities" (deposits and "repos"). The upshot is only greater supply/demand imbalance between the virtually endless supply of liquidity creation and the limited issuance of (perceived safe and liquid) longer maturity U.S. securities to be purchased by foreign central banks. This imbalance is complicated by the proliferation of variable-rate mortgages - a prime example of how financial sector "evolution" sustains Bubbles. Here again, there is a creation of liquidity that stokes over-consumption and trade deficits that is then accumulated by Asian central banks and others - and immediately "recycled" back to a confined quantity of long-term U.S. securities.

The pricing of finance (or, traditionally, "capital") resides at the very heart of Capitalism. Only an operative pricing mechanism will effectively allocate limited resources. And only through the interaction of supply and demand can a pricing mechanism function properly. A functional pricing mechanism would tend toward self-adjustment, limiting imbalances rather than augmenting them. The Great Dilemma of contemporary finance and economics is the limitless nature of the supply of finance/Credit/liquidity ("Global Wildcat Finance"). With no gold anchor or any restriction on the quantity of issuance, Credit will be issued in excess and the resulting liquidity will generally under-price finance (the cost of borrowing/market interest rates). Imbalances will be exacerbated - with extended booms validating mispriced Credit - and the system will become only more unstable over time (and why I use "dysfunctional").

I would argue (as Master of the Obvious) that the Treasury and agency (and the intricately linked "swaps") markets have developed into the "anchor" for the global price of finance. And The Great Dilemma today is one of Way Too Many Dollar Balances Chasing Too Few Treasury and Agency Securities. This has led to a seductive dislocation in the pricing of Treasuries/agencies, with extraordinary demand at the "anchor" fixing rates artificially low throughout.

The dislocation in the price of finance is most conspicuous in the market for U.S. mortgage Credit. Just hankering for trouble, our system today basically offers an unlimited supply of cheap (mispriced) real estate finance to virtually any borrower (reminiscent of telecom finance during 1999/2000). And the resulting liquidity creation and housing inflation keep transaction volume high and the average life ("duration") of mortgage securities relatively short (and the hedgers on their heels!). Increasingly distended home prices and Fed policies contribute to the proliferation of variable-rate mortgages - again limiting the quantity of longer-dated, higher-yielding securities in the marketplace (pasting the hedgers firmly on their heels!). And, importantly, these shorter-maturity securities are easier to leverage and to hedge - thus prime product for the speculating community (including the REITs) desperate for strong returns. Why not aggressively "repo" variable-rate mortgages? And (mispriced) Credit inflation begets only greater inflation.

The Great Dilemma is that the finance pricing mechanism is busted and there is no hope for its repair. There is no self-adjustment or correction - only augmentation. Seemingly endless cheap finance spurs massive mortgage government and mortgage borrowings - the greatest explosion of non-productive Credit creation in history. The perpetually "devaluating" dollar, ironically, incites financial market liquidity excess in the U.S. and globally, while at the same time forcing our trading partners into artificially low rates. The U.S. Credit Bubble begets a global Bubble.

At this point, there remains a strong inflationary bias throughout the bond market. Each time when it appears that rates are finally commencing the much needed upward adjustment - they instead stubbornly reverse. There certainly remains a strong inflationary bias in housing prices; if rates don't go higher, prices will. And the danger lies in the reality that this locomotive of a Credit and Asset Bubble will burst at some point. Asset prices don't grow to the moon, and it is the final "parabolic" price rise that sets the stage. And as much as Credit excess stokes higher asset prices and only greater marketplace liquidity, the downside will also be self-reinforcing. Recall the telecom debt bust.

The Great Dilemma is that inflating U.S. home prices have developed into the most important issue in global finance. And the tightening link between inflated American home prices, mispriced global finance, massive U.S. current account deficits, deteriorating government finance, a faltering dollar, endemic speculative leveraging, and deepening economic distortions is emerging as the crucial facet of latent financial fragility.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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Source: The Contrarian Take http://blogs.forbes.com/michaelpollaro/
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