The Disparate Approaches of Messrs. Trichet and Greenspan

By: Doug Noland | Fri, Feb 4, 2005
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UNEDITED!

The bears were in full retreat throughout global equity and bond markets. For the week, the Dow and S&P500 advanced about 2%, reducing year-to-date losses to less than 1%. The Utilities jumped 3.6%, and the Transports gained 1.5%. The Morgan Stanley Cyclical index rose almost 3%, and the Morgan Stanley Consumer index increased about 2%. The broader market was exceptionally strong. The small cap Russell 2000 and S&P400 Mid-cap indices surged 4%. The technology sector was somewhat less impressive, although the NASDAQ100 and Morgan Stanley High Tech indices did rise 2%. The Semiconductors surged 5%. The Street.com Internet index gained 2%, and the NASDAQ Telecommunications index added 1%. The Biotechs rose 3%. The Broker/Dealers gained 2%, and the Banks rose almost 3%. With bullion sinking $12.30, the HUI index declined 2%.

Two-year Treasury yields rose 4 basis points to 3.29%, while five-year Treasury yields dipped one basis point to 3.68%. Ten-year Treasury yields declined 5.5 basis points to 4.08%. Long-bond yields sank 12 basis points to an astonishing 4.49%. The spread between 2 and 30-year government yields dropped 16 basis points to 120. Benchmark Fannie Mae MBS yields sank 10 basis points. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note widened 2 basis points to 39, and the spread on Freddie's 5% 2014 note widened 2 basis points to 36. The 10-year dollar swap spread declined 0.25 to 38.25. Corporate bonds generally performed well. The implied yield on 3-month March Eurodollars was about unchanged at 2.975%.

Corporate debt issuance slowed to about $14 billion (from Bloomberg). This week's investment grade issuers included Morgan Stanley $4 billion, Merrill Lynch $2.6 billion, Wells Fargo $2.25 billion, Met Life $1.2 billion, Marshall & Ilsley $550 million, Detroit Edison $400 million, TTX $300 million, DR Horton $300 million, Harrahs $250 million and Stewart Enterprises $200 million.

Junk bond fund flows reversed this week, with inflows of $118 million. Junk issuers included American Real Estate $480 million, Zeus Special $480 million, Cincinnati Bell $350 million, Dyncorp $320 million, PQ Corp $275 million, Las Vegas Sands $250 million, Mohegan Tribal Gaming $400 million, Constar International $210 million, Time Warner $200 million, Radio One $200 million, Uno Restaurant $142 million, and Vitro Envases $80 million.

Convert issuers included Open Solutions $254 million and Xoma $60 million.

Foreign dollar debt issuers included Brazil $1.25 billion, International Bank of Reconstruction & Development $750 million, and Unibanco Cayman $125 million.

Japanese 10-year JGB yields were about unchanged at 1.31%. Emerging bonds generally performed quite well. Brazilian benchmark bond yields dropped 14 basis points to 7.91%. Mexican govt. yields ended the week at 4.99%, down 9 basis points for the week. Russian 10-year dollar Eurobond yields declined 5 basis points to 5.89%.

Freddie Mac posted 30-year fixed mortgage rates dipped one basis point this week to 5.63% (the lowest level since the first week of April). Fifteen-year fixed mortgage rates were unchanged at 5.14%. One-year adjustable mortgage rates jumped 5 basis points to 4.23% (highest in 10 weeks). The Mortgage Bankers Association Purchase applications rose slightly for the week. Purchase applications were down 3% from one year ago, with dollar volume up 3%. Refi applications jumped 16.6% to the highest level in 11 weeks. The average new Purchase mortgage increased to $234,600, and the average ARM jumped to $319,200. ARMs increased to 32.5% of total applications.

Broad money supply (M3) jumped $16.3 billion (up $54.1bn over two weeks) to $9.488 Trillion (week of January 24). For the week, Currency added $1.8 billion. Demand & Checkable Deposits surged $32.8 billion. Savings Deposits dropped $23.2 billion. Small Denominated Deposits gained $3.3 billion. Retail Money Fund deposits added $0.8 billion, while Institutional Money Fund deposits declined $2.6 billion. Large Denominated Deposits fell $3.3 billion. Repurchase Agreements declined $4.4 billion, while Eurodollar deposits rose $11.0 billion.

Bank Credit rose $11.4 billion for the week of January 26 to $6.854 Trillion, with four-week gains of $109.5 billion. For the week, Securities holdings added $0.4 billion, and Loans & Leases expanded $11.0 billion. Commercial & Industrial (C&I) loans increased $2.9 billion. Real Estate loans added $0.3 billion. Real Estate loans are up $318.1 billion, or 14.2%, over the past 52 weeks. For the week, consumer loans were unchanged, while Securities loans surged $13.6 billion. Other loans declined $5.7 billion. Elsewhere, Total Commercial Paper declined $11.1 billion to $1.407 Trillion (up 8.6% over 52 weeks). Financial CP dropped $10.3 billion to $1.267 Trillion. Non-financial CP dipped $0.8 billion to $140.7 billion. Non-financial Commercial Paper is up 20.2% from one year ago.

Fed Foreign Holdings of Treasury, Agency Debt declined $875 million to $1.346 Trillion for the week ended February 2 (up $230bn, or 20.6% from a year earlier). Federal Reserve Credit rose $3.7 billion for the week to $784.2 billion.

ABS issuance surged to $17 billion (from JPMorgan), including $10 billion of home equity ABS. Year-to-date issuance of $72.5 billion is running about 75% ahead of comparable 2004. Simply Amazing...

Currency Watch:

The dollar index gained 1% to end the week at the highest level since mid-November. The Uruguay peso rose 2.7%, the Chilean peso 2%, the Turkish lira 1.8%, and the Brazilian real 1.2%. On the downside, the South African rand dropped 3.7%, the Swiss franc 2.0%, Iceland krona 1.8%, and Norwegian krone 1.7%.

Commodities Watch:

January 31 - Bloomberg (Xiao Yu): "Steel demand in China, the world's biggest consumer of the alloy, may rise 9.4 percent this year because of increased demand from builders and machinery producers, the State Council's Development Research Center said. Consumption of steel products, including cold-rolled coil used in car bodies, may rise to 303 million metric tons..."

February 3 - Bloomberg (Matthew Craze): "Lead use last year exceeded supply from mines and scrapyards by the most since 1973 as China used more of the metal in car batteries, the International Lead and Zinc Study Group said. Lead consumption rose 3.4 percent to 5.3 million metric tons, exceeding production from mines and scrapyards by 236,000 tons..."

March Crude Oil dipped 70 cents this week to $46.48. The Goldman Sachs Commodities index declined 2%, reducing its year-to-date gain to 3.2%. The CRB index declined 1%, with a 2005 decline of almost 1%.

China Watch:

February 3 - Bloomberg (Koh Chin Ling and Li Yanping): "China rebuffed a threat by U.S. lawmakers to seek trade sanctions unless the Chinese government eases the yuan's peg to the dollar, saying the country has the right to adopt policies that are in its own economic interest. 'We think each country's financial policies are implemented and determined for the ultimate benefit of that country's economic development,' Kong Quan, a spokesman for China's foreign ministry, said at a regular briefing in Beijing. The proposed U.S. legislation isn't a way to resolve differences over the peg, Kong said."

February 1 - Bloomberg (Le-Min Lim): "Guangdong, China's biggest exporting province, faces a shortfall this year of 1 million low-level laborers, who make up three-quarters of the workforce at Hong Kong, Macau and Taiwan-run companies... The shortage will be acute in the Pearl River Delta, a cluster of cities in Guangdong that supplies the world's toys, shoes and clothes, China's statistics bureau said...Factories will find it tougher to fill repetitive jobs that pay poorly and offer few benefits... 'Some companies realize that China's era of endless cheap labor is over,' the statistics bureau said."

Asia Inflationary Boom Watch:

January 31 - Bloomberg (Cherian Thomas): "India revised its economic growth for the last financial year ended March 31, 2004, to 8.5 percent from its previous estimate of 8.2 percent as farm production grew faster than earlier forecast."

February 3 - Bloomberg (Ramya Venugopal): "Bank of India and Union Bank of India are among local lenders planning to sell bonds to increase their capital and meet rising demand for loans before the end of the fiscal year in March. Growth in bank loans was the fastest this year in at least 34 years after India, Asia's third-largest economy, expanded 8.5 percent, the quickest in 15 years. Interest rates at a three-decade low are encouraging Indians to borrow to purchase cars and homes and companies to seek funds to meet expansion needs."

February 3 - Bloomberg (Kartik Goyal): "India's per capita income rose 7.1 percent in real terms in the fiscal year ended March 31, 2004... Gross domestic product per head at 1993-94 prices rose to 11,799 rupees ($272) from 11,013 rupees a year earlier... At current prices per capita income rose 10.2 percent..."

February 4 - Bloomberg (Yu-huay Sun): "Taiwan's foreign-currency reserves, the third-highest in the world, rose in January to a record $243 billion, boosted by net foreign capital inflows and investment returns, the central bank said..."

February 1 - Bloomberg (Heejin Koo): "South Korean export growth eased in January to the slowest pace in a year and a half as gains in the won eroded the value of overseas sales and global electronics demand cooled. Exports rose 19 percent from a year earlier to $22.5 billion, narrowing from a 20 percent advance in December..."

January 31 - Bloomberg (Anuchit Nguyen): "Thailand's industrial production expanded at its slowest pace in almost three years in December as overseas and local demand for electronics and electric appliances waned, the central bank said. Manufacturing output rose 3 percent from a year earlier compared with a revised 10 percent increase in November..."

February 3 - Bloomberg (Stephanie Phang and Chan Tien Hin): "Malaysian exports grew at the slowest pace in 11 months in December as overseas demand for electronics parts including semiconductors faltered and petroleum and palm oil prices fell. Exports rose 12.8 percent from a year earlier..."

February 4 - Bloomberg (Francisco Alcuaz Jr. and Jun Ebias): "The Philippine inflation rate eased to 8.4 percent in January, its first slowdown in 11 months..."

February 1 - Bloomberg (Shanthy Nambiar): "Indonesian inflation accelerated to 7.32 percent in January, the Central Statistics Bureau said... The increase in consumer prices from a year earlier was bigger than the gain of 6.4 percent in December..."

Global Reflation Watch:

February 3 - Bloomberg (Tatsuo Ito and Lindsay Whipp): "Bank of Japan Governor Toshihiko Fukui told parliament today that wages have stopped falling and there's a ``strong' chance they may increase. Declining wages have been holding back a full recovery in consumption, which makes up more than half the world's second-largest economy. Fukui said it will take more time for Japan to achieve a sustained recovery and overcome deflation. 'The Japanese economy is gradually gathering latent strength,' Fukui told lawmakers in Tokyo."

January 31 - Bloomberg (Lily Nonomiya): "Japanese construction orders rose for the first time in four years in 2004, led by private demand... Orders for last year totaled 13.1 trillion yen ($127 billion), 4.2 percent higher than 2003... The gain was the biggest since 1996, when orders rose 4.8 percent..."

January 31 - Bloomberg (Greg Quinn): "Canadian existing home sales rose to a record for the fourth-straight year in 2004, buoyed by low mortgage rates and rising employment. Sales may fall this year... Sales rose 4.8 percent from the previous year to 456,500 units, according to the Canadian Real Estate Association... The average selling price rose 9.7 percent to C$227,200 ($183,000) last year, the fifth-straight record."

February 1 - Associated Press: "Mexicans living and working in the United States sent $16.6 billion to their homeland during 2004, an increase of 24% over 2003, the Bank of Mexico said... It was the second year in a row that remittances were greater than direct foreign investment. In 2003 remittances became the country's second-most-important source of revenue after oil."

February 3 - Bloomberg (Christian Baumgaertel): "European service industries grew at the fastest pace in three months in January, as last year's export-led expansion prompted companies to spend more on services such as banking and travel. An index based on a survey of about 2,000 purchasing managers...rose to 53.4 from December's 52.6..."

February 4 - Bloomberg (Rainer Buergin): "Factory orders in Germany, Europe's largest economy, rose the most in more than a decade in December, led by demand for goods such as factory machinery. Orders for goods ranging from trucks to toasters increased 7.1 percent after dropping 2.4 percent in November..."

February 1 - Bloomberg (Alan Katz): "French car and light-truck sales rose 5.8 percent in January, helped by falling unemployment and demand for models from Renault SA and General Motors Corp."

February 1 - MarketNews: "Spanish new car registration totaled 104,874 units in January, up 6.1% y/y...the Spanish Association of Car and Trucks Manufacturers said... January's figure was a new record for the first month of the year..."

February 3 - Bloomberg (Koh Halia Pavliva): "Russia's foreign currency and gold reserves jumped $9.6 billion in the seven days to Jan. 28, their biggest ever weekly gain, as Russian companies borrowed abroad and exporters brought more revenue home. The reserves rose to a record $128.3 billion as of Jan. 28, from $118.7 billion as of Jan. 21, the central bank said..."

February 1 - Bloomberg (Garfield Reynolds): "Russia's economy expanded by 7.1 percent last year, Interfax reported, citing Andrei Klepach, head of the Economy Ministry's macroeconomic forecast department. Russia's economy expanded 7.3 percent in 2003 and is expected to grow by 6 percent this year..."

February 2 - Bloomberg (Dylan Griffiths): "South African vehicle sales surged 21 percent in January from the same month last year as the lowest interest rates in 24 years boosted consumer and business spending, an industry group said."

February 3 - Bloomberg (Dylan Griffiths): "South African house prices rose an annual 29.6 percent in January as the country's property boom entered its sixth year, said Absa Group Ltd., the country's biggest home-loan provider."

Latin America Reflation Watch:

February 4 - Bloomberg (Adriana Arai): "Mexico reduced net foreign debt to 11.1 percent of gross domestic product in 2004, its lowest level in 32 years, by replacing it with peso denominated bonds, the Finance Ministry said..."

February 3 - Bloomberg (Alex Emery): "Peru's economy expanded 5 Percent last year on higher manufacturing output, the fastest pace of growth since 2001, the economy minister said. Peru's economy was driven by industrial production, which jumped 10.7 percent in December ..."

February 2 - Bloomberg (Alex Kennedy): "Venezuelan imports surged in November to a three-year high as the government boosted the sale of dollars to importers amid an economic recovery. Imports of products such as cars, chemicals and electronic goods increased 77 percent to $1.65 billion in November from the same month a year earlier..."

February 4 - Dow Jones: "Venezuela's automobile industry sold 9,002 vehicles in January, up 33% from the same period last year, and an 18% increase from December, the Cavenez automobile industry chamber reported Friday."

Bubble Economy Watch:

February 4 - Reuters: "U.S. inflation pressures rose in January as a result of faster growth in loans, but that was offset by slower growth in input prices, a report said on Friday. The Economic Cycle Research Institute's Future Inflation Gauge, which is designed to anticipate cyclical swings in the rate of inflation, rose to 120.0 in January from an upwardly revised 118.7 in December... The index's annualized growth rate, which smoothes out monthly fluctuations, rose to 4.5 percent in January from an upwardly revised 3.4 percent in December. 'The index is designed to signal the future direction of inflation, and it is clearly telling us that there is no downturn or easing of inflation in sight...' said Lakshman Achuthan, Managing Director of ECRI."

December Construction Spending was reported at a stronger-than-expected increase of 8.7% from December 2003. For the year, Total Construction Spending was up 9%, a big gain from 2003's 5.1% increase and the strongest rise since 1996. Private Construction Spending was up a blistering 10.9% for the year, while Public spending increased 3.4%.December residential spending was up 25% from December 2002.

December New Home Sales were reported at a weaker-than-expected annualized rate of 1.098 million. Sales were down slightly from a year ago, with the average price up 8.9% to $276,600. Sales for the year were 8% above 2003's record, while the Inventory of New Homes was up 14.6% to a huge 432,000.

February 3 - Dow Jones: "MasterCard International's fourth-quarter gross dollar volume rose 12.5%, driven by growth across all regions, as total purchases on MasterCard credit and off-line debit cards increased 12.1%."

February 1 - Bloomberg (Alan Ohnsman): "Nissan Motor Co. and Hyundai Motor Co. sold more cars and trucks in the U.S. in January, giving Asian automakers a record share of the world's largest vehicle market... The 10 Japanese and Korean carmakers that compete in the U.S. raised their combined market share by 0.7 percentage point to a record 36.3 percent, according to Bloomberg data."

Financial Bubble Watch:

January 28 - Bloomberg (Robert Schmidt and Michael McKee): "Hedge funds, with their newfound popularity and high fees, may be 'an accident waiting to happen,' U.S. Securities and Exchange Commission Chairman William Donaldson said. The SEC, which voted last year to extend its oversight to the $973 billion industry, will use targeted inspections to police the investment pools designed for wealthy investors, Donaldson said."

February 3 - Dow Jones (Christine Richard): "The battle lines are being drawn in a court in Wilmington, Del. in what could be a devastating corporate bankruptcy for individual bondholders. More broadly, though, the bankruptcy of American Business Financial Services, a...sub-prime mortgage lender, illustrates how large sophisticated lenders, like banks and hedge funds, are able to secure their exposure to companies of lower credit quality by laying claim to specific assets in bankruptcy, leaving unsecured creditors with what's left. In this case, there may not be much left for the 20,000 unsecured creditors, mostly small investors... Over the last few years, American Business Financial, which filed for bankruptcy protection on Jan. 21 with $1.07 billion in debt, pledged most of its assets - mainly mortgages and mortgage-related securities - to large lenders and hedge funds who provided it with capital. It owes about $490 million to unsecured noteholders. With a history of failing to generate positive cash flow, the company was reliant on small investors to fund its operations. It ran advertisements in newspapers across the country offering notes yielding as much as 10% to 13% for a one-year investment..."

Mortgage Finance Bubble Watch:

Countrywide Financial reported disappointing fourth quarter earnings, one of the first casualties of the flattening yield curve. And if the spread between assets and liabilities is contracting, well just accumulate more assets! Countrywide Total Assets expanded by $7.1 billion, or 27% annualized, to $111.5 billion. Assets were up 14% for the year and 92% over two years.

Recently turned mortgage REIT New Century Financial expanded assets at a 79% annualized rate during the quarter to $19.0 billion. Total Assets were up 114% during 2004, and increased from $2.4 billion to begin 2003. Fourth quarter Total Originations were up 39% from comparable 2003 to $11.5 billion. Adjustable-rate increased to 78% of originations, up from the year ago 74.1%. Notably, Interest-only originations increased from $215 million to $2.45 billion, to an eye-opening 21.3% of Total Originations.

Mortgage REIT Annaly Mortgage Management expanded Total Assets at a 27% rate during the fourth quarter to $19.6 billion. Assets were up 51% for the year. Repurchase Agreements comprise $16.7 billion of liabilities. Stockholder's Equity ended the year at $1.7 billion.

Mortgage REIT Anworth Mortgage Asset expanded assets at a 56% annualized rate to $6.81 billion. Total Assets were up 60% for the year. Adjustable-rate mortgages comprise most of assets. On the liability side, Repurchase Agreements total $4.72 billion. Shareholder's Equity ended the year at $507 million.

The Disparate Approaches of Messrs. Trichet and Greenspan:

Bloomberg's John Berry noted that immediately after yesterday's announcement from the Fed there was basically no movement in any instrument along the entire yield curve. "Call it, if you will, case of perfect transparency." The market new exactly what to expect and it was fully discounted. Throughout the marketplace, the Fed's policy of open transparency and "baby step" adjustments receives universal adoration. It shouldn't.

Not only do I take exception that "perfect transparency" is a good idea to begin with - in a world of Global Wildcat Finance and endemic speculation - it also occurs to me that the Fed is really being less than forthright with its communications. We now appreciate that Federal Reserve meetings do include discussion of important issues such as asset prices and excessive risk taking, yet official meeting pronouncements offer little more than colorless boilerplate. And in public communications, as was demonstrated again today, our Fed Chairman retains distinction as The Master of Obfuscation./p>

I much prefer the ECB's Straight Talk approach to disciplined central banking.

European Central Bank President Jean-Claude Trichet speaking yesterday at the regular ECB news conference: "Further insight into the outlook for price developments in the medium to long-term horizons is provided, as you know, by the monetary analysis. That latest monetary data confirm the strengthening of M3 growth observed since mid-2004. This increasingly reflects the stimulative effect of historically very low level of interest rates in the euro area. As a result of the persistently strong growth in M3 over the past few years, there remains substantially more liquidity in the euro area than is needed to finance non-inflationary economic growth. This could pose risks to price stability over the medium term and warrants vigilance. The very low level of interest rates is also fueling private sector demand for Credit. Growth in loans to non-financial corporations has picked up further in recent months. Moreover, demand for loans for house purchase has continued to be robust, contributing to strong house price dynamics in several euro area countries. The combination of ample liquidity and strong Credit growth could, in some part of the euro area, become a source of unsustainable price increases in property markets."

That's the way central bankers are supposed to talk! Ad from the question and answer session:

Mr. Trichet: "As for house prices...at the level of the full-body of the euro area, we are not alarmed. In some part of the euro area we see phenomenon that are not in our view sustainable and certainly are not necessarily welcome."

Questioner: "You say you are not alarmed at the asset prices and housing prices."

Mr. Trichet: "At the level of the euro area as a whole!"

Questioner: "In your statement you said the combination of ample liquidity and strong Credit growth could become a source of unsustainable price increases in property markets. What is the function of forward-looking monetary policy? When have you to react - do you react before the Bubble is bursting or after the Bubble has burst?"

Mr. Trichet: "Before the Bubble burst...as you know full well. And it is the reason why I insist on vigilance, permanently. We also insist - even if it is not been noted in the question - on the fact that the monetary analysis calls for vigilance, as I said, because we see dynamism of M3 and dynamism by definition by the counterpart of M3, which means that we - from that standpoint, from that analysis - can see that we could have an overhang of liquidity and even in the short-run this does not necessarily materialize in inflation. In the long-run, we see in our own analysis that - and the reason that we have a monetary analysis - we see that it can materialize in inflation. So I would say we follow this evolution of the monetary aggregates with great care. We see phenomena that have to be monitored very, very clearly. We could see that the explanation we had on the portfolio shifts and then the unwinding of portfolio shifts - which was a convincing element to understand what was happening - doesn't seem now, in our own analysis, to be convincing to explain the present dynamism of M3. So it is a real, real cause for being vigilant, that's clear."

Jean-Claude Trichet, speaking today before the Group of Seven meeting:"Clearly what we have ... is that there is a level of lack of savings which has to be corrected, certainly in the United States and we all agree on that... The industrialized world as a whole is in deficit, that is the current account deficit, and there is no offsetting of the US current account deficit by the other industrialized countries and that of course means that we are asking the rest of the world to finance us. It doesn't seem to be that it's acceptable as a sustainable, long-term feature of the present functioning of the global economy."

Mr. Trichet speaks clearly and cautiously, befitting of the President of what has become the world's preeminent central bank.

Chairman Greenspan, on the other hand, today gave another intriguing New Age Economics talk in London titled "Current Account." He garrisons his Pollyannaish and New Paradigm view that "the increased flexibility of the American economy will likely facilitate any adjustment without significant consequences to aggregate economic activity." I'll provide a few excerpts, but I encourage readers to go to the Fed's website and read it in its entirety.

"International trade has been expanding as a share of world gross domestic product since the end of World War II. Yet through 1995, the expansion was essentially a balanced grossing up of cross-border flows. Only in the past decade has expanding trade been associated with the emergence of ever-larger U.S. current account deficits...

A number of factors have recently converged to lessen restraints on cross-border financial flows as well as on trade in goods and services.

The advance of information and communication technology has effectively shrunk the time and distance that separate markets around the world. The vast improvements in these newer technologies have broadened investors' vision to the point that foreign investment appears less exotic and risky...

Both deregulation and technological innovation have driven the globalization process... The effect of these developments has been to markedly increase the willingness and ability of financial market participants to reach beyond national borders to invest in foreign countries... Implicit in the movement of savings across national borders to fund investment has been the significant increase in the dispersion of national current account balances... The decline in home bias, as economists call the parochial tendency to invest domestic savings at home, has clearly enlarged the capacity of the United States to fund deficits.

Arguably, however, it has been economic characteristics special to the United States that have permitted our current account deficit to be driven ever higher, in an environment of greater international capital mobility. In particular, the dramatic increase in underlying growth of U.S. productivity over the past decade lifted real rates of return on dollar investments. These higher rates, in turn, appeared to be the principal cause of the notable rise in the exchange rate of the U.S. dollar in the late 1990s. As the dollar rose, gross operating profit margins of exporters to the United States increased even as trade and current account deficits in the United States widened markedly. But these deficits have continued to grow over the past three years despite a decline in the dollar, whose broadly weighted real index is now much of the way back to its previous low in 1995.

"To understand why the nominal trade deficit--the nominal dollar value of imports minus exports--has widened considerably since 2002, even as the dollar has declined, we must consider several additional factors. First, partly as a legacy of the dollar's previous strength, the level of imports exceeds that of exports by about 50 percent. Thus exports must grow half again as quickly as imports just to keep the trade deficit from widening--a benchmark that has yet to be met. Second, as is well-documented, the responsiveness of U.S. imports to U.S. income exceeds the responsiveness of U.S. exports to foreign income; this difference leads to a tendency--even if the United States and foreign economies are growing at about the same rate--for the growth of U.S. imports to exceed that of our exports. Third, as of late, the growth of the U.S. economy has exceeded that of our trading partners, further reinforcing the factors leading imports to outstrip exports. Finally, our import bill has expanded significantly as oil prices have risen in recent years."

"we may be approaching a point, if we are not already there, at which exporters to the United States, should the dollar decline further, would no longer choose to absorb a further reduction in profit margins."

Besides market pressures, which appear poised to stabilize and over the longer run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction. The voice of fiscal restraint, barely audible a year ago, has at least partially regained volume... An increase in household saving should also act to diminish borrowing from abroad. The growth of home mortgage debt has been the major contributor...to the decline in the personal saving rate in the United States from almost 6 percent in 1993 to its current level of 1 percent. The fall in U.S. interest rates since the early 1980s has supported both home price increases and, in recent years, an unprecedented rate of existing home turnover.

All told, home mortgage debt, driven largely by equity extraction, has grown much more rapidly in the past five years than during the previous five years... Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit... over the past two decades, major innovations in the United States have improved the availability and lowered the costs of home mortgages. These developments likely spurred homeowners to tap increasing home equity to finance consumer expenditures beyond home purchase. In contrast, mortgage debt is not so readily available among our trading partners as a vehicle to finance consumption expenditures."

There is no mystery surrounding the correlation of home mortgage debt and the current account. By its very nature, home mortgage Credit excesses will tend to inflate home values, sales and construction - all the while stimulating consumption. After years of accommodation, such dynamics will ensure a powerful infrastructure dedicated to consumption and asset-based lending - along with the resulting deeply maladjusted economy. Mr. Greenspan is inferring that mortgage Credit can now be expected to slow meaningfully, thus stabilizing and improving the current account deficit. He is a brave man (as opposed to a cautious central banker!) for attempting to call the top of the Great Mortgage Finance Bubble.

And I take strong exception to much of Mr. Greenspan's analysis. "Restraints on cross-border financial flows" have been "lessened" primarily because of the explosion in global speculative finance and the unparalleled expansion central bank holdings. And let's face a little reality here and recognize that these are not the most pristine of market dynamics. The U.S. government and financial sector have greatly inflated the quantity of dollar balances flowing to the rest of the world, and the global financial system has evolved to accommodate these flows. That tends to be the nature of Bubbles.

And I do believe that true economic returns have virtually noting to do with our massive current account deficits. The vast majority of inflows are merely the recycling of excess dollar balances back to U.S. securities markets. And, clearly, the onslaught of finance into the U.S. during the late-nineties was poorly rewarded. The technology Bubble burst, telecom debt collapsed and the boom in direct foreign investment came to a screeching halt. The King Dollar blow-off was then fueled by massive speculative flows (dollar "recycling") into the U.S. bond market to profit from Greenspan's widely-telegraphed post-tech Bubble interest rate collapse. Economic returns? No.

"It has been economic characteristics special to the United States that have permitted our current account deficit to be driven ever higher" qualifies as Mr. Greenspan's most dangerous ("anti-cautious") reasoning. My hunch is that the so-called "productivity revolution" is more related to the nature of inflating service-sector "output" and an undercounting of the hours actually worked. And if real returns of U.S. investment are so high, why has direct foreign investment remained so low? Why would most of the flows into the U.S. result in Treasuries, agencies, and ABS purchases? Why would foreign central banks be forced into the role of dollar buyers of last resort?

And why use the language "the responsiveness of U.S. imports to U.S. income exceeds the responsiveness of U.S. exports to foreign income." Of course we consume more of our income than anyone else, and the structure of our economy dictates that a large portion of any additional consumption must come from imports. That's precisely why we have enormous Current Account Deficits: We consumer too much and invest too little in productive capacity. And I do not believe that it is accurate to today claim that our economy is growing more rapidly than our trade partners - this is certainly not the case with Asia or, increasingly, the emerging markets. And, yes, part of the ballooning trade deficit is related to higher fuel prices. And these prices are rising specifically because of unrelenting Credit inflation, U.S. trade deficits, and the weak dollar. There is no way to grow our way out of this dilemma, nor is possible to rectify imbalances through currency devaluation.

The only way to return to some semblance of a balanced current account would be to sharply reduce mortgage debt growth. Mr. Greenspan, presumably, believes that higher interest rates will soon induce this process. Indeed, at 2.5%, we have already reached a level that many not all too long ago forecasted would mark the end of Fed "tightenings." The Fed may have raised the cost of overnight borrowings 150 basis points, but 10-year Treasury yields are actually a few basis point lower today than they were a year ago. And mortgage rates remain at historically low levels and, not surprisingly, real estate lending remains robust. General Credit availability and marketplace liquidity are as easy as ever. The backdrop is not conducive to restraint, and the Fed has a lot of work to do.

But this is the very nature of Bubbles: they so refuse to succumb easily or quietly. And the bigger they are the more challenging it is to get them to fall - that is without causing one heck of a ruckus.This is why Mr. Trichet is committed to caution and vigilance - why there is a focus on the short, medium and long-term prospects for price stability. As consummate central bankers, Mr. Trichet and the ECB are resolute in their pursuit of comprehensive monetary analysis and forward-looking monetary policy. They don't have to partake in creative analysis or sophisticated obfuscation. And, importantly, they appreciate the necessity for reacting to Bubble "dynamism" as it develops and not waiting for Bubbles to burst.

Mr. Trichet repeatedly refers to "price stability." Contemporary finance and economics dictate that this term must be used broadly. One important consequence of globalization is that a price index for a basket of goods (largely produced in Asia) is no longer a good indicator of domestic monetary conditions. Securities markets and asset prices must now be the focus. U.S. Credit inflation clearly manifests foremost into asset inflation and Trade Deficits. And, especially over the past two years, massive Current Account deficits manifest into unprecedented official flows into U.S. Treasuries and agency markets. The securities markets are at the threshold of contemporary Monetary Disorder.

Today was as good a day as any to witness Monetary Disorder and Price Instability at work in the U.S. bond market (ok, equities also). A somewhat weaker-than-expected report on non-farm payrolls incited a huge short-squeeze and derivatives unwind that saw yields lurch lower. The consensus view may be that a slowing economy explains the bond rally, but I remain quite skeptical. It would appear to me that this is one more example of any ebb in the typical ebb and flow of economic activity fostering an exaggerated response from the bond market. There's too much liquidity at home and abroad.

Ten-year yields are now more than 30 basis points below where they spiked in early December, while mortgage rates are at the lowest level since late last March. There remains a strong inflationary bias in the nation's housing markets, and I believe there is an unappreciated expansionary bias throughout much of the economy. I cannot at this time buy into the "deflation" story, but instead continue to believe the surprise going forward will be the resiliency of the Mortgage Finance Bubble and the U.S. and global economy overall.

Perhaps I will be proved dead wrong. The U.S. Bubble economy could be weaker than I perceive and the global economy not as sensitive to the extraordinary liquidity backdrop. And, perhaps, the Wild Mortgage Finance Bubble is poised to quietly succumb. But there is just nothing in my analytical war chest that points toward a warm and happy ending to this story. Mortgage rates need to be moving higher, but the distorted marketplace and the global liquidity Bubble are thus far incapable of orchestrating an orderly adjustment. And these artificially low rates will stimulate continued robust demand for mortgage and other borrowings.

Imbalances - most important being the Current Account - will not conform to Mr. Greenspan's expectations. And a ballooning Current Account equates to further inflationary distortions, including the inflating pool of destabilizing global speculative finance. And, I will suggest, a surge in economic activity would these days catch the bond market especially unprepared. Bubble dynamics have forced the marketplace into a destabilizing squeeze and derivatives unwind that creates only greater vulnerability for a reversal and problematic spike later on. My fear of a 2005 dislocation in the interest-rate markets is being anything but allayed.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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