More from Mr. Otmar Issing

By: Doug Noland | Fri, Feb 11, 2005
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There was certainly enough volatility. For the week, the Dow gained almost 1%, and the S&P500 was slightly positive. The Transports rose 0.4%, while the Utilities declined 0.6%. The Morgan Stanley Cyclical index was slightly positive, and the Morgan Stanley Consumer index was about unchanged. The broader market was little changed. The Russell 2000 was slightly negative and the S&P400 Mid-cap index slightly positive for the week. Technology stocks were mixed. The NASDAQ100 dipped 0.3% and the Morgan Stanley High Tech index declined 0.4%. Yet the Semiconductors jumped 4% to go into the black for the year. The Street.com Internet index declined 1.5%, and the NASDAQ Telecommunications index fell 1.4%. The Biotechs lost 1.5%. Financial stocks were mixed. The Broker/Dealers gained 1.7%, while the Banks declined 0.8%. With bullion up $6.20, the HUI Gold index recovered about 5%.

The yield curve again demonstrated some unusual hour-to-hour and day-to-day volatility. Two-year Treasury yields ended the week up 4 basis points to 3.32%. Five-year Treasury yields added one basis point to 3.69%. Ten-year Treasury yields also added one basis point, to 4.09%. Long-bond yields declined one basis point to 4.48%. The spread between 2 and 30-year government yields narrowed about 5 basis points to 116. Benchmark Fannie Mae MBS yields jumped a notable 9 basis points. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note added one basis point to 39, and the spread on Freddie's 5% 2014 note added one basis point to 37. The 10-year dollar swap spread dipped 0.25 to 38. Corporate bonds somewhat underperformed, although junk bonds continue to hold their own. The implied yield on 3-month March Eurodollars was unchanged at 2.975%.

February 9 - Bloomberg (David Russell and Mark Pittman): "Pulte Homes Inc., the third-largest U.S. homebuilder by stock market value, is among companies saving on 30-year debt because of proposed pension plan reforms. Yields for corporate bonds maturing in 2020 or later narrowed this week to within 1.14 percentage points of U.S. Treasury securities maturing in more than 15 years, the smallest gap since 1998, according to a Merrill Lynch & Co. index. Demand for longer-dated debt has risen on speculation reforms proposed by the Bush administration will stoke demand for the securities. Pulte, which sold 13,424 homes last quarter, issued $300 million of bonds due in 2035 on Feb. 7 at a yield spread of 1.6 percentage points"

Corporate debt issuance was a slow $6.4 billion (from Bloomberg). This week's investment grade issuers included Aiful Corp $500 million, Centurytel $810 million, Ameren $345 million, Southwest Air $300 million, and Hospitality Properties $300 million.

Junk bond fund inflows increased to $287.2 million, the second straight week of positive flows. Junk issuers included Valor Telecom $400 million, NTK Holdings $400 million, Mercer International $310 million, Builders First $275 million, ACF Finance $200 million, Holly Energy $150 million, Innophos Investment $120 million, and Hydrochem Industries $150 million.

Convert issuers included Protein Design Labs $250 million.

February 9 - Bloomberg (Steve Rothwell): "Emerging market bonds, approaching the highest prices in at least seven years, will keep rising as the economies of countries such as Brazil, Russia and Mexico attract investors, said Mohamed El-Erian of Pacific Investment Management Co., which manages the world's biggest bond fund. 'You have the potential for attractive yields and selective capital appreciation,' El-Erian, who manages $18 billion of developing-nation debt for...Pimco... 'We are seeing first and foremost a long-term climb up the credit quality curve. In addition we are seeing a very favorable external environment.'"

Japanese 10-year JGB yields jumped 9 basis points to 1.40%. Brazilian benchmark dollar bond yields sank 12 basis points to 7.79%. Mexican govt. yields ended the week about unchanged at 5.00%. Russian 10-year dollar Eurobond yields dipped 3 basis points to 5.86%.

Freddie Mac posted 30-year fixed mortgage rates declined 6 basis points this week to 5.57%, the lowest level since the first week of April. Fifteen-year fixed mortgage rates were down 4 basis points to 5.10%. One-year adjustable mortgage rates sank 12 basis points to 4.11%. The Mortgage Bankers Association Purchase applications index increased 1% the past week. Purchase applications were up 8% from one year ago, with dollar volume up 20%. Refi applications jumped 7.8% to the highest level since April. The average new Purchase mortgage increased again, rising to $238,400. The average ARM surged to $323,700. ARMs declined to 31.9% of total applications.

Broad money supply (M3) increased $15.6 billion (up $65.3bn over three weeks) to $9.503 Trillion (week of January 31). For the week, Currency rose $2.3 billion. Demand & Checkable Deposits jumped $13.8 billion. Savings Deposits declined $9.6 billion. Small Denominated Deposits increased $2.4 billion. Retail Money Fund deposits dipped $1.1 billion, while Institutional Money Fund deposits actually rose $4.6 billion. Large Denominated Deposits increased $0.6 billion. Repurchase Agreements added $2.0 billion, and Eurodollar deposits increased $0.4 billion.

Bank Credit surged $46.7 billion for the week of February 2 to a record $6.90 Trillion, with a six-week gain of a noteworthy $156 billion (up 8.6% over the past year). For the week, Securities holdings increased $14.1 billion, and Loans & Leases jumped $32.5 billion. Commercial & Industrial (C&I) loans rose a steady $3.6 billion. Real Estate loans expanded $5.1 billion. Real Estate loans are up $320 billion, or 14.2%, over the past 52 weeks. For the week, consumer loans dipped $3.2 billion, while Securities loans rose $9.9 billion. Other loans jumped $17.7 billion. Elsewhere, Total Commercial Paper jumped $16.3 billion to $1.424 Trillion (up 8.8% over 52 weeks). Financial CP surged $16.5 billion to a near-record $1.283 Trillion. Non-financial CP dipped $0.2 billion to $140.5 billion. Non-financial Commercial Paper is up 24.1% from one year ago.

Fed Foreign Holdings of Treasury, Agency Debt fell $6.3 billion to $1.340 Trillion for the week ended February 9. "Custody" holdings are up only $4.5 billion during the first six weeks of the year. Federal Reserve Credit dropped $7.6 billion for the week to $776.6 billion.

An industry conference held ABS issuance to $1.6 billion (from JPMorgan). Year-to-date issuance of $74 billion is running 48% ahead of comparable 2004. Home equity ABS issuance has already reached $45 billion.

Currency Watch:

It was an interesting week in the currencies. The dollar was volatile, but ended the weak with only a small gain. The Australian dollar jumped 2.4%, the South African rand 2.2%, New Zealand dollar 2.0%, and Canadian dollar 1.54%. On the downside, the Uruguay peso dropped 1.8%, the Japanese yen 0.8%, and Indian rupee .8%.

Commodities Watch:

March Crude Oil gained 68 cents this week to $47.16. The Goldman Sachs Commodities index jumped 2.6%, increasing year-to-date gains to 5.9%. The CRB index rose 1.7%, with a 2005 gain of almost 1%.

China Watch:

February 7 - Bloomberg (George Stein): "Hong Kong's retail sales rose in December as tourists thronged the city and rising stock and property prices prompted local consumers to spend more. Sales rose 8.7 percent from a year earlier..."

February 8 - Bloomberg (Rob Delaney): "China's January export growth picked up speed, defying expectations that a weaker U.S. dollar would slow the trend... China's exports rose 42 percent from a year earlier to $51 billion yuan, up from 33 percent growth in December, and 35 percent for the whole of last year... Imports rose 25 percent, unchanged from December. 'The long-anticipated soft landing in China's exports is nowhere in sight,' said Tim Condon, head of Asian financial markets research at ING Groep NV in Singapore. 'China's trade surplus is huge and growing and contrasts with a huge and growing trade deficit in the U.S.'"

Asia Inflationary Boom Watch:

February 10 - Bloomberg (Anuchit Nguyen): "Thailand may use as much as a third of the nation's $49 billion in foreign-currency reserves to help finance a 1.5 trillion baht ($39 billion) plan to build subways and other public works projects, Prime Minister Thaksin Shinawatra's top adviser said. The government needs other sources of financing besides tax revenue, Pansak Vinyaratn said today... The appropriate level of Thailand's foreign-currency reserves should be at about $32 billion, he said."

Global Reflation Watch:

February 8 - Bloomberg (Lily Nonomiya): "Japan's bank lending fell 3 percent in January from a year earlier, the smallest decline in more than six years, Bank of Japan figures released in Tokyo today showed. Money supply rose. Bank lending had the smallest decline since September 1998..."

February 9 - Bloomberg (Komaki Ito and Mariko Iwasaki): "Personal bankruptcies in Japan fell 8.6 percent in December from the same month a year earlier, according to the Supreme Court of Japan."

February 7 - Bloomberg (Eduard Gismatullin): "London office rents increased 16 percent last year, the largest gain among all European cities, the London-based Times reported, citing a Jones Lang LaSalle study. Office rents in Brussels, Belgium, had the second largest increase, with 7.3 percent, among the West European cities, the newspaper said. Luxembourg rents rose 5.7 percent, France's Lyon had a 3.2 percent and Spain's Barcelona had a 0.7 percent gain, the newspaper said."

February 8 - Bloomberg (Brian Swint): "Industrial production in Germany, Europe's largest economy, increased the most in eight months in December as the retreat in oil prices eased concern about a slowdown in global growth. Output at construction sites, factories, utilities and mines gained 1.2 percent from November..."

February 8 - Bloomberg (Francois de Beaupuy): "The French economy, Europe's third-biggest, grew about 2.4 percent last year, the fastest pace in four years, Finance Minister Herve Gaymard said."

February 10 - Bloomberg (Jacob Greber): "Swiss consumer confidence unexpectedly rose in January to the highest in almost three years, reflecting optimism about economic growth over the next 12 months."

February 9 - Bloomberg (Halia Pavliva): "Russia's foreign trade surplus was at $105.9 billion in 2004, compared with $76.3 billion in 2003, as exports rose faster than imports, Interfax news agency reported... Russian exports increased 35.8 percent in 2004 from 2003 to $181.5 billion, while imports rose 31.8 percent to $75.6 billion..."

February 7 - Bloomberg (Halia Pavliva): "Russian consumer prices rose a faster than expected 2.6 percent in January, led by service costs, raising concerns the government may not be able to cut the inflation rate to its target of 8.5 percent this year."

February 10 - Bloomberg (Gemma Daley): "Australia added jobs for a fifth month in January, keeping the unemployment rate at a 28-year low and worsening a skills shortage which the central bank says may push up wages and prompt it to raise interest rates. The nation's currency rose and bonds tumbled after a report showed the economy added 44,500 jobs, nine times as many as forecast..."

February 9 - Bloomberg (Gemma Daley): "Australian consumer confidence in February remained close to its highest in almost 11 years, spurred by increased employment and rising share prices."

February 8 - Bloomberg (Tracy Withers): "New Zealand's wages rose at the fastest annual pace on record in the fourth quarter after the jobless rate slumped to a 19-year low, putting pressure on employers to pay more to hire and retain skilled workers. Wages, including overtime, for non-government workers gained 2.5 percent from a year earlier, the fastest pace since the series began in 1993..."

February 10 - Bloomberg (Dylan Griffiths): "South African retail sales rose an annual 12.6 percent in November, close to a five year-high, as the lowest interest rates in 24 years fueled consumer spending."

Latin America Reflation Watch:

February 10 - AP: "Brazil's industrial output surged 8.3 percent in 2004, the biggest annual increase in 18 years, the government said Thursday. Industrial production in December rose 0.6 percent from a month earlier and 8.3 percent from December 2003, the government's IBGE statistics institute said. Brazilian industry hasn't done that well since 1986, when output grew 10.9 percent, the IBGE said."

February 10 - Bloomberg (Heather Walsh): "Chile, the world's biggest supplier of copper, had its first budget surplus in four years in 2004, after a surge in copper prices increased revenue. Chile had a surplus equivalent to 2.2 percent of gross domestic product..."

California Bubble Watch:

February 10 - Los Angeles Times (Annette Haddad): "For the first time in 19 months, the year-over-year rate of housing appreciation in Los Angeles County has dropped below 20%... The median price in the county in January rose 17% to $414,000, according to DataQuick... It was the slimmest increase since June 2003, putting the county's median price where it stood seven months ago, after hitting an all-time high in December at $418,000... The number of homes sold last month fell 5% to 7,633 from a year earlier."

Bubble Economy Watch:

The December Trade Deficit was up 28% from one year ago to $56.4 billion. Goods Exports were up 14% from December '03 to a record $71.1 billion, while Goods Imports were up 18% to a record $131.7 billion. Goods Imports were up 27% from December 2002. The Trade Deficit for all of 2004 was up 24% from record 2003 to $617.7 billion. This was up almost 4-fold from 1998's $165 billion.

February 8 - Bloomberg (Simon Kennedy): "The U.S. Treasury wants Congress to approve a 13 percent funding boost to cover interest payments on government debt next year as part of its overall request for an increase in funding... The increase would be the highest in at least 18 years and the request comes the same day the White House predicted the federal budget deficit will rise to a record $427 billion in the current fiscal year, which ends Sept. 30., forcing the Treasury to issue government securities to plug the gap. Interest on debt payments will rise an estimated 8.2 percent to $347.9 billion in fiscal 2005, from $321.6 billion last year."

February 9 - Bloomberg (William Selway): "U.S. state governments' revenue from taxes rose during the last fiscal year at the fastest pace since 2000, buoyed by an increase in personal income and $8 billion in tax increases, according to a study. State governments' tax revenue rose 7.5 percent to $501.9 billion during the 2004 budget year, according to the Nelson A. Rockefeller Institute of Government in Albany, New York. It is the fastest growth since tax revenue rose 8.7 percent four years earlier as benchmark U.S. stock indexes surged to records."

February 7 - The Wall Street Journal (Sarah Lueck): "To see how Medicaid is devouring state budgets across the country, take a look at Mississippi. Over the past five years state and federal spending in Mississippi on Medicaid -- the health program for the poor and disabled -- has doubled to $3.5 billion. Fully one-quarter of state residents are in the program. 'Medicaid is a cancer on our state finances," says Mississippi Gov. Haley Barbour..."

February 10 - San Francisco Chronicle (Peter Fimrite): "The Golden Gate Bridge District, still reeling from a back-breaking budget deficit, outlined a series of proposals Wednesday to bring in more cash, including a $6 toll and possible charges to pedestrians and bicyclists crossing the span."

February 9 - The Wall Street Journal (Ryan Chittum): "Office-building values jumped in the fourth quarter as the leasing market began strengthening, while apartment values rose more slowly, but buyers are still paying a considerable premium for commercial real estate, according to a new study. Office values jumped 3.3%, the most in two years, to $138.59 a square foot in the fourth quarter from $134.13 in the third quarter, according to the study of the top 50 U.S. markets prepared by Reis Inc.... Apartment values were up 1.4% to $72,128 a unit in the fourth quarter from $71,132 in the third quarter. For the year, office values were up 2.8%, compared with a 5.6% decline in 2003. Apartment values rose 4.8% in 2004, while they declined 0.33% in 2003."

From Freddie Mac: "With no dramatic change in our interest-rate forecast or GDP estimates, forecasted housing starts are the same as last month's projections. We show a 3% decline to about 1.90 million units in 2005 and then falling to around 1.80 million units in 2006. Similarly, total home sales are forecasted to fall by 3% to 7.66 million units in 2005 (marking their second best year) and then to around 7.27 million in 2006. Gradually rising mortgage rates should help slow home price appreciation from 10.5% in 2004 to around 7.8% in 2005 and to around 6.3% in 2006. Given lower home sales, less new construction, fewer refinancings and slower house-price appreciation, overall mortgage originations are expected to decline by about 6 % to $2.6 trillion in 2005 and to $2.3 Trillion in 2006. The refinance share of new mortgage applications should decline to 41% in 2005 and to 33% in 2006. There's enough momentum from last year's strong housing market to maintain strong mortgage debt growth in 2005. We expect mortgage debt growth to average around 12.6 percent in 2005 and then ease to 11.0 percent in 2006."

Financial Bubble Watch:

February 9 - Bloomberg (Karen Brettell): "U.S. derivatives professionals got as much as much as 20 percent more in bonuses in 2004 as banks struggle to keep their best traders from joining hedge funds or competitors, recruitment consultants said. The top managing directors in equity, credit and interest-rate derivatives at the largest banks received average bonuses of $3 million, rising from $2.5 million last year, said Mike Karp, co-founder of Options Group, a New York-based executive search firm. 'With hedge funds increasingly hiring experienced traders, banks are finding it harder to hire or keep staffers with experience,' Karp said. The best-paid managing directors in derivatives trading will have received between $3.5 million and $5 million, he said."

February 7 - Bloomberg (George Stein): "Merrill Lynch & Co. and UBS AG vaulted into the top three among merger advisers, joining perennial leader Goldman Sachs Group Inc., in the hottest U.S. takeover market since 2000. About $150 billion of acquisitions were announced since January, up 32 percent from the first five weeks of 2004, according to data compiled by Bloomberg.... 'The way 2005 has begun, we could rapidly get back to the peak levels of 1999 and 2000,' said Scott Bok, president of Greenhill & Co., a merger advisory firm... 'Some of the large deals will set off a chain reaction.'"

Mortgage Finance Bubble Watch:

February 7 - The Mortgage Bankers Association: "Commercial and multifamily mortgage bankers' loan originations set a record during 2004... The $136 billion in loan originations reported for 2004 were up by 16 percent from the $117 billion reported in 2003. MBA also reported that loan originations in the fourth quarter were the highest ever recorded in MBA's quarterly survey. The fourth quarter total of $42.7 billion was $7.1 billion above third quarter 2004 volume and $3.8 billion above fourth quarter 2003 volume. 'The continued availability of capital from lenders and demand from borrowers combined to produce new record loan originations in 2004,' noted Douglas G. Duncan, MBA chief economist... 'With commercial property values strong, interest rates low, the economy growing, and real estate markets starting to improve, 2005 looks to produce more of the same.'"

Assuming Countrywide's volumes remain indicative of mortgage lending for the entire industry, 2005 is off to a strong start. At $2.1 billion, Average Daily Mortgage Applications were at their strongest level since last March (up 19% from Jan. '04). The Mortgage Loan Pipeline was up slightly from December to $47.8 billion, fully 25% above year ago levels. Total Fundings ($28.5bn) were down from December's $34.7 billion, but were up 38% from January 2004. Purchase Fundings were up 37% from a year earlier to $12.7 billion and Non-purchase (refi) Fundings were up 37% to $15.6 billion. At $15.1 billion, ARMs were up from the year ago $9.5 billion to 53% of total fundings. Home Equity Fundings were up 75% from January 2004 to $2.7 billion, and Subprime was up 92% to $3.9 billion. Bank Assets increased about $2.3 billion during the month to $43.3 billion (up 113% y-o-y).

Subprime mortgage originator Accredited Home Lenders Total Assets expanded at a 53% rate during the fourth quarter to $6.14 billion. Total Assets doubled in twelve months, and were up from $1.80 billion to begin 2003. Shareholder's Equity ended the year at $212 million. Origination volume was up 56% for the year to $12.4 billion.

More from Mr. Otmar Issing

We are this week provided a few moments of central bank sanity from our old favorite ECB Chief Economist, Mr. Otmar Issing. I have excerpted from his short paper "Monetary Policy and Asset Prices," available online at www.boersen-zeitung.com.

"Which role should asset prices play in the conduct of monetary policy? This question has gained more and more attention in recent years. However, the answers are anything but straightforward..."

"Prevention is the best way to minimize costs for society from a longer-term perspective. Central banks are confronted with this responsibility, but there is no easy answer to this challenge. So far, only some tentative conclusions can be drawn."

"First, in their communication central banks should certainly avoid contributing to unsustainable collective euphoria and might even signal concerns about developments in the valuation of assets."

"Second, the argument that monetary policy should consider a rather long horizon is strengthened by the need to take into account movements of asset prices."

"Finally, it should not be overlooked that most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit."

"With stable prices money serves society best as a unit of account, medium of exchange, and store of value. Any index of consumer prices covers only a segment of prices in an economy - although an important one. Prices of assets like real estate or equities are excluded from the definition."

"We have learned on many occasions that excess liquidity can show up in excessive asset valuations and not only in consumer price inflation. Sooner or later, then, unsustainable asset price trajectories may translate into sizeable risks to price stability -- in either direction -- and often much further down the road as the long-run fallout of the Japanese bubble of the late 1980s has shown."

"To my mind the risks associated with asset price inflation and subsequent deflation are an important additional reason for paying close attention to money and credit, over and above the regular and well-established link between money and consumer prices."

"Thus, a monetary policy strategy that monitors closely monetary and credit developments as potential driving forces for consumer price inflation in the medium and long run has an important positive side effect: it may contribute at the same time also to limiting the emergence of unsustainable developments in asset valuations. In other words: as long as money and credit remain broadly well-behaved the scope for financing unsustainable runs in asset prices should remain limited."

"The tendency of modern textbooks on monetary theory and policy to relegate money and related concepts to inconsequential footnotes can be no comfort. What is the role of liquidity, financial frictions and the flow of funds for the real economy and the relation of money vis-à-vis a broader range of asset classes? While a full grasp of the interplay between the real economy and monetary and financial variables remains elusive, the asset price cycle playing out in the late 1990s and peaking in early 2000 has again forcefully brought to the front the importance of careful analysis of financing flows and balance sheets considerations, on the side of households, the corporate sector as well as the financial system."

"The more the monetary and financial side of the economy is given its proper weight in the ongoing analysis of central banks and in their monetary policy deliberations and the more extended its policy horizon, the lesser will be the need to contemplate exceptional 'escape clauses' for the monetary policy strategy. At the same time, such a strategy offers a framework to face up to central banks' responsibilities in this realm..."

It is refreshing to read central banking philosophy from the well-grounded ECB perspective. What a contrast to that espoused by the Greenspan Federal Reserve. The ECB recognizes the necessity for adopting a long-term focus, while the Fed's realm is the short-term and zealous activism. Mr. Issing exhorts that "central banks should certainly avoid contributing to unsustainable collective euphoria." Mr. Greenspan has over recent years become a proponent of "the New Economy," derivatives, structured finance, and even the liquidity and "flexibility" benefits of an expansive hedge fund community. Indeed, the activist Fed specifically targeted leveraged speculation and mortgage borrowings as the key reflating mechanisms in the post-technology Bubble environment. With short-term expedients come long-term costs and uncertainties.

There is today - in The Intoxicating Global Liquidity Bubble World - little appreciation that Mr. Greenspan's short-term activism is coming home to roost. Back in November he made a remarkable comment: "Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money." If only the world's marketable securities-based Credit systems and the massive global pool of speculative finance could be managed so easily. I would argue that the essence of Mr. Greenspan's comments lie at the very heart of failed Fed policymaking - and attendant Monetary Disorder.

Ponder for a moment a scenario where, let's say, the Fed had warned in 1999 that NASDAQ was poised to decline. Duly warned, investors, day-traders, Wall Street proprietary trading desks, hedge funds and others would surely have simply gone out and purchased put options and locked in bull market gains (choosing to buy insurance while playing the hot game for all it's worth!). In theory, life in the markets would have been just swell.

But the reality of the situation was quite to the contrary. NASDAQ was in a powerful yet unsustainable Bubble. When the Bubble eventually burst, those that wrote NASDAQ derivative exposure were on the hook for major losses. And it is important to appreciate that those writing put options and other derivative protection are generally thinly capitalized financial institutions and speculators. Such players must rely on "dynamic trading" hedging strategies that entail selling/shorting, in this case, NASDAQ stocks and instruments to offset the "insurance" exposure that escalates when a market commences a major decline. And when a large portion of the (fully-invested) marketplace acquires put options to "lock in a bull market," this assures massive "dynamic" selling into a declining market with few willing and able buyers. The inevitable outcome is a collapse in marketplace liquidity.

Yet, there is more to this basic NASDAQ/"market hedging" example that may offer some insight into the current peculiar bond market environment. Let's say the Fed warned of the coming NASDAQ decline in mid-1999. And, over the following few months, participants aggressively shorted tech stocks and NDX futures, while loading up on puts. The writers/sellers of these derivatives would then partially hedge their exposure by shorting individual stocks and/or indices. Hedges and bearish bets, rational ones at that, would be put on in size.

End of cycle euphoria and Bubble dynamics would, virtually by definition, create ample liquidity to accommodate these sales. There would be, as well, critical dynamics in the "economics sphere" to match those in the "financial sphere." Importantly, this same "blow-off" liquidity would tend to significantly distort ("inflate") fundamental factors such as company/industry revenues, earnings, and cash flow. Arguably, bull markets and booms create their own liquidity and "positive" fundamentals. As such, contemporary finance demonstrates a proclivity to foster extraordinarily unstable marketplaces replete with, on the one hand, seemingly exceptional fundamentals and, on the other, rising short and derivative positions. Moreover, these bearish positions - as Bubble dynamics again make certain - reside in "weak hands." The bloodied bears and the derivative players with shorts become open game in what becomes a wildly speculative marketplace. This is one aspect of the very unstable nature of financial Bubbles and why the ECB is correct in arguing that they must be dealt with long before they burst.

I strongly argue that such a scenario - the confluence of Bubble dynamics, central bank warnings, system-wide hedging, and acute "economic sphere" distortions - create the perfect backdrop for major market dislocation. And, in reality, the NASDAQ100 index did double from its elevated June 1999 level during the subsequent nine months. A historic short-squeeze and enormous derivative positions played instrumental roles in this spectacular market breakdown. And while an overt Fed warning was not a factor, the Fed was raising rates and was exhibiting increasing public concern. The existence of highly liquid markets for derivative protection clearly played an instrumental role in fostering boom and bust dynamics and acute financial fragility.

While some participants do effectively use derivatives to, it is impossible for a large portion of the market to successfully hedge against a major market move. I assert that the circumstance of major share of the marketplace hedging market exposure during the late-stage of Bubbles greatly increases the probability one of two scenarios: One, the market commences a downward spiral, overwhelmed by self-reinforcing "dynamic" derivative-related selling pressure. The second scenario - and I argue passionately that Bubble dynamics increase the likelihood of this outcome - is one of a final "classic" spectacular marketplace blow-off: the animated crowd recognizes that the game is nearing its end and puts in place its bearish bets and hedges, only to get run over by the final short-squeeze and buyer's panic melt-up (including the throngs of attentive speculators buying in front of those caught short). Marketplace dynamics virtually assure that the crowd and their derivative counterparties will be forced to unwind hedges in the final dislocation. Not only does this lead to heightened marketplace volatility and indecision, it also exacerbates the widening chasm between current market prices and prospective economic values.

One other key aspect of the final short covering/derivative unwinds/speculator euphoria melee is not as obvious: This process creates massive liquidity that perpetuates and exacerbates the attendant boom in the industry/economy ("economic sphere"). The financial sphere will have over time expanded and evolved to over-finance the Bubble, while the most aggressive risk-takers ("proved right") will have been elevated to top decision-making positions. Support from the political establishment also reaches full bloom. Importantly, this final destabilizing liquidity onslaught fosters the most egregious excesses throughout the real economy. These include misallocation of resources and - certainly as we saw throughout the tech/telecom sectors - over and mal-investment that ensures the collapse of industry profits as soon as the unsustainable liquidity bulge runs its course.

This brings us to the current environment. Despite Mr. Greenspan's warnings and six Fed rate increases, the U.S. Credit system's liquidity bulge has at this point anything but run its course. The homebuilding and consumption boom runs full steam ahead. Should we have expected anything less? It is my view that interest-rate markets succumbed to a marketplace dislocation not unlike NASDAQ in that fateful period second-half 1999 to early 2000. An enormous amount of interest-rate hedging was put in place that was, in reality, untenable. Again, I would assert that the Fed's warnings of higher rates and the market's rational reaction (large-scale hedging and bearish speculating) assured either a self-reinforcing downward spiral in bond prices (spike in rates) or an unfolding major "squeeze," derivative unwind and destabilizing drop in rates. We are witnessing the latter.

With nightmares of 1994 - and cognizant of today's highly leveraged and fragile financial landscape - the Fed expressly erred on the "side of caution." Ample warning, extraordinary "transparency," and promised ultra-baby step (with pauses?) rate hikes were incorporated specifically to accommodate the leveraged players. At the same time, the financial sector was afforded ample time and opportunity to adjust its products and programs to assure uninterrupted boom-time Credit Availability and liquidity. The Mortgage Finance Super-industry, in particular, developed and aggressively marketed variable-rate products, interest-only loans, and flexible home equity lines of Credit. Wall Street investment bankers focused on issuing variable-rate corporate debt, while the "financial engineers" in structured financed set their sights on transforming $100s of billions of variable-rate and subprime mortgage loans into enticing collateralized debt obligations (CDOs), MBS, ABS, and myriad derivative products.

The Credit system hasn't missed a beat, and that's a problem. The ongoing liquidity onslaught throughout the U.S. and global Credit system, echoing NASDAQ 1999, has wreaked distortion havoc on both the "economic sphere" and the "financial sphere." Conspicuously, over-consumption, massive Current Account Deficits and unprecedented central bank dollar security purchases have taken center stage. The greater the U.S. lending and spending excesses, the greater the force of foreign central bank recycling operations back to the Treasury and agency markets. And talk of a paradigm shift to permanently low market rates (all too reminiscent of "blow-off" notions of enduring tech multiples) grows louder. Bubble distortions - foremost liquidity excess - under the façade of amazing fundamentals have played a major role in inciting a short-squeeze and unwind of interest-rate hedges throughout the Credit market.

And while on the surface not as spectacular as the technology stock melt-up, we do have the homebuilders. Further evidence of blow-off excess can be found in paltry corporate, junk, ABS, and MBS spreads. Credit default swap prices have sunk as well. Globally, emerging bond spreads are extraordinarily narrow, while equity markets remain red hot. Basically, liquidity excess and multi-year low risk premiums have become the norm throughout global finance. The system is poised for another Trillion plus year of Mortgage Credit growth.

And no discussion of Bubble distortions and potential dislocation in the interest-rate markets would be complete without some mention of GSE balance sheets. Unfortunately, Fannie and Freddie haven't issued financial statements in awhile. But looking at 2003 year-end statements, Fannie and Freddie had at the time combined short-term liabilities approaching $800 billion (total assets of about $1.8 Trillion). Let's assume those numbers have stayed about the same, and then add an additional $200 billion or so for the FHLB. We can throw out a rough estimate of $1 Trillion of GSE short-term borrowings. As derivative kings, the GSEs have aggressively entered into interest-rate swap agreements and acquired other derivative "insurance" to hedge their mismatch between the expected life of their (generally) mortgage assets and the average duration of their borrowings.

We can only hope that the GSEs are more adept at derivative hedging than they are accounting. But one can look at the current yield curve environment and see plenty of potential for error. Let's say the GSEs entered into swap agreements to hedge the risk associated with a Fed tightening cycle. In such a swap, they might choose to pay some fixed rate to receive whatever is the going 10-year Treasury yield. Historical models would forecast that 10-year yields would likely experience a greater increase in yields than the rise in Fed short-term rates (recall 1994) - models would expect 10-year yields to rise and the yield curve to steepen. This swap would be expected to hedge against the rising cost of their short term debt. But what would happen if the cost of financing the massive GSE short-term debt rose but 10-year Treasury yields actually dropped? And what would be the consequences if such hedges began to falter for the GSE and throughout the marketplace? Would players be forced to restructure their hedges - perhaps forced to buy the 10-year (on leverage, of course) and short the 2-year instead? And would the yield curve effects of such a move by huge market players force others to cover short positions and unwind hedges out the yield curve, while shorting, say, 2-year Treasuries? Am I suffering from a wild imagination when I ponder the possibility that such operations could be inciting destabilizing yield curve gyrations and derivative hedging tumult?

Well, enough conjecture for this week. But a very fascinating dichotomy is developing in the marketplace. After beginning the year with a hiccup, global bond and equity markets have generally regained their strong momentum (U.S. equities are lagging). And we see this week continued price gains in the energy markets, as well as the resurgent commodity markets. Furthermore, the "commodity currencies" were quite strong this week. While I appreciate that many are calling for the demise of the "reflation trade" - long commodities, commodity currencies, and emerging markets, while short the dollar - recent weakness may prove only a pause that refreshes. It is also worth noting that economists have begun to revise U.S. growth higher, and there are signs the global economy is demonstrating similar resiliency (not surprising considering the interest-rate and liquidity backdrop).

So if reflation retains its vigor; economies their resiliency; and the Global Liquidity Bubble its tenacity; what the devil is the 10-year Treasury yield doing at 4.09%? Has the recent drop in yields (and yield curve gyrations) been fundamentally or technically driven? Are we in the midst of the best of times for the bond market or, instead, an environment characterized by instability and dislocation? How exposed has the marketplace become to an abrupt reversal of fortunes? I suspect that short covering and the unwinding of derivative hedges is placing the marketplace in an increasingly vulnerable position. And it's always these abrupt market "Vs" that cause the derivative players the most grief. As was the case with NASDAQ, one day derivative traders can be panic buyers only to have a market reversal hastily transform them into aggressive sellers.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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