The Fed's Dilemma

By: Doug Noland | Fri, Apr 8, 2005
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Major market indices were mostly on the plus-side this week, although action was generally unimpressive and bear market-like today. For the week, the Dow and S&P500 gained just under 1%. The Transports were slammed for 2%, while the Utilities posted a 0.5% gain. The Morgan Stanley Consumer index rose 2%, and the Morgan Stanley Cyclical index was slightly positive. The broader market went nowhere. Both the small cap Russell 2000 and S&P400 Mid-cap indices were about unchanged for the week. Technology stocks were somewhat stronger. The NASDAQ100 added 1%, with the Morgan Stanley High Tech index up marginally. The Semiconductors gained 1.4%. The Street.com Internet Index and NASDAQ Telecommunications indices were up fractionally. The manic-depressive Biotechs jumped 4.6%. The Broker/Dealers were slightly in the black for the week, and the Banks gained 1%. Although bullion mustered an 85 cent gain, the HUI Gold index declined 2%.

The bond market rally petered out. Two-year Treasury yields ended the week up 2 basis points to 3.74%. Five and 10-year Treasury yields also added 2 basis points, ending the week at 4.14% and 4.47%. The long-bond yield rose 4 basis points to 4.76%. The spread between 2 and 30-year government yields widened about 2 basis points to 102. Benchmark Fannie Mae MBS were notably unimpressive, with yields surging 10 basis points. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note narrowed one basis point to 36, while the spread on Freddie's 5% 2014 note widened 2 basis points to 36. The 10-year dollar swap spread gained another 1.25 to end the week at a 7-month high 47.5. The corporate bond market generally traded in line with Treasuries, although junk spreads widened again this week. The implied yield on 3-month December Eurodollars rose one basis point to 4.175%.

It was another very slow week of corporate debt issuance. Investment grade issuers included International Lease Finance $800 million, Pinnacle West $500 million, XTO Energy $400 million, John Deere Capital $250 million, Mack-Cali Realty $150 million, Connecticut L&P $200 million, Consumer Energy $150 million and TTX $150 million.

Junk bond fund outflows continued, although they declined to $357 million.

Foreign dollar debt issuers ANZ Bank $1.5 billion and Manitoba $350 million.

Japanese 10-year JGB yields rose 3 basis points to 1.36%. Emerging debt markets were choppy but held their own. Brazilian benchmark dollar bond yields declined 5 basis points to 8.61%. Mexican govt. yields ended the week down 3 basis points to 6.04%. Russian 10-year dollar Eurobond yields dropped 11 basis points to 6.25%.

Freddie Mac posted 30-year fixed mortgage rates dropped 11 basis points to 5.93%, only 14 basis points higher than one year ago. Fifteen-year fixed mortgage rates declined 10 basis points to 5.48%. One-year adjustable rates fell 10 basis points to 4.23%. The Mortgage Bankers Association Purchase Applications Index declined 5.3% this past week. Purchase applications were down almost 7% from one year ago, with dollar volume about unchanged. Refi applications declined 3.1%. The average new Purchase mortgage declined to $235,800. The average ARM dropped to $323,600. The percentage of ARMs dipped to a still strong 35.2% of total applications.

Broad money supply (M3) surged $39.7 billion to $9.551 Trillion (week of March 28), and the gains were atypically broad-based. Year-to-date, M3 has expanded at a 3.6% rate, with M3-less Money Funds growing at a 7.0% pace. For the week, Currency added $1.8 billion. Demand & Checkable Deposits increased $14.1 billion, while Savings Deposits rose $7.2 billion. Small Denominated Deposits added $2.2 billion. Retail Money Fund deposits slipped $0.3 billion, while Institutional Money Fund deposits expanded $9.8 billion. Large Denominated Deposits increased $11.8 billion. Repurchase Agreements declined $2.0 billion, and Eurodollar deposits dropped $5.0 billion.

Bank Credit dropped $40.4 billion during the final week of the quarter, reducing the year-to-date expansion to $263 billion, or 15.6% annualized. Securities Credit is up $89.8 billion, or 18.7% annualized, year-to-date. Loans & Leases expanded at a 14% pace during the first quarter. For the week, Commercial & Industrial (C&I) loans dipped $0.2 billion. Real Estate loans added $2.4 billion. Real Estate loans have expanded at a 16.5% rate during the first 13 weeks of 2005 to $2.646 Trillion. Real Estate loans are up $330.8 billion, or 14.3%, over the past 52 weeks. For the week, consumer loans gained $2.9 billion, while Securities loans declined $7.5 billion. Other loans fell $7.8 billion.

More than recovering the previous week's (quarter-end) decline, total Commercial Paper surged a noteworthy $31.7 billion last week to $1.461 Trillion (high since July '01). Total CP has expanded at a 12.4% rate y-t-d (up 10.5% over the past 52 weeks). Financial CP jumped $21.9 billion last week to $1.315 Trillion. Non-financial CP increased $9.8 billion to $146.2 billion.

Fed Foreign Holdings of Treasury, Agency Debt dipped $1.7 billion to $1.390 Trillion for the week ended April 6. "Custody" holdings are up $54.2 billion, or 15.1% annualized, year-to-date (up $214bn, or 18.2%, over 52 weeks). Federal Reserve Credit added $1.1 billion for the week to $783.4 billion, down 3.4% annualized y-t-d (up $49.9bn, or 6.8%, over 52 weeks).

ABS issuance was a relatively slow $5.3 billion (from JPMorgan). Year-to-date issuance of $155 billion is now slightly below comparable 2004. At $97 billion, y-t-d home equity ABS issuance is only slightly above the year ago level.

Currency Watch:

The dollar rally stalled along with U.S. bonds. On the upside, the Brazilian real rose almost 3%, the Chilean peso 1.9%, South African rand 1.5%, and the New Zealand dollar 1%. On the downside, the Iceland krona fell 1.9%, the Canadian dollar 1.2%, the Thai baht 0.9%, and the Taiwan dollar 0.7%.

Commodities Watch:

Hyper-volatile trading saw May crude oil sink $3.95 to $53.32. For the week, the CRB index fell 2.4%, dropping y-t-d gains to 7.2%. The Goldman Sachs Commodities index sank 5.8%, reducing 2005 gains to 18.9%.

China Watch:

April 4 - Bloomberg (Nerys Avery): "China's manufacturing growth gathered pace for a third straight month in March as factories expanded to meeting surging demand at home and abroad. An index based on a survey of purchasing managers at more than 350 companies rose to 55.2 from 52.9 in February, CLSA Asia-Pacific Markets said in an e-mailed statement. That's the highest the index has been since April 2004's reading of 57.1..."

April 8 - Bloomberg (Janet Ong): "Shanghai passed a new law requiring home owners to pay off their mortgages before selling their properties, as part of efforts to cool curb real-estate speculation in China's fastest-growing real estate market. Starting April 6, home owners must pay off their entire mortgages before they can transfer the deed to new buyers, the Shanghai Housing and Land Administration Bureau said... Shanghai is trying to curb speculation in a market where prices jumped 10 percent in the fourth quarter alone."

April 7 - AFX: "China's major ports handled 230 mln tons of cargo in March, up 10.1 pct year-on-year, the Ministry of Communications said... Container throughput at the ports increased 20 pct to 5.11 mln TEUs (twenty-foot equivalent units). The ports handled 97.77 mln tons of cargo earmarked for foreign trade last month, up 25.6 pct from a year earlier. Coal transported via the ports was up 15.2 pct year-on-year at 31.04 mln tons. Oil imports via the ports rose 13.7 pct from a year earlier..."

April 8 - AFX: "(Hong Kong) Retail sales in February rose 16.5 pct year-on-year... while sales by volume were up 16.0 pct, the government said... For the first two months of this year, retail sales increased by 9.6 pct in value and 8.8 pct by volume over the same period a year earlier."

Asia Inflationary Boom Watch:

April 5 - AFX: "GDP in Asia, excluding Japan, will grow 6.5-6.9 pct in 2005-2007, supported by domestic demand that will likely provide some cushion against a potential deterioration in the external environment, the Asian Development Bank (ADB) said. ADB projects GDP growth of 6.7-7.2 pct over the three-year period for East Asia, 5.4-5.9 pct for Southeast Asia, 6.2-6.9 pct for South Asia, 8.7-9.2 pct for Central Asia and 1.4-2.3 pct for the Pacific."

April 3 - UPI: "South Korea's exports rose to a record $24.1 billion in March, up 14.2 percent from the same period of 2004, the Korea Times reported Sunday. The Ministry of Commerce, Industry and Energy said March was the seventh consecutive month that exports topped $20 billion."

April 5 - Bloomberg (Heejin Koo): "South Korea's foreign-exchange reserves rose to a record $205.5 billion at the end of March as weakness of the U.S. dollar boosted the value of assets denominated in euros and other currencies, the central bank said. The reserves, the world's fourth-largest, rose $3.3 billion from February and were up a quarter from a year earlier..."

April 4 - Bloomberg (James Peng): "Taiwan's foreign-currency reserves, the third-highest in the world, rose in March to a record $251 billion, boosted by 'substantial' foreign capital inflows and investment returns, the central bank said in a statement today. The reserves, which trail those of Japan and China, rose for a 45th month from $247 billion in February..."

April 4 - Bloomberg (Stephanie Phang): "Malaysia's exports grew in February at the fastest pace in three months, boosted by sales of electronics, oil and liquefied natural gas to Asia and the U.S. Exports rose 13.2 percent from a year earlier..."

April 5 - Bloomberg (Francisco Alcuaz Jr. and Jun Ebias): "Philippine inflation held near a six-year high in March as record crude-oil prices boosted energy and transport costs, increasing pressure on the central bank to raise its key interest rate for the first time in five years. Consumer prices rose 8.5 percent from a year earlier..."

April 8 - Bloomberg (Cherian Thomas and Kartik Goyal): "India's exports rose faster than the government expected last fiscal year, boosted by shipments of textiles, gems and jewelry to the U.S. Exports rose 24 percent to a record $80 billion in the year ended March 31, Commerce and Industry Minister Kamal Nath (said)..."

Global Reflation Watch:

April 8 - Bloomberg (Mayumi Otsuma): "New Bank of Japan policy board member Kiyohiko Nishimura said it's important to gradually shift away from the central bank's current monetary policy, which he likened to a patient on 'morphine.' 'Morphine is a drastic medicine and we know it's better to stop administering it, but if we do so suddenly it will just cause pain,' Nishimura, 52, said today...What's important in policy is to gradually withdraw morphine' from the economy."

April 7 - AFX: "A record 5.7 trln yen in securitized loan instruments were issued in Japan in the financial year to March 31, up 42 pct from the previous year, the Nihon Keizai Shimbun reported... The business daily noted that the market for securitized loans - mainly mortgages and other loan claims bundled into securities for sale to investors -- has grown to rival in size the domestic corporate straight bond market, which totalled about 5.9 trln yen... The size of the Japanese securitized loan market has grown more than sevenfold since it began seven years ago, it said."

April 8 - CNW: "Sales of upper-end homes in the Greater Toronto Area continue to spiral upward, climbing 33 per cent in the first quarter of 2005 compared to the same period one year ago, according to RE/MAX Ontario-Atlantic Canada. Two hundred and ninety-six homes have sold in excess of $1 million on the Toronto Real Estate Board so far this year, surpassing the annual figures reported in 1996 (113), 1997 (175), 1998 (211), and 1999 (289)."

April 5 - Bloomberg (Vladimir Todres): "Russian consumer prices increased by 5.3 percent in the first quarter of the year, led by higher costs for meat and municipal services, the country's central bank chairman said."

April 5 - Bloomberg Nasreen Seria): "South African house-price inflation slowed for a second month, falling to an annual 26.9 percent in March as the country's property boom made prices unaffordable for some, said Absa Group Ltd., the country's biggest home-loan provider."

Dollar Consternation Watch:

April 5 - Market News International (Steven K. Beckner): "Although a growing world economy has increased the global financial system's 'resilience,' concerns about the U.S. current account deficit could cause 'a significant decline of the dollar' and a resulting spike in interest rates, the International Monetary Fund warns in a report released Tuesday. Although financial markets are prepared for a gradual increase in interest rates they are not ready for the kind of 'abrupt' rise in rates that a 'sharp' decline in the dollar's value could trigger, the IMF's Global Financial Stability report warns. Such a scenario could in turn cause economically damaging corrections in asset prices, according to the IMF semi-annual report. The IMF staff-written report says that the low level of financial market volatility, along with low credit spreads, could prove dangerous by 'encourag(ing) investors to seek higher returns through leverage or by taking positions in riskier assets.'"

Bubble Economy Watch:

April 7 - Bloomberg (Robert Willis): "This year's average U.S. income-tax refund has risen 5.3 percent to $2,210, the Internal Revenue Service said... The U.S. Treasury returned $148.2 billion to individuals as of April 1..."

Mortgage Finance Bubble Watch:

Are moderately higher rates so far having a meaningful impact on mortgage lending? Not if behemoth Countrywide Financial's March data is indicative of the entire industry: "Mortgage loan fundings rose by 35 percent over February to $36 billion, helped in part by four more working days in March than in February, and were 12 percent higher than March 2004, which had the same number of working days. Total mortgage funding activity for the first quarter of 2005 was $91 billion, 20 percent more than the first quarter of 2004..." March Purchase Fundings were up 26% from a year ago to $16.5 billion, the strongest production since September. At $19.5 billion, ARM lending was up 40% from a year earlier to 54% of Total Fundings. Home Equity Fundings were up 63% to a record $3.4 billion, and Subprime Fundings were up 22% from March 2004 to $3.4 billion. Bank Assets increased a notable $5.2 billion during the month to $51.1 billion and were up 116% over the past 12 months.

April 7 - Dow Jones (Danielle Reed): "March mortgage bond prepayment speeds - reflecting the rate at which mortgages are repaid as borrowers refinance or sell their homes - came in higher than expected, with 30-year mortgage speeds increasing as much as 45% to 55%... Given that most of the mortgages backing those bonds averaged only around 5.44%, and the five-year hybrid adjustable rate was only 5.2% - not enough to motivate refinancing - the pickup in prepayment speeds is somewhat counterintuitive. J.P. Morgan's conclusion: 'There likely continues to be a steady pace of cash-out activity," or borrowers refinancing out of 30-year loans into new loans, possibly interest-only or adjustable rate loans...'"

April 5 - The Wall Street Journal (Ryan Chittum): "Average office rents rose in the first quarter for the first time in four years, according to a survey, as businesses continued to add jobs and take new space. The vacancy rate, meanwhile, dropped to its lowest level in nine quarters."

The Fed's Dilemma

Due to time constraints, I will attempt to employ brevity. (I will return to my usual rambling next week.)

I believe the coming weeks in the markets - and perhaps next week in particular - will be decisive. I sense a lot of "hoping" by market participants. And markets are not typically accommodative to those clinging to hopes and prayers. There is hope that a slowing U.S. and global economy will stem escalating global inflationary pressures and bail out the highly leveraged and speculative U.S. bond market. There is hope that the darkening clouds of financial scandal and systemic fragility will spook the Fed, state attorneys general, OFHEO, the regulatory community and Congress into forbearance and passivism. There's also a lot of hope that U.S. equities will be able to muster the much anticipated rally. There is similarly much hope that the recent shallow decline in yields is not the best the bond bear has to offer. There is, as well, hope that the dollar has stabilized.

All the complacency and hopefulness has left curiously little room for fear. I've always appreciated the old adage, "You know you're in a bear market when people are losing money but feeling pretty good about it." It seems especially pertinent today in various markets. After all, acute market vulnerability manifests most forcefully from an environment where the fanatical crowd has begun to part with its money yet clutches to the notion that fundamentals are sound and the worst has passed. And when the crowd is highly leveraged with bets in myriad markets - as it is to unparalleled extremes these days - it is appropriate to think in terms of systemic fragility and instability. Sensing a high degree of concerted hoping in various markets leads me to believe that the next bout of selling may prove decisive. If a series of (seemingly vulnerable) bets falter simultaneously - say, rates rise, stocks drop, the currencies and commodities break big one way or the other, and spreads widen - the big loser would be systemic liquidity.

I am not comforted by the general perception of the underlying soundness of the U.S. economy and financial system, while the markets' complacency with regard to the scandal unfolding throughout the U.S. financial sector is rather amazing. Yesterday's discussion between CNBC's Ron Insana and the astute Jim Chanos regarding the similarities of AIG to Enron should have been good enough for a few hundred points down on the Dow - at least.

Taking a step back for a moment and contemplating the financial world, one is left with a sense that "contemporary finance," as we have come to know it, has commenced a radical shakeout. The scope of the problem is staggering. There is Fannie and Freddie, with their combined books of business of $3.8 Trillion backed (hopefully) by a little sliver of shareholder's equity. Troubled GM and Ford have total liabilities of $740 billion with equity stated at $45 billion and absolutely dismal prospects. AIG has total liabilities of almost $700 billion (SH Equity of $83bn). Combined, these five companies' exposure of almost $5.3 Trillion is in the neighborhood of 30 times reported equity. In the best of times, there was no room for error or chicanery. These may be the worst. And one does not want to forget MBIA. This troubled risk guarantor has written insurance - "Net Debt Service Outstanding" - of $890 billion, with shareholder's equity of $6.6 billion. To witness such a massive and pervasive Credit system problem at this pinnacle stage of system excess and asset inflation portends a devastating down cycle.

Now, I am the first to admit that the Credit system, immersed in Bubble "blow-off" excess, for now still packs sufficient punch to adequately finance the Bubble Economy and the Bubble Asset Markets. But this endeavor will become increasingly untenable. Underneath the Bubble facade, the New Age Risk Intermediation Scheme is increasingly impaired and susceptible to crisis. This has future ramifications for both Credit Availability and Marketplace Liquidity, something the stock market should increasingly begin to discount. And there is still the specter of the loss of U.S. financial sector integrity inciting a run on the dollar and U.S. securities. The indomitable GSE's "backstop bid" has simply vanished for the interest rate markets; how dependable is the foreign central bank "backstop bid" going forward in the currency markets?

And there is the important issue of a very serious dilemma developing for the Fed, as well as for the markets as they grapple with how the Fed may choose to deal with its predicament. One the one hand, a critical segment of the U.S. Credit system has been defiled and the systemic contagion risk is high. "Structured finance" is increasingly suspect. Yet, past experience provides marketplace solace that the Fed will err on the side of caution. On the other hand, the Mortgage Finance Bubble is running white hot in a text book speculative blow-off. The Fed, at this point, should be feeling the heat to raise rates sufficiently to rein in conspicuous and destabilizing Credit and speculative excess. Bonds are cheering (praying?) for Fed restraint, while the dollar is desperate for some real tightening of Credit conditions. My hunch is that the Fed may actually believe all its talk of "resiliency" and be ready to ratchet up rates and initially downplay signs of systemic stress. It is not easy for me to envisage a scenario that is supportive of inflated equity prices.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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