Bernanke and Yield Curve Analysis

By: Doug Noland | Fri, Feb 17, 2006
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For the week, the Dow gained 1.8%, and the S&P500 rose 1.6%. Economically sensitive issues were strong, with the Morgan Stanley Cyclical index rising 2.5% and the Transports gaining 1.9%. The Morgan Stanley Consumer index increased 1.8%. The broader market rally resumed, with the small cap Russell 2000 up 1.9% (up 8.6% y-t-d) and the S&P400 Mid-cap index gaining 1.2% (up 5% y-t-d). Earnings again weighed on big tech, with the NASDAQ100 gaining only 0.7% and the Morgan Stanley High Tech index up 0.8%. The Semiconductors fell 0.9%, reducing 2006 gains to 11.7%. The Street.com Internet Index added 0.3%, and the NASDAQ Telecommunications index rose 1.7% (up 12.4% y-t-d). The Biotechs jumped 4%, increasing y-t-d gains to 6.8%. The Broker/Dealers surged 3.6%, increasingly 2006 gains to 12.4%. The Banks rose 2.2% this week. With bullion up $1.10 to $552.10, the HUI gold index added 1%.

For the week, two-year Treasury yields dipped 2 bps to 4.66%. Five-year government yields declined 4 bps to 4.55%, and bellwether 10-year Treasury yields fell 5 bps to 4.54%. Long-bond yields declined 5 bps to 4.51%. The spread between 2 and 10-year yields "de-verted" 2 to an inverted 8 bps. Benchmark Fannie Mae MBS yields dipped 2 bps to 5.83%, this week slightly underperforming Treasuries. The spread on Fannie's 4 5/8% 2014 note narrowed 1.5 to 33.5, and the spread on Freddie's 5% 2014 note narrowed one to 35. The 10-year dollar swap spread narrowed 0.5 to 53.0. Investment-grade spreads were little changed, while junk spreads widened moderately this week. The implied yield on 3-month December '06 Eurodollars declined 1.5 bps to 5.05%.

For the week, investment grade issuers included Cisco Systems $6.5 billion, Residential Capital $2.25 billion, Istar Financial $1.0 billion, Comerica $500 million, Weatherford International $350 million, Dominion Resources $330 million, Vornado Realty $250 million, Hartford Life $250 million, and Foundation RE $105 million.

Junk issuers included Wind Acquisition $650 million, Steinway Music $175 million, and Solectron $150 million.

Convertible issuers included Amgen $5.0 billion.

Foreign dollar debt issuers included Rentenbank $1.0 billion and Shinsei Cayman $750 million.

February 15 - Bloomberg (Garfield Reynolds): "Russia auctioned 3.5 billion rubles ($120 million) worth of 30-year domestic bonds at an average yield of 6.99 percent, the longest-maturity debt sold in the Russian currency since the collapse of the Soviet Union... Investors placed bids for the 30-year bonds worth 22.4 billion rubles, or 6.47 times the amount sold, the central bank said..."

Japanese 10-year JGB yields sank 8.5 bps this week to 1.51%, as the Nikkei 225 index fell 3.3% (down 2.5% y-t-d). Emerging markets were generally strong. Brazil's benchmark dollar bond yields dropped 10 bps to 6.15%. Brazil's Bovespa equity index surged 4% (up 14.8% y-t-d). The Mexican Bolsa added 1%, with y-t-d gains of 3.8%. Mexican 10-year govt. yields dipped one basis point to 5.46%. Russian 10-year dollar Eurobond yields rose 4 bps to 6.57%. The Russian RTS index jumped 4.6%, increasing 2006 gains to 27% (one-yr. gain of 115%).

Freddie Mac posted 30-year fixed mortgage rates rose 4 bps to 6.28% (up 66 bps in a year) to a 9-week high. Fifteen-year fixed mortgage rates jumped 8 bps to 5.91% (up 77 bps in a year). One-year adjustable rates added 2 bps to 5.36%, an increase of 121 basis points from one year ago. The Mortgage Bankers Association Purchase Applications Index fell 7.3% last week. Purchase Applications were down 8.1% from one year ago, with dollar volume down 5.6%. Refi applications declined 6.5%. The average new Purchase mortgage slipped to $228,200, and the average ARM dipped to $336,200.

Broad money supply (M3) rose $9.3 billion to a record $10.280 Trillion (week of Feb. 6). During the past 38 weeks, M3 has inflated $654 billion, or 9.3% annualized. Over 52 weeks, M3 has expanded 8.2%, with M3-less Money Funds up 8.3%. For the week, Currency added $0.4 billion. Demand & Checkable Deposits fell $26.4 billion. Savings Deposits jumped $24.2 billion, and Small Denominated Deposits increased $2.6 billion. Retail Money Fund deposits slipped $0.6 billion, while Institutional Money Fund deposits rose $11.0 billion. Large Denominated Deposits declined $11.0 billion. Over the past 52 weeks, Large Deposits were up $264 billion, or 23.3% annualized. For the week, Repurchase Agreements jumped $12.6 billion. Eurodollar deposits declined $3.5 billion.

Bank Credit gained $2.8 billion last week (5-wk gain of $103bn) to a record $7.591 Trillion. Over the past 52 weeks, Bank Credit has inflated $676 billion, or 9.8%. For the week, Securities Credit declined $6.1 billion. Loans & Leases were up 12.0% over the past 52 weeks, with Commercial & Industrial (C&I) Loans up 15.3%. For the week, C&I loans declined $3.6 billion, while Real Estate loans expanded $8.9 billion. Real Estate loans have expanded at a 10.9% pace over the past 20 weeks and 14.5% during the past 52 weeks. For the week, Consumer loans were about unchanged, and Securities loans increased $7.6 billion. Other loans declined $4.3 billion.

Total Commercial Paper dropped $14.5 billion last week to $1.675 Trillion. Total CP is up $25.4 billion y-t-d (7wks), while having expanded $241 billion over the past 52 weeks, or 16.8%. Last week, Financial Sector CP borrowings declined $13.5 billion to $1.537 Trillion, with a 52-week gain of $247 billion, or 19.2%. Non-financial CP declined $1.0 billion to $137.7 billion, with a 52-week decline of 4.0%.

Asset-backed securities (ABS) issuance increased to $22.7 billion last week, including $11.9 billion of Home Equity Loan (HEL) ABS (from JPMorgan). Year-to-date ABS issuance of $94.6 billion is running 5% ahead of 2005's record pace. Year-to-date HEL issuance of $67.3 billion is 22% ahead of last year's record pace.

Fed Foreign Holdings of Treasury, Agency Debt jumped $12.6 billion to a record $1.557 Trillion for the week ended February 15. "Custody" holdings were up 16.5% annualized during the past 20 weeks and $214 billion (16.0%) over the past 52 weeks. Federal Reserve Credit expanded $6.7 billion to $816 billion. Fed Credit has expanded 5.0% annualized over the past 20 weeks and 4.1% over the past 52 weeks.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $458 billion, or 12.3%, over the past 12 months to a record $4.166 Trillion.

Currency Watch:

The dollar index was about unchanged for the week. On the upside, the South African rand rose 2.1%, the Brazil real 2.1%, the Chilean peso 1.2%, and the Romanian leu 1.1%. On the downside, the New Zealand dollar fell 1.5%, the Swedish krona 0.6%, the Indian rupee 0.6%, and the Philippines peso 0.6%.

Commodities Watch:

This week saw March crude oil decline $1.96 to $59.88. March Unleaded Gasoline gained 2.8%, while March Natural Gas fell 1.8%. For the week, the CRB index declined 1.6%, with a y-t-d decline of 1.7%. The Goldman Sachs Commodities index dipped 0.7% this week, with a y-t-d decline of 3.6%.

China Watch:

February 15 - XFN: "China has bought nearly 40% of new U.S. Treasury issuance in recent years... 'Without fund inflows from China, it would be impossible for the US to keep its interest rates at such a low level with its surging budget deficit,' Yi said...

February 14 - Bloomberg (Lee Spears): "China's money supply expanded at the fastest pace in two years in January, exceeding the central bank's official target for an eighth straight month. M2...grew 19.2 percent from a year earlier to 30.4 trillion yuan ($3.8 trillion) after expanding 17.6 percent in December, the People's Bank of China said..."

February 15 - MarketNew International: "Strong exports of electronic products boosted Chinese exports in the first month of the year, custom figures released Monday by the official Xinhua news agency show. Exports of electronic products rose 42.6% from a year earlier to $14.48 bln in January..."

February 16 - XFN: "China's January vehicle sales were up 44.62% year-on-year at 530,100 units, with passenger car sales surging 72.63% to 418,900 units, the official Xinhua news agency reported."

February 17 - Bloomberg (Hanny Wan): "Hong Kong's unemployment rate fell to the lowest in more than four years last month as restaurants boosted hiring during the Lunar New Year holiday. The seasonally adjusted jobless rate dropped to 5.2 percent..."

Asia Boom Watch:

February 17 - Bloomberg (Lily Nonomiya): "Japan's economy grew five times faster than the U.S. in the fourth quarter as exports climbed and growth in consumer spending doubled. The world's second-largest economy expanded at an annual 5.5 percent pace in the three months to Dec. 31..."

February 16 - Bloomberg (Cherian Thomas and Bibhudatta Pradhan): "India's economy may grow faster than 8 percent in the year ending March 31 and this expansion will be a 'precursor to better times in future,' President A.P.J. Abdul Kalam said. 'Our economy is on the move and people are on the march,' Kalam told lawmakers..."

February 14 - Bloomberg (Kartik Goyal): "India's exports rose 21 percent in January to $8.45 billion, the Commerce and Industry Ministry said... Imports rose 10.6 percent to $11.36 billion in January, narrowing the trade deficit to $2.9 billion from $3.3 billion a year ago, the ministry said."

February 16 - Bloomberg (Heejin Koo): "South Korea's January jobless rate fell to 3.4 percent, a 22-month low, adding to expectations that growth in Asia's third-largest economy is picking up."

February 16 - Bloomberg (Shamim Adam and Chan Sue Ling): "Singapore's economy expanded at a 12.5 percent annual pace in the fourth quarter, faster than economists expected, after exports grew at a record pace in December... Singapore's government raised its 2006 growth forecast to as much as 6 percent after the economy expanded faster than economists expected in the fourth quarter on exports of electronics and drugs."

February 14 - Bloomberg (Stephanie Phang and Soraya Permatasari): "Malaysia's exports grew in December at the fastest pace in nine months as companies such as Malaysian Pacific Industries Bhd. shipped more electronics and higher oil prices lifted commodity sales. Exports rose 13.2 percent from a year earlier to 49.5 billion ringgit ($13.3 billion)..."

February 15 - Bloomberg (Aloysius Unditu and Arijit Ghosh): "Indonesia's economy expanded at the slowest pace in six quarters in the final three months of 2005 as higher borrowing costs curbed consumer spending. Southeast Asia's largest economy grew 4.9 percent from a year earlier after expanding a revised 5.6 percent in the third quarter..."

Unbalanced Global Economy Watch:

February 16 - Bloomberg (Ben Sills): "Inflation in Spain, Europe's fifth-largest economy, accelerated in January to its fastest pace in at least nine years as higher energy costs fed through into the price of other goods. Consumer prices rose 4.2 percent from a year ago..."

February 15 - Bloomberg (Tasneem Brogger): "Danish housing costs as a percentage of home owners' incomes in the fourth quarter reached the highest since at least 1998, Nykredit Bank A/S said."

February 15 - Bloomberg (Radoslav Tomek): "Slovak economic growth accelerated in the fourth quarter to the fastest pace in more than a decade as companies built new factories and boosted job creation. The economy grew an annual 7.5 percent..."

February 13 - Bloomberg (Tracy Withers): "New Zealand house prices rose 17 percent in January from a year earlier, accelerating for a third month, according to a report by Quotable Value New Zealand Ltd., the government valuation agency."

Latin America Watch:

February 15 - Bloomberg (Patrick Harrington): "Mexico's economic expansion slowed more than expected in the fourth quarter as consumer demand remained slack and hurricanes wiped out some bean, sugar and corn crops. Gross domestic product, the broadest measure of a country's output in goods and services, expanded 2.7 percent in the quarter from a year ago after growing a revised 3.4 percent in the third quarter..."

February 16 - Bloomberg (Katia Cortes and Herica Christian): "Brazil's government expects the economy to grow more than four percent this year, said Budget Minister Paulo Bernardo."

February 17 - Bloomberg (Daniel Helft): "Argentina's economy grew 9.1 percent in 2005, the fastest pace in 13 years, as a surge in government spending boosted domestic demand and exports such as soybeans, oil and steel jumped to a record high."

February 17 - Bloomberg (Alex Kennedy): "Venezuela's economy grew for a ninth quarter...as increased government spending fueled consumer demand, the central bank said. Gross domestic product, the broadest measure of a country's production of goods and services, expanded 10.2 percent in the fourth quarter from the year-earlier period..."

February 15 - Bloomberg (Alex Emery): "Peru's economy expanded a faster-than-expected 7.4 percent in December, led by surging output of gold, silver and natural gas. The annual growth rate rose to an eight-year high of 6.7 percent."

Bubble Economy Watch:

January Retail Sales were up 8.9% from January 2005, with Sales Ex-Autos up 9.8%. Leading sectors included Gasoline Station sales were up 22.0%, Building Materials 17.6%, Furniture 9.5%, Electronics 6.9%, Health, Personal Care 8.1%, and Eating & Drinking Establishment 10.2% y-o-y. At an annualized pace of 2.276 million, January Housing Starts were at the strongest (seasonally-adjusted) pace since March 1973. January Import Prices were up 8.8% y-o-y. The Philly Fed general activity index rose in February to the highest level since August.

February 15 - PRNewswire: "Despite an uptick in mortgage rates and signs of a lull in economic growth, existing single-family homes in Florida reached a statewide median sales price of $246,300 for fourth quarter 2005, an increase of 29 percent over the median price of $190,700 in fourth quarter 2004, according to the Florida Association of Realtors. For fourth quarter 2000, the statewide median sales price was $117,400, which marks an increase of about 109 percent over the five-year period..."

February 16 - Bloomberg (Patrick Cole and Liz Willen): "New York parents sending their kids to some of the city's elite high schools this fall will pay more than $30,000 for the first time. Riverdale Country School boosted tuition 5.8 percent to $31,200..."

February 16 - Bloomberg (Linda Sandler): "Laurence Graff, a London jeweler, paid a record $425,000 a carat for a ruby in the Swiss resort of St. Moritz yesterday, smashing the previous record of $275,000 and indicating demand for precious stones is still increasing. Graff, whose flagship store is on New Bond Street, paid $3.6 million for the 8.62-carat stone at a Christie's International auction that raised $16.7 million, 37 percent more than Christie's St. Moritz sale a year ago..."

Mortgage Finance Bubble Watch:

February 15 - Bloomberg (Kathleen M. Howley): "The cost of repairing 95,000 New Orleans houses damaged by Hurricane Katrina and the flooding that followed will range from $8 billion to $10 billion, Mortgage Bankers Association said..."

Speculator Watch:

February 16 - Financial Times (Tony Tassell): "Hedge funds made a strong start this year, posting their best monthly returns for more than five years last month. After a lacklustre 2005, January saw a sharp recovery in investment returns, even in some of the more beleaguered investment strategies such as convertible arbitrage. The Credit Suisse/Tremont Hedge Fund Index rose by 3.23 per cent in January, propelled by strong gains in funds betting on emerging markets, macro-economic trends and events such as takeovers."

Financial Sphere Watch:

February 16 - American Banker (Barbara A. Rehm): "Thrifts regulated by the Office of Thrift Supervision earned a record $4.3 billion in the fourth quarter, 7% more than the third quarter and 15% more than a year earlier..."

Bernanke and Yield Curve Analysis:

It was my intent to devote this week's Bulletin to Chairman Bernanke's Washington testimony. I thought he did a nice job, but in the process provided me less "material" than anticipated. He resisted temptation to pander to the "gentle ben" crowd and generally kept to the "middle of the fairway" of Greenspan Federal Reserve doctrine. It even slipped out that, in regard to the Current Account Deficit, "the immediate implication...is that the U.S. economy is consuming more than it's producing. And the difference is being made up by imports from abroad, which in turn are being financed by borrowing from abroad. So the concern is that, over a period of time, we will be building up foreign debt to other countries which, all else equal, lowers national wealth and lowers our ability to consume in the future." I appreciate these comments and give Credit where Credit is due.

Ohio Representative Michael Oxley: "Mr. Chairman. Let me begin by saying, there's been a lot written and a lot discussed about - and as a matter of fact, your predecessor described it as a conundrum - the whole issue of rate inversion. The conundrum being that when you raise the short-term rates, the long-term rates don't respond accordingly. And I think it was interesting that Chairman Greenspan, at least on more than one occasion, I think, described that as a conundrum. Is it a conundrum or is it a major problem going forward with the economy, or is the economy strong enough to do that? I know you addressed that in your prepared testimony. I wonder if you could expand on that issue.

Chairman Bernanke: Mr. Chairman, the conundrum is a very interesting question. The issue is that unusually long-term interest rates are lower than short-term interest rates, so we have an inverted yield curve. There are at least two broad sets of reasons for why that's occurring.

The first is that term premiums, the premiums that investors charge for holding long-term debt, have fallen in recent years, reflecting a variety of influences, including, I believe, greater confidence that inflation will be kept low, greater stability in the economy more generally, and additional influences such as demand for duration, the idea that pension funds, for example, are looking for longer-term assets to hold. So the term premium has come down, therefore the normal term structure is going to be flatter now than it was in the past.

The second factor, and one that I've talked about myself in some speeches, is that currently there are a lot of savings in the global capital markets looking for returns. That appears to have driven down, to some extent, the real return to capital around the world. And that factor also has contributed to lowering long-term real interest rates. And as we can see, it's a global phenomenon. We're seeing inversion in other countries. We're seeing lower long-term real interest rates in other countries. The question arises is whether or not this inversion portends a slowdown in the real economy.

Historically, there has been some association between inversion of the yield curve and subsequent slowing of the economy. However, I think at this point in time that the inverted yield curve is not signaling a slowdown. First, the historic relationship has certain weakened in the last 15 years or so. But more importantly, in the past, when the inverted yield curve presaged a slowdown in the economy, it was usually in a situation where both long-term and short-term interest rates were actually quite high in real terms, suggesting a good bit of drag on the economy. Currently, the short-term real interest rate is close to its average level and the long-term real interest rate is actually relatively low compared to historical norms. And so with the real interest rate not creating a drag on economic activity, I don't anticipate that the term structure is signal of oncoming slowing of the economy."

I included the following Hyman Minsky quote in a December 2001 Bulletin titled "Financial Arbitrage Capitalism:"

"In both Keynes and Schumpeter the in-place financial structure is a central determinant of the behaviour of a capitalist economy. But among the players in financial markets are entrepreneurial profit-seekers who innovate. As a result these markets evolve in response to profit opportunities which emerge as the productive apparatus changes. The evolutionary properties of market economies are evident in the changing structure of financial institutions as well as in the productive structure. In the Theory of Economic Development, Schumpeter called the banker/financier the ephor of market economies. The ephor was a magistrate of Sparta who contained and controlled the kings. In Schumpeter's vision it is the banking structure of a capitalist economy which controls and delineates what can be financed, and only that which is financed enters the realm of the possible. But nowhere is evolution, change and Schumpeterian entrepreneurship more evident than in banking and finance and nowhere is the drive for profits more clearly the factor making for change. But in an evolutionary system the power and efficacy of the ephor is also endogenously determined. To understand the short-term dynamics of business cycles and the longer-term evolution of economies it is necessary to understand the financing relations that rule, and how the profit-seeking activities of businessmen, bankers and portfolio managers lead to the evolution of financial structures."

"Financial Arbitrage Capitalism" is, within the framework of Minsky's "Wall Street Paradigm", an evolution from "Money Manager Capitalism." My premise is that "financiers" (chiefly leveraged speculators) seeking financial spread profits (playing interest-rate differentials and Credit spreads and generally funding these speculations through securities finance arrangements) are today's "magistrates" of financial and economic development. To better understand today's extraordinary economic backdrop it is first helpful to appreciate the governing financing arrangements and relationships. I was pleased to hear Governor Bernanke's analysis that he doesn't believe the inverted yield curve is indicating economic weakness. Instead, stubbornly low global real long-term rates are among some profound manifestations directly the consequence of today's highly unusual global Credit mechanisms and financial structures.

Examining the current domestic economic backdrop, we see that January Retail Sales were up 8.9% from the year-earlier period. Housing starts for the month were at the highest level since 1973, and overall construction remains at record levels. January Producer Prices were up 5.7% y-o-y. Exports are currently running at record levels, yet Current Account Deficits are of unprecedented dimensions. Capacity Utilization is near the highest rate in five years. At 4.7%, January's Unemployment Rate was the lowest since July 2001. Wages are rising at the fastest rate in at least several years. And from Treasury data we know that January Individual Income Tax Receipts were up 16.9% from January 2005. Four months into the new fiscal year, year-to-date federal Individual Income Tax Receipts are running an eye-opening 10.8% above the year-ago level. Total y-t-d Government Receipts are running 10.3% ahead, nonetheless with a projected deficit of $400 billion.

A solid case can be made that 14 rate increases have failed to tighten monetary conditions. Despite the inverted yield curve, credit conditions are generally as loose as ever and, as one would expect, imbalances balloon only larger. Of course, the bond bulls will contend that we are merely waiting patiently for the traditional monetary policy lags to run their course. I suggest there's much more to it than that. The bulls will argue that we simply have to hold tight just a little longer for weakening housing markets to work their magic. I contend it's anything but that simple.

The entire analytical basis for this long and drawn out "baby step" process of rate "normalization" rests upon the presumption of acute systemic fragilities, frailty associated with a highly leveraged financial system and economy. Yet it should be by this time undeniable that "Financial Arbitrage Capitalism" - the nucleus embodied by enterprising global "money center" banks, Wall Street and global securities firms, hedge funds, proprietary traders, the ABS and MBS markets, derivatives markets, and "financial engineering" generally - comprises a Herculean financial apparatus. On one hand, these profit-seeking purveyors of prodigious Credit, speculation and asset inflation rest upon fragile underpinnings - sustainability issues, aka "inflate or die." However, never in history has there been a Credit mechanism with greater capacity (unrestricted electronic "money" and "money"-like Credit) and overwhelming widespread support to lend and speculate. Never. To accommodate such financial structures - as the Fed and global bankers have clearly done - is to guarantee problematic excess and unwieldy Bubbles.

Importantly, today's "Financial Arbitrage" commanded marketable-securities Credit apparatus responds, adjusts and adapts to monetary policy all-together differently than traditional Bank loan-centric systems did in the past. Indeed, it is the very nature of "structured finance" to adapt to and aggressively exploit changing market conditions to an extent previously unimaginable. Moreover, contemporary (securities and non-bank based) finance enjoys no inherent restraint, in contrast to the bank deposit and capital reserve era of days long past. And, importantly - for the traditional Credit system governed by the financing of capital investment - diminishing rates of return imposed Credit and spending restraint. For one, excessive investment over time worked to depress profitability (both within the Economic Sphere and Financial Sphere). Secondly, monetary policy tightening exacted moderation by immediately increasing the cost of funds, thereby reducing the profitability of marginal borrowing, lending and speculating.

In contrast, predictable moderate rate increases these days have marginal impact on either financial or economic profits. For the ballooning leveraged speculating community, narrowing interest-rate spreads have in all likelihood encouraged only greater leveraging. Throughout the behemoth mortgage lending juggernaut, declining returns foster easier Credit terms and the aggressive pursuit of lending volume. And with late-stage Credit Bubble liquidity inundating corporate America, rising short-term rates have been immaterial to surging profitability. Throughout the Unchecked Financial Sphere, intense competition has nurtured ultra-easy Credit Availability and Marketplace Liquidity Overabundance, irrespective of short-term rates.

Asset market-based (as opposed to capital investment) lending and speculating is the centerpiece of "Financial Arbitrage Capitalism." And, as we have witnessed, as long as asset inflation exceeds the (after-tax) cost of funds, "baby-step" rate increases may actually turn only more accommodating over-time (overcome by "goliath-step" asset price inflation). Yet, and as we observe nowadays, there is the prevailing expectation that eventually the rising cost of funds will catch decelerating asset (home) inflation and impose restraint.

This comforting hope, however, overlooks a discomforting fundamental dynamic of processes intrinsic to "Financial Arbitrage Capitalism:" As long as the Credit cycle is in an expansive mode (boom-time inflationary psychology), the bloated marketplace and financial apparatus will continually evolve to fund myriad new strains of asset inflation and other inflationary manifestations (inflation begets inflation; Credit excess begets additional Credit). Yes, household mortgage debt growth may actually moderate somewhat this year. At the same time, however, our Credit system is already well on its way to (over)financing mergers & acquisitions; the huge energy and commodities sectors; U.S. corporate needs generally (including enormous stock buybacks); unlimited global borrowing requirements; commercial real estate; state and local governments; and, of course, our gluttonous federal government. It is very unlikely that, at current market yields and Credit Availability, a slowing housing market will impose sufficient restraint on either economic activity or marketplace liquidity.

It is worth noting that broad money supply has rapidly approached $10.3 Trillion. It is also worth pondering that M3 has inflated almost 40% since Fed funds were last at 4.50% (May 2001). At a 5% rate, M3 savers will receive more than $500 billion of interest-income, a huge increase from only a couple years back when rates were 1% and M3 was significantly smaller. There is scant attention paid to this source of augmented income, with analysts instead focusing on the restraining effect of adjustable-rate mortgage resets. But with the ongoing proliferation and easy-availability of mortgage products with low initial payments (teaser-rate ARMs, negative amortization and option-ARMs, and balloon structures), I would be surprised if the household sector in aggregate experiences a significant increase in monthly mortgage payments this year.

Thinking back to the rather brutal 1994 tightening cycle (M3 about $4 Trillion), the augmented household income associated with rising rates was more than offset by the significant hit to wealth suffered at the hands of a vicious bond bear market. Remarkably, and seemingly by design, short-term rates have to this point risen concurrently with the inflating value of most asset classes; even the bond market has posted positive returns. Thus far, is has been a New Paradigm case of monetary policy and asset market management: Our highly indebted economy experienced an unparalleled increase in financial asset wealth during the Fed-orchestrated interest rate collapse ("reflation"), only to enjoy additional spectacular asset price gains during the subsequent rate "normalization" (but continued massive Credit inflation!). There are powerful dynamics at work, and traditional analysis will continue to prove rather unhelpful.

In terms of the sectoral flow of finance, rising rates will now create additional purchasing power for the saver. But because of the nature of the current financial apparatus, it is not easy to discern who will suffer a reduction of purchasing power. The household sector will increase total borrowings more than enough to finance the reset mortgage payments, for now likely to impose limited restraint on spending. Similarly, the government will simply issue more Treasury securities to finance its higher borrowing costs, while continuing to inflate outlays.

Within the Financial Sphere, the leveraged speculators have acclimatized to higher borrowing costs either with rising interest income or (in the case of narrowing spreads) with additional leveraging. And since a key aspect of recent "Financial Arbitrage Capitalism" financial structures is lending short-term against variable-rate securities ("Borrow Short, Lend Short"), higher funding costs are matched by rising yields from speculative holdings. Nobody loses and no one is forced to de-leverage, that is as long additional massive Credit creation and liquidity is forthcoming. Across the board, one can envisage the deleterious processes of monetization and imbedded inflation.

Despite a series of Federal Reserve rate increases, the current Asset-Based Global Securities Credit Mechanism is generating unparalleled levels of new Credit and liquidity. No meaningful restraint has yet been imposed and, excluding possible financial crisis, none appears in the offing. Financial conditions are extraordinarily loose almost everywhere, and these days liquidity will flow from wherever it is available at the lowest expected cost (i.e. today Japan). The global securities financial apparatus now operates across national borders and outside the purview of individual central banks. When the Fed bumps up rates, enterprising speculators and their brokers and/or derivative salespersons simply look overseas for cheap funding sources. An applicable yield curve would today be steeply upward sloping, incorporating the nominal expected cost of borrowing short-term in yen.

The problems inherent to the current global financial apparatus are many, although the seeming advantages are today much more conspicuous (at least to the speculators). Moderate Federal Reserve rate increases are largely ineffective with respect to tightening Credit and liquidity conditions, or for imposing even a modicum of financial discipline. Moreover, the higher rates are now pushed the more enticing international interest-rate differentials become. Leveraged speculators - and the derivatives markets generally - have evolved into major (unstable) accumulators of dollar assets, in the process sustaining the massive inflation of dollar claims.

Aggressive concerted central bank rate increases would today be required to tighten the extreme loose financial conditions that reign globally. This would clearly be deemed unjust and unacceptable by the less robust economies, a natural and predictable consequence of Credit Bubbles' uneven effects and unjust redistributions of wealth. Global securities finance has evolved to the point where there is neither policymaker accountability nor responsibility.

And while my focus has been on Financial Sphere effects, let's not lose sight that the current "financial structure is a central determinant of the behavior of a capitalist economy." Current financial structures continue to foster historic asset inflation, over-consumption, and mal-investment throughout the U.S. real economy, manifesting into untenable but precariously self-reinforcing Current Account Deficits. And throughout Asia, commanding financial structures continue to champion massive over-investment in export capacity. And now the oil producers experience a massive inflationary stimulus. At home and abroad, the current Credit apparatus has no propensity for adjustment or self-correction.

The bottom line is that massive dollar flows emanating from U.S. Current Account Deficits are recycled back to top-rated U.S. securities markets - the very markets operating as the financing linchpin for securities-based "Financial Arbitrage Capitalism." And here we find what I believe is the most convincing explanation for The Conundrum: Massive U.S. Credit creation and resulting Current Account Deficits creating unprecedented global liquidity excess that is recycled through international financing networks directly back to a limited supply of liquid, "money"-like dollar securities. The (over-liquefied) marketplace for contemporary "money" then provides the baseline, a virtually unlimited source of cheap finance (through the "repo" market and securities shorting) for which to arbitrage higher-yielding securities and assets. And this (John Law-style) Credit mechanism works miraculously until it doesn't.

Global securities finance is the centerpiece - the fountainhead of "Financial Arbitrage Capitalism." These financial structures have matured to become only more powerful, commensurate with the concurrent global inflation in U.S. and international securities markets. It is unlike any financing environment since the "Roaring Twenties." And it is imperative to appreciate that this Global Credit Mechanism is fomenting highly aberrant and divergent inflationary manifestations. Don't be fooled by benign CPI or the somewhat inverted U.S. term structure of interest rates. Contemporary Yield Curve Analysis is Global Financial Structures and Liquidity Flow Analyses. And, just perhaps, Chairman Bernanke is moving up the learning Curve.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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