What Difference Does a Year Make

By: Doug Noland | Sat, Jun 3, 2006
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For the week, the Dow gained 0.4%, and the S&P500 rose 1.2%. Economically sensitive sectors generally outperformed. The Transports rose 2.5%, and the Morgan Stanley Cyclical index gained 1.6%. The Utilities surged 4%, and the Morgan Stanley Consumer index added 0.4%. The broader market rallied. The small cap Russell 2000 jumped 1.6% (up 9.5% y-t-d), and the S&P400 Mid-cap index jumped 2.4% (up 5.7% y-t-d). Technology stocks continue to lag. The NASDAQ100 gained 0.8%, and the Morgan Stanley High Tech index added 0.6%. The Semiconductors rose 2.5%, and the NASDAQ Telecommunications index advanced 1.3% (up 13.2% y-t-d). The Street.com Internet Index dipped 0.5%. The Broker/Dealers gained 1.8% (up 10.8% y-t-d), and the Banks rose 1.4% (up 6.6% y-t-d). Although bullion declined $14.90, the HUI gold index rallied 2.9%.

For the week, two-year Treasury yields dipped 3 bps to 4.91%, and five-year yields declined 4 bps to 4.90%. Bellwether 10-year yields dropped 6 bps to 4.99%. Long-bond yields fell 6 bps to 5.10%. The 2yr/10yr spread ended the week at a positive 8 bps. Benchmark Fannie Mae MBS yields declined 8 bps to 6.16%, this week outperforming Treasuries. The spread on Fannie's 4 5/8% 2014 note ended the week one bp narrower at 25, and the spread on Freddie's 5% 2014 note was one bp narrower at 27. The 10-year dollar swap spread increased 0.5 to 55.25. Corporate bond spreads were little changed, with junk spreads narrowing slightly. The implied yield on 3-month December '06 Eurodollars declined 3.5 bps to 5.305%.

Investment grade issuers included JPMorganChase $5.0 billion, Credit Suisse $2.7 billion, Citigroup $600 million, BB&T $600 million, Connecticut Light & Power $250 million, Ryland $250 million, Post Apartments $150 million, United Dominion Realty $125 million, Washington REIT $100 million, and TTX $100 million.

Junk issuers included Harrahs $750 million, Trinity Industries $450 million, Pogo Producing $450 million, and Beazer Homes $275 million.

Convert issuers included Cubist Pharmaceuticals $350 million.

May 31 - The Wall Street Journal (Michael M. Phillips): "Developing nations are growing increasingly dependent on cheap foreign capital, a situation that some economists warn is reminiscent of the lead-up to the financial meltdown of the late 1990s. In a report to be released today, the World Bank calculates that private investors plowed a record $491 billion into developing-country stocks, bonds, factories and other assets last year, up from $397 billion the previous year."

Japanese 10-year JGB yields jumped 5.5 bps this week to 1.905%. The Nikkei 225 index declined 1.1% (down 2.0% y-t-d). German 10-year bund yields rose 4.5 bps to 3.92%. Emerging markets were mixed. Brazil's benchmark dollar bond yield rose 4 bps to 7.20%. Brazil's Bovespa equity index declined 1.8%, reducing 2006 gains to 13.4%. The Mexican Bolsa dipped 0.8% for the week (up 9.1% y-t-d). Mexico's 10-year $ yields fell 10 bps to 6.27%. Russian 10-year dollar Eurobond yields gained 1.5 bps to 6.85%. The Russian RTS equities index rallied 2.6%, increasing 2006 gains to 36% and 52-week gains to 127%. India's Sensex equities index was wild, ending the week down 3.3% (up 11.2% y-t-d).

Freddie Mac posted 30-year fixed mortgage rates jumped 5 bps to 6.67%, up 105 basis points from one year ago to the highest level since June 2002. Fifteen-year fixed mortgage rates added 3 bps to 6.26%, 106 bps higher than a year ago. One-year adjustable rates surged 7 bps to 5.68%, an increase of 144 bps over the past year to the highest level since August 2001. The Mortgage Bankers Association Purchase Applications Index was about unchanged for the week. Purchase Applications were down 14.2% from one year ago, with dollar volume down 11.9%. Refi applications dropped 4.8% last week. The average new Purchase mortgage increased to $229,400, while the average ARM jumped to $349,300.

Bank Credit rose $16.9 billion last week to a record $7.918 Trillion, with a y-t-d gain of $412 billion, or 13.6% annualized. Bank Credit inflated $754 billion, or 10.5% over 52 weeks. For the week, Securities Credit fell $4.3 billion. Loans & Leases jumped $21.2 billion for the week, with a y-t-d gain of $249 billion (11.3% annualized). Commercial & Industrial (C&I) Loans have expanded at a 15.7% rate y-t-d and 12.5% over the past year. For the week, C&I loans dipped $0.3 billion, while Real Estate loans jumped $11.0 billion. Real Estate loans have expanded at a 10.7% rate y-t-d and were up 12.9% during the past 52 weeks. For the week, Consumer loans added $2.1 billion, while Securities loans slipped $0.4 billion. Other loans were up $8.8 billion. On the liability side, (previous M3 component) Large Time Deposits were unchanged.

M2 (narrow) "money" supply jumped $24.8 billion to $6.804 Trillion (week of May 22). Year-to-date, narrow "money" has expanded $115 billion, or 4.2% annualized. Over 52 weeks, M2 has inflated $306 billion, or 4.7%. For the week, Currency added $1.1 billion. Demand & Checkable Deposits gained $10.1 billion. Savings Deposits rose $6.1 billion, and Small Denominated Deposits increased $3.0 billion. Retail Money Fund assets gained $4.5 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, fell $10.6 billion last week to $2.064 Trillion. Money Fund Assets have increased $17.3 billion y-t-d, with a one-year gain of $176 billion (9.3%).

Total Commercial Paper jumped $18.8 billion last week to $1.788 Trillion. Total CP is up $139 billion y-t-d, or 19.9% annualized, while having expanded $280 billion over the past 52 weeks (16.6%).

Asset-backed Securities (ABS) issuance slowed to $8 billion. Year-to-date total ABS issuance of $296 billion (tallied by JPMorgan) is running slightly ahead of 2005's record pace, with y-t-d Home Equity Loan ABS sales of $205 billion 7% above last year.

Fed Foreign Holdings of Treasury, Agency Debt ("US marketable securities held by the NY Fed in custody for foreign official and international accounts") declined $2.0 billion to $1.615 Trillion for the week ended May 31st. "Custody" holdings are up $95.5 billion y-t-d, or 14.9% annualized, and $188 billion (13.2%) over the past 52 weeks. Federal Reserve Credit rose $4.1 billion to $827.0 billion. Fed Credit has increased $567 million y-t-d, or 0.2% annualized. Fed Credit increased 4.4% ($34.5bn) during the past year.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - are up $388 billion y-t-d (22.7% annualized) and $589 billion (15.3%) in the past year to $4.3 Trillion.

Currency Watch:

June 1 - Bloomberg (Mayumi Otsuma and Tatsuo Ito): "Imbalances of global trade shouldn't be addressed only by the adjustment of foreign-exchange rates, Japan's Finance Minister Sadakazu Tanigaki said. 'We would deviate from the right track if we depended on the adjustment of currencies alone' to correct lopsided flows of trade and investment, Tanigaki told reporters..."

The dollar index sank 1.4% this week. On the upside, the Swedish krona jumped 2.5%, the Iceland krona 2.3%, the Norwegian krone 2.2%, the Swiss franc 1.5%, the Danish krone 1.5%, and the Euro 1.5%. On the downside, the Turkish lira declined 5.0%, the South African rand 2.2%, Mexican peso 1.6%, and Brazilian real 1.5%. Russia's ruble this week traded to a six-year high.

Commodities Watch:

June 1 - Bloomberg (Saijel Kishan and Choy Leng Yeong): "Olav Refvik and George 'Beau' Taylor are the new benchmarks on Wall Street. Morgan Stanley's Refvik, the firm's head oil trader, and JPMorgan Chase & Co.'s Taylor, who runs global energy, probably have annual incomes of at least $10 million, according to executive recruiters. Like other top commodity traders, they're making five times more than in 2000..."

For the week, Gold fell 2.3% to $638.80, and Silver dropped 5.1% to $12.09. Copper was hit for 6%. Energy markets were a different story. July crude jumped 96 cents to $72.33. July Unleaded Gasoline jumped 3.9%, and July Natural Gas gained 7.6%. For the week, the CRB index added 0.6% (y-t-d up 5.5%). The Goldman Sachs Commodities Index (GSCI) gained 0.9%, increasing y-t-d gains to 11.7%.

Japan Watch:

May 31 - Bloomberg (Megumi Yamanaka): "Japan, the world's largest oil user after the U.S. and China, said oil imports rose for a third straight month in April, gaining 14 percent from a year earlier."

May 30 - Bloomberg (Lily Nonomiya and Jason Clenfield): "Japan's industrial production rose to a record in April and unemployment stayed at a seven-year low as manufacturers expanded automobile and electronics factories. Production climbed a seasonally adjusted 1.5 percent... The jobless rate was unchanged at 4.1 percent for a third month..."

China Watch:

May 29 - Reuters (Emma Graham-Harrison and Chen Aizhu): "China's apparent demand for oil climbed 10.8 percent in April from a year earlier, the strongest rise since 2004, after an increase in state-set fuel prices encouraged refiners to boost supplies to the domestic market. The world's second-largest oil consumer used 6.69 million barrels per day (bpd) last month..."

May 29 - Bloomberg (Ying Lou): "China's increasing number of vehicles will help sustain gains in oil demand in the world's second-largest energy consumer, the International Energy Agency said. Surging transportation needs, prompted by the fastest growth rate of any major economy will probably hinder China's efforts to curb oil demand and imports... Car sales in China, the world's third-largest vehicle market, may rise to a record 6.5 million units this year..."

May 31 - Bloomberg (Yanping Li): "China's economy will grow by about 10 percent this year, the central bank said, adding that investment is growing too quickly, threatening to stoke inflation."

June 1 - Bloomberg (Christina Soon and Yanping Li): "China should use its foreign-currency reserves, the world's largest, to buy gold and oil as a hedge to guard against the risk of a sudden drop in the U.S. dollar, said a member of the central bank's advisory board. China has about 1 percent of its reserves in gold, compared with more than 70 percent in the U.S., and rising demand may add to gains in the metal this year that pushed prices to a 26-year high. Booming exports and investment doubled Chinese reserves to $819 billion in the past two years..."

May 31 - Bloomberg (Christina Soon and Yanping Li): "China's central bank said it will start withdrawing from the country's currency market, allowing investors a greater role in setting exchange rates... 'The frequency and strength of the central bank's open market currency operations will gradually weaken and be phased out,' the bank said in its quarterly monetary policy report."

May 29 - Bloomberg (Irene Shen and Yanping Li): "China's government raised the minimum down payment for larger apartments to 30 percent and more than doubled the period during which a sales tax will apply, stepping up efforts to cool surging property prices. The down-payment ratio for apartments measuring more than 90 square meters (969 square feet) will be raised from 20 percent effective June 1..."

May 29 - Bloomberg (Ying Lou and Yanping Li): "General Electric Co...said sales in China may rise 20 percent this year as government policies to curb pollution spur demand for cleaner engines and power stations. Sales may climb to more than $6 billion in China, Jeffrey Immelt...said... Revenue in the world's fastest-growing major economy has surged fivefold since 2001."

May 29 - Bloomberg (Le-Min Lim): "A 1960 oil painting by China-born Chu Teh-Chun led a Hong Kong auction of Asian modern art by Christie's International Plc that fetched a total of HK$353 million ($45.5 million), double the amount expected. 'Village de pluie rouge, Maison de nuage blanc No. 53' by Paris-based Chu went to an unidentified Asian collector for HK$25.9 million, four times the top-end estimate, Christie's said. 'Amnesia and Memory: Boy,' a 2005 oil-painting by Zhang Xiaogang fetched HK$3.5 million ($451,243), 12 times the official top estimate at yesterday's sale."

June 1 - Bloomberg (Nipa Piboontanasawat): "Hong Kong's retail sales unexpectedly grew at a faster pace in April as rising incomes left consumers with more to spend. Sales climbed 9.4 percent from a year earlier..."

Asia Boom Watch:

May 31 - Bloomberg (Cherian Thomas): "India's economy grew at the fastest pace in more than two years last quarter as bumper harvests and hiring at computer-related companies spurred spending on housing and mobile phones. Asia's fourth-biggest economy expanded 9.3 percent in the three months ended March from a year earlier..."

June 1 - XFN: "South Korean exports surged 21.1% year-on-year to a record $28 bln in May, supported by higher prices of oil products and stronger global demand for TFT-LCDs, cars and ships, the Ministry of Commerce, Industry and Energy said."

May 31 - Bloomberg (Stephanie Phang): "Malaysia's economy expanded at a faster-than-expected pace in the first three months of the year... Southeast Asia's third-largest economy grew 5.3 percent in the first quarter from a year earlier after a 5.2 percent gain..."

May 31 - Bloomberg (Laurent Malespine): "Thailand's economy grew more than 5 percent in the first quarter, Finance Minister Thanong Bidaya said..."

May 30 - Bloomberg (Subramaniam Sharma): "Neville Tuli is looking for $33.5 million to invest in what may be India's hottest market: Art. Soaring prices for contemporary Indian works prompted the chairman of Mumbai-based Osian's Connoisseurs of Art Ltd. to start the nation's second art investment fund. Osian, with sale rooms in New Delhi and Mumbai, will start raising money on June 5, Tuli said..."

Unbalanced Global Economy Watch:

May 30 - Bloomberg (Rich Miller and Simon Kennedy): "The fastest global economic growth in more than three decades is stoking inflation worldwide and raising the chances of a hard landing as central banks act to combat the mounting price pressures. 'The risks of a boom-bust are rising,' says Nariman Behravesh, chief economist of... consultant Global Insight Inc... Global expansion of 4.9 percent this year will cap the strongest three-year stretch since the early 1970s, the International Monetary Fund says."

May 31 - Bloomberg (Theophilos Argitis): "Canada's economy grew at a greater-than-expected 3.8 percent pace in the first quarter, reflecting a jump in spending on housing. The currency rose to a 28-year high. Growth in the world's eighth-largest economy accelerated from a 2.6 percent rate in the fourth quarter..."

May 31 - Bloomberg (Simon Kennedy): "Confidence in Europe's economy unexpectedly rose to the highest in five years in May as German retail sales jumped and unemployment fell, cementing the case for higher interest rates next week."

May 30 - Bloomberg (Fergal O'Brien): "Irish house prices rose at the fastest pace in more than two years in April, suggesting that the threat of higher interest rates is not deterring buyers in the euro area's fastest growing economy. Prices rose 1.4 percent from the previous month... The average price of a home rose 13.2 percent from a year ago to 291,678 euros ($375,500)."

June 1 - Bloomberg (Jacob Greber): "Swiss economic growth accelerated in the first quarter to the fastest annual pace in almost six years as surging exports prompted companies to invest more in equipment. Gross domestic product, adjusted for inflation and seasonal swings, expanded 3.5 percent from a year earlier..."

May 30 - Bloomberg (Jonas Bergman): "Swedish retail sales rose 1.8 percent in April from the previous month, led by an increase in sales of goods such as clothing and furniture. Sales advanced 12.5 percent from a year earlier, a record annual gain..."

May 31 - Bloomberg (Jonas Bergman): "The pace of domestic borrowing in Norway slowed in April from the fastest in 18 years the month before... Credit growth for households, companies and municipalities was an annual 13.7 percent, compared with 13.9 percent in March, which was the most since March 1988..."

May 31 - Bloomberg (Dorota Bartyzel): "Poland's $320 billion economy expanded in the first quarter at the fastest annual pace in almost two years as record-low interest rates spurred consumer and corporate borrowing. Gross domestic product grew 5.2 percent, following a revised 4.3 percent in the fourth quarter..."

May 30 - Bloomberg (Hans van Leeuwen and Gemma Daley): "Australia's retail sales climbed almost five times as much as economists expected in April as rising wages and low unemployment buoyed consumer spending at department stores, stoking growth in the Asia-Pacific's fifth-largest economy."

May 30 - Bloomberg (Nasreen Seria and Vernon Wessels): "South African economic growth accelerated to an annualized 4.2 percent in the first quarter as a surge in vehicle production helped manufacturing to rebound. Growth accelerated from a revised 3.2 percent in the fourth quarter..."

June 1 - Bloomberg (Ayla Jean Yackley): "Turkey's exports increased 22 percent last month from a year earlier, according to figures from the Turkish Exporters' Assembly."

June 2 - Bloomberg (Mark Bentley): "Turkish inflation unexpectedly accelerated to 9.9 percent in May, the highest since October 2004, increasing pressure on the central bank to raise interest rates to meet targets pledged to the International Monetary Fund."

Latin America Watch:

June 1 - Bloomberg (Thomas Black): "Mexican companies are struggling to find workers in some areas because higher economic growth is creating more jobs, Finance Minister Francisco Gil Diaz said."

May 31 - Bloomberg (Carlos Caminada and Adriana Brasileiro): "Brazil's economy expanded at the fastest pace in three quarters in the January-March period as declining interest rates boosted demand... Gross domestic product...grew 3.4 percent in the first quarter from the year-earlier period after expanding 1.4 percent in the fourth quarter..."

June 1 - Bloomberg (Carlos Caminada): "Brazil's exports rose at the slowest pace in almost three years after a rally by the country's currency made goods from Latin Americas biggest economy less competitive. The slowdown in exports growth cut Brazil's trade surplus for a second month as they rose 4.7 percent from a year earlier..."

Central Bank Watch:

May 30 - Bloomberg (John Fraher and Matthew Brockett): "Money supply in the 12 nations using the euro unexpectedly increased the most in almost three years in April as economic growth fueled a surge in loans, reinforcing the argument for higher interest rates. M3, the European Central Bank's preferred measure of money supply, rose 8.8 percent from a year earlier after growing 8.6 percent in March..."

Bubble Economy Watch:

April Construction Spending was up 8.5% from April 2005. At 7.2% y-o-y, expenditures on Residential construction are slowing. At the same time, the Non-residential construction boom gathers strength. Led by a boom in lodging, office, and healthcare, Non-residential spending was up 10.2% from a year earlier. April factory orders were down 1.8% from March but up 8.7% from a year earlier. Capital Goods orders were up 18.9% y-o-y. The ISM Prices Paid index jumped 5.5 points to 77, the highest level since last November. The ISM New Orders index dipped almost 3 points to the lowest level in a year. The Chicago Purchasing Managers Index gained 4.3 points to the highest level since November.

Mercedes-Benz reported a record May in the U.S., with sales up 21.4% from a year earlier. Year-to-date sales are running 17.1% ahead of last year. BMW's May sales were up 5.3% from a year earlier. Lexus sales were up 13.4%.

June 1 - Bloomberg (Alex Tanzi): "U.S. same store sales rose 4.1 percent in May from a year earlier to $48.4 billion, according to the International Council of Shopping Centers. Total store sales rose 12.5 percent from a year earlier."

June 1 - Bloomberg (Joe Richter): "Job cuts announced by U.S. employers dropped 35 percent in the 12 months that ended in May to the lowest level since November 2000. Announcements fell to 53,716 last month from 82,283 a year ago, Challenger, Gray & Christmas Inc...said..."

May 31 - USAToday (Noelle Knox): "If you're a renter trying to save for a down payment, or you're just trying to move out of your parents' home, it'll likely get harder this year. Rents are rising faster than they have in six years. Apartment rents are expected to increase 5.3% this year - about double last year's increase - the National Association of Realtors says. That's the highest jump since 2000, when the Internet boom created lots of jobs for young adults out of college. In April, rising rents were largely to blame for a sharp jump in consumer inflation."

June 1 - Bloomberg (Patrick Cole): "U.S. college and university operational costs rose 5 percent in fiscal 2006 compared to 3.5 percent in 2005, the Chronicle of Higher Education reported."

June 1 - Bloomberg (Andrea Rothman): "Airlines' fuel costs will probably rise about 20 percent this year to $110 billion, outstripping the benefits of higher travel demand and increasing losses, an industry group said..."

Real Estate Bubble Watch:

May 31 - Bloomberg (Jim Kennett): "Emily Burguieres and her fiancé started house-hunting in Houston's most expensive neighborhood during December, expecting an easy search. What they found was a market where buyers must move fast. 'We made an offer on one that we were really excited about, but it was priced at a point where it had four other offers in one day,' Burguieres, 32, said of a $1.5 million house in the city's River Oaks area. 'Our realtor told us it went over the asking price.'"

Mortgage Finance and Real Estate Bubble Watch:

May 31 - MarketNews: "Freddie Mac said Tuesday its accounting problems should be settled by 2007, while a federal regulator considers imposing new restrictions on the government-sponsored enterprise as it attempts to stiffen its financial controls. '[OHFEO]Director (James) Lockhart has indicated that he intends to consider whether additional remedial actions may be appropriately applied to Freddie Mac while we continue to fix our control environment, and this could include consideration of portfolio growth limitations for some period of time' Chief Executive Officer Richard Syron said..."

Combined Fannie and Freddie's Book of Business expanded $23.9 billion, or 7% annualized, during April to $4.12 Trillion. Their combined Retail Portfolios grew at a 14% annualized rate to $1.454 Trillion, the strongest gain since December. Fannie's Retained Portfolio expanded at a 15.7% rate during the month to $730 billion, bringing its year-to-date growth to 1.2%. Fannie's Book of Business is up 7.2% y-t-d to $2.380 Trillion. Freddie's Retained Portfolio has expanded at an 8.7%

Energy and Crude Liquidity Watch:

May 30 - Bloomberg (Shigeru Sato): "Japan's government plans to help companies boost overseas oil assets to 40 percent from 15 percent of the country's total oil imports by 2030 in an effort to ensure supplies as resource competition intensifies with China and India. The government needs to strengthen ties with oil-producing nations and give financial aid to Japanese oil explorers for developing overseas projects, said a draft proposal on energy policy released today by the Trade Ministry."

May 30 - Bloomberg (Vineeta Anand): "On the day before Exxon Mobil Corp.'s annual shareholder meeting, lawmakers and shareholders are trying to get the world's biggest oil company to cover a $3.9 billion shortfall in its pension fund. George Miller, a California representative and senior Democrat on the House Education and Workforce Committee, wrote to Exxon Mobil Chief Executive Officer Rex Tillerson today that the company should use its $31.9 billion in cash to close the gap... 'Exxon Mobil's underfunded pension is a symbol of a system that allows thriving companies to provide CEOs with outsized stock-option grants, corporate jets and retirement packages, while leaving ordinary employees' pensions underfunded,' Miller, whose committee has oversight for pensions, said in the letter to Tillerson..."

June 1 - Bloomberg (Will McSheehy and Khalid Qayum): "Dubai World, a group that manages state assets for the Persian Gulf emirate, will spend $10 billion to develop waterfront homes and hotels in Karachi, Pakistan's commercial capital..."

Speculator Watch:

June 1 - Bloomberg (Alex Tanzi): "The global estimated amount of outstanding over-the-counter contracts stood at $284.8 trillion, as of the end of 2005, according to the Bank of International Settlements."

June 2 - Financial Times (Ralph Atkins): "Hedge funds have created a 'major risk' to global financial stability for which there are no obvious remedies, the European Central Bank warned yesterday in one of the bluntest official statements yet on the rapidly growing sector. In a clear hint of rising official nervousness about the multi-billion-dollar industry, the ECB ranked an 'idiosyncratic collapse of a key hedge fund or a cluster of smaller funds' in the same category as a possible bird flu pandemic as the type of shock that could trigger fresh disruption in financial markets... The ECB's concerns about hedge funds contrasts with a more relaxed attitude from other international regulators. Alan Greenspan...said last month: 'Hedge funds are a plus for the financial system. They increase the efficiency of the markets by taking advantage of mispriced securities and other market inefficiencies.'"

June 2 - Bloomberg (Katherine Burton): "Hedge fund managers gave up about half of this year's market gains in May as prices for stocks, oil and metals fell, investors said. Most funds were down 3 percent to 6 percent last month, said Stuart Bohart, head of alternative investments at Morgan Stanley..."

May 31 - Financial Times (Richard Beales ): "Errors in trading complex credit derivatives among Wall Street banks doubled last year. The figure highlights the operational risks that are faced by the world's biggest financial institutions in keeping track of the rapidly growing $17,000bn market. One in every five credit derivatives trades made by big dealers initially contained mistakes, according to a survey from the industry's leading lobbying group, the International Swaps and Derivatives Association. The surge in errors come as dealers struggle to clean up market practices under pressure from regulators, who are concerned at the huge potential risks involved in privately-traded derivatives markets if transactions are not properly documented."

What Difference Does a Year Make:

The Office of Federal Housing Enterprise Oversight (OFHEO) released first quarter housing price data this week. Nationally, prices were up 2.03% (8.12% annualized) during the quarter, with a y-o-y gain of 12.54%. While this was the weakest quarterly price gain in eight quarters, it is worth noting that not a single quarter surpassed 2% appreciation during the entire decade of the nineties.

Highlights include: "Arizona continues to exhibit the greatest appreciation rate, although prices growth has dropped significantly... Quarterly appreciation in Arizona dipped from approximately 7.4% to 3.8%, while its four quarter appreciation dropped from over 35.5% to 32.8%... Rapid increases continue to be widespread in Florida. Out of the 20 MSAs with the largest percentage house price gains in the past year, 10 were in Florida... The Pacific Census Division has regained its position as the fastest appreciating division..."

As we contemplate an extraordinarily uncertain future, it's interesting to reflect back a year. I certainly don't remember anyone forecasting yet another year of double-digit mortgage Credit and home price gains. The consensus view had housing slowing rapidly, in the process forcing the U.S. consumer to retrench. Some saw the Fed wrapping things up last June at 3.25%; others expected that the Fed would be well into another easing cycle by now. With 10-year bond yields stubbornly below 4% this time last year, a view was taking shape that the global economy was beset by intransigent disinflationary forces. If inflation hadn't made its appearance after a few years of ultra-loose global monetary policy, we were told, it just wasn't likely to happen. Or so they thought.

As the dollar index approached a double-digit gain by mid-2005, a fanciful notion also took hold that the risks associated with dollar weakness had passed. The "Bretton Woods II" hypothesis became all the rage. It was going to remain mutually beneficial for U.S. consumers to consume and Asian producers to produce, while their tightfisted consumers and determined central bankers ensured at least several more years of Asia as steadfast buyer and price-setter for our Treasury and bond markets. It was similarly explained to us how there was too little global consumption and a glut of global savings, ensuring that U.S. and global bond yields would stay low (and even likely go lower). It is such a fascinating (Global Credit Bubble) environment where things can change radically in a year.

We haven't of late heard much of the global disinflationary backdrop or the virtues of Bretton Woods II. Instead, there has been a reality check as inflationary pressures take center stage. Global bond yields have surged to multi-year highs; the dollar is sinking back toward multi-year lows; and commodities price indices are near record highs. Where did the sanguine inflation and rate analysis go wrong?

First of all, the view from a year ago that anticipated a rebirth of global disinflationary pressures was the upshot of a flawed analytical framework. It simply disregarded the ongoing massive (U.S.-led) global Credit inflation and attendant financial flows, choosing instead to fixate on generally tame global goods prices and the underlying surfeit of cheap labor. Yet there is a huge disadvantage in employing such a narrow view of "inflation." Not only can it provide dreadfully wrong signals, it guarantees obliviousness to the key dynamics of Credit and liquidity excess - along with attendant asset inflation and speculative dynamics. To be sure, rampant Credit creation ensures evolving financial flows and deviating inflationary manifestations. The difficult but key aspect of the analysis is to recognize how financial flows are changing and the ramifications for such change.

Today from the Financial Times (Steve Johnson): "The spectre of Asian central banks sending the dollar into freefall by taking the axe to their vast reserves of the US currency has taken a back seat in the past 18 months. The dollar's three-year slide up to 2004 was punctuated by reports of diversification away from the dollar. But the dollar's subsequent up trend, allied to ever-improving yields on US assets, pushed the issue into the background. However, the dollar's 5 per cent slide against the euro since the start of March has been accompanied by speculation that Asian central banks are once more selling dollars for euros. Only this time, instead of the debate centring on east Asian countries such as China, all eyes are focused on the increasingly cash-rich banks of the Middle East. 'The dollar moves smack of diversification. They have all the hallmarks of reducing dollar demand from oil exporters,' says Chris Turner, head of currency research at ING Financial Markets. 'Diversification is happening, and it's happening much quicker than we thought it would,' says Emma Lawson, FX strategist at Merrill Lynch. The US Treasury estimates that the oil export revenues of the 10 largest exporters surged from $256bn in 2002 to more than $600bn last year, while their cumulative current account surpluses jumped 68 per cent to $331bn. Even if exporters merely wanted to maintain the currency mix of their reserves, they would need to sell a slice of these dollars and buy other currencies."

Crude oil is up about 50% from one year ago, and conditions are ripe for it to go even higher. This has been no price spike caused by a temporary supply interruption. And while there is surely a speculative dynamic at play, I don't believe the crude market is a Bubble waiting to burst. Instead, I view $70-plus crude as the most prominent price manifestation to emerge from global Credit inflation dynamics. This price surge should be recognized as a major escalation from inflationary effects that were until recently isolated largely to asset markets ("Asset Price Inflation") and Asian manufacturing capacity ("Investment Inflation").

It was only a matter of time before our unending Current Account Deficits and (resulting) unhinged global Credit systems created both heightened demand for energy and the excess liquidity to drive its price significantly higher. And it was precisely this amount of time until speculators fancied oil, metals and commodities rather than Treasuries. On multiple levels, the breaking away this past year of major financial flows from the recycling of dollar balances by Asian central banks has unleashed inflationary forces in all directions. No longer are price pressures largely contained by the methodical flow of finance between the U.S. financial sector, Asia and then U.S. asset markets.

I recognize that it is popular nowadays to predict the imminent bursting of myriad Bubbles - "energy," "emerging markets," "global risk assets," "commodities," and "hedge funds," etc. Bursting Bubbles are expected to lessen global liquidity, aggregate demand and general price pressures. What I don't see much of is analysis of the ramifications for the historic shift in the flow of global finance to the oil producing economies and their financial institutions. I am certainly not this evening going to claim I have any great insight other than to suggest to readers to contemplate the possibility that current monetary trends are moving in the direction of a radical departure from the nature of global (dis-)inflation experienced over the past two decades.

With the price of crude up sharply, oil producing revenues (for the top 10 producers noted above from the FT) will be significantly above last year's $600 billion. Importantly, this massive flow of finance will come from U.S. energy consumers as well as our trading partners. With this in mind, I fear we may soon have reason to put to rest the notion of a painless ("Bretton Woods II") dollar recycling mechanism. Middle Eastern banks, oil companies, investors, and policymakers have altogether different priorities than Asian central bankers, and we already have evidence that oil producing economies are keen to diversify away from dollars. It is also reasonable to suggest that oil producing citizens have dissimilar spending and saving propensities when compared to their Asian counterparts, and certainly today have much less inclination to hold U.S. securities. Across the spectrum of recipients, much of today's increased global purchasing power (Credit Inflation) will be expended (by oil producing economies and oil consumers) much differently than it has been in the recent past (by pre-oil surge Asian policymakers).

I believe the unfolding shift of finance to oil producers throws a problematic monkey wrench into the very premise of a manageable global monetary regime ("Bretton Woods II"). The proposition that our trade deficits were being driven by the purchase of under-priced discretionary consumer goods from undervalued ("mercantilist") Asian currency regimes must now be adapted. Going forward, a major part of our trade imbalance will be due to high-priced energy priced (for now) in our own depreciating dollar. Accordingly, the weaker the dollar the higher the ongoing bill for our oil dependency. The hope that a weaker dollar will rectify global imbalances can be thrown out the window, along with the dream that it will always be in the interest of our trade partners to buy dollar securities.

For some years now, our Current Account Deficits were accumulated largely by Asian manufactures, which sold them to their exertive central banks - that would then immediately recycle them right back to top-rated U.S. securities. Importantly, this (at first Japanese and then) Asian proclivity to accumulate Treasuries and Agencies ("Inflationary Bias") provided a tremendous (irresistible) liquidity backstop that enticed the leveraged speculating community and others to buy right along with them. Massive U.S. Credit Inflation manifested auspiciously into over-consumption, Trade Deficits, unfailing Asian recycling and foreseeable inflated U.S. bond and asset prices. This culminated with the so-called "conundrum," and there is today every reason to contemplate the possibility that this dynamic has changed and changed for good.

It is wishful thinking to expect oil producing central banks to be such anxious buyers of dollar balances from their domestic companies, and almost inconceivable that these central banks would so predictably recycle balances back to the U.S. bond market. And to play along with these escalating flows, the leveraged speculating community has instead gravitated to European equities, emerging markets, the precious metals and non-U.S. property markets. Not only has this undercut the liquidity backstop for U.S. bonds, this radical departure in the flow of global finance has itself altered the liquidity and inflationary backdrop (impacting bond prices globally). The prices of non-U.S. things and securities have dramatically outperformed U.S. bonds, encouraging a reduced propensity for even Asian purchases of U.S. securities. Throughout Asia, governments are now keen to build strategic oil and commodities stockpiles, with the enterprising Chinese in particular anxious to diversify.

To state that global monetary - and, specifically, dollar "recycling" - dynamics are today much more uncertain is quite an understatement. As much as I despise the "Bretton Woods II" hypothesis, there was some truth to the notion of the symbiotic relationship between the U.S. as borrower and consumer and Asia as producer and saver. The significant Financial and Economic Power now shifting to the oil producers entails quite different dynamics and should be cause for concern. We do not enjoy such a symbiotic relation with the oil producing community, while the rising prominence of energy on the world stage will diminish the Asian infatuation with our securities markets. We could always count on the Japanese to do what we wanted, and the Chinese and other Asian countries have to this point basically followed a similar path. But many oil exporting countries clearly hold us in contempt. That we have become so economically and financially dependent on the Middle East is contemptible.

I purposely attempt to stay well clear of geopolitics in my articles, but I am this evening compelled to mention the deteriorating situation in Iraq. Recent accusations of habitual mistreatment and atrocities by our military upon innocent Iraqi civilians have the clear potential to push an already dire situation past the breaking point. Factoring in the potential showdown with Iran, the scenario of a hopeless Iraqi quagmire and escalating regional instability appears anything but a low probability event. U.S. standing in the region is heading from quite bad to absolutely terrible, at the same time that relations with Russia are increasingly strained. Considering the confluence of problematic global financial flows, acute dollar vulnerability, and U.S. financial and economic fragilities, I see ample evidence to suggest an unambiguous risk of an unfolding liquidation of dollar holdings.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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