Contemplating the Dynamically Hedged Economy

By: Doug Noland | Fri, Mar 21, 2003
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Now that was something else. For the week, the Dow surged 8.4%, its strongest performance in 20 years. The S&P500 gained 8%, the Transports 12%, and the Utilities 5%. The Morgan Stanley Cyclical index jumped 11% and the Morgan Stanley Consumer index 8%. The small cap Russell 2000 and S&P400 Mid-cap indices gained less than 7%. The NASDAQ100 and Morgan Stanley High Tech indices added about 6%, increasing year-to-date gains to 11% and 8%. The Semiconductors surged 10%, with y-t-d gains of 16%. The Street.com Internet index gained 7% (y-t-d 11%) and the NASDAQ Telecommunications index 7% (y-t-d 15%). The Biotechs jumped 8% this week. The Securities Broker/Dealer index surged 13% and the Banks 8%. With bullion down $10.50, the HUI Gold index dropped 4%. From the week ago Wednesday's intraday lows, the Dow surged 15%, the S&P500 14%, The Transports 18%, the Morgan Stanley Cyclical index 17%, the NASDAQ100 16%, the Semiconductors 21%, NASDAQ Telecom 16%, and the Securities Broker/Dealers 22%.

Yields shot higher. For the week, two-year Treasury yields jumped 25 basis points to 1.78%, with five-year yields surging 40 basis points to 3.08%. The 10-year Treasury yield jumped 40 basis points to 4.10%, while the long-bond saw its yield rise 33 basis points to 5.04%. Benchmark mortgage-back and agency yields gained about 35 basis points. The 10-year dollar swap spread added three to 47.5, while the spread on Fannie's 5 3/8 2011 note widened two.  Corporate spreads narrowed sharply. The dollar rallied 2%, while the CRB index sank about 4%. Extreme moves everywhere.

The corporate debt issuance boom is running at full throttle. This week Wells Fargo sold $1.1 billion of bonds, Bear Stearns $1.25 billion, US Bancorp $500 million, News Corp $1.5 billion, Liberty media $1.5 billion, Ambac $175 million, Shurgard Storage $200 million, Alaska Energy $150 million, Mandalay Resort $350 million, Dole Foods $475 million, El Paso Energy $300 million, Duke Energy $200 million, Centerpoint Energy $650 million, Denbury Resource $225 million, Wisconsin Energy $200 million, Nexstar Finance $130 million, Pemex $500 million, Swift & Co. $150 million, and Diageo Cap $1 billion (excluding many issuers). Asset-backed issuance totaled $7.7 billion this week, with the y-d-t total of $96 billion a new quarterly record (up 10% from 2002's first quarter).

Broad money supply (M3) declined $12.6 billion. Demand and Checkable Deposits combined to drop $19.8 billion. Savings Deposits jumped $20.9 billion and Institutional Money Fund deposits declined $13.3 billion. Retail Money Fund deposits declined $5.3 billion. Large Denominated Deposits added $5.7 billion.  Elsewhere, Total Bank Assets jumped $15.8 billion last week, with six-week gains of $171 billion. Loans and Leases jumped $21.5 billion, with Real Estate loans up $15.9 billion and Commercial and Industrial loans up $0.6 billion. Security loans added $3.1 billion. For comparison, Total Bank Assets declined $23.5 billion in the six weeks preceding January 1991's Desert Storm rally and were basically unchanged from mid-July 1990.

March 20 - Bloomberg:  "Mexico's central bank said it will start buying pesos to reduce foreign currency reserves that are growing by as much as $1 billion a month as high oil prices boost export revenue. Mexican reserves have swelled about 10 percent since December to above $50 billion, and holding the extra dollars has become expensive, the central bank said. Mexico pays a yield of 8.6 percent to borrow for three months in pesos, while it can earn only 1.2 percent investing in three-month U.S. Treasuries."

There were 35,659 bankruptcy filings last week, up 8% y-o-y. The "Philadelphia Fed" manufacturing index sank to the lowest level since December 2001. Yet the Prices Paid component jumped almost nine points to 25.1, the highest reading since October 2000. Today's stronger-than-expected 0.6% CPI rise provides additional evidence of heightened (and broadening) pricing pressures. Indeed, one must go back to 1990 for a stronger monthly CPI gain. The CPI's 3.0% y-o-y gain is the highest since June 2001, and compares to the year ago 1.1%.  Year-over-year, by sector, we see Food & Beverage up 1.4%, Housing up (only?) 2.6%, Private Transportation 7.8%, Medical Care (only?) 4.5%, Education and Communication 2.2%, Commodities 2.6%, and Other Goods & Services 2.5%. By major categorization, All Items Ex-food jumped 3.2% y-o-y, Energy up 22% y-o-y, Nondurables 4.6% y-o-y, and Services Ex-rent on Shelter up 4% y-o-y.

March 20 - Los Angeles Times (Jesus Sanchez): "The median home price in Los Angeles County hit a record $284,000 in February, surging 19.8% from a year ago as low mortgage rates continued to keep buyers in the market, according to housing figures released Wednesday… 'If you have a good house that is decently priced ... it gets multiple offers and is out the door,' said Richard Mathies, executive vice president of Dilbeck Realtors… Prices on a year-over-year basis moved up strongly across the entire six-county region. Orange County remained the region's highest-priced market overall, as the median jumped 21.1%, to $384,000… The gain was the largest since May 1989, when the median rose 22.8%."

In blow-off week 39 of The Great Mortgage Finance Bubble, the Mortgage Bankers Association's Refi index jumped another 5% from last week's (off the charts) record to  almost 600% of the year ago level. The Purchase application index gained slightly to about 12% above one year ago. Housing Starts data was unimpressive (weakest in 10 months), but perhaps weather and geopolitical affected. Year-over-year, Starts were down 9%, although remained 9% above pre-Bubble February 1997 levels. At the same time, new Housing Permits support the view of continued strength. Permits were up 1% y-o-y to 1.786 million units, and were up 24% from pre-Bubble February 1997. Furthermore, there has been only one stronger Permits report (December's 1.887 million) since the mid-eighties boom.

March 17 - American Banker (Todd Davenport): "Even the most ambitious bank hesitates before projecting annual growth of 40% for an established product line, so what does it mean when the entire industry achieves that mark? Commercial banks and thrifts held $256.4 billion of home equity lines on their balance sheets at the end of last year, according to the Federal Deposit insurance Corp., over 39% more than a year earlier - and more than double the $121.3 billion on their balance sheet at the end of 1999… Low interest rates, increasing housing prices, and limited demand for other lending products, particularly commercial and industrial credits, have made the home equity line the right product at the right time. Consumers want it, and banks, hungry for loan growth, are happy to supply it. 'Mainstream America has caught on to what a great financial tool the home equity line of credit is,'" stated an industry executive.

March 17 - American Banker (Robert Julavits): "The values of some luxury residences in Manhattan have dived in the past six months, but not because of the economy, the possible war with Iraq, or the mythic housing Bubble. The culpit? Mold. What started in the Southwest as a homeowners insurance crisis has spread to other regions and turned into a problem for lenders as well. Concerns about mold have sent owners out of their homes and into the courts. Increasingly, insurers are refusing to pay claims, and lenders are stuck with plummeting property values. Complaints in New York City about mold have risen dramatically in the past year. Its sudden appearance in a luxury Park Avenue co-op building has so rattle real estate brokers that some will not show the property to clients."

Freddie Mac 30-year mortgage rates jumped 18 basis points this week to 5.79%. Curiously, February was another restrained month for Freddie Mac. Freddie's Total "book of business" declined at a 7.8% annualized rate during the month, with its retained portfolio contracting at a 14.7% rate.

February was another dismal month for federal finances, with the largest monthly deficit on record. With year-over-year revenues down 8.6% and spending up 6.8%, February's deficit surged 26.7% to $96.33 billion. Year-to-date (5 months of the fiscal year) revenues are down 8.2% to $705 billion, while outlays are up 7.6% to $899 billion. The y-t-d deficit of $194 billion compares to the comparable year ago $67 billion deficit. Looking at the largest departments, y-t-d Defense spending is up 19% y-o-y, Education 23.7%, Health & Human Services 12.6%, Veterans 22%, Social Security 6.6%, and Agriculture 4.5%. Year-to-date Interest expense is down 2%.

March 20 - Reuters: "Before the first shot was even fired in Iraq, a handful of hedge funds lost hundreds of millions of dollars when markets turned against them on hopes the fighting would end quickly. So-called commodity trading advisors, or CTAs, who rely on computer models to track long-term trends, were hurt badly when stocks and the dollar suddenly swung around and raced higher. Some of these funds recorded declines of as much as 25 percent in five days, sources familiar with their trading said. 'For many CTAs, this was the perfect storm,' said Philippe Bonnefoy, head of alternative investment strategies at Commerzbank Securities. 'Most of the CTAs suffered double-digit reversals because all of the trends changed in one fell swoop, in one day, in fact.' CTAs pursue a style that can, and most recently did, pay off when markets were being pummeled. But their bets on currencies, interest rates, and commodities also are considered to be more volatile than other strategies."

Understandably, there is considerable comparison of today's environment to that of early 1991. Those with a bullish bias believe that a successful resolution of the Iraq issue will, like 1991, mark the conclusion of the bear and usher in a new bull market. This perspective is emboldened by this week's 8.4% gain in the Dow (1991 saw a 7% 4-day surge off bear market lows). And with underlying fundamentals generally sound (according to this viewpoint), a resumption of economic growth and the equity bull market are virtually assured. All the necessary ingredients are present for a return to the good old days. The bearish consensus, on the other hand, seemingly sees a financial system so impaired and economy so distorted that the much hoped for triumphant conclusion to the war will be inconsequential to a big picture of irreparable U.S. financial and economic troubles. My sense is that these diametrically opposed views share in dismissing the critical importance of the current extraordinary financial landscape.

In the past couple of Bulletins I have written that a great deal is riding on bringing the Iraqi crisis to successful conclusion. The financial system and economy were tottering dangerously. Most fortunately, it appears this resolution process is proceeding quite favorably. It has also been my view that the hyperactive financial sphere is a major issue; after this past week I am anything but inclined to back down. It is difficult to imagine financial markets more unstable - a paramount Credit inflation manifestation.

It is today worth keeping in mind that an enormous amount of financial insurance has been employed over the past weeks/months. Along with significant hedging, the current financial landscape ensures unparalleled amounts of financial speculation. Equity, currency, gold, commodity, and Credit spread markets have basically become one big trade. This phenomenon can be accurately characterized as one wild and woolly play on Systemic Risk.  Recently those hedging and betting on heightened systemic instability were being rewarded. This week, those on the wrong side of the systemic stability trade were run over. We have witnessed one heck of a squeeze in the stock and "risk" markets.

In the age of the proliferation of derivative trading and the unprecedented dimensions of the global Leveraged Speculating Community, the importance of The Systemic Risk Trades cannot be overstated. Over the past nine months in particular, we have witnessed an extraordinary ebb and flow of financial fragility. This week it ebbed spectacularly.

Importantly, there is a dynamic trading aspect to these systemic "plays" that has become only more pronounced over time. First, the sellers of systemic derivative protection must protect/hedge their exposure. This leads to self-reinforcing trading behavior, where, in the case of the stock market, weakness necessitates additional selling/shorting. A sinking market also incites additional demand for insurance (hedging), creating only greater potential for a vicious spiral and/or catastrophic dislocation. Central bankers, of course, will respond to heightened risk by fostering liquidity creation, so there is a strong and unrelenting proclivity for over-liquefying the system.

Then there is the truly massive Leveraged Speculating Community that will respond aggressively to any meaningful market move, either increasing bets (responding to faltering markets along with expectations of heightened liquidity/lower rates) or unwinding previous speculations. Again, more trend-augmenting behavior. And today this pool of speculative finance is only enhanced by unrelenting and rampant Credit expansion. (Bubble dynamics in their purest form.) Here I see the major inflationary manifestation of this cycle, and it lies at the very heart of what will be unending financial and economic instability. The financial sphere is suffering awful convulsions, although they do appear a whole lot less frightening when the market spasms upward.

It is my view that today's perverse market dynamics, and resulting acute instability, have become a permanent fixture of contemporary (destabilized) market-based Credit systems.  There is at this point way too much leverage and speculation for the current system to stabilize without some type of crisis. Certainly, these dynamics exacerbated recent equity market weakness at home and abroad (especially in Europe). Then, at an instant, they incite an episode of shock and awe panic buying.

It is worth noting how the vast pool of speculative finance fuels Bubbles both monstrous and mini, and absolutely distorts the marketplace while destroying the effectiveness of the capital allocation process. A case in point would be a seemingly reasonable 2003 "defensive" play of investing in defense, consumer staples, and gold stocks.  In a destabilized system characterized by excessive liquidity and speculation, even a "defensive" position becomes almost immediately engulfed in boom and bust dynamics. This environment may be difficult for the speculators, but it has become absolutely inhospitable to true investors (are there any remaining?).

And with "market neutral" trading strategies dominating the speculating community, there is the dynamic where players are abruptly caught with their long positions declining while their shorts moved higher. In this regard, it is worth noting that the NASDAQ100 has a year-to-date gain of 11% while the Morgan Stanley Consumer index has declined 2% (HUI Gold index down 20% y-t-d). Importantly, with much of the speculating community struggling for performance (and, in many cases, survival), we are faced with a marketplace made only more volatile by anxious traders scratching and clawing for gains, while maintaining minimal tolerance for losses.

But from a systemic point of view the Credit market is at the very epicenter of The Systemic Risk Trade. There is absolutely no doubt that interest rates, in the face of massive mortgage borrowings and heightened pricing pressures, have been pushed lower by the confluence of faltering equity markets, the weakening economy and resulting liquidity creating operations. And, as we witnessed, when rates declined the refi boom took hold, with an enormous amount of hedging activity fostering a self-reinforcing interest-rate meltdown. This unusual confluence has propelled extreme mortgage Credit creation and over-liquefication. Once again, the result of this inflation is additional fuel flowing throughout the destabilized financial sphere. The household sector is today sitting on considerable liquidity, while businesses enjoy greater access to easy Credit. How will these factors impact the distorted and imbalanced economic sphere going forward?

For now, the tide has turned and The Systemic Risk trade is under intense pressure to be unwound.  Equities, the dollar and interest rates are all now shooting higher, while crude, gold and commodities sink lower. Whether we are early or late in this process is unclear. And while it is easy to dismiss the impact the financial sphere's erratic ebb and flow has on the economic sphere, as serious analysts we must analyze and contemplate. The ebb of sinking stock markets exacerbated faltering consumer confidence, in self-reinforcing dynamics (The Dynamically Hedged Economy). We shall now watch carefully (and objectively), while expecting a likely market-induced rebound in confidence. As long as things continue to go so smoothly in Iraq, I will lean toward a scenario where a bounce-back in confidence sets the stage for sporadic spurts of stronger-than-expected economic activity.

And this returns us to the comparison of today's financial environment with that of early 1991. The stunning Desert Storm victory merited the euphoric reaction in the stock market. Yet the Credit system was at the time severely impaired. The country was in the midst of a deep banking crisis after the bursting of real estate Bubbles on both coasts (preceded by the oil patch boom and bust, the farm crisis, junk bond collapse, etc.). The S&L industry was insolvent and the banking system facing very strong "headwinds." And with Communist economies in absolute taters, Latin America still reeling from the eighties debacle, and Japan in the early stages of its historic bust, there were acute domestic and global deflationary forces at work. Ten-year Treasury yields were above 8% and heading much lower. Mortgage rates were above 9%. Leverage and speculation played an insignificant role in the Credit system. This is not 1991.

I would argue that the current environment is quite different, in some respects dusk and dawn to 1991. As much as the consensus would take exception to this analysis, there is today a stronger inflationary bias than that which existed during the early nineties.   Importantly, the Mortgage Finance Bubble is nowadays running completely out of control, with inflating housing Bubbles in California, the East Coast and elsewhere - night and day to the early nineties.  Accordingly, the S&L industry and much of the domestic banking system are today in rapid expansion. Structured finance, in its early infancy during 1991, is in the midst of an historic boom. The mighty leveraged speculating community has ballooned amazingly in 12 years. So rather than the early nineties "headwinds," a strong case can be made that we are in an environment today dictated by the strong and destabilizing Credit system "tailwinds." Navigating through such gale force and shifting winds will remain challenging and unpredictable. We are certainly not drifting toward calm waters.

Over the past few weeks there has been considerable news and discussion of global central bankers supporting financial markets. Facing the prospect of collapsing stock markets and potential war disruptions, efforts to stabilize markets would be understandable, if not necessarily advisable. But supporting equity markets in a general environment dictated by rampant speculation and over-liquefied Credit markets is playing with fire. The weak early nineties economy was a consequence of faltering liquidity and Credit availability, while recent weakness has been in spite of unprecedented liquidity and Credit availability.

As I have noted repeatedly, the U.S. and global Credit markets have remained extraordinarily liquid. Credit has been made amply available for much of the economy, although faltering confidence and maladjustments have been holding back borrowing and consuming, as well as, perhaps, business spending and investment (suffering from post-Bubble trauma). But what if the economy experiences a significant post-war pop in consumer and business sentiment? And what about all the (performance chasing, "inflating asset" loving) liquidity sloshing around the financial sphere?

Understandably, the Treasury and agency markets are now in full retreat. Ten-year Treasury yields jumped 57 basis points in seven sessions, with benchmark mortgage-back yields up 55 basis points in two weeks. Rates have done precisely the type of zigzag over the past six weeks that causes consternation or worse for the anxious crowd of speculators and hedgers. Whether this is the beginning of a (THE) serious Credit market dislocation is today unknown, but the potential (gross overleveraging and speculation) is certainly there. At the same time, we don't see the Fed raising rates anytime soon and are mindful of Dr. Bernanke's comments regarding the potential for the Fed to peg long-term yields if necessary. Nothing would surprise us… The Fed will surely continue erring on the side of ultra-easy money and a wide-open liquidity spigot. I will continue to keep a watchful eye for inflationary manifestations.

At this point, rates certainly have not jumped up sufficiently to squelch the Mortgage Finance Bubble. It will be fascinating to follow housing market activity if consumer confidence snaps back strongly, with all eyes on inflating prices and a dearth of inventory out in the Golden State.

So we are left to ponder the near-term prospects for the imbalanced and distorted U.S. economic sphere. Over the past couple of months it could be characterized as The Dynamically Hedged Economy. The faltering stock market augmented economic weakness, as a vicious spiral of sinking equities and confidence took hold. Will the economic sphere again shadow the destabilized financial sphere, this time irregularly on the upside? Don't dismiss this scenario out of hand. Indeed, we suspect the Fed fudged on its "risk bias" because it appreciates the potential for the gasping economy to lurch violently in either direction.

There is an extraordinary amount of liquidity and Credit availability in the system currently. But fully expect these unhealthy financial convulsions to reverberate unkindly to the malfunctioning real economy. There's no happy scenario. We are not witnessing a replay of 1991's commencement of an historic financial and economic bubble, but 2003's desperate and ill-advised efforts to sustain it. We can today celebrate the unfolding accomplishments of our brave soldiers, while holding disdain for our less than courageous central bankers.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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