Off Topic

By: Doug Noland | Fri, Mar 28, 2003
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It was another week of extraordinary developments and violent financial convulsions. For the week, the Dow dropped 5% and the S&P500 4%. The Transports and Morgan Stanley Consumer indices dipped 4%, and the Morgan Stanley Cyclical index shed 5%. The Utilities lost 1%. The broader market proved much more resilient than the major averages, with the small cap Russell 2000 and S&P400 Mid-Cap indices declining 2%. Technology stocks also gave back some of recent strong gains, with the NASDAQ1000 declining 4%, the Morgan Stanley High tech index 5%, and the Semiconductors 7%. Showing resilience, The Street.com Internet declined only 2% and the NASDAQ Telecommunications index dipping 3%. The Biotechs declined 3%. The Securities Broker/Dealer index declined 3% and the Banks 4%. With bullion gaining $5.50, the HUI gold index posted a 6% gain.

Credit market yields reversed abruptly as well. For the week, the two-year Treasury yield sank 28 basis points to 1.50%, with five-year yields declining 27 basis points to 2.81%. Ten-year yields dropped 20 basis points to 3.90%, while the long-bond saw its yield decline 12 basis points to 4.91%. Benchmark mortgage-back yields sank 27 basis points, while the implied yield on agency futures contracts dropped 22 basis points. The spread on Fannie's 5 3/8% 2011 note narrowed 2, while the 10-year dollar swap spread declined 3 to 44.5. Corporate spreads widened moderately. The dollar reversed, dropping 2% for the week.

It was, according to Bloomberg, the slowest week of corporate debt issuance of the year. However, the financial sector was the notable borrower, with Goldman Sachs raising $1 billion, Lehman $1.5 billion, Bank of America $1 billion, Morgan Stanley $1.35 billion, and Amsouth Bank $500 million. Elsewhere, DTE Energy sold $400 million of bonds, Raytheon $425 million, and Westport Resources $125 million. First-quarter asset-backed issuance of $100 billion was up 9% y-o-y.

Looking back, HSBC's acquisition (bailout) of troubled Household International this past October was a seminal event with respect to tranquilizing acute financial fragility. Recently the market witnessed faltering subprime auto lender AmeriCredit attain $1 billion of desperately needed funding ("whole loan purchase facility"). Similarly desperate subprime Credit card company Metris then received an $850 million funding arrangement from its bankers. And this week we see troubled Sears' stock and bonds surge on news the company is considering selling its Credit card business.

And the following are Bloomberg story excerpts from this week: "Broadwing Inc., saddled with more loans than it could handle after a failed acquisition, said banks and investors agreed to a debt restructuring that ensures the company will have enough cash to survive until 2006. The plan will reduce debt by about $500 million, said… the parent of local-telephone company Cincinnati Bell." "Fleetwood Enterprises Inc., the second-largest U.S. maker of manufactured housing, agreed to a $130 million credit line that eases a profit requirement… The revised credit line is an increase of $20 million and is from a group led by Bank of America Corp… 'There were some real liquidity concerns, and this eases them.'" "Shares of Amerco, the parent of U-Haul International Inc., rose 46 percent after the moving-van renter received a four-year credit line of as much as $865.8 million to reorganize debt in a bid to avoid bankruptcy. Wells Fargo & Co.'s Foothill Capital unit proposed the senior secured credit facility…" As students of the Credit market, we cannot dismiss that tight Credit conditions in the corporate sector have softened.

Broad money supply (M3) surged $43.4 billion last week. "Money" is up $280 billion, or 7.6% annualized, to $8.597 Trillion since early October (23 weeks) and $524 billion, or 6.5% y-o-y. Broad Money Supply is up $1.92 Trillion, or 29%, over three years, and $3.0 Trillion, or 54%, over five years. There may be vociferous inculcation that we are face-to-face with the evil of deflation, and perhaps there is heightened deflationary risk, but the fact of the matter is that we are witnessing an unremitting historic "money" and Credit inflation. Last week Savings Deposits jumped $17.6 billion to $2.88 Trillion, with 10-week gains of $108.6 billion (20.4% annualized). Evidencing the expanding role of traditional bank Credit inflation, Savings Deposits are up an astonishing $465 billion, or 19.2%, during the past year. Over two years, Savings Deposits have expanded $925 billion, or 47%. Last week also saw Institutional Money Fund deposits jump $20.2 billion, as Large Denominated Deposits added $7.3 billion. Retail Money Fund deposits, Repurchase Agreement, and Eurodollars changed only marginally.

Commercial Paper borrowings jumped $16.6 billion last week, largely reversing the previous week's $18 billion decline. Financial Sector CP borrowings jumped $19.7 billion, while Non-financial declined $3.2 billion. Year-to-date, Non-financial and Financial Sector CP are both about unchanged. Following recent strong gains, bank assets dropped $46.8 billion. Securities holdings sank $36.2 billion and Loans and Leases declined $9.8 billion. Commercial and Industrial loans declined $3.4 billion and Real Estate loans dropped $20.6 billion.

March 27 - American Banker: "In the early 1990s, U.S. government securities made up 80% of U.S. commercial banks' securities holdings. That figure has fallen, remaining below 60% since late 2000."

March 27 - Bloomberg: "U.S. bond funds last month recorded an inflow of $19.6 billion, the second-biggest ever… Investors added 51 percent more than they did in January… The record remains $28 billion in July. Stock funds had $11.1 billion in outflows, up from $371 million the month before. Pimco Funds, American Funds and Vanguard Group were the best-selling fund firms last month, helped by the popularity of their fixed-income funds. Pimco, paced by sales of Bill Gross' Total Return Fund, had net sales of $2.6 billion. 'We're seeing dramatic flows coming in, Pimco spokesman Phil Neugebauer said. Investors 'are still putting money into Total Return, but they're also investing into high-yield and emerging market funds.'"

March 27 - Dow Jones (Allison Bisbey Colter): "Macro funds, which can invest in any kind of security anywhere in the world, have profited handsomely over the past 18 months by betting that stocks would decline and bonds rally while the dollar weakened against the euro. But many were caught by surprise last week when financial markets abruptly turned against them. Commodity trading advisers, which invest in many of the same markets as macro funds but tend to rely on technical trading signals and spread their bets more widely, also experienced a reversal of fortune. 'Last week was the biggest drawdown macro managers and CTAs have seen in recent years,' said David Smith, chief investment director of Global Asset Management… It's been a sharp turnaround. Global macro funds were among the best-performing hedge-fund strategies last year, returning an average 14.66%, and were up 3.94% in the first two months of this year… Managed futures funds did even better, gaining an average 18.33% in 2002 and 12.89% in the first two months of this year. But Smith said some of these funds lost 5% or 10% in a single day last week, effectively wiping out the gains they had made for the year… Fund managers say what tripped them up last week was the speed with which many financial markets changed course."

March 26 - Bloomberg: "Investors are buying collateralized debt obligations, bonds backed by other securities, as banks raise yields to make up for credit-rating downgrades in a market that had sales of $269.3 billion last year. Global sales of CDOs surged 36 percent in 2002, according to Bank of America Corp. Investors are looking for ways to make money as global stocks extend declines and government bond yields drop. In CDOs, banks bundle bonds or other assets, parcel them and then sell these new securities in chunks of differing quality. Typically, the riskiest portions absorb losses first and cushion buyers of the top-rated parts. Some of the securities suffered last year as a record 234 companies defaulted on $178 billion of debt worldwide, according to Standard & Poor's… Global CDOs returned 13.3 percent last year, including reinvested interest, more than double the previous year's gain, a Merrill Lynch & Co. index shows."

There were 35,102 bankruptcy filings last week, up 9% y-o-y. March University of Michigan Consumer Confidence declined to the lowest level since August 1993.

Personal Income and Spending data remain interesting and are key statistics to follow in regard to the thus far successful efforts to sustain inflation ("reflation"). After December's surge in Personal Consumption Expenditures (up 1.10%), Spending has flat-lined for two months (not a depressing performance under the circumstances). While this development is to be followed closely, let's not lose sight of the fact that February Personal Spending was up 4.2% year-over-year. Importantly, Personal Income continues to expand. Up 0.3% for February, Personal Income is up 3.6% year-over-year. By category, Wages and Salary was up 0.3% during the month, with Private Goods Producing down 0.2% and Service up 0.6%. After jumping 1% during January, Government Wage and Salary was up 0.7% during February. Year-over-year, Government wages are up 4.9% and Services 4.1%. Led by a 15.8% surge in Unemployment Insurance income, Transfer Payments are sporting a year-over-year gain of 7.1%. After stagnating for much of 2001 (virtually unchanged between March and November), Personal Income has been expanding at a 4% rate for the past 15 months.

March 27 - Bloomberg: "China's factories, refineries and other producers raised prices in the first two months of this year, reflecting a surge in crude oil prices ahead of the then looming U.S. war with Iraq. Producer prices rose 3.2 percent in January and February from a year earlier, the National Bureau of Statistics said. That followed a 0.4 percent increase in December. Economists count the first two months of the year together to allow for the impact of Chinese New Year falling in different months. Rising producer prices are forcing retailers to increase the costs of the goods they stock, stoking inflation after more than a year of falling consumer prices. Rising prices may boost consumption, helping the government achieve its target of growing the economy by at least 7 percent this year, as people no longer defer purchases in the expectation goods will become cheaper."

February New Home Sales were reported at a much weaker-than-expected 854,000 annualized unit pace, down 9% y-o-y. Sales are now down 20% from December's record 1.063 million unit pace, although much of this decline is explained by a spike (and reversal) in Midwest sales. February's average price of $235,000 was up 3.8% y-o-y. The Inventory of New Homes was up another 4,000 units to 352,000 (5 months worth). Unsold units are now up 20% since the trough level of March 2001, to the highest level since June 1996.

While down 4% from January's record, February Existing Home Sales were reported at 5.84 million annualized units (the fourth-strongest on record). Year-over-year, average national prices were up 8.1% ($204,900), with prices up 11.7% in the Northeast ($222,800), 3.2% in the Midwest ($160,100), 13.8% in the South ($197,600), and 3.8% in the West ($259,300).  Calculated Transaction Value (annualized sales multiplied by annualized average prices) was up 7% from a year ago and is up 32% from February 2001. Notably, the inventory of Existing Homes is up only 2% year over year, with 4.4 months of supply. For comparison, inventory of existing homes hit a peak at 9.9 months during September 1990 and averaged about nine months during 1990/91.

The California Association of Realtors reported a relatively unimpressive February, with year-over-year median prices up 11.1% to $327,600. Sales were down 7.1% y-o-y, while the months supply of inventory rose to 3.5. Interestingly, some of the higher priced markets are demonstrating quite a sales slowdown (Santa Clara down 33.5% y-o-y, San Francisco Bay down 21.8%, Santa Cruz 19%, and Monterey County 40%). While too early to be confident of the analysis, it appears the vulnerable California Real Estate Bubble is being sustained at the lower end with trouble brewing at the high-end. We'll be watching California and general real estate activity especially closely going forward.

For the economy as a whole, February was a slow month. Yet it is a difficult month read too much into the trend, with the unusually poor weather and the impending war. It is today worth noting that initial jobless claims dropped last week to the lowest level in six weeks. In addition, the Mortgage Bankers Association (MBA) weekly application index proved interesting. Purchase applications jumped 10.5%. This was the highest level since November and up 16% y-o-y. With rates jumping higher, refi applications declined 13% from last week's all-time high, although remaining up 460% from the year ago level. Refi applications were the third highest level, behind only the two previous weeks. Also worth noting, through the first three weeks of March the MBA's purchase application index is running up 9% from February.

March 27 - Financial Times (Peter Fisher, Undersecretary of the U.S. Treasury): "Later this month, the Treasury will publish the annual Financial Report of the United States Government. This includes an assessment of the government's net liability for Social Security, for Medicare and for government worker and military retirement benefits. The government has assumed these obligations and has designated taxes and revenues to pay for them. Last year's report concluded that, looking forward over 75 years, these programmes collectively have a current negative net present value of $26,000bn. Projecting total federal revenues as a share of the economy at the average rate of the past 40 years, the current net financial position is 'only' a negative $23,000bn. So on a backward-looking basis, counting only the amounts that we have borrowed, our debt-to-GDP ratio is 34 per cent. But on a forward-looking basis, our total liabilities-to-GDP ratio is well over 200 per cent. As these numbers suggest, relying only on current deficits and debt to guide our way to fiscal balance is like trying to drive a car while peering only into the rear-view mirror. Forecasts of future deficits are just an artist's impression of what we may see through the rear window once we get a little further down the road. Our misdirected attention creates perverse incentives that weaken our real fiscal position. Conventional analysis of the federal budget understates the cost of future promises, providing an incentive for making more of them through the creation and extension of benefit and guarantee programmes. Today's liabilities will be tomorrow's outlays, ultimately contributing to deficits, just not in the year of enactment."

Recently I have written that it is my view that a great deal is riding on the outcome of the War. The Administration chose a path fraught with immeasurable risks. Moreover, this enormous bet was placed while holding an unappreciated weak hand. Still, at this time last week it looked to me as if they may have actually pulled it off. Saddam appeared to have been taken out, his regime on the brink of collapse, and surrender appearing imminent. I wanted to believe a miraculous military victory was at hand without the ugliness of war. Thoughts of jubilant Iraqis dancing in the Streets of Baghdad as U.S. Marines arrived was imaginable.

It may only be seven days later but it's such a different world. The ugliness of war is being beamed 24 hours a day to audiences domestic and international. The message internationally is of Americans as aggressors and invaders, and it's absolutely heartbreaking. Iraq's Tariq Aziz commented that, yes, Americans would be welcome in Baghdad, although not with the anticipated flowers and music but with bullets. This view is today conspicuously credible. And with a wall of death and destruction destined to fall on these people, our President's continued call for "liberation" sounds unconvincing at best domestically.  At this point, a terrible humanitarian disaster appears quite possible.

It is my view that our Administration has gambled big and lost. It now becomes only a matter of the size, scope, and timing of losses. The loss of life is so tragic, with the risk of catastrophe not remote. Here at home, away from the chaotic desert battlefield, the much hoped for Desert Storm-type thrust of financial market, dollar, and economic confidence is missing in action. Yes, we will surely win the war, but the cost will be enormous - let us all hope it's not the ultimate Pyrrhic victory.  The determination for decisive victory, while advantageous for domestic political purposes, will entail greater destruction of life and property that will appear absolutely senseless and terribly unjust elsewhere in the world. Furthermore, and quite importantly, it is today difficult to see how we, after winning the war, do not decisively lose the peace. Again, the price will be enormous, much beyond anything apparently contemplated in Washington. The Administration today may try to blame the media for portraying war developments in a negative light, but sensible Americans are today asking "was this the plan and what was expected from its execution?." Spin control will not change the fact that the American people were not aware of nor informed of the potential costs and risks to this conflict.

Only an immediate victory would have placed some semblance of a cap on escalating losses (human, economic, political, and international goodwill/standing). These costs are today both unknowable and uncontrollable. Throughout the world, we are making only more enemies and losing friends. But it seems obvious to me that in a world of increasingly dangerous enemies, one needs to safeguard and nurture friendships. We shouldn't so haphazardly go about destroying important relationships, albeit with individual countries or the United Nations. What a discomforting contrast to a "kinder and gentler nation." We are an overconfident military power introvert, although our financial and economic vulnerabilities leave us today an insecure loner. Indeed, this Washington mindset that we are a self-sufficient superpower becomes only more dangerous by the week. We are only a superpower, and regrettably THE superpower in an unstable world with many desperate for a scapegoat.

It has always been my objective to keep the Bulletin "close to home," attempting a disciplined focus on the U.S. Credit system, financial markets, economic theory, and the American economy. I have a quite narrow "expertise," and I will not attempt to fool myself or our readers. But it is these days difficult to avoid the tangled mess of geopolitical analysis, so please excuse my taking liberties this week. I'll be back On Topic next week.

First of all, we have these days a serious dollar problem - the unfolding bursting of the dollar Bubble. Secondly, we have an exceedingly vulnerable Credit system and Bubble economy, sustained by gigantic household mortgage borrowings and unprecedented financial leveraging and speculation. Both the faltering dollar and Mortgage Finance Bubble are today acutely vulnerable to waning confidence.  As I have averred many times, Confidence Games are Risky Business.

A quick and "clean" resolution to the war was crucial for bolstering flagging dollar confidence. Today's open-ended "resolution" is a loss from financial perspective. So at this point we are left to contemplate the distinct possibility that the growing prospect for a protracted and ugly war could be a catalyst for the looming dollar crisis. After all, over the past five years, Rest of World (from the Fed "Flow of Funds" report) has increased holdings of U.S. financial assets by a staggering $2.7 Trillion, or 56%, to $6.3 Trillion. My heightened concern today is that these massive positions were accumulated under the perception of a world almost unrecognizable to what is now unfolding; a vastly different American economy; an alarmingly deteriorating global economic and political backdrop; and an altered view of the United State's international role and standing.

Holdings of U.S. financial assets were not accumulated with the expectation of massive federal deficits and a wartime economy. The perception of a vibrant, productivity and technology-driven juggernaut is quickly giving way to the reality of a stagnant U.S. economy with enormous expenditures for defense, both international and domestic (not to mention a mortgage finance Bubble!). Keeping in mind our thesis of the exponential growth in non-productive Credit - escalating inflation of U.S. financial claims - foreign holders of U.S. financial assets are now faced with steadfast devaluation of their share of the underlying wealth producing assets of our economy. It's an accident in wait.

It is both shocking and sobering to observe the rage of anti-Americanism running rampant throughout the world. I see nothing good coming from this development, and it has been a mistake for our policymakers to be so dismissive of its relevance. Only the quick and clean war scenario would have not (perhaps) thrown gas on this inferno. Now the genie is out of the bottle, and it is difficult today to imagine the rosy scenario with the Middle East as a safer, more stable region anytime soon. On the other hand, the risk of things spiraling out of control is increasing - regional political instability, an escalating region conflict (Syria, Iran, Turkey?), and perhaps even an oil embargo at some point in the future. At the minimum, the quagmire scenario of a large American military presence in a devastated, unstable, violent, ethnically divided Iraq seems quite likely. Here again, the gamble to be perceived throughout the region as the benevolent liberator has surely failed and backfired. The war strategy may be "on plan," but surely this is not the scenario envisioned.  

It is not conceivable that intensifying global animosity towards American hegemony is a positive for the dollar as the world's reserve currency. Sure, global central bankers appear today determined to support the dollar and the dollar reserve system. But with things seemingly moving quickly, unpredictably, and uncontrollably, we are on a course where foreign politicians and citizens may decide at some point down the road that dollar hegemony is not in their best interest. And it is disturbing on many levels to watch our relations with France and Russia, in particular, degenerate so rapidly and dramatically. Even our good neighbors Mexico and Canada are looking askance.

And while we may satisfy our anger by abstaining from French wine, there is the unfortunate reality that we are in no position to pick a "trade" fight. Indeed, it is now likely that anti-American sentiment will be something akin to a tariff on our products, with intensifying animosities the impetus for a serious blow to global trade. Clearly, any slackening of demand for U.S. goods will only aggravate a vulnerable dollar weighed down by our dependence on foreign-made goods (and, of course, oil and other commodities), massive foreign liabilities and faltering confidence. Sadly, we are the world's debtor economy, and our house is not in order for a long conflict.

All the same, we remain in a curious market environment where dollar weakness puts no upward pressure on U.S. interest rates. Should the markets take this for granted? It certainly hasn't always been like this, and it's not this way for other countries. But, then again, there has never been an environment where a central bank enjoyed the luxury of governing the world's fiat reserve currency, allowing authorities to guarantee marketplace liquidity. Deteriorating fundamentals - escalating deficits (as far as the eye can see) and the risk of heightened inflationary pressures - would traditionally dictate higher market rates. Yet the Fed, especially in the face of war worries, is more determined than ever to keep rates low and the ultra-easy money flowing. In fact there is added talk this week of the Fed pegging long-term Treasury rates if necessary.

I just can't shake the unease that the Federal Reserve and Administration have individually set course on very risky strategies. And I worry that President Bush and Chairman Greenspan share absolute steadfast resolve in their respective endeavors. I fear that, for both, there is absolutely no turning back, whether things develop favorably or spiral disastrously out of control. There is no backup plan, with setbacks met with only greater risk taking. The President sees no option but decisive victory; Chairman Greenspan no alternative than to buttress the U.S. financial and economic Bubbles.

From a financial markets standpoint, I am troubled that things are diverging dramatically from previous sanguine expectations. Companies didn't anticipate this type of environment when they over-borrowed and bought back so much stock. Politicians had a distorted view of reality when they spent so lavishly. The financial sector has ballooned with the expectation that it commanded the position at the very center of the Universe and its faithful partner, the Federal Reserve, was right there to resolve any potential issue. Debt-crazed households, having been convinced of blue skies forever, could not today be more vulnerable. And we have these massive retirement liabilities that will be coming due soon. Somehow we've wasted unthinkable resources and failed to invest sufficiently to support our retirees or pay back our foreign creditors. Our authorities are resolute in their determination to inflate our way out of this mess. Like the war, the Fed gambled and lost, and its only a matter of the scope of the losses.

This is not the environment envisioned by either investors or the aggressive speculators. I fear that excessive liquidity and speculation are widening the gap between perceptions and reality. As the week came to its conclusion, the weak link was showing signs of vulnerability - the dollar was again under considerable pressure. We also contemplate to what extent gold and other commodities were caught up in speculative trading dynamics, with players on the wrong side of losing bets forced to unwind and clean up portfolios for quarter-end.

This is not the world we bargained for. We need a lot of things to go right to avoid a mess. For our brave troops, I hope this somehow can be resolved swiftly with minimal loss of life.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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