The Pause

By: Doug Noland | Sat, Aug 5, 2006
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It was choppy, but the general market ended the week little changed. The Dow added 0.2%, and the S&P500 inched 0.1% higher. The Transports dropped 0.8%, while the Utilities added 0.1%. The Morgan Stanley Cyclical index jumped 1.4%, while the more defensive Morgan Stanley Consumer index dipped 0.2%. The broader market was generally in the black. For the week, the small cap Russell 2000 gained 0.2%, and the S&P400 Mid-Cap index rose 0.3%. The NASDAQ100 declined 0.4%, the Morgan Stanley High Tech index dipped 0.2%, and the Semiconductors fell 0.3%. The Street.com Internet Index declined 0.9%, and the NASDAQ Telecommunications index was hit for 2.5%. The Biotechs declined 1.4%. The Financial stocks continue to outperform. The Broker/Dealers jumped 2.2% (up 10.2% y-t-d), and the Banks gained 0.9% (up 8.2% y-t-d). With bullion up $11.55, the HUI Gold index added 2.2%.

The Pause that refreshes... For the week, two-year Treasury yields declined 7 bps to 4.91%. Five-year yields dropped 8 bps to 4.83%, and bellwether 10-year yields fell 9 bps to 4.90%. Long-bond yields declined 8 bps to 4.99%. The 2yr/10yr spread ended the week inverted one basis point. The implied yield on 3-month December '06 Eurodollars declined 2.5 bps to 5.425%. Benchmark Fannie Mae MBS yields dropped 11 bps to 6.1%, outperforming Treasuries and declining to the lowest yields since April. The spread on Fannie's 4 5/8% 2014 note ended the week two narrower to 34, and the spread on Freddie's 5% 2014 note was also narrowed to 34. The 10-year dollar swap spread declined one to 56, the low since June 13th. Corporate bonds continue to lag the rallying Treasuries.

Investment grade issuers included Morgan Stanley $3.75 billion, HSBC $2.0 billion, Caterpillar $1.25 billion, Federal Express $1.0 billion, Wal-Mart $1.0 billion, DaimlerChrysler $1.0 billion, CNA Financial $750 million, Baxter International $600 million, and Bellsouth Burlington Northern $235 million.

Junk bond funds saw inflows of $336 million during the week (from AMG). Junk issuers included Ford Motor Credit $3.75 billion, Nielsen Finance $1.7 billion, Qwest $600 million, Ashtead Capital $550 million, Arizona Public Service $400 million, Steelcase $250 million, PNA Group $250 million, TFS Acquisition $190 million, Mxenergy Holdings $190 million, Pan American Energy $250 million, and US Shipping Partners $100 million.

International dollar debt issuers included ANZ National $1.0 billion and CESP Energy Sao Paulo $220 million.

August 1 - The Wall Street Journal (Joseph Rebello and Marc Hopkins): "The U.S. central bank has been raising interest rates. Oil prices have soared above $70 a barrel. Such developments usually portend good times for the country's corporate restructuring specialists. Not this time. Corporate bankruptcy filings dropped this year to their lowest level in at least six years."

Japanese 10-year "JGB" yields declined 5.5 bps this week to 1.865%. The Nikkei 225 index rose 1%, reducing 2006 losses to 3.8% (one-yr gain of 30.4%). German 10-year bund yields dipped 1.5 bps to 3.90%. Emerging debt and equities markets performed well. Brazil's benchmark dollar bond yields dropped 10 bps to 6.52%, the lowest level since late March. Brazil's Bovespa equity index gained 1.2%, increasing 2006 gains to 13.2%. The Mexican Bolsa added 0.5% this week (up 14.4% y-t-d). Mexico's 10-year $ yields fell 10 bps to 5.87%, also a low since late-March. Russian 10-year dollar Eurobond yields sank 11 bps to 6.81%. The Russian RTS equities index surged 4.7%, increasing 2006 gains to 45% and 52-week gains to 105%. India's Sensex equities index added 1.7% (up 15.6% y-t-d).

Freddie Mac posted 30-year fixed mortgage rates dropped 9 bps to 6.63%, down 17 bps in two weeks but up 81 basis points from one year ago. Fifteen-year fixed mortgage rates declined 7 bps to 6.27%, 89 bps higher than a year earlier. One-year adjustable rates dropped 9 bps to 5.69%, an increase of 132 bps. The Mortgage Bankers Association Purchase Applications Index declined 3.3% this week. Purchase Applications were down 23% from one year ago, with dollar volume down 24%. Refi applications slipped 2.3% last week. The average new Purchase mortgage was unchanged at $222,700 and the average ARM increased to $347,900.

Bank Credit rose $9.5 billion last week to a record $7.990 Trillion, with a y-t-d gain of $484 billion, or 11.2% annualized. Bank Credit inflated $697 billion, or 9.6%, over 52 weeks. For the week, Securities Credit declined $8.6 billion. Loans & Leases surged $18.2 billion during the week, and were up $324 billion y-t-d (10.3% annualized). Commercial & Industrial (C&I) Loans have expanded at a 14.0% rate y-t-d and 12.0% over the past year. For the week, C&I loans added $0.7 billion, and Real Estate loans increased $4.4 billion. Real Estate loans have expanded at a 12.7% rate y-t-d and were up 12.4% during the past 52 weeks. For the week, Consumer loans slipped $3.2 billion, while Securities loans rose $13.7 billion. Other loans added $2.5 billion. On the liability side, (previous M3 component) Large Time Deposits dropped $15.4 billion.

M2 (narrow) "money" supply declined $4.9 billion to $6.856 Trillion (week of July 24). Year-to-date, narrow "money" has expanded $166 billion, or 4.3% annualized. Over 52 weeks, M2 has inflated $303 billion, or 4.6%. Currency added $0.5 billion for the week, and Demand & Checkable Deposits jumped $19.0 billion. Savings Deposits sank $34 billion, while Small Denominated Deposits gained $5.7 billion. Retail Money Fund assets rose $3.8 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, jumped $22 billion last week to $2.171 Trillion (the highest level since Sept. 2003). Money Fund Assets have increased $114 billion y-t-d, or 9.3% annualized, with a one-year gain of $248 billion (12.9%).

Total Commercial Paper declined $3.3 billion last week to $1.790 Trillion. Total CP is up $152 billion y-t-d, or 15.5% annualized, while having expanded $224 billion over the past 52 weeks (14.3%).

Fed Foreign Holdings of Treasury, Agency Debt rose $8.8 billion to a record $1.654 Trillion for the week ended August 2nd. "Custody" holdings were up $135 billion y-t-d, or 14.9% annualized, and $198 billion (13.6%) over the past 52 weeks. Federal Reserve Credit expanded $7.1 billion to $833 billion. Fed Credit has increased $6.6 billion y-t-d, or 1.3% annualized. Fed Credit is up 4.2% ($33.9bn) over the past year.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $516 billion y-t-d (21% annualized) and $661 billion (17%) in the past year to $4.55 Trillion.

August 4 - Bloomberg (Anoop Agrawal): "India's foreign-exchange reserves rose by $675 million to $164.02 billion in the week ended July 28, central bank data showed."

Currency Watch:

August 2 - Bloomberg (Kabir Chibber): "U.S. officials are becoming more relaxed about a weaker dollar if a recent report from the International Monetary Fund is anything to go by, according to Goldman Sachs Group Inc. The IMF said last week that the dollar may be overvalued by 15 percent to 35 percent when adjusted for inflation. It concluded, based on discussions between IMF staff and officials from the U.S. Treasury and Federal Reserve..."

The Pause the "Refreshes." The dollar index dropped 1% to 84.38, the low since June 6th. On the upside, the Iceland Krona jumped 3.7%, the Polish Zloty 2.4%, the British pound 2.2%, and the Turkish lira 1.9%. %. On the downside, the Nicaragua cordoba fell 2.6%, the South Korean won 0.9%, the Uruguay peso 0.6%, and the Malaysian ringgit 0.5%.

Commodities Watch:

August 2 - Bloomberg (Sarah Tolkoff): "Corn and soybean prices rose the most in three weeks in Chicago on concern that extreme heat in the U.S. Midwest will damage crops already stressed by lack of moisture. Record temperatures were reported across parts of Iowa and Illinois and in the central and southern Great Plains..."

August 3 - Bloomberg (Madelene Pearson): "Australia, the world's second-largest wheat exporter, had its forecast for the coming harvest cut by 13 percent after drought and frost reduced potential yield, the U.S. Department of Agriculture said."

August 2 - Bloomberg (Claudia Carpenter): "Coffee prices rose to a six-year high in London as roasters compete for supplies amid a reduction in exports from Vietnam, the world's biggest producer of robusta. Robusta beans, used by processors such as Nestle SA to make canned and instant coffee, have climbed 21 percent in the past year after a drought in Vietnam slashed the harvest..."

The Pause that Refreshes... Gold jumped 1.8% to $647, and Silver surged 10% to $12.49. Copper added 2.4%, increasing y-t-d gains to 88%. September crude rose $1.52 to end the week at $74.76. September Unleaded Gasoline added almost 1%, with similar gains for September Natural Gas. For the week, the CRB index gained 1.8% (y-t-d up 5.5%). The Goldman Sachs Commodities Index (GSCI) rose 2.1%, increasing 2006 gains to 15.1%.

Japan Watch:

August 1 - Bloomberg (Lily Nonomiya): "Land prices in Japan rose for the first time in 14 years in 2005... The average price of land in the world's second-biggest economy climbed 0.9 percent to 114,000 yen ($995) per square meter...the National Tax Agency said... Prices in Tokyo...rose for the second year, surging 5.4 percent from 2004."

China Watch:

August 1 - XFN: "Auto output in China is expected to reach about 7 million units this year, compared with 5.7 million in 2005, the official Xinhua news agency reported."

August 4 - Bloomberg (Samuel Shen): "Tomson Group Ltd. sold an apartment in Shanghai for 130 million yuan ($16 million), or 130,000 yuan per square meter -- the highest price ever quoted for an apartment in China, the Oriental Morning Post reported..."

July 31 - Bloomberg (Kelvin Wong): "Office rents in Hong Kong's central business district will probably rise 30 percent this year because of increased demand and limited new supply, according to property agency CB Richard Ellis Group Inc. The vacancy rate in the city's prime office market is at a historical low of 4.07 percent..."

August 2 - Bloomberg (Kelvin Wong): "Hong Kong's property sales fell 42 percent in July, the biggest percentage fall in six months as rising interest rates made it more expensive for buyers to finance their purchases."

Asia Boom Watch:

August 1 - Bloomberg (Seyoon Kim): "South Korea's exports grew at the slowest pace in three months in July as labor strikes at Hyundai Motor Co. curbed production of cars and shipments of liquid-crystal display panels fell. Exports gained 12.4 percent from a year ago..."

August 3 - Bloomberg (Anuchit Nguyen and Beth Jinks): "Thailand's economy grew by 5.4 percent in the first half of 2006 from a year ago, said central bank governor Pridiyathorn Devakula."

August 2 - Bloomberg (Luzi Ann Javier and Clarissa Batino): "The International Monetary Fund trimmed its forecast for growth in the Philippines economy next year because of high oil prices. The economy will expand at 5.5 percent next year..."

Unbalanced Global Economy Watch:

August 4 - Bloomberg (Greg Quinn): "Canadian employers unexpectedly shed 5,500 jobs in July, marking the first consecutive monthly declines in almost two years... The unemployment rate rose to 6.4 percent from 6.1 percent in June, which was the lowest since 1974..."

July 31 - Bloomberg (Craig Stirling): "U.K. mortgage approvals rose in June at the fastest pace in five months, the Bank of England said, a sign the revival in Britain's $6.2 trillion property market may last through the rest of the year."

August 4 - Financial Times (Chris Hughes): "The number of insolvencies in England and Wales has hit record levels, highlighting the number of Britons hit by spiralling debt. The number of individual insolvencies in England and Wales rose to 26,021 in the second quarter of 2006 - a rise of 66% compared with last year and the highest figure so far recorded."

August 1 - Bloomberg (Rainer Buergin and Andreas Cremer): "Germany's unemployment rate in July fell to the lowest in almost two years as growth accelerates in Europe's largest economy... The unemployment rate, adjusted for seasonal swings, declined to 10.6 percent from 10.8 in June..."

July 31 - Bloomberg (Brian O'Neill): "Irish lending expanded at the fastest annual pace in more than six years last month, led by borrowing by companies and demand for mortgages. Lending rose 30.3 percent from a year earlier, the most since March 2000..."

July 31 - Bloomberg (Dara Doyle): "Irish house prices will climb 12 percent this year, pushing the average price of a home in the fastest growing economy in the 12 nation euro region to 395,000 euros ($503,000), according to Bank of Ireland Plc."

August 2 - Bloomberg (Fergal O'Brien): "Irish tax revenue climbed an annual 12 percent in the seven months through July, twice as fast as the government predicted earlier this year, underpinned by sales taxes and levies on property transactions."

August 3 - Bloomberg (Ben Sills): "Spain's economy, Europe's fifth-largest, accelerated at the fastest annual pace in more than four years in the second quarter... The Spanish economy expanded by 3.6 percent from the year earlier period..."

July 31 - Bloomberg (Jonas Bergman): "Norway's domestic credit growth accelerated in June at the fastest pace in more than 18 years, adding to pressure on the central bank to raise interest rates. Credit for households, companies and municipalities rose an annual 14.4 percent, the most since March 1988, up from 13.7 percent in May..."

August 1 - Bloomberg (Svenja O'Donnell): "Russia's manufacturing industries grew at the fastest pace in almost six years last month as output and new orders increased, a gauge of industrial production showed."

July 31 - Bloomberg (Garfield Reynolds): "Russia will raise its forecasts for economic growth in 2006 and 2007, Interfax said, citing Andrei Klepach, head of macroeconomic forecasting at the Economy Ministry... Klepach's department will propose forecasting 6.5 percent growth for gross domestic product in 2006 (up from 6.1%)...and recommend raising the 2007 forecast to 6 percent (from 5.7%)..."

August 1 - Bloomberg (Ben Holland): "Turkey's exports rose 22 percent in July from a year earlier, according to the Turkish Exporters' Assembly, as the lira's decline made goods cheaper abroad."

August 3 - Bloomberg (Steve Bryant): "Turkey's inflation rate rose to the highest level in more than two years in July as oil prices soared and the lira fell, increasing pressure on the central bank to raise borrowing costs. Inflation accelerated for a ninth consecutive month to 11.7 percent from 10.1 percent in June..."

August 1 - Bloomberg (Nasreen Seria): "South African manufacturing production grew at a record pace in July, a survey indicated, as the rand plunged 16 percent against the dollar in the previous two months, improving the competitiveness of exports."

July 31 - Bloomberg (Nasreen Seria): "South African credit growth accelerated to an annual 23.9 percent in June, higher than forecast, as seven interest rate cuts in the 22 months through April 2005 continued to boost consumer spending."

July 31 - Bloomberg (Hans van Leeuwen): "Lending to Australian consumers and businesses rose in June, signaling the central bank's interest-rate increase in May hasn't slowed credit growth. Total credit provided by banks and other financial institutions gained 1.2 percent from May... Credit rose 14.2 percent from a year earlier."

Latin America Watch:

July 31 - Bloomberg (Patrick Harrington and Adriana Arai): "Mexico's economy maintained its fastest growth rate in almost six years going into the second quarter and is set to expand more than 4 percent in 2006, a Finance Ministry official said."

August 1 - Bloomberg (Fabio Alves and Carlos Caminada): "Brazil's trade surplus widened to a record in July after exports jumped 19 percent. The surplus widened to $5.64 billion from $4.08 billion in June... The surplus was $5 billion in July 2005... Exports rose to a record $13.6 billion... Imports rose 8.6 percent from June to $7.98 billion, also a record."

August 4 - Bloomberg (Guillermo Parra-Bernal): "Brazil's industrial output unexpectedly fell in June, signaling that growth in local consumer demand for manufactured goods is losing momentum. Output fell 0.6 percent in June from a year earlier..."

August 1 - Bloomberg (Daniel Helft): "Argentina's July tax revenue rose 27 percent from a year earlier fueled by value-added and income taxes, the country's tax agency reported."

July 31 - Bloomberg (Guillermo Parra-Bernal): "Caracas real estate prices jumped 20 percent in the first half, reflecting a surge in government subsidies for homebuyers and a shortage of housing, El Universal said, citing the nation's real estate dealers' association."

Central Bank Watch:

August 4 - Financial Times (Chris Giles & Gerrit Wiesmann): "Interest rates rose across Europe on Thursday as the European Central Bank increased rates by an expected quarter point to 3 per cent, while the Bank of England surprised markets with an equivalent rise of its main interest rate to 4.75 per cent. The world's leading central bankers are now as one in tightening monetary policy. Thursday's European rate rises followed swiftly on the Bank of Japan's move to end its long-standing zero interest rate policy and the Federal Reserve's quarter-point rate rise to 5.25 per cent late last month. Australia this week also raised its key rate by 25 basis points to 6 per cent. Central bankers believe that four years of rapid global economic growth, high energy prices and historically low interest rates have led to mounting inflationary pressure worldwide."

August 1 - Financial Times (Raphael Minder): "Glenn Stevens was on Tuesday named as the next governor of the Reserve Bank of Australia (RBA), replacing Ian Macfarlane, who has overseen one of the most successful decades for the country's economy... Mr. Stevens will take over on September 18, amid growing concerns about inflation following publication last week of the consumer price index, which showed inflation reaching an annual rate of 4 per cent... Mr Stevens, 48, joined the RBA in 1980 and has spent his entire career holding various positions within the central bank, except for a brief stint as a visiting scholar at the Federal Reserve Bank of San Francisco."

Bubble Economy Watch:

July Average Hourly Earnings were up 3.8% y-o-y. Total private sector Average Weekly Earnings (AWE) were up 4.1% y-o-y. AWE in the Goods sector was up 4.3% y-o-y, led by Mining up 6.4%, Construction 4.2%, and Manufacturing 4.1%. Service Providing AWE were up 6.0% y-o-y, Transportation/Utilities up 4.8%, Information 7.6%, Financial Activity 6.7%, Professional/Business 8.7%, Education/Health 4.1%, and Leisure 5.8%. Wage gains are notable and notably broad-based.

June Personal Income was up 6.5% from June 2006, with the Wage & Salary component up 6.9% y-o-y. June Personal Spending was up 6.2% y-o-y. The July ISM Manufacturing index rose almost one point to a stronger-than-expected 54.7. The Prices index rose 2 points to 78.5, the high since last October. The June PCE (Personal Consumption Expenditures) Deflator reading of up 3.5% y-o-y is second only to Sept. '05's 3.8% over the past 15 year period. June Factory Orders were up 6.0% from a year earlier, with New Orders Ex-Transportation up 7.8%. June Construction Spending was up 6.8% from a year ago. And while Residential Construction Spending was unchanged y-o-y, Nonresidential Spending was up a notable 15.8%. The July ISM Non-Manufacturing index declined 2.2 point to 54.8, the lowest reading since last September. Total July vehicle sales came in at a stronger-than-expected and respectable 17.2 million pace.

August 4 - Bloomberg (Kevin Orland): "U.S. companies' second-quarter earnings rose by an average of 19 percent as energy producers, bolstered by record oil prices, regained their standing as the fastest-growing industry group. Oil and gas companies reported a 45 percent increase on average, the largest among the index's 10 main industry groups."

July 31 - Bloomberg (Bob Bensch): "Tiger Woods...tops the list of Sports Illustrated magazine's top-earning athletes for the third straight year. Woods earned more than $97.6 million in 2005... The world's top-ranked golfer made over $10.6 million in on-course earnings and another $87 million in endorsements..."

Real Estate Bubble Watch:

August 2 - Bloomberg (Daniel Taub): "California home-loan defaults rose at the fastest pace in 14 years in the second quarter as slowing price appreciation made it harder for homeowners to sell and pay off mortgages, DataQuick...said. Banks and other lenders sent 20,275 default notices to California homeowners in the second quarter, up 67.2 percent from a year earlier and up 10.5 percent from the first quarter..."

Energy Boom and Crude Liquidity Watch:

August 3 - Bloomberg (Andy Critchlow): "Saudi Arabia, the Middle East's largest-economy, will spend $283 billion in the next seven years building oil facilities and infrastructure projects as it seeks to capitalize on record oil revenue, Samba Financial Group said. The Persian Gulf monarchy...the world's largest oil-exporter, plans to build 37 'large-scale' projects including oil and gas production facilities, refineries, chemical plants and real-estate ventures..."

July 31 - CNW Telbec: "Alberta's economy is expected to grow by a spectacular 6.6 per cent in 2006, and high energy prices mean that the torrid pace is unlikely to subside any time soon, according to the Conference Board's Provincial Outlook...'Among Canadian provinces, Alberta is in a league of its own,' said Marie-Christine Bernard, Associate Director, Provincial Outlook."

August 2 - Bloomberg (Will McSheehy): "Personal debt in the United Arab Emirates, the second-largest Arab economy, jumped 64 percent last year as rents climbed and inflation outpaced wage growth."

August 1 - Bloomberg (Lucian Kim): "OAO Gazprom, the world's biggest natural-gas producer, said net income rose 54 percent in the second quarter from the same period last year. Unconsolidated net income rose to 63.8 billion rubles ($2.4 billion)..."

Climate Watch:

August 2 - Associated Press: "The U.S. in recent years has been sweltering through three times more than its normal share of extra-hot summer nights, government weather records show... A top federal research meteorologist said he 'almost fell out of my chair' when he looked over U.S. night minimum temperature records over the past 96 years and saw the skyrocketing trend of hot summer nights. From 2001 to 2005, on average nearly 30% of the nation had 'much above normal' average summertime minimum temperatures, according to the National Climatic Data Center..."

August 2 - Dow Jones (Matthew Dalton and Christine Buurma): "Scorching temperatures on Wednesday drove demand for electricity to fresh record highs in the Northeast, the mid-Atlantic and parts of the Midwest, causing scattered outages... Power demand for electricity in New England surged to a record of 28,041 megawatts... That surpasses the previous record of 27,401 megawatts set Tuesday."

August 2 - Bloomberg (Larry DiTore): "Saratoga Race Course in New York canceled its horse races today because of the severe heat that's gripping the U.S. East Coast, the first time the 143-year-old track shut down because of high temperatures."

Speculator Watch:

August 1 - Financial Times (Steve Johnson): "Times are tough for the majority of the hedge funds specialising in the currency market. After suffering probably their worst year for a decade in 2005, a number of large, high-profile funds have chalked up further losses this year. The three currency hedge funds operated by John W Henry, a noted US manager, have all lost between 10.3 and 21.5 per cent this year, while the AHL Currency fund run by the UK's Man Group lost 9.8 per cent in the first half."

August 1 - Bloomberg (Harris Rubinroit): "Kohlberg Kravis Roberts & Co. and Bain Capital LLC plan to borrow $16 billion to finance the biggest leveraged buyout ever and will be charged the highest interest since 2001 to get the deal done."

The Pause...

Chalk one up for my now long-standing "analytical nemesis" - Paul McCulley. July's less-than-robust employment report - following June's and a flurry of weak housing data - appears to have locked in an August 8th pause. Mr. McCulley has not only been forecasting that the Fed would pause, he has been ranting that they have already gone too far. "Easing, probably serious easing, is coming into view on a 2007 horizon."

Well, I've never been accused of being a good loser. With this in mind, I'll tell you that I sometimes think back to the op-ed piece Mr. McCulley wrote with his cohort, Goldman's Bill Dudley, for the Financial Times back in April 2003. The article began:

"The Federal Reserve has won its long war against inflation. And, with victory, go the spoils - evident in President George W. Bush's decision to reappoint Alan Greenspan for another term as chairman. But to ensure an enduring legacy, Mr. Greenspan now needs to solve a different problem: inflation is too low, rather than too high. How so? The economy needs a buffer of inflation above price stability to ensure that monetary policy has room to work effectively in the event of shocks to aggregate demand."

I repudiated this line of analysis (rank "inflationism") at the time and am today only more secure in the analytical basis for this derision. It is worth noting that data actually had CPI up in the neighborhood of 3% y-o-y when this article was written, having quickly recovered from the cyclical low of between 1% - 2% during 2002. At the time, the dollar was under heavy selling pressure (having lost almost 20% of its value in the preceding 13 months). Import Prices had recovered quickly from the y-o-y declines experienced throughout much of 2001/2002. The CRB commodities index had already risen about a third from 2001 lows, and crude oil prices had then recently surpassed $35 after trading below $20 in early 2002. California median home prices had inflated about 40% in the two-year period ended in April 2003 - and have since inflated nearly another 60%. Average US Home Prices had jumped about 20% during those two years, fueled by 9.5% household mortgage debt growth during 2001, 11.9% during 2002, and 14.3% during 2003.

In hindsight, instead of "Mission Accomplished - The Fed has Conquered Inflation," an appropriate banner would have displayed, "Move Immediately with Leveraged Positions to Capture Glorious Gains from Historic Asset and Commodities Inflation." To be sure, the speculative juices were flowing generously throughout the expanding leveraged speculating community; households were anxious to forget about stocks and pile into real estate; and the Mortgage Finance Bubble was demonstrating powerful inflationary biases. Inflation - not deflation - was the clear and present risk, and in absolutely no way should the Fed have held rates at 1% until June 30, 2004. This was one of the more spectacular blunders in the history of central banking, and notions from 2003 that "now the promised land of price stability has been reached" seem today like a bad joke.

Candidly, I don't trust contemporary bond markets. In an age of unlimited ("Wall Street") finance, market yields are no longer determined by the interaction of a relatively defined supply of available funds ("savings") and shifting demand for borrowings (Credit). For some time now there have been no restraints on US Financial Sphere expansion, and one can argue restraints have been lifted for most global Credit systems over the past few years. It is too easy to expand financial system liabilities, in the process creating new Credit/liquidity, with asset prices - both real and financial - inflated by an overabundance of global liquidity.

This dynamic has altered so many financial and economic facets and relationships, including bond managers no longer needing to fret over the heightened demand for finance that comes with booming economies and asset markets (indeed, bond managers have grown to love the abundant liquidity created by booms!). The poor archaic "bond vigilante" mindset is at a decided disadvantage in this Brave New Financial World of derivatives, sophisticated securitizations, complex spread and yield curve plays, and myriad international "carry trades". What's more, the insidious loss of long-term investor purchasing power to inflation is of little concern in this age of short-term relative performance fixation.

More than ever before, global bond markets are commanded by leveraged speculators. Market yields are largely determined in the marketplace based upon some spread to global central bankers' pegged short-term rates. To some extent, one can think in terms of market yields as some (generally narrow) spread to an average global central bank-dictated "cost of funds." The composition of these "baskets" of rates is determined by current relative short-term rates and expectations for the direction of the spectrum of "pegged" rates and prospective currency values (i.e. if participants expect that the BOJ will keep rates low and that the yen will not rise in relative value, speculators will increase borrowings/draw more cheap finance from Japan to finance high yielding securities elsewhere).

The "supply" of finance is frustratingly amorphic, although we can surmise a few things. It is today global in nature; it is heavily influenced by securities leveraging at home and abroad; it is augmented by energized financial sectors globally; and it is enlarged by $800 billion U.S. Current Account Deficits. I can make a strong case that the nature of the global "supply" of finance has changed (expanded) profoundly during just the past four years. Not only have U.S. Current Account Deficits doubled in size, structural dollar weakness has provided extraordinary leeway to global Credit systems around the world. Across the globe, economies and financial systems have been buttressed by the revaluation of currencies and commodities (dollar devaluation). In addition, the methods and principles of Wall Street finance have taken the world by storm, while the ballooning leveraged speculating community has become keen to play non-dollar asset markets. Additionally, U.S. institutions and investors have discovered the joys of profiting from a deflating greenback. The great inflation in energy prices has, as well, fostered additional Credit growth in the U.S. and elsewhere, both bolstering the supply of global finance and initiating huge shifts in the flow of finance (profoundly altering inflationary manifestations).

It bothered me tremendously back in 2003/04 when the reflationists contrived analytical justifications and rationalizations to support recklessly loose monetary policy - when it was clear that the consequences of this massive inflation included ballooning household mortgage debt and problematic housing Bubbles. Frankly, Wall Street has never met a Bubble it didn't love and it is certainly today keen to ensure no end to the long series of Bubbles that work to sustain the Great Credit Bubble. It is both curious and unfortunate that contemporary bond managers can cheerlead every Bubble. But they know clearly that Bubble risks will force central bankers to accommodate ongoing excess, while expecting that it ensures aggressive rate cuts at the first indication of Bubble vulnerability.

It is worth noting that benchmark Fannie Mae MBS yields ended today's session 42 bps below the 6.48% high yield posted on June 28th. Financial markets both at home and abroad have of late been significantly more accommodative to general consumer and business sentiment (hence economic activity) than they were over the past couple months. I remain content with the view that financial markets today lead the economy much more than economies lead markets.

I expect recent lower market yields to support mortgage borrowings and housing prices, while throwing a additional fuel on the already hot sectors. And if the Fed does Pause next week we cannot rule out the possibility that an old fashioned short-squeeze and derivative unwind (once again) envelops the fixed income marketplace. Perhaps a long shot, but such a scenario would prove highly destabilizing. Financial markets - certainly including the U.S. bond market - remain over-liquefied, a problematic circumstance apparently carrying little weight at the Fed.

August 4 - The Wall Street Journal (Greg IP): "Federal Reserve officials see the recent rise in underlying inflation as mostly a temporary response to rising energy prices, not an overheating economy. That assumption underpins their view, laid out in speeches and testimony, that inflation ought to fall back over the next year and a half without the Fed having to engineer a jarring economic slowdown with sharply higher interest rates. And it is central to the argument that the Fed should pause soon in its two-year campaign of interest-rate increases."

I view surging energy, commodities, and emerging markets as today's prominent inflationary manifestations, not dissimilar to Bubbling home prices in 2003/2004 - back when the inflationists were trumpeting deflationary risks. It is astounding that the Fed would call it a day with heightened inflationary pressures, $800 billion Current Account Deficits, and highly liquefied and speculative financial markets, especially with their global comrades in tightening mode. Acquiescing to current excess ensures that the recent rise in underlying inflation is anything but temporary.

I was reminded yesterday that I had in the past stated the view that there was no Bubble of sufficient size to replace the mortgage finance Bubble. Well, this view might prove incorrect, but at the minimum it needs updating and clarifying. First of all, I won't back away from my belief that a bursting Mortgage Finance Bubble would pose a very serious dilemma for both the Credit system and U.S. economy. This is why the emergence of closely related energy/alternative-energy/commodities/emerging market booms are today of such profound importance. It is not so much that they have the capacity to replace a bursting mortgage Bubble, as much as they do have the clear potential to provide the key marginal source of Credit, spending, and income growth that would work to sustain home prices and mortgage Credit growth generally.

And as for Mr. McCulley's bold "probably serious easing" call, well, it's...bold. While he definitely has history on his side, he also assumes the status quo: 1) The Fed retains control to do as it wishes, with unrelenting U.S. economic growth as its foremost objective. 2) Recent inflation trends are aberrational and benign. 3) The global backdrop today is not significantly different than in the past. 4) The dollar is not acutely vulnerable.

I actually believe that major Greenspan-style unilateral rate cuts in response to economic weakness are a thing of the past. Whether it appreciates it today or not, the Bernanke Fed has lost significant autonomy to the now massive flows of global finance. Importantly, this powerful pool of global finance Bubble increasingly dictates inflationary trends, and the Fed's determination to sustain the U.S. Credit Bubble only ensures that these global flows become only more commanding and destabilizing. Inflationary pressures are building and, as we are observing with energy prices, increasingly destabilizing. And, the dollar...

The vulnerable dollar is poised to play spoiler for the inflationists and the Fed. In this regard, it is worth pondering this evening that when the Fed cut rates 50 bps to 6% on January 1, 2001, the dollar index traded at 110. A year later, after the Fed had quickly dropped rates to 1.75%, the dollar index was approaching its high of 120. Clearly, the Fed back then enjoyed great leeway to cut and inflate. Conversely, the Fed began raising rates from the low of 1% in June of 2004 with the dollar index at about 90. Now, 17 hikes later, the dollar index is near 84. It is also worth repeating that when the Fed was cutting rates aggressively in 2001 Current Account Deficits were running less than $100 billion quarterly. They are now double this amount.

The problem with ("Keynesian") monetary policy today (as it was in 2001-2004) is that it specifically seeks to thwart the unwind of Bubbles. The bigger they become, the greater the effort to sustain them. But nurturing Credit, speculative and asset Bubbles eventually becomes a losing proposition. Credit excess is certainly not easily suppressed. Notably, despite rising household Credit problems, inflationary pressures forced the Bank of England this week to raise rates after a two-year hiatus. The Reserve Bank of Australia raised rates 25 bps this week to 6%. Recall that Australia began raising rates in 2002 and pushed them to 5% in early 2005. Despite considerable angst that real estate Bubbles and the economy were going to collapse, the Australian economy's boom and inflationary pressures intensified. The extraordinarily loose global financial backdrop has played a key role to buttressing the UK and Australian booms, and I don't see why it won't for the time being lend support to the U.S. Bubble Economy. The Pause the refreshes; we'll have to wait and see.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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