Financial Structure

By: Doug Noland | Fri, Aug 18, 2006
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For the week, the Dow gained 2.6% and the S&P500 rose 2.8%. Economically sensitive issues surged, with the Transports jumping 5.9% and the Morgan Stanley Cyclical index gaining 3.8%. The S&P 500 Homebuilding index jumped 7.2%, the S&P500 Restaurant index 5.5%, and the Morgan Stanley Retail index 4.7%. The Utilities added 1.2%, and the Morgan Stanley Consumer index gained 1.9%. The broader market rallied strongly. The small cap Russell 2000 surged 4.8%, and the S&P400 Mid-cap index rose 3.5%. Technology stocks burst higher. For the week, the NASDAQ100 jumped 6%, and the Morgan Stanley High Tech index surged 8.2%. The Semiconductors lurched 10% higher. The Street.com Internet Index gained 6.4%, and the NASDAQ Telecommunications index jumped 8.4%. The Biotechs rallied 5.7%. The Broker/Dealers gained 4.6% (up 11% y-t-d), and the Banks rose 1.8% (up 7.6% y-t-d). With bullion down $17.50, the HUI index dipped 1%.

For the week, two-year Treasury yields declined 9.5 bps to 4.87%. Five-year yields fell 12 bps to 4.785%, and bellwether 10-year yields dropped 13 bps to 4.84%. Long-bond yields sank 12 bps to 4.98%. The 2yr/10yr spread ended the week inverted 3 bps. The implied yield on 3-month December '06 Eurodollars fell 4 bps to 5.44%. Benchmark Fannie Mae MBS yields sank 14 bps to 5.985%, outperforming Treasuries as MBS yields fell to lows since late-March. The spread on Fannie's 4 5/8% 2014 note ended the week two narrower at 32, and the spread on Freddie's 5% 2014 note three narrower at 31. The 10-year dollar swap spread declined 2.25 to 52.75, a 3-month low. Corporate bonds had difficultly keeping up with Treasuries, with junk spreads widening 5 bps.

Investment grade issuers included Citigroup $1.75 billion, CIT Group $1.0 billion, Bear Stearns $1.0 billion, Lehman Brothers $850 million, American General $750 million, Duke Realty $700 million, FPL Group $600 million, American Express $400 million, Burlington Northern $300 million, MassMutal $250 million, Pacific Life $250 million, Cintas Corp $250 million and Caterpillar Finance $200 million.

Junk bond funds saw outflows of $73 million during the week (from AMG). Junk issuers included Xerox $650 million, Lamar Media $215 million, and Broadview Network $210 million.

August 15 - Bloomberg (Mark Pittman): "Developers led by Sam Zell's Equity Office Properties Trust and Mortimer Zuckerman's Boston Properties Inc. are using record-high stock prices to lower their borrowing costs. Real estate investment trusts this year have sold more than $4.1 billion of bonds convertible into stock, almost triple the amount issued in all of 2005."

Convertible issuers included ERP Operating LP $600 million and Macrovision $240 million.

International dollar debt issuers included ICICI Bank $340 million.

Japanese 10-year "JGB" yields increased one basis point this week to 1.85%. The Nikkei 225 index jumped 3.5%, fully erasing 2006 losses and increasing one-year gains to 31%. German 10-year bund yields fell 8 bps to 3.90%. Emerging debt and equity market rallies continued. Brazil's benchmark dollar bond yields declined 7 bps to 6.38%. Brazil's Bovespa equity index added 1.6%, increasing 2006 gains to 12.2%. The Mexican Bolsa jumped 3.8% this week (up 18.2% y-t-d). Mexico's 10-year $ yields fell 6 bps to 5.92%. Russian 10-year dollar Eurobond yields declined 5 bps to 6.78%. The Russian RTS equities index gained 2.8%, increasing 2006 gains to 41.7% and 52-week gains to 90%. India's Sensex equities index rose 2.8% (up 22% y-t-d).

Freddie Mac posted 30-year fixed mortgage rates declined 3 bps to an 18-week low 6.52%, a decline of 28 bps in four weeks - but up 72 basis points from one year ago. Fifteen-year fixed mortgage rates were unchanged at 6.20%, 80 bps higher than a year earlier. One-year adjustable rates were fell 4 bps to a 10-week low 5.65%, an increase of 107 bps y-o-y. The Mortgage Bankers Association Purchase Applications Index dipped 0.8% this week. Purchase Applications were down 22% from one year ago, with dollar volume down 23%. Refi applications jumped 4.6% last week to a 13-week high. The average new Purchase mortgage was little changed at $223,900, while the average ARM declined to $353,600.

Bank Credit declined $12.6 billion last week to $7.997TN. Year-to-date, Bank Credit has expanded $491 billion, or 10.6% annualized. Bank Credit inflated $666 billion, or 9.5%, over 52 weeks. For the week, Securities Credit added $2.5 billion. Loans & Leases dropped $15.2 billion during the week and were up $327 billion y-t-d (9.7% annualized). Commercial & Industrial (C&I) Loans have expanded at a 16.4% rate y-t-d and 14.4% over the past year. For the week, C&I loans added $1.6 billion, while Real Estate loans declined $2.6 billion. Real Estate loans have expanded at an 11.8% rate y-t-d and were up 10.8% during the past 52 weeks. For the week, Consumer loans increased $0.9 billion, while Securities loans fell $6.5 billion. Other loans dropped $8.5 billion. On the liability side, (previous M3 component) Large Time Deposits declined $9.2 billion.

M2 (narrow) "money" supply jumped $24 billion to $6.849 Trillion (week of August 7). Year-to-date, narrow "money" has expanded $159 billion, or 3.9% annualized. Over 52 weeks, M2 has inflated $298 billion, or 4.6%. For the week, Currency slipped $0.6 billion, and Demand & Checkable Deposits dropped $22.9 billion. Savings Deposits surged $37.8 billion, and Small Denominated Deposits gained $6.0 billion. Retail Money Fund assets increased $3.7 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, jumped $20 billion last week to $2.196 Trillion. Money Fund Assets have increased $139 billion y-t-d, or 10.6% annualized, with a one-year gain of $258 billion (13.3%).

Total Commercial Paper jumped $10.4 billion last week to $1.805 Trillion. Total CP is up $164 billion y-t-d, or 15.8% annualized, while having expanded $228 billion over the past 52 weeks (14.5%).

Asset-backed Securities (ABS) issuance this week increased to $16 billion. Year-to-date total ABS issuance of $444 billion (tallied by JPMorgan) is running about 5% below 2005's record pace, with y-t-d Home Equity Loan ABS sales of $309 billion 2% above last year.

Fed Foreign Holdings of Treasury, Agency Debt gained $4.9 billion to a record $1.667 Trillion for the week ended August 16th. "Custody" holdings were up $148 billion y-t-d, or 15.4% annualized, and $199 billion (13.5%) over the past 52 weeks. Federal Reserve Credit expanded $4.0 billion to $829 billion. Fed Credit has increased $2.8 billion y-t-d, or 0.5% annualized. Fed Credit is up 4.5% ($35.5bn) over the past year.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $545 billion y-t-d (21% annualized) and $689 billion (18%) in the past year to $4.592 Trillion.

August 17 - Bloomberg (Garfield Reynolds): "Russia's foreign currency and gold reserves, the world's third largest, rose to a record $277 billion, as oil and natural-gas prices hovered near all-time highs. The reserves soared $10.1 billion in the week to Aug. 11..."

Currency Watch:

August 15 - Bloomberg (Hannah Gardner): "Russia's central bank bought $57.3 billion from exporters in the first half of the year amid high oil prices, increasing the country's money supply and making it harder to meet the bank's inflation targets, Vedomosti said. The central bank's buying of dollars swelled the money supply by almost 44 percent in the year to July 1..."

The dollar index declined 0.5% to 84.98. On the upside, the Chilean peso gained 1.9%, the Iceland krona 1.8%, the New Zealand dollar 0.9%, and the Brazilian real 0.8%. On the downside, the South African rand dropped 3.3%, the Hungarian forint 2.1%, the Thai baht 0.4%, and the British pound 0.4%.

Commodities Watch:

August 14 - Bloomberg (Christina Soon): "China should buy gold with some of its currency reserves, which are the world's biggest, and three-quarters of its current foreign-exchange holdings would suffice, said a researcher at the State Council."

August 14 - Bloomberg (Wing-Gar Cheng): "China's wholesale crude oil prices rose 8.3 percent in July from a year earlier, and fell 0.3 percent from June, the People's Bank of China said."

August 18 - Bloomberg (Chanyaporn Chanjaroen): "Nickel headed for a fourth consecutive weekly gain on the London Metal Exchange because of a shortage of the metal used in stainless steel. Stockpiles of nickel monitored by the LME have plunged 83 percent this year because of rising stainless-steel production. Prices of the metal for immediate delivery exceeded benchmark three-month prices by as much as $4,240 a ton as of yesterday, more than twice as much as at the start of the week."

Gold declined 2.8% to $614.70, while Silver added 1.2% to $12.03. Copper dipped 1%, reducing y-t-d gains to 76%. September crude dropped $3.34 to end the week at $71.01. September Unleaded Gasoline fell 5.5%, and September Natural Gas sank 6.9%. For the week, the CRB index dropped 3.5% (up 0.1% y-t-d). The Goldman Sachs Commodities Index (GSCI) fell 3.8%, reducing 2006 gains to 10.1%.

Japan Watch:

August 18 - Bloomberg (Chris Cooper and Shanthy Nambiar): "The Japan Bank for international Cooperation, the government's main overseas lender, is in talks with Malaysia's central bank to sell dollar-denominated Islamic bonds, according to a spokesman. The Japanese bank may sell $300 million to $500 million of Islamic debt by January to attract Middle Eastern investors..."

China Watch:

August 14 - XFN: "China has more than enough foreign exchange reserves and should use some of its holdings to fund corporate acquisitions offshore, a senior economist said. Xia Bin, an economist at the Development Research Center, an influential think tank under the State Council or cabinet, said China would be able to meet its needs with foreign reserves of about $700 bln."

August 16 - Financial Times (Richard McGregor): "China's measures to cool the economy may not have a large and immediate impact because of the increasing role of profits in funding investment, the main driver of the country's double-digit growth this year, according to the World Bank. The bank...said total profits of the state and private sectors had grown by 28 per cent in the first half of 2006, year-on-year, nine points higher than for the same period in 2005. 'One reason for the resilience of fixed-asset investment to tightening measures is that profits, which finance over half of investment, picked up momentum,' the report said."

August 16 - Bloomberg (Nerys Avery): "Investment in China's real estate, factories and utilities rose at a slower pace in July... Fixed-asset investment in towns and cities climbed 30.5 percent in the first seven months from a year earlier..."

August 15 - Bloomberg (Nerys Avery and Nipa Piboontanasawat): "China's industrial production rose last month at the slowest pace since April... Output at manufacturers, mines and power plants climbed 16.7 percent from a year earlier..."

August 14 - Bloomberg (Nipa Piboontanasawat and Nerys Avery): "China's retail sales increased 13.7 percent in July as rising incomes in the world's fourth-largest economy spurred spending on clothes, furniture and cell phones."

August 16 - Bloomberg (Kelvin Wong): "Hong Kong's rents for top-quality offices rose 18 percent in the first half of 2006 from a year earlier on the improved economy and a lack of new supply, according to CB Richard Ellis..."

Asia Boom Watch:

August 18 - Bloomberg (Kartik Goyal): "India's export of gems, textiles and other manufactured products accelerated in July, spurring industrial production. Exports increased 35 percent to $10.2 billion in July from a year earlier..."

August 18 - Bloomberg (Kartik Goyal): "Overseas investment in Indian companies rose 47 percent in the quarter ended June 30 as expanding economic growth enhanced the nation's appeal as an investment destination."

August 17 - Bloomberg (Theresa Tang and Yu-Huay Sun): "Taiwan's economic growth cooled in the second quarter as higher credit-card and energy bills deterred consumers from spending on cars and clothing. Gross domestic product rose 4.57 percent from a year earlier after climbing a revised 4.92 percent in the first quarter..."

August 14 - Bloomberg (Aloysius Unditu and Arijit Ghosh): "Indonesia's economic growth accelerated for the first time in 1 1/2 years, boosted by exports of agricultural commodities such as palm oil and rubber. Gross domestic product...grew 5.2 percent in the second quarter from a year earlier..."

Unbalanced Global Economy Watch:

August 16 - Bloomberg (Greg Quinn): "Canadian factory shipments rose 1.9 percent in June, the fastest since last August, led by energy and automobiles."

August 16 - Bloomberg (Brian Swint): "An index of U.K. house prices rose in July by the most in more than two years, suggesting the country's $6.2 trillion property market is maintaining momentum, the Royal Institute of Chartered Surveyors said."

August 16 - Bloomberg (Katy Watson): "Nickel futures rose for a sixth straight session in London, trading at their highest in at least 19 years. Nickel for delivery in three months on the LME climbed...to $28,000 a metric ton... The contract has more than doubled this year."

August 14 - Bloomberg (Fergal O'Brien): "The economy of the euro nations grew the most in six years in the second quarter, making it likely that expansion this year will beat the European Central Bank's forecast... The $10 trillion economy expanded 0.9 percent from the first quarter..."

August 14 - Bloomberg (Matthew Brockett): "The German economy, Europe's largest, expanded at the fastest pace in five years in the second quarter, led by construction and company spending on equipment. Gross domestic product, the value of all goods and services, grew 0.9 percent from the first quarter..."

August 18 - Bloomberg (Sandrine Rastello): "French job creation increased the most in more than five years in the second quarter as Europe's third-largest economy expanded at the fastest pace since 2001."

August 14 - Bloomberg (Paul Tobin and Ben Sills): "Spanish economic growth accelerated to the fastest annual pace in more than four years... The Spanish economy expanded 3.6 percent from the year earlier period..."

August 14 - Bloomberg (Alice Ratcliffe): "Austria's economy expanded at the fastest pace in two years in the second quarter as export demand fueled domestic investments."

August 15 - Bloomberg (Tasneem Brogger): "Danish wages increased an annual 3.3 percent in the second quarter, the largest gain since the same quarter in 2004, as a shortage of qualified workers forced employers to pay higher salaries."

August 16 - Bloomberg (Jonas Bergman): "Norway's central bank raised its benchmark interest rate to 3 percent to cool economic growth and keep inflation in check after unemployment plunged in the world's third-largest oil exporter."

August 14 - Bloomberg (Alistair Holloway): "Finland's economy expanded an annual 9.6 percent in June...driven by the paper industry where an industrial dispute halted output in the year-ago period."

August 17 - Bloomberg (Alistair Holloway): "The cost of goods leaving Finnish factories and mines rose for a seventh consecutive month in July... Producer prices gained 0.9 percent from June, with the annual increase accelerating to 5.3 percent..."

August 17 - Bloomberg (Hannah Gardner): "Russia's gross domestic product expanded 6.3 percent in the first half of this year, accelerating from 5.4 percent growth in the year-earlier period, amid surging oil prices."

August 15 - Bloomberg (Hannah Gardner): "Russia attracted 42 percent more foreign investment in the first six months of this year than in 2005, the Federal Statistics Service said..."

August 14 - Bloomberg (Garfield Reynolds): "Russia's current account surplus widened 22 percent in the second quarter from a year earlier, as oil and natural gas exports boomed amid record international fuel prices. The second-quarter surplus reached $27.3 billion..."

August 17 - Bloomberg (Mahmoud Kassem): "Egypt's government will take measures to fight inflation, Al-Alam Al-Yom newspaper reported today citing unnamed banking sources. Egypt's inflation in July was 8.4 percent..."

August 16 - Bloomberg (Tracy Withers): "New Zealand faces 'uncomfortably strong' inflation as fuel prices surge and unemployment falls to a record low, Finance Minister Michael Cullen said. The nation's jobless rate fell to a record 3.6 percent in the second quarter, creating labor shortages that may boost wages and fan inflation..."

August 16 - Bloomberg (Hans van Leeuwen): "Australian wages growth picked up in the second quarter... The wage price index...rose 1.1 percent in the three months ended June 30 after gaining 0.9 percent in the first quarter... Australia's 30-year-low jobless rate has created a worker shortage, forcing companies and government agencies to pay more to attract and retain staff."

August 16 - Bloomberg (Hans van Leeuwen): "Australian consumer confidence plunged to a five-year low in August after the central bank raised interest rates a second time this year to stem inflation."

Latin American Boom Watch:

August 16 - Bloomberg (Thomas Black): "Mexico's economy grew more than 4 percent for a second straight quarter, giving the country its strongest first half in six years, as car and oil exports surged and lower interest rates buoyed spending. Latin America's second-biggest economy expanded 4.7 percent in the April-to-June period..."

August 16 - Bloomberg (Daniel Helft and Eliana Raszewski): "Argentina's economic growth in June remained above 8 percent for a third month in four... The economy expanded 8.2 percent from a year earlier...and 8 percent in the first six months of the year... 'The economy continues to grow fast on strong internal demand as well as exports,' said Pablo Morra, a Goldman, Sachs & Co. economist."

August 15 - Bloomberg (Alex Kennedy): "Venezuela's economy from April through June grew more than 9 percent for a fifth straight quarter as President Hugo Chavez boosted government spending, bolstered by a surge in oil income."

August 17 - Financial Times (Andy Webb-Vidal): "Bankers traditionally face firing squads in times of revolution. But in Venezuela, they are having a party. Dirán Sarkissián, president of the local subsidiary of Stanford Bank, a US bank with offshore operations based on the Caribbean island of Antigua, is proud of his rapidly lengthening list of high-net-worth customers who are enjoying President Hugo Chávez's self-styled 'Bolivarian Revolution'."

August 15 - Bloomberg (Alex Emery): "Peru's economy grew through June at the fastest rate since December 1997 on surging copper, gold and natural gas production. Peru's 12-month gross domestic product growth accelerated to 6.82 percent..."

Central Bank Watch:

August 18 - Bloomberg (Nerys Avery): "China raised benchmark lending and deposit rates simultaneously for the first time in two years to curb an investment boom that threatens to fan inflation and leave the nation with too many factories. The People's Bank of China raised the one-year lending rate 27 basis points to 6.12 percent..."

August 16 - Bloomberg (Tasneem Brogger): "Iceland's central bank raised the benchmark interest rate to a record 13.5 percent in order to cool inflation that it says may soar to more than four times the target by the end of the year."

Bubble Economy Watch:

University of Michigan Consumer Confidence dropped a larger-than-expected 6 points to the lowest level since October. The Consumer Price index was up 4.1% y-o-y during July. This compares to y-o-y gains in July 2005 of 3.2%, July 2004 of 3.0%, July 2003 of 2.1%, and July 2002 1.5%. July Producer Prices were up 4.5% from a year earlier. The Philly Fed index unexpectedly jumped to the highest level since August.

August 18 - EconoPlay.com (Gary Rosenberger): "Truckers are hauling slightly more goods than they did last summer - but capacity constraints caused by driver shortages continue to tip pricing power in their favor, generating billings that are disproportionate to actual demand, industry officials say. Another inflationary push comes from fuel surcharges, which were up 6% or more in the last 30 days, and now account for almost a third of the total cost of moving goods by truck. With capacity handcuffed by driver shortages, even an average peak shipping season is likely to mean bottlenecks for shippers scrambling to move goods to retail shelves in time for Christmas - suggesting still more inflationary pressures on the way... Among other observations: truckers report strong business from manufacturers even as consumer segments show signs of faltering from earlier levels. Also, the impact from the slowdown in housing on transportation demand appears to be surprisingly muted."

August 15 - The Wall Street Journal: "The closest thing to a lifetime sinecure in America is a federal government job, and now it turns out that it's also a very lucrative way to make a living. New data from the U.S. Bureau of Economic Analysis confirm that the average federal civilian worker earns $106,579 a year in total compensation, or twice the $53,289 in wages and benefits for the typical private worker. This federal pay premium costs taxpayers big bucks because Uncle Sam's annual payroll is now $200 billion a year. No wonder that, with a per capita income of $46,782 a year, Washington, D.C. is the fourth richest among the nation's 360 metropolitan areas... The Cato Institute's Chris Edwards...finds that in 1950 the average federal bureaucrat received $1.19 for every dollar that a private employee earned. By 1990 that ratio had risen to $1.51 and is now $2. In 2005 federal wages rose 5.8% compared to 3.3% in the private sector."

August 17 - Dow Jones (Campion Walsh ): "U.S. manufacturing will likely grow faster this year than was previously expected, then slow sharply next year to a rate closer to the country's overall economic growth, according to an industry forecast... U.S. factory output will increase a 'robust' 5.0% this year and then slow to 2.5% next year, while real gross domestic product grows 3.3% this year and 2.5% next year, according to the latest forecast by Manufacturers Alliance/MAPI."

August 17 - Bloomberg (Eddie Baeb): "The New York Yankees and the New York Mets have almost identical records, leading their divisions in Major League Baseball. In the municipal bond market, the Yanks are beating their crosstown rivals. The teams raised $1.57 billion this week to pay for new stadiums. The biggest portion of each sale was a 40-year bond with the same credit ratings, interest coupons and insurance against default. The Yankees...will pay a yield of 4.51 percent, better than the 4.57 percent the Mets [will pay]..."

August 16 - The Wall Street Journal (Ilan Brat): "It's a great time to be a welder. Months before he graduated from the four-year welding-engineering program at Ferris State University...21-year-old Will Chemin had two offers for jobs paying $50,000-plus. The one he took, working...for Deere & Co... pays $55,500 a year, plus a $2,500 signing bonus and full relocation coverage... Welding, a dirty and dangerous job, has fallen out of favor over the past two decades... Now, thanks to a global boom in industrial manufacturing, skilled welders are in greater demand than ever. Companies can't find enough of them."

Real Estate Bubble Watch:

July Housing Starts dropped to the lowest level since November 2004. At 1.795 million annualized units, Starts were down 13.3% from the near record pace from a year ago.

August 16 - Bloomberg (Shobhana Chandra): "Confidence among U.S. homebuilders plunged to the lowest level in 15 years this month as buyers cancelled orders and inventories of unsold dwellings piled up, a private survey showed."

Financial Sphere Bubble Watch:

August 14 - Bloomberg (Adrian Cox): "Wall Street bonuses will jump 15 percent this year, with investment bankers and equities traders reaping the rewards of rising stock markets and record mergers and initial share sales, according to a report released today. Bonuses for bankers at firms such as...Goldman Sachs Group Inc., Citigroup Inc. and JPMorgan Chase & Co., this year's top three mergers advisers, will probably surge 25 percent..."

Energy Boom and Crude Liquidity Watch:

August 16 - Financial Times (Krishna Guha): "The recycling of surplus petrodollars through the global financial system is set to intensify, with Saudi Arabia and the five other members of the Gulf Co-operation Council exporting at least $450bn of capital over the course of this year and next, the Institute of International Finance predicted... The capital exports are the mirror image of the oil-rich region's massive current account surplus. The IIF, a lobby group for global financial institutions, forecasts that this surplus will jump 37 per cent this year to $227bn... If these estimates are correct, the six GCC countries - Saudi Arabia, Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates - will together accumulate foreign assets almost as rapidly as China is expected to add to its foreign exchange reserves over the two-year period. This would put them at the centre of the global debate on economic imbalances."

August 16 - Bloomberg (Greg Chang): "Southern California Edison...should build more electricity generating capacity by the middle of 2007 after last month's heat wave strained supplies, state regulators said in a ruling. The utility...was directed to pursue the development of 250 megawatts of electricity generators that can be quickly turned on to meet surges in demand, in an order issued by the California Public Utilities Commission yesterday."

August 16 - Bloomberg (Wahyudi Soeriaatmadja and Arijit Ghosh): "Indonesia is seeking more investment in industries producing energy from palm oil, sugarcane and jatropha to help create 5 million new jobs and cut government fuel subsidies, President Susilo Bambang Yudhoyono said. The government will set aside 1 trillion rupiah ($110 million) to help farmers pay interest on loans they take to expand plantation of crops that can be used to produce bio-fuels..."

Climate Watch:

August 16 - Associated Press: "A severe drought in southwestern China has forced the authorities to begin trucking in water to millions of people after wells and rivers went dry, state media said... In dozens of counties surrounding the industrial center of Chongqing, many households were surviving on a ration of just two buckets of water a day delivered by water wagons, the Xinhua News Agency said. Two-thirds of the city's rivers and lakes have dried up since the drought began in mid-May..."

August 16 - Reuters (James Grubel): "A third of the world is facing water shortages because of poor management of water resources and soaring water usage, driven mainly by agriculture, the International Water Management Institute said...Water scarcity around the world was increasing faster than expected, with agriculture accounting for 80 percent of global water consumption... Globally, water usage had increased by six times in the past 100 years and would double again by 2050, driven mainly by irrigation and demands by agriculture..."

August 18 - Dallas CBS 11 News (Eileen Gonzales): "Wednesday marked the 32nd day this year that north Texas has baked under triple-digit heat. With the high demand for air conditioning, the Texas Public Utility Commission says the area is expected to set a record for energy usage. The extra energy use is putting a strain on power grids... According to TXU Energy, energy supplies are just barely keeping up with demand."

Speculator Watch:

August 16 - Financial Times (Gillian Tett): "Hedge funds and banks are set to spend almost $500m on new information technology this year as they scramble to improve their credit derivatives trading systems...The extra spending on new systems...represents a six-fold leap from 2004, when data was first collected, according to Aite Group..."

Fiscal Watch:

August 17 - Bloomberg (Brian Faler): "The U.S. budget deficit will shrink for the third consecutive year in 2006 to $260 billion and rise to $286 billion in 2007, according to the Congressional Budget Office. A surge in tax revenue will cut the current fiscal year's deficit by 18 percent to $260 billion... The $286 billion deficit estimate in 2007 is up from a $270 billion CBO forecast in January."

Financial Structure:

Excerpts from the Bond Market Association's August 2006 Research Quarterly:

"Bond issuance during the first half of the year hit $2.84 trillion, a 3.1% increase from the $2.76 trillion issued in the first half of last year. The $1.43 trillion volume in the second quarter topped the first quarter by 1.1% [and compares to Q2 2005's $1.36 trillion]. The year-over-year growth was led by gains in the corporate and mortgage-related sectors...

"Gross U.S. Treasury coupon issuance was $436 billion in the first half of calendar year 2006, a 5.5% increase over the $413.5 billion issued during the same period in 2005... Daily trading volume of Treasury securities by primary dealers averaged $546.4 billion in the first half of the year, compared to $568.2 billion in the same period of 2005..."

"Long-term issuance by federal agencies [GSE] totaled $364.5 billion in the first half of 2006, up 5.8% from the $344.4 billion issued in the first half of last year..."

"Total short and long-term municipal securities issuance was $195.0 billion in the first half of 2006, 14.6% less than the $228.5 billion issued during the first half of 2005. Unlike last year when refunding activity generated a municipal issuance record, the rising-interest-rate environment has translated into fewer refunding opportunities... New money issuance totaled $121.0 billion in the first half of 2006, a 12.6% increase from...the same period of 2005."

"Gross corporate bond issuance surged to $421 billion during the first half of 2006, a 17.3% increase over the $359.4 billion issued a year ago. Second quarter volume rose by 3.0% to $213.8 billion, up from $207.6 billion in the first quarter and by 31.6% compared to the second quarter of 2005... The twin drivers of increased corporate issuer demand have been shareholder-friendly strategies and business capital investment spending growth... New issue volume of non-convertible investment-grade debt increased 20.9% to $384.5 billion during the first half of 2006... The financial services industry continued to be the dominant issuance sector. In the first six months, it accounted for $211.0 billion in issuance [up 14% from first half 2006], more than half of the total investment-grade volume. Manufacturing was the second largest sector, accounting for $32.9 billion in the first six months of 2006... Non-convertible high-yield issuance totaled $36.9 billion through the first half of 2006, a 10.7% decline from...the same period a year ago... Issuance of medium-term notes increased to $147.9 billion in the first half of 2006, 24.9% higher than...a year ago... Total convertible issuance reached $31.1 billion during the first half of 2006, more than triple the volume from a year ago."

"Asset-backed securities (ABS) issuance volume decreased 18.0% to $471.7 billion in the first half of the year... Home-equity loan (HEL) issuance increased year-over-year, by 25.1% in the first half, to $264.8 billion. Second quarter volume rebounded to $137.3 billion after a slow first quarter... Through the first half of the year, student loans were the second largest and fastest growing ABS sector, with issuance of $40.5 billion in the first half, 36.4% higher than...the first half of 2005... Credit card ABS issuance also increased in the first half of the year to $33.0 billion , compared to the $23.7 billion issued in the same period last year... Auto loan ABS issuance decreased 18.5% in the first half of 2006 to $31.4 billion..."

"Issuance of mortgage-related securities, including agency and non-agency pass-throughs and collateralized mortgage obligations (CMO), increased to $992.2 billion in the first half of the year, 16.0% higher than...the same period last year. Second quarter issuance rose to $502.9 billion, compared to the $489.3 billion issued in the first quarter [and up 17% from Q2 2005's $429.9 billion]. According to the Mortgage Bankers Association (MBA), mortgage originations reached an estimated $678 billion in the second quarter, higher than the $547 billion in the previous quarter [down from the year ago $779 billion - first half originations down 11% y-o-y]... Strong consumer demand for cash-out by refinancings contributed to higher volumes... Non-agency MBS issuance, including residential and commercial mortgage-backed securities, surged to $384.6 billion in the first half of 2006, about 50% higher than the first half of last year [up 126% from first half 2004]...

"Commercial mortgage-backed securities (CMBS) issuance continued to grow, with volume of $81.9 billion in the first half of the year, a 28.0 percent increase from the first half of last year... Investor demand for CMBS has grown based on higher yield. in the increasingly commoditized structured finance marketplace, as well as benign credit conditions."

"Daily outstanding repurchase (repo) agreements averaged $3.41 trillion in the first half of 2006, a 7.2% increase over the $3.12 trillion as of March, 2006... Over $204.2 trillion in repo trades were submitted by GSD [Fixed Income Clearing Corporation's Government Securities Division] participants through the second quarter of 2006, with an average daily volume of approximately $1.6 trillion [curiously unchanged from a year ago]..."

"The outstanding volume of total money market instruments, including commercial paper (CP), large time deposits and bankers' acceptances, totaled just over $3.7 trillion at June 30, a 6.0% increase from the...end of the first quarter [and up 17.5% from a Q2 2005]... Elevated yields during the period of Fed tightening and the flat to inverted yield curve have attracted investors to the CP market."

"The U.S. asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) markets have experienced significant growth over the past five years. ABS and CMBS issuance has increased at average annual rates of 25-35% from 2000 to 2005. ABS issuance set a record in 2005, surpassing $1 trillion, and accounted for about a fifth of total bond issuance."

I read some bullish bond research this week that described real M2 as "one of the most reliable of all leading indicators," and that it "has declined from a 9% growth rate in December of 2001 to a miniscule 1.1% expansion in the twelve months ending June, 2006." The report continued: "To have a money/price/wage spiral develop and become entrenched in the economy, money growth must accelerate, be sustained, and lead to a speed-up of price increases across the board... This happened in the 1960s and 1970s... M2 growth averaged 7% in the 1960's, and then accelerated to almost 10% in the 1970s... The current situation is extremely different. In the past two years, M2 growth has averaged just 4.2% per annum, a far cry from the pattern in the 1960s and 1970s, and well below the 6.6% average increase in M2 since 1900."

I've proffered the view that the (narrow "money") monetary aggregates have become one of the most deceptive of all indictors. Importantly, the U.S. Financial Structure has gone through a radical transformation over the past decade, a process that has only accelerated the past few years. M2 components (chiefly currency, bank demand & savings deposits, and retail money market fund assets) have been largely trivialized by financial evolution and simply no longer capture the essence of system Credit expansion. On many levels, "Wall Street finance" has taken full command of the financial apparatus, relegating traditional monetary indicators and analysis to the status of hopelessly obsolete.

From the Bond Market Association research noted above, we see that ABS issuance "increased at average annual rates of 25-35% from 2000 to 2005." What's more, the "outstanding volume of money market instruments, including [non-M2] commercial paper (CP), large time deposits and bankers' acceptances" totaled $3.15 Trillion at the end of June. There was eye-opening 17.5% growth during the past year, with nominal "money market instrument" expansion of $550 billion significantly outpacing the $300 billion y-o-y increase in M2. During the past two years, outstanding "money market instruments" inflated by over $1 Trillion, or 40%, with CP posting a two-year expansion of 34% and Large Time Deposits surging 46%. Such historic monetary expansion is completely at odds with the bullish notion of persisting disinflation.

I've made the case repeatedly that when analyzing pricing trends and the nature of Inflationary Manifestations one must diligently concentrate on the expansion of the broadest range of "money" and Credit instruments. With such a perspective, one can recognize the current Financial Structure as a spectacular inflationary engine, although much of this inflation has of course manifested in higher asset and commodities prices.

There are, as well, some key idiosyncrasies in today's Financial Structure that are playing an increasingly profound role in both fashioning Economic Maladjustment and exacerbating Financial Fragility. These would include the extraordinary resiliency of both Credit growth and speculation to central bank rate increases. Below are excerpts from a few articles that recently caught my eye. They capture some of the nuance of Contemporary Wall Street Finance.

August 18 - New York Times (Jenny Anderson): "The rich are not like us. These days, they spend a lot more time watching the Weather Channel. Inspired by the weird profit opportunities that natural disasters create, hedge funds have been piling into reinsurance, the business of insuring insurers, scrambling to find ways to offer the kind of reinsurance in shortest supply these days: property catastrophe reinsurance, specifically for Florida and the Gulf of Mexico coastal region. According to the Reinsurance Association of America, $23 billion in capital has been raised for new or existing reinsurers since Hurricane Katrina. Hedge funds and private equity firms have led the way in the $7.3 billion that has been pumped into Bermuda start-up companies and $3.6 billion in "sidecars" -- special-purpose entities through which hedge funds give additional capital to existing reinsurers."

August 17 - Reuters (Al Yoon): "Residential loans that have raised eyebrows at the Federal Reserve and other regulators are increasing in popularity with lenders as a way to buoy profits in a shrinking market. So-called payment-option adjustable-rate mortgages have become popular in the $10 trillion U.S. home-loan market as borrowers facing high prices try to lower early payments at the risk of later payment shocks. The demand has delighted lenders, who have found the loans are coveted assets on Wall Street, where their prices top those on many other kinds of loans... 'Option ARMs are the best-executing product in the market right now, despite the market noise,' said Brad Morrice, chief executive officer at...New Century Financial Corp. The company is selling non-prime loans at about 102 1/2 cents on the dollar, compared with option ARMs 'north of 104,' he said."

August 18 - Financial Times (John Authers): "There's money in acronyms. This has been a great year for the BRICs - a concept coined in 2003 by Goldman Sachs to combine Brazil, Russia, India and China, the four largest emerging markets. Morgan Stanley's MSCI BRIC index is up 26.6 per cent for the year to date, against 11.7 per cent for the emerging markets as a whole. They are far out-performing all the developed markets. BRIC has been a successful marketing ploy, not just an investment strategy. According to Emerging Portfolio Fund Research of Boston, dedicated BRIC funds have taken in 25 per cent of all emerging markets equity fund flows this year. Add on flows to funds specialising in the four countries involved, and the BRICs have taken in more than $12bn - over three-quarters of all the money going into the emerging markets."

August 18 - Financial Times (Gillian Tett): "Back in the mania of the late 1990s internet bubble, a group of Cassandras...regularly wailed that the markets had gone mad. But, equally regularly, these warnings were ignored by investors, who kept gobbling up internet shares far longer than rational observers ever expected... Echoes of that now seem to be afoot in the private equity world....One wrinkle of this mania that has tended to escape attention is the fashion for conducting 'leveraged recapitalisations'. This is the practice whereby a private equity group does a leveraged buyout and then quickly pays itself fat dividends from that company, funded not by anything as humdrum as corporate cash flows but the issuance of yet more debt. Until recently, this practice was something of a rarity. After all, the idea of pocketing fat fees while raising leverage has traditionally looked pretty greedy and reckless, even to many bankers. But this year 'recaps' have been spreading like wildfire... What is perhaps more surprising, however, is that many investors have motives to buy this debt too, particularly in the hedge fund world. Take the case of 'payment in kind' (PIK) instruments, which have widely been used to fund recaps. These are expensive for companies to issue and often look highly risky for investors, since they are highly subordinated and do not pay any interest for several years. But many hedge funds are nevertheless keen to buy them. Why? One reason is that a hedge fund typically collects 20 per cent of profits booked each year on its investments. However, since PIK instruments are difficult to value in the market, particularly when they are loans, what some funds do is book a PIK loan at its face value, plus interest, after a year. Hence, if a fund buys a PIK instrument paying 15 per cent, after a year it typically collects 20 per cent of 15 per cent of the note. Of course, there is still a risk this loan will default in the future. But if that unhappy scenario materialises, the hedge fund will not repay the 20 per cent fee."

To get started, where's the heightened risk aversion one would expect late in a tightening cycle? Where are the tightened "financial conditions" after 17 Fed rate increases? Where are the chastened borrowers, lenders, financiers, and speculators? Well, the leveraged speculating community flourishes and hasn't missed a beat, and with this growth comes a thus far insatiable appetite for risky assets. Combining the powerful Wall Street firms, the global money center securities/insurance/"banks," and thousands of hedge funds and you've got one almighty juggernaut "speculator community" that controls $10's of Trillions of U.S. and global assets. To be sure, players today operate with an incentive structure unrecognizable to the traditional bank loan officer. Hedge funds typically take 20% of (realized and unrealized) fund gains at year-end, while Wall Street traders, investment bankers, derivative specialists and the like enjoy a share of booked profits with the arrival of their generous year-end bonuses. Such incentive structures nurture an all-consuming institutional inflationary bias.

It is, apparently, going to take a more intimidating housing slowdown to alarm speculators enticed by higher-yielding mortgage securities. The conspicuous excess that has of late beset corporate finance is anything but dissuading speculation in risky PIK (payment in kind) debt and other high-yielding corporate securities - especially not with the convenient embracement of "mark-to-model" pricing. And the incentive to write insurance (and immediately book much of the premium as "profit") is simply too enticing to pass up, whether it is catastrophic weather reinsurance, Credit default derivatives, market hedges, or the myriad types of financial insurance/guarantees that have taken the U.S. and global Credit systems by storm. It is also clear that the perception of ongoing Federal Reserve accommodation has emerging market securities again in hot demand.

The current Financial Structure, dominated by Wall Street securitizations, leveraging, derivatives, and asset/securities speculation, inherently incites and then feeds runaway Credit, asset and speculative Bubbles. Under present conditions, the nature of this energized financing mechanism is not going to change, but rather only the sectors and asset classes where over-financing ensures spectacular boom and bust cycles.

"It appears that the current housing slowdown, which we first saw in September '05, is somewhat unique: It is the first downturn in forty years - in the forty years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors. Instead, it seems to be the result of an oversupply of inventory and a decline in confidence. Speculative buyers who spurred demand in '04 and '05 are now sellers; builders who built speculative homes must now move their specs; and nervous buyers are canceling contracts for homes already under construction." Robert Toll, Chairman & CEO Toll Brothers

In a predictable replay of the Technology Bubble, the U.S. homebuilding industry now faces the inevitable consequences from a period of spectacular over-finance and over-speculation (including massive industry overcapacity, collapsing profit margins and acute price uncertainty and instability). Industry executives have not previously experienced similar dynamics to this downturn specifically because there has never been a Financial Structure so capable of completely inundating the entire housing and mortgage arenas with cheap finance for such an extended period - never. As we witnessed with tech, destabilizing speculative flows appear seductively miraculous until they don't.

Ultra-easy finance incited and then fed a speculative Bubble in home buying. At the same time, the nature of the Financial Structure saw to it that the homebuilders were also overwhelmed with finance, ensuring an enormous, destabilizing and self-reinforcing building boom. And the higher homebuilder stock prices ran and the cheaper their debt financings became, the greater the incentive to ignore the warning signs and race to develop more properties - to keep the dream alive and the liquidity spigot wide open. Moreover, the greater the boom the more the various segments of the ballooning U.S. Financial Sphere that wanted their piece of the action. And the resulting creative financing arrangements and instruments - and greater Credit Availability generally - the easier it became to finance ballooning transactions at higher prices (yet with lower individual mortgage payments!). Households inevitably succumbed to panic buying.

Many analysts these days hone in on the housing slowdown and the likelihood that the Fed has already raised rates too much to sustain the economic boom. My focus and concerns are instead directed at the precarious nature of a prevailing Financial Structure that ensures Serial Bubbles and Cumulative Economic Impairment and Financial Fragility. With acute vulnerability pervading some key housing markets - as well as the general risk to the Mortgage Finance Bubble - in the spotlight, the Fed is poised to accommodate the ongoing profligate financing environment. I find it astounding that our policymakers have absolutely no inclination - or demonstrate any sensitivity to their responsibility - to discipline or subdue "Wall Street finance." Instead, they are determined to safeguard a highly improvident and destabilizing financial backdrop and incentive structure. This may very well perpetuate the current aged boom somewhat, but their will be no avoiding the painful aftermath. Today's Menacing Financial Structure has decisively sealed such a fate.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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