Expanding on El-Erian

By: Doug Noland | Fri, Jan 26, 2007
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Weekly changes mask heightened equities volatility. For the week, the Dow and S&P500 both added 0.6%. The Utilities gained 0.5%, while the Transports were hit for 3.0%. The Morgan Stanley Cyclical index declined 0.5%, and the Morgan Stanley Consumer index fell 1.0%. The small cap Russell 2000 gained 0.4% and the S&P400 Mid-Cap index 0.3%. The NASDAQ100 declined 1.3%, and the Morgan Stanley High Tech index lost 0.5%. The Semiconductors gained 1.3%, and the Street.com Internet Index added 0.2%. The NASDAQ Telecommunications index dipped 0.2%. The Biotechs dropped 2.4%. The Broker/Dealers fell 1.0%, and the Bank dipped 0.1%. With bullion gaining $10.90, the HUI Gold index rallied 4.4%.

Two-year government yields rose 5.5 bps to 4.97%. Five-year yields jumped 8.5 bps to 4.87% (high since August 15), and 10-year Treasury yields surged 10 bps to 4.87%. Long-bond yields jumped 11 bps to 4.97%. The 2yr/10yr spread ended the week inverted 10 bps. The implied yield on 3-month December '07 Eurodollars rose 9 bps to 5.20%, the high going back to mid-August. Benchmark Fannie Mae MBS yields surged 12 bps to 5.94%, this week underperforming Treasuries. The spread on Fannie's 5 1/4% 2016 note increased 2 to 33, and the spread on Freddie's 5 1/2% 2016 note increased one to 31. The 10-year dollar swap spread increased 1.8 to 51. Corporate bond spreads remain exceptionally tight, with junk spreads narrowing a couple bps this week.

Investment grade issuers included Alcoa $2.1 billion, Merrill Lynch $2.0 billion, Met Life $2.0 billion, JPM Chase Capital $1.85 billion, Wachovia $1.5 billion, Apache $1.5 billion, PNC Funding Corp $1.25 billion, Kinder Morgan $1.0 billion, and CIT Group $500 million.

Junk issuers included Baldor Electric $550 million, T2 Capital Finance $500 million, Cooper $350 million, Snoqualmie $330 million, Greif $500 milion, Allis-Chalmers Energy $250 million, Alion Science $250 million, Mastec $150 million, and Sbarro $150 million.

International issuers included Brazil $2.5 billion, Rentenbank $1.25 billion, Nordic Investment Bank $1.0 billion, Development Bank of Japan $900 million, Andina Fomento $500 million, Independencia $225 million, and Banco Macro $150 million.

January 24 - Bloomberg (Hamish Risk and John Glover): "The risk of owning European corporate bonds dropped to a record as companies reduced borrowing, according to credit-default swap traders."

Japanese 10-year "JGB" yields rose 2.5 bps this week to 1.68%. The Nikkei 225 added 0.6% (up 1.1% y-t-d). German 10-year bund yields gained 4 bps to 4.09%. Emerging debt markets were under pressure, while equities were mostly higher. Brazil's benchmark dollar bond yields jumped 15 bps this week to 6.13%. Brazil's Bovespa equities index surged 4.6% (down 0.1% y-t-d). The Mexican Bolsa gained 3.2% (up 2.3% y-t-d). Mexico's 10-year $ yields rose 9 bps to 5.81%. Russia's 10-year Eurodollar yields increased 5 bps to 6.77%. India's Sensex equities index added 0.5% (up 3.6% y-t-d). China's Shanghai Composite index rose 1.7%, increasing 2007 gains to 7.7%.

Freddie Mac posted 30-year fixed mortgage rates rose 2 bps last week to an 11-week high 6.25% (up 13bps y-o-y). Fifteen-year fixed mortgage rates were unchanged at 5.98% (up 28bps y-o-y). And one-year adjustable rates dipped 2 bps to 5.49% (up 29bps y-o-y). The Mortgage Bankers Association Purchase Applications Index fell 8.4% this week. Purchase Applications were down 5.2% from one year ago, with dollar volume declining 2.8%. Refi applications dropped 9.6%. The average new Purchase mortgage increased to $234,900 (up 2.5% y-o-y), while the average ARM declined to $373,200 (up 10.7% y-o-y).

Bank Credit expanded $12.7 billion (week of 1/17) to a record $8.312 TN. Bank Credit expanded $782 billion, or 10.4%, over 52 weeks. For the week, Securities Credit added $2.8 billion. Loans & Leases rose $10.0 billion to a record $6.094 TN. Commercial & Industrial (C&I) Loans expanded 12.5% over the past year. For the week, C&I loans jumped $7.9 billion, while Real Estate loans declined $6.1 billion. Bank Real Estate loans were up 14.2% over the past year. For the week, Consumer loans added $0.5 billion, while Securities loans declined $5.3 billion. Other loans surged $13.0 billion. On the liability side, (previous M3) Large Time Deposits rose $16.5 billion.

M2 (narrow) "money" jumped $18.3 billion to a record $7.076 TN (week of 1/15). Narrow "money" expanded $364 billion, or 5.4%, over the past year. M2 has expanded at a 7.4% pace during the past 20 weeks. For the week, Currency dipped $0.4 billion, while Demand & Checkable Deposits rose $15.3 billion. Savings Deposits increased $5.5 billion, and Small Denominated Deposits added $1.0 billion. Retail Money Fund assets declined $3.0 billion.

Total Money Market Fund Assets (from Investment Company Institute) increased $12.8 billion last week to $2.391 Trillion. Money Fund Assets inflated $341 billion over 52 weeks, or 16.6%. Money Fund Assets have expanded at a 21% rate over the past 20 weeks.

Total Commercial Paper dipped $1.1 billion last week to $1.994 Trillion. Total CP has increased $301 billion, or 17.8%, over the past 52 weeks. Total CP has expanded at a 19% pace over the past 20 weeks.

Asset-backed Securities (ABS) issuance slowed this week to $9 billion. Year-to-date total ABS issuance of $37 billion (tallied by JPMorgan) is running behind the $47 billion from comparable 2006.

January 23 - Dow Jones (Anusha Shrivastava): "Ratings upgrades hit a quarterly record in the asset-backed securities market in the fourth quarter of 2006, according to...Standard & Poor's... This was primarily due to the 'strong performance of various auto loan and single-issue synthetic transactions,' the report said."

Fed Foreign Holdings of Treasury, Agency Debt rose $6.9 billion last week (ended 1/24) to a record $1.779 Trillion. "Custody" holdings were up $242 billion y-o-y, or 15.8%. Federal Reserve Credit last week declined $8.9 billion to $837 billion. Fed Credit was up $25.1 billion y-o-y, or 3.1%.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $805 billion y-o-y (19.5%) to a record $4.936 Trillion.

Currency Watch:

January 24 - Bloomberg (Will McSheehy): "Kuwait, the third-largest Arab oil producer, may abandon the dinar's peg against the dollar in favor of a basket of currencies to help minimize economic harm after the dollar declined. 'We might go to a basket for an interim period,' Bader al-Humaidhi, Kuwait's finance minister, told reporters... 'The dollar fell a lot against the euro last year, but if we'd been linked to a basket we wouldn't have suffered' as much."

The dollar index gained 0.5% this week to 85.11. On the upside, The Thai baht gained 5.1%, the Norwegian krone 1.7%, and the Uruguay peso 0.6%. On the downside, the Polish zloty declined 2.4%, the Australian dollar 2.1%, the Hungarian forint 2.0%, the South African rand 1.7%, and the Mexican peso 1.5%.

Commodities Watch:

January 26 - Financial Times (Kevin Morrison): "Metal markets were buoyed yesterday by supply concerns and news that China, the world's largest consumer of metal, is using more copper than estimated. This extended nickel's record breaking run to seven successive sessions, tin touched another near 20-year high while copper rose by more than 2 per cent...data showed China's refined copper consumption in 2006 rose 15.4 per cent, confounding sceptics who forecasted a fall for the year."

January 26 - Bloomberg (William Bi): "China, the world's most populous country, may struggle to meet its grain needs as farmland shrinks and rising demand triggers shortages that can't be met by imports, the Ministry of Agriculture said."

For the week, Gold gained 1.7% to $646.20 and Silver 3.9% to $13.44. Copper rallied 4%. March crude gained $2.13 to $55.53. February Gasoline recovered 5.9%, and February Natural Gas gained 4.8%. For the week, the CRB index gained 1.9% (down 3.7% y-t-d), and the Goldman Sachs Commodities Index (GSCI) jumped 2.9% (down 4.5% y-t-d).

Japan Watch:

January 24: "Fitch Ratings says in a special report released today that it expects the mortgage-backed securitization (MBS) issuance to lead the growth in Japan's structured finance market this year, extending the rapid growth seen in 2006. Fitch conservatively estimates that issuances in the Japanese structured finance market in 2006 totaled approximately JPY10 trillion, following an annual growth of 12%, cementing the trend seen throughout 2005."

China Watch:

January 22 - Bloomberg (Yanping Li): "China's economic expansion may stay above 10 percent in 2007, as investment and domestic consumption bolster growth, the official Shanghai Securities News reported, citing Chinese economists."

January 25 - Bloomberg (Nipa Piboontanasawat): "China's economy grew 10.4 percent in the fourth quarter and inflation accelerated, prompting speculation the central bank will raise interest rates for the first time since August. Consumer prices climbed 2.8 percent in December, the most in nearly two years, the National Bureau of Statistics said in Beijing today. The world's fourth-largest economy expanded by 10.7 percent in 2006, the fastest in 11 years."

January 23 - Bloomberg (Yanping Li): "China still faces 'great' pressure from a rebound in investment growth because banks have too much money available for lending, said Han Yongwen, secretary general of the National Development and Reform Commission. Overall fixed-asset investment in China is estimated to have grown 24 percent last year, higher than the targeted level, Han said..."

January 26 - Bloomberg (Rob Delaney): "China will tighten environmental controls to restrain investment in factories that stoked the nation's fastest annual economic growth since 1995, central bank Deputy Governor Wu Xiaoling said."

January 21 - Bloomberg (Li Yanping and Christina Soon): "China's currency regulator said it will ease rules for capital to flow out of the country this year while making it harder for funds to enter, in a move to cap increases in the world's largest foreign exchange reserves."

January 25 - Bloomberg (Nipa Piboontanasawat): "China's retail sales rose at a faster pace in December. Retail sales climbed 14.6 percent last month from a year earlier after climbing 14.1 percent in November..."

January 25 - Market News International: "Hong Kong's exports in December rose 13.7% from a year earlier...with growth decelerating from a 14.2% year-on-year increase recorded in November..."

January 26 - Financial Times (Sundeep Tucker and Tom Mitchell): "Sir Richard Branson's Virgin Group is in advanced talks to secure land in Macao, the Chinese special administrative region, on which it intends to build a $3bn casino resort. Macao overtook the Las Vegas Strip as the world's biggest gaming centre by revenues in October."

India Watch:

January 26 - Bloomberg (Yoolim Lee): "Last year 'was the first year you could feel the pulse' of India's presence at Davos, says K.V. Kamath, chief executive officer of...ICICI Bank Ltd., India's largest lender... This year, the pulse is racing. About 70 Indian business leaders are attending..."

Asia Boom Watch:

January 25 - Bloomberg (Seyoon Kim): "South Korea's economy slowed more than expected in the fourth quarter as exports fell for the first time in two years and consumer spending remained weak. Asia's third-largest economy grew 0.8 percent from the third quarter, when it advanced 1.1 percent..."

January 22 - Bloomberg (Anuchit Nguyen): "Thailand's exports increased 'almost 17 percent' last year due to sales into new markets, Commerce Minister Krirk-krai Jirapaet said..."

January 23 - Bloomberg (Francisco Alcuaz Jr): "The Philippine economy likely grew 5.1 percent to 5.9 percent in the fourth quarter, Economic Policy and Planning Director Dennis Arroyo said... The economy grew 4.8 percent in the third quarter."

Unbalanced Global Economy Watch:

January 23 - Bloomberg (John Fraher): "Corporate chieftains are the most confident in at least a decade as more than 2,500 business leaders...gather in Davos, Switzerland, a survey showed. Ninety-two percent of 1,084 executives questioned said they are 'confident' or 'very confident' about their prospects this year..."

January 22 - Bloomberg (John Fraher): "Lawrence Summers has a message for investors heading to the Swiss mountain resort of Davos this week to toast a year of booming returns and record bonuses. 'It's worth remembering that markets were very upbeat in the early summer of 1914,' the former U.S. Treasury secretary observes. While Summers isn't predicting the onset of another world war, he and European Central Bank President Jean-Claude Trichet are among those who are warning the more than 2,200 movers and shakers at the 37th annual meeting of the World Economic Forum that they've become too complacent about risks ranging from trade imbalances to terrorism. A glut of cheap money and the strongest global economic growth in three decades have encouraged banks, private-equity firms and hedge funds to bet that the good times will keep rolling."

January 24 - Bloomberg (John Fraher): "Surging demand for derivatives is making financial markets more vulnerable to any slowdown in the global economy, said economists and executives at the World Economic Forum. 'You can easily get liquidity from the market every second for anything,' said Bank of China Vice President Zhu Min at a panel discussion on the global economy in Davos, Switzerland. 'We really don't know what the risks are.' The use of derivatives grew at the fastest pace in eight years during the first half of 2006 as a glut of cheap money allowed investors to bet more borrowed funds in financial markets."

January 22 - Bloomberg (Jennifer Ryan): "U.K. house prices advanced in January as bankers received their bonuses and a shortage of housing pushed up values throughout the country, Rightmove Plc said. House prices rose...13.5 percent in the year..."

January 23 - Bloomberg (Jennifer Ryan and Craig Stirling): "U.K. factories raised domestic prices at the fastest pace since July 1995 as new orders rose, a quarterly survey by the Confederation of British Industry showed."

January 25 - Bloomberg (Andreas Scholz and Rainer Buergin): "The German government will next week raise its economic growth forecast for this year to just under 2 percent from 1.4 percent, a senior government official said..."

January 23 - Bloomberg (Sharon Smyth): "House prices in Spain are overvalued by as much as 30 percent, creating the risk of a sharp decline that could hurt economic growth, the Organization for Economic Cooperation said."

January 23 - Bloomberg (Tasneem Brogger): "Danish house-price inflation slowed for a second quarter in the three months through December after the central bank raised interest rates and the effect of new types of loans wore off. Prices rose an annual 18.5 percent from 24.2 percent in the previous quarter..."

January 25 - Bloomberg (Tasneem Brogger): "Denmark's jobless rate unexpectedly dropped to 3.9 percent in December, the lowest since 1974, fueling concern that a labor shortage is set to push up wages and inflation."

January 24 - Bloomberg (Robin Wigglesworth and Beate Evensen): "A labor shortage in Norway, which has the second lowest unemployment rate in Europe, is getting worse, while the flow of foreign workers may slow, Finance Minister Kristin Halvorsen said."

January 26 - Bloomberg (Svenja O'Donnell): "Russian retail sales rose at the fastest pace in more than a decade as rising wages boost consumer demand and economic growth. Retail sales grew a faster-than-expected 14.8 percent in the year, up from an annual 13.9 percent in November..."

Latin American Boom Watch:

January 23 - Bloomberg (Alex Emery): "Peru's exports jumped by more than a third to a record last year as demand from China spurred surging sales of copper, gold and zinc. The country's exports soared 36 percent to $23.4 billion..."

January 25 - Bloomberg (Andrea Jaramillo): "Colombia's industrial output climbed 17.1 percent in November from the year-ago month, the national statistics agency said."

Central Banker Watch:

January 26 - Bloomberg (Matthew Brockett): "Money-supply growth in the euro region unexpectedly accelerated in December to the fastest pace in almost 17 years, increasing pressure on the European Central Bank to raise interest rates. M3 money supply...rose 9.7 percent from a year earlier after gaining an annual 9.3 percent in November, the central bank said... That's the highest growth rate since February 1990... Loans to the private sector rose 10.7 percent in December from a year earlier after growing 11.2 percent in November..."

January 24 - Bloomberg (Robin Wigglesworth and Beate Evensen): "Norway's central bank unexpectedly raised the benchmark deposit rate by a quarter point for a third consecutive month to 3.75 percent to cap inflation and prevent the economy overheating... Norway's economy has expanded for 11 quarters in a row, the longest uninterrupted period of growth since at least 1978, bringing unemployment to an 18-year low and spurring consumer spending."

January 26 - Market News International: "The People's Bank of China is 'seriously concerned' about the rising consumer price index and gains in asset prices...'The central bank is seriously concerned about CPI and asset prices,' said Yi Gang, assistant governor of the PBOC..., on the sidelines of a conference here."

Bubble Economy Watch:

January 22 - Bloomberg (Vince Golle): "More U.S. companies said they plan to boost hiring through the middle of 2007 even as labor shortages force up wages, a quarterly survey by the National Association for Business Economics showed. The poll found that a third of executives would boost payrolls in the next six months, up from 29 percent last quarter. Thirty-five percent, the most since April, reported that wages and salaries increased in the last three months."

January 25 - Associated Press: "Homeowner insurance premiums will rise by 25% along the coast this year as a result of the rising cost of homes, higher repair costs and a recent history of severe damage from storms, North Carolina's Insurance Commissioner Jim Long said."

Financial Sphere Bubble Watch:

January 24 - Bloomberg (Bradley Keoun): "Merrill Lynch & Co. gave Chairman and Chief Executive Officer Stanley O'Neal a 30 percent raise to more than $48 million after he led the 93-year-old firm to record earnings and its biggest profit gain in three years."

January 22 - Financial Times (Kevin Allison): "The amount of money poured into US start-ups last year hit its highest level in five years as venture capitalists threw cash at new deals in healthcare, consumer internet and alternative energy, according to new data published on Monday. The study by Dow Jones, VentureOne and Ernst &Young found that VC groups pumped $25.8bn into fledgling US companies in 2006, an increase of 8 per cent over 2005....the total amount invested was the highest since 2001..."

Mortgage Finance Bubble Watch:

January 22 - Financial Times (Jim Pickard): "The commercial property market had another record year for investment in 2006 with $643bn of stock changing hands, a jump of 33 per cent on the previous year. In spite of widespread predictions that the global boom is unsustainable, institutions and private investors have continued to pour money into shopping centres, offices and industrial parks. Europe and Asia saw strong growth last year with volumes up 50 per cent and 48 per cent respectively, according to a survey by Cushman & Wakefield... The trend comes amid a surge in both property prices and deal volumes that can be traced back to the stock market collapse of six years ago. In the wake of these falls in equity prices, many pension funds and other investors earmarked more cash towards alternative asset classes, including property as well as commodities, private equity and infrastructure. As prices were forced upwards, pushing up total returns, ever more buyers have entered the market."

Real Estate Bubbles Watch:

December Existing Home Sales were reported near expectations at a 6.22 million annualized pace. This was down 7.9% from December 2005. Average (mean) Prices increased to $269,200, the highest level since August and unchanged from a year earlier. The Inventory of Homes declined 300,000 to 3.508 million (low since April), and the Months Supply of inventory declined to 6.8 months (low since June). Existing Homes sales for 2006 were down 8.4% from 2005 to 6.648 million. And while 2006 was the weakest year of sales since 2003's 6.175 million, keep in mind that Existing Home Sales averaged 3.993 million annually during the nineties.

December New Home Sales were reported at a stronger-than-expected 1.12 million annualize pace, the fastest pace since September - yet down 11% from a year earlier. Average Prices were steady at $290,100, unchanged from December 2005. The Inventory of Unsold New Homes declined 5,000 during the month (2-mnth decline of 16,000) to 537,000, the low since January 2005. For the year, New Home Sales dropped 17.3% from record 2005 levels to the lowest sales since 2003. For comparison, sales averaged 698,300 during the nineties.

California December Home Sales were down 15.3% from a year ago. Median Prices were up $20,290, or 3.7%, to $567,690 (2-year gain of $93,420, or 20%), the highest level since August. The months supply of inventory declined from November's 7.4 months to 6.8 months, also a low since August. California Condo Sales were down 18.1% from a year earlier, and Median Prices were down 2.5% to $420, 180.

January 24 - Bloomberg (Daniel Taub): "Home-loan defaults in California rose to their highest level in eight years in the fourth quarter amid a slowdown in sales of houses and condominium that made it harder for owners to sell their homes and pay off mortgages. Banks and other lenders sent 37,273 default notices to California homeowners in the fourth quarter, more than double the 15,196 sent a year earlier and up by more than a third from the 27,218 sent in the previous three months...DataQuick...said..."

January 25 - Florida Association of Realtors: "Florida's housing market mirrored the national trend in 2006, with sales of existing single-family homes slowing to a more sustainable pace following a five-year run of record closings. By year's end, a total of 180,037 homes changed hands statewide for a 28 percent decrease compared to the 248,575 homes sold in 2005... At the same time, 2006 sales figures made it into the record books for several markets around the state; 2006 also is expected to be the third highest sales year on record nationally... Statewide, the median existing home sales price rose 6 percent to reach $248,300; in 2005, it was $235,200."

January 26 - Bloomberg (Hui-yong Yu): "U.S. rents for prime downtown office space rose 18.2 percent on average in 2006 as demand outstripped supply, and they may climb as much as 15 percent this year, according to a Colliers International report. Vacancies at the end of last year were 12.55 percent, down from 13.59 percent a year earlier... Vacancies are now the lowest this decade, and well below the 16.4 percent level at the end of 2003..."

M&A and Private-Equity Bubble Watch:

January 24 - Bloomberg (Jesse Westbrook): "Wall Street firms are trying to figure out how to finance leveraged buyouts of $75 billion or more, twice the size of the largest deal on record, a Citigroup Inc. executive said. 'I have talked about deals larger than $75 billion, conceptually,' Tyler Dickson, Citigroup's global head of equity capital markets, said... 'I don't know when larger LBOs will happen. People are discussing them.' Buyout firms...announced a record $739 billion of leveraged buyouts last year, almost triple the 2005 total..."

Climate Watch:

January 25 - Bloomberg (Stephen Voss): "The changing climate is more threatening than previously thought, a U.S. government study will show, the report's author said. The six-month study was conducted for a U.S. national security entity and will be published officially in coming weeks, said Peter Schwartz, chairman of Global Business Network... 'The rate of climate change is much faster than we all think,' Schwartz said at the annual meeting of the World Economic Forum in Davos... 'There will be many extreme large weather events. It is more urgent and catastrophic than we previously thought.'"

January 26 - Financial Times (Kevin Morrison): "John Howard, the Australian prime minister, on Thursday announced the most ambitious attempt yet to overhaul the drought-ridden country's inefficient water management system and improve his environmental credentials ahead of elections later this year. But the success of the A$10bn (US$7.8bn) plan could hinge on whether Mr Howard can persuade the six state governments...to cede most of that power to the federal government..."

Fiscal Watch:

January 24 - Market News International (John Shaw): "The Congressional Budget Office's revised budget and economic report, which was released Wednesday, says the fiscal year 2007 deficit will be $172 billion and then will dip to $98 billion in FY 2008. The updated CBO report gives economic and budget estimates from FY 2008 to FY 2017. The report assumes that current spending and tax policies remain. Among other things, the CBO estimates assume that a number of tax cuts passed in recent years will expire. The CBO sees deficits of $116 billion in FY 2009, $137 billion in FY 2010, and $12 billion in FY 2011."

January 26 - Dow Jones (John Godfrey): "While public confidence in Congress remains low, market confidence in Washington may be keeping interest rates low, Congressional Budget Office Director Peter Orszag said..."

Expanding on El-Erian:

Bloomberg's Tom Keene: "Your op-ed piece in today's Financial Times - it certainly got my attention and many others here at Davos, and you do lead it with much of the discussion at these meetings on a changed global economy. The headline is classic El-Erian - "Complex Finance in a Brave New World Economy." First, what's new now that's different, say, five or ten years from now?"

Mohamed El-Erian, CEO Harvard Management Co.: "I think what's new is you've got a group of countries that have become systemically important in influencing growth, trade and, critically, capital flows. And they behave differently from what we've been used to. So the result is we're coming across all these aberrations in markets - in economic behavior - that we're all trying to explain. And unless we recognize that there are structural changes, we tend to get stuck on a debate between what is sustainable and what is less than sustainable, as opposed to what are the underlying factors that are now in play..."

"What we are in right now is bit of a journey; a journey where global growth is being supported by the coming on stream of these new economies. And where the decisions to allocate their wealth is helping countries maintain relatively low interest rates and relatively low borrowing costs overall. This is the journey and the journey feels better than most people expected. But the jury is still out as to what the destination looks like. And there are risks there both of the economic and geopolitical perspectives..."

"We've had a dramatic revolution in financial instruments. The proliferation of derivative-based instruments - that tend to decouple trading from the underlying market- has allowed many investors to get involved in markets that otherwise would have been difficult to access. You see this here in the United States in terms of the exotic mortgage, which allows people to buy homes that they couldn't otherwise afford. You also see it in terms of capital flows, in terms of Credit default swaps, etc. If you step back and ask, "What is the major change?" - is that the barriers to entry to these markets have come down, with the result that liquidity and velocity has gone up."

Bloomberg's Tom Keene: "Are you concerned about the complacency that we see here looking out this window - this gorgeous valley filled with CEO and executive complacency? Is it remarkable where spreads are?"

Mr. El-Erian: "It's totally remarkable where spreads are. I think that it would be wrong to think that spreads reflect the level of risk. They don't - they underestimate the level of risk. But they're there because of technical influences. So, the big message - and that's what I tried to emphasize in the article today - is that what we normally are used to looking at in terms of market signals - the shape of the yield curve, the level of volatility, the level of risk spreads - all that is being distorted during this transition. So, risks are not as low as risk spreads would suggest - volatility is not as low as volatility measures would suggest. But there is a good reason why these measures are distorted right now."

From Mr. El-Erian's FT article: Complex Finance and the Brave New World Economy

"Much of the discussion at the World Economic Forum in Davos has two themes. First, the continued robustness of the global economy as defined by sustained high growth and low inflation. Second, the steady rise in economic and financial risks. The tendency is to treat these themes as competing and engage in an interesting but inconclusive debate about their relative merits. A better approach is to recognise that these themes are consistent with structural changes in the world and seek to recalibrate the perspective used for defining the way forward.

"In the past few years there has been an acceleration in the realignment of the global economy. Two developments have been particularly important. First, the productivity shock resulting from the absorption into the global labour force of massive numbers of workers in emerging economies; and second, the increase in commodity prices that has transferred wealth to raw material exporters mainly in the emerging world.

"As a result a new set of countries now exercises a greater (and different) influence on four key global variables: growth, trade, price formation and capital flow. For some of these countries, the transition is nothing short of a regime shift. The most visible is, of course, the move from international debtor status to international creditor status, with the concurrent provision of cheap funding back to countries such as the US.

"The systemic impact of this global realignment would have been less dramatic were it not for a technical factor: the bout of financial innovation triggered by the proliferation of derivative based instruments. This has reduced the barriers to entry to almost all markets and encouraged the migration of capital towards more illiquid and leveraged asset classes.

The interaction of these economic and technical changes has altered market valuations, volatility, velocity and liquidity. No wonder various markets seem to be sending conflicting signals. No wonder market participants are having trouble predicting central bank policies, which are becoming more tentative. No wonder economists cannot resolve debates on the outlook for global payments imbalances... We should view these themes not as competing but as part of a fundamental change in the global economy..."

I'll begin with the caveat that taking exception to Mr. El-Erian's analysis is risky business. He is an astute analyst and forward thinker on global financial and economic developments with few equals. And I certainly concur with his view that we have been witnessing "a fundamental change in the global economy." I will, however, attempt to expand upon his thinking and to do so from a competing analytical framework.

Yes, as Mr. El-Erian explains, we now have a "group of countries that have become systemically important in influencing growth, trade and, critically, capital flows. And they behave differently from what we've been used to." This is today a huge issue that goes way beyond derivatives and "barriers to entry." The growing prominence of the "emerging" economies is only a subplot to the story, and to appreciate the nuances of the unfolding storyline one must reflect back upon the early chapters.

From my perspective, analyzing today's extraordinary global environment must begin with the recognition of the profound role a weakened U.S. is playing in this Monumental Shift in Global Market and Economic Power from the "Core" to the "Periphery." A previous chapter included the episode where the Greenspan Fed in the early-nineties acquiesced to Wall Street, the GSEs and aggressive "financial innovation" in response to a severely impaired banking system. Part of the story would be how the U.S. economy consumed the "peace dividend" after the collapse of the Soviet Union and frittered away the bounty associated with the status as the only superpower and controller of the world's reserve currency. There are, as well, the subplots of how the powerful Financial Sphere abused its new prominence and how each time the Fed and policymakers ignored the real issues and simply choose the inflation expedient to temporarily find their way out of trouble.

I would suggest that the unprecedented inflation of dollar-denominated Credit instruments has been the decisive catalyst for the momentous financial and economic changes that the world is only now beginning to appreciate. The complete breakdown in U.S. monetary discipline - operating at the "Core" of the global financial system - has fostered a period of unlimited cheap global finance. The Chinese, Indian and Asian, Russian and oil producing nations, and other emerging economies would look a whole lot differently today were it not for this backdrop of endless liquidity that has inflated global commodities, real estate and securities markets, while promoting unprecedented ("Periphery") capital investment.

Mr. El-Erian notes, "The systemic impact of this global realignment would have been less dramatic were it not for a technical factor: the bout of financial innovation triggered by the proliferation of derivative based instruments." I would further emphasize that the commanding role of "contemporary finance" cannot be overstated. But I suggest that the key dynamic has been the massive Credit and Liquidity Inflation at the "Core" - the upshot of booming domestic lending, securitizations, derivatives and securities finance/leveraging. The influence of "financial innovation" in fostering dollar liquidity inflation has been even more significant than its role in removing "barriers to entry" for the emerging economies.

The "Core" versus "Periphery" analysis is especially critical when it comes to the issue of sustainability. For some time, many analysts have presumed that the emerging economies were invariably at the brink of a nineties-style boom turned ugly bust. But the massive and unrelenting flood of liquidity emanating from the U.S. Credit system (Current Account Deficits, speculative financial flows, and investment flows) has to this point been more than adequate to finance ongoing booms at the "Periphery." With this in mind, my analytical focus has been - and remains - our powerful but aged U.S. Credit Bubble.

On a side note, I find it curious that Mr. El-Erian's analysis highlights the impact financial innovation has had on "liquidity" and "velocity," while maintaining a safe distance from the critical issues of Credit Availability and Unrestrained Credit growth. To be sure, the "proliferation" of Credit Excess, and resulting marketplace liquidity and speculative excesses, is the root of today's unstable global financial and economic backdrop.

The divergence between the discernable escalation of global risks (financial, economic and geopolitical) and the market's pricing of risk (i.e. overvaluation and meager spread/risk premiums) is receiving a fair amount of attention of late in Davos and elsewhere. From my perspective, spectacular global asset inflations transpire only during - are products of - periods of underlying Monetary Disorder - a circumstance today readily explained by Credit system dysfunction at the "Core." Such a circumstance creates uncommon risks, as booming asset markets are seen as confirming bullish perceptions and expectations. Boom-time liquidity conditions and economic growth are then extrapolated far into the future. Festering geopolitical issues are easily disregarded.

Lawrence Summers, commenting this week in Davos: "It's worth remembering that markets were very upbeat in the early summer of 1914." Well, it is certainly not unprecedented for global markets to rise spectacularly in the face of mounting geopolitical risks. Indeed, the underlying (financial and economic) disorder covertly fueling the boom can be expected to have complex and manifold causation and, certainly, broad geopolitical ramifications. I believe the current Monetary Disorder and resulting global boom are much the consequence of waning U.S. financial and economic supremacy, replete with all the geopolitical risks associated with such a historic development.

Credit Bubbles and their inevitable myriad inflationary effects are always a wealth-redistributing phenomenon - and, accordingly, inevitably quite problematic. Yet, for some period of time the liquidity and asset inflation effects do seductively stimulate investment, wealth creation and robust economic activity. However, the steep cost of the inflationary process begins to emerge later when inflation's increasingly destabilizing effects promote myriad avenues of wealth destroying behavior (mal/over-investment, resource misallocation, waste, fraud, and profligacy). The growing divergence between waning wealth creation and the escalating expansion of financial claims (the "scourge" of non-productive Credit Inflation) then progressively heightens systemic risk. Still, for awhile the major inflation in perceived financial wealth works to mask the underlying impairment to the economic structure, while booming liquidity and asset prices ensure most (including market professional and monetary policymaker) remain inattentive to risk dynamics.

Today we're in (and hoping to extend) the stage where the "Periphery" still readily accepts and accumulates our increasingly suspect financial claims (securities and debt instruments). The deepening impairment to the U.S. economy is obscured by unrelenting Credit expansion - the whirlwind of new financial claims that are accepted globally in exchange for needed goods/resources, as well domestically to sustain the finance/asset inflation/"services"-based U.S. economy. At the same time, inflating securities markets at home and abroad work to bolster confidence, self-reinforcing Credit expansion, speculative excess, and continued income and spending growth.

I continue to believe the probabilities are high that current dynamics are brought to a conclusion by some type of financial dislocation. I certainly recognize, however, that the weakened U.S. will act on every impulse to continue its current inflation, while the ascending "emerging" economies will remain steadfast in their pursuit of greater prosperity. So, for now, I'll ponder ramifications for a continuation of an unstable status quo.

For the most part, analysts have missed key dynamics. The prevailing view has been one of sanguine global integration of "emerging" economies' cheap labor and manufacturing capacity, within the context of an ongoing technology and productivity-induced boom in the developed world - the confluence of these powerful forces pointing to a further secular decline in inflationary pressures. This "disinflationary" backdrop, as the thinking goes, will pacify U.S. and global central bankers and engender lower global market yields (and rising global securities prices!) for some time to come.

The flaw in this line of thinking lies in its disregard for underlying Credit Inflation and Bubble Dynamics, as well as a complete lack of appreciation with regard to the inflationary ramifications of waning U.S. financial and economic supremacy. In reality, there has been no secular ebbing of inflation, but instead an alluring Secular Shift in Inflationary Effects. The bullish optimists were snared by the inflationary boom's captivating initial facets - in this case ones especially conducive to serious analytical and policymaker error (including asset price inflation, muted CPI, generally robust growth, strong profits, low market yields and massive global "Investment Inflation"). Additionally, the marketplace's perception of a "disinflationary" backdrop and the Fed's likely course of accommodation - in conjunction with a historic bout of financial innovation - played a decisive role in fomenting the Global Credit Bubble and unparalleled financial excess the world over.

As we now proceed to a much more problematic phase of a runaway global boom, analysts and market operators are being forced to begin reexamining previous assumptions. Instead of the placid inflation and interest rate environment anticipated by the consensus, there is this highly inflationary global Credit and liquidity backdrop requiring higher market yields and tighter Financial Conditions than would have otherwise been the case. Or, stated differently, the Structural Increase in Global Credit Availability and Marketplace Liquidity will necessitate tighter-than-anticipated monetary policies by global central bankers - in particular the Federal Reserve.

Until some development impedes the global Credit boom, monetary policy will be dictated more by the need to lean against loose Credit Conditions and Global Liquidity than any by any measure or index of consumer prices. How ironic that this circumstance revealed itself as the leading proponent of "inflation targeting" was assuming the helm of the Federal Reserve System.

The increasing awareness by holders of inflating quantities of suspect (dollar) Credit instruments that they are being shortchanged should weigh on U.S. markets, and keep in mind that strong U.S. markets have provided major support for our faltering currency. And as the Bubble's inequitable (re)distribution of wealth gains greater recognition, the strains between the "haves" and the "have nots" - between debtor and creditor - between the U.S. and its highly liquefied competitors for global resources - will surely intensify. The global grab for limited resources should be expected to at some point turn more hostile, providing greater incentive for the U.S. to inflate and for others to aggressively exchange dollar liquidity for more attractive stores of wealth/value.

As Mr. El-Erian states, "the jury is still out as to what the destination" of this "journey" will look like. A black tide of protectionism, nationalism, radicalism, trade frictions, capital controls, and militarism certainly cannot be ruled out as the ugly outgrowth of this historic inflationary boom. And, from this perspective, the growing divide between the over-liquefied markets' mis-pricing of risk and escalating financial and geopolitical risk is no conundrum.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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