Way Behind the Curve

By: Doug Noland | Fri, Aug 22, 2003
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It was another week of "adventure" for unsettled global financial markets. The dollar enjoyed its largest gain in 2 ½ years, Semiconductor stocks surged 11%, unleaded gasoline jumped almost 10%, and the two-year Treasury yield traded this week to the highest level since December.

As for the stock market, equities continued their upward momentum, led by episodes buyers' panic (semiconductor and tech stocks). The Dow Jones Industrial Average gained 0.3% for the week, and the S&P 500 added 0.2%. The Transports added 0.7% and the Utilities dropped 0.5%. Economically sensitive issues outperformed, with the Morgan Stanley Cyclicals gaining 1.2% (up 23% y-t-d). The Morgan Stanley Consumer index gave back 1.3%. The broader market was much stronger, as the Russell advanced 2.9% (up 27% y-t-d) and the S&P 400 Midcap rose 2.1% on the week. The tech-heavy Nasdaq100 surged, with its 4% rise increasing 2003 gains to 33%. The Morgan Stanley High Tech index added 6.2%, increasing y-t-d gains to 41%. The Semiconductors enjoyed another excellent week, up 11.4% (up 52% y-t-d). The Street.com Internet index added 6.6% (up 51% y-t-d) and the Nasdaq Telecom index gained 1.3% (up 38% y-t-d). The Biotechs moved upward by 1.9% this past week. Financial stocks were unimpressive, with the Broker/Dealers down slightly. Banks continued their underperformance from last week, dropping 2.1%. In the face of a surging dollar, gold was notably resilient. With bullion up 70 cents, the HUI Gold index was down less than 1%.

It was another wild ride for the Credit market. On the week, 2-year Treasury yields increased 11 basis points to 1.91%, with 5-year yields adding 3 basis points to 3.44%. Ten-year yields declined 7 basis points to 4.46% and the long-bond yield dipped 14 basis points to 5.26% this past week. While volatile, the spread on Fannie's 4 3/8% note narrowed almost 2 to 48, while the spread on Freddie's 4 ½% note was about unchanged at 49. The 10-year dollar swap spread narrowed 0.5 to 49. Benchmark mortgage-backed spreads widened 1 basis point. Corporate spreads narrowed somewhat, with junk bonds outperforming. The yield on December 2004 3-month Eurodollars rose 9.5 to 2.89%.

This week marked the slowest week of debt issuance this year, with $1.9 billion of issuance below this year's daily average of $2.7 billion (from Bloomberg). Boeing Capital issued $500 million, Commonwealth Edison $250 million, Consumer Energy $400 million, and Oil Insurance LTD $300 million. Junk issuance slowed to a trickle, with NVL Financial selling $200 million, and Monitronics International issuing $160 million. Oxford Automotive postponed its planned $240 million junk debt sale. The convert market saw STM Micro issue $1.4 billion (boosted size 15%) and Alkermes $100 million.

Japanese government bond (JGB) yields jumped 25 basis points this week to 1.35%, with 2-week gains of 48 basis points. Yields have now tripled since June 11th.

Commodity prices are on the move. The CRB index traded above 240 for the first time since May, with y-o-y gains of almost 12%. Gasoline (NY futures) prices surged almost 10% yesterday, "the largest gain in more than 12 years" (according to Bloomberg). National gas reserves declined for a fifth consecutive week to a nine-month low (down 15% y-o-y). Natural gas traded to a six-week high this week. From Bloomberg: "Gas for delivery during the five-month North American heating season averaged $5.662 today, up 5.2 percent from last Friday and 47 percent higher than a year ago..." Platinum prices traded near 23-year highs. Soybeans are up 15% this month. Pork bellies futures were up the trading limit today on a report of depleting inventories, with prices up 40% y-o-y.

Headlines from foreign economies: Yesterday from Interfax: "Russia's GDP went up 6.9% in January-July 2003 against the same period last year ..." Yesterday from Bloomberg: "Taiwan's export orders rose in July at their fastest pace in six months to an all-time high as spending on notebook computers, cell phones and other goods picks up in China and other key overseas markets. Orders - indicative of shipments in one to three months - rose 15 percent from a year earlier ..." Also from Bloomberg: "South Korea's exports rose 19 percent from a year ago to $8.4 billion in the first 20 days of this month ..." Global growth is accelerating, but it is as unbalanced as the domestic U.S. economy.

The Philadelphia ("Philly") Fed index surged a much stronger-than-expected 13.8 points to 22.1, the highest reading since June 1998. The index traded at a low of negative 33.6 during January 2001. The index is up strongly from April's reading of negative 8.8. New orders gained 4.2 points to the strongest reading since January. Prices paid surged a noteworthy 22.5 points to 16, the highest reading since April.

Market News International (Steven K. Beckner): "Federal Reserve Governor Mark Olson said he has no specific timetable in mind for when the Fed should begin to move away from its very low interest rate stance but said he would like to see some evidence of increased business pricing power and employment growth before the Fed does so. Olson, in a Wednesday interview with Market News International, was upbeat about the economic outlook and said the threat of deflation is steadily diminishing but doubted the country is 'out of the woods' on further 'disinflation.' Asked what circumstances would justify a move away from negative real interest rates, Olson replied, 'One would have to see evidence of pricing power... We have not seen evidence of pricing power in the market yet.' Also, Olson said he would want to see increased employment as a prerequisite. 'When the employment rate starts moving up, at that point it will start to feel more like a full recovery,' he added. Olson had no specific numerical goal or timetable for returning to full employment, but said, 'I would like to see the overall economy growing at a rate that exceeds the rate of productivity so we create more jobs, but I don't have a time frame.'"

There were 29,356 bankruptcy filings last week, up 2.8% y-o-y. Year-to-date filings are up 7.6%.

The federal government ran a $54 billion deficit during July, compared to the year ago $29 billion deficit. For the month, revenues were down 8.1% and spending was up 8.7%, with Defense spending surging 17.4%. After 10 months, the fiscal year-to-date deficit has climbed to $324 billion. This compares to the year earlier $178 billion. Year-to-date revenues were down 3.9%, while spending was up 7.1%. Year-to-date Individual Tax Receipts sank 6.4%, and Corporate Income Tax Receipts were down 14.8%. Social Insurance Receipts were up 2.0%. The spending side is a rather amazing story. Defense expenditures are up 16.5% year-over-year to $318 billion. Health & Human Resources spending was up 8.6% to $420 billion, while Social Security disbursements were up 4% to $423 billion. Labor department spending jumped 9.7% to $58 billion, and federal Education spending was up 24.6% to $47 billion. Treasury interest expense was down 3.5% to $289 billion. Fiscal y-t-d spending on Veterans was up 12.5% ($47 billion) and Agriculture was up 3.9% ($62 billion).

The Ports of Los Angeles and Long Beach reported a surge of activity during July. For the month, combined container Imports jumped 10% from June (558,000), while Exports increased 11% (to 178,000). Year-over-year, inbound containers were up 9% and outbound containers were up 16%. The number of containers leaving the two ports empty was up 10% y-o-y to 310,000, fully 56% of inbound containers.

August 20 - Bloomberg: "As U.S. consumers squeeze a growing amount of cash out of their homes in the form of home equity loans, securities backed by the loans have surged, creating a bonanza for the banks that underwrite them. In the first half of 2003, sales of home-equity-loan-backed bonds grew 39 percent from a year earlier to $90 billion, according to Bloomberg data... Overall, home-equity-loan-backed bonds generated $224.5 million in fees for underwriters in the first half -- more than the fees from debt backed by loans on autos and credit cards combined... Industrywide, bonds that repackage subprime second mortgages accounted for 83 percent of all home-equity-loan-backed bonds sold in the first half, up from 75 percent in 2000, according to Moody's. 'It's an area of lending that's really gone mainstream,' says Engelken. Home-equity-loan-backed bonds appeal to investors stung by credit rating downgrades on other ABSs, says Anthony Thompson, head of U.S. ABS research at Deutsche Bank Securities Inc."

August 20 - Dow Jones (Christine Richard): "Capitol Commerce Mortgage, a California-based wholesale mortgage lender with operations in eight states, isn't talking about why it shut down its operations Friday. But mortgage industry observers say the company ran into problems hedging its exposure to sharply rising interest rates. And that's raising concerns that other financial intermediaries in the mortgages market could be facing similar problems. 'There are many more mortgage companies out there that are taking nasty hits,' said Bob Walters, chief economist for Quicken Loans ... 'This is the first really significant player to fall,' he added. Capitol Commerce is estimated to have had around $6 billion in mortgages in its pipeline and was one of the top mortgage wholesalers in its home state of California, according to a person familiar with the mortgage industry there."

August 20 - Dow Jones (Dawn Kopecki): "The entire financial marketplace would feel the impact of a rating downgrade on the debt of either Fannie Mae or Freddie Mac, Rep. Richard Baker, R-La., says in an upcoming issue of Money magazine... 'If a GSE had its credit rating downgraded, it would have a dramatic, instantaneous impact on the entire financial marketplace because of the implications to capital held at (federally insured banks)...' GSE debt made up 95% of all bank capital held by federally insured commercial banks at the end of 2002. At the same time, he admitted that efforts to pass legislation moving Fannie and Freddie's regulator from the Department of Housing and Urban Development to the Treasury Department are not politically popular. 'It's not something many homeowners or taxpayers are even aware of, so if you make the change and provide for adequate safeguards, that's not something you can go home and run a 30-second ad about,' Baker said. 'It's a difficult policy question with only political downside.' Even federal investigators looking into Freddie's accounting scandal are treading very carefully, Baker said. 'There's a concern by many that if an inappropriate regulatory action is taken, it could hurt one of the strongest legs of the economy, which has been the real estate boom,' Baker said when asked about the Department of Justice and Securities and Exchange Commission, which are both investigating numerous accounting problems at Freddie. 'If it could be alleged that any regulator took an action which in some fashion damaged the secondary mortgage market and slowed down the sales of homes, that would be a very bad political thing to do.'"

Freddie Mac posted 30-year fixed mortgage rates rose 4 basis points to 6.28% last week, a 107 basis point increase from mid-June. One-year adjustable mortgage rates jumped 9 basis points to 3.84%, up only 30 basis points since June. The Mortgage Bankers refi application index dropped another 15% last week to the lowest level since July 2002. Purchase applications declined 6.5% to a level only 5% above one year ago. The dollar value of purchase applications, however, was up about 14% y-o-y. Last week, variable rate mortgages accounted for 23.3% of total new mortgages, up from 13.4% during the final week of June. Last week's variable rate ratio was the highest since May 2000.

The National Association of Home Builder's activity index jumped 6 points this month to 71. This was up from April's 52 to the strongest reading since January 2000. The homebuyers' panic runs unabated in Southern California.

August 21 - Los Angeles Times (Bonnie Harris): "The Southern California housing market delivered another strong performance last month, setting an all-time record for sales in the Inland Empire and the 30th consecutive month of double-digit price increases for the entire six-county region... The median price for homes sold in the Southland hit a new record of $328,000 in July - up 21% from a year earlier... In addition, a total of 33,561 new and existing homes were sold, which was the highest monthly sales count in nearly 15 years. Riverside and San Bernardino counties easily led the region in sales of new homes, with year-over-year increases of 35% and 36%, respectively. Median home prices rose from a year ago in all six counties, with Orange County again fetching top dollar at $428,000. In July, the median price for new houses and condominiums in Orange County was $549,000, for existing houses it was $465,000 and for existing condominiums, $300,000. Only Ventura County topped Orange County's median price in any category, with a $619,000 median price for new homes in July. That was a year-over-year increase of 48%. 'It is absolutely crazy,' said Veronica Sheffield, a Pacific West Realtors agent in Ventura. 'Two months ago, I couldn't imagine [prices] going any higher, and now this. How much more can we honestly expect to see?'"

The Mortgage Bankers Association reported that new commercial mortgages jumped to $29.5 billion during the second quarter, up almost 29% y-o-y.

August 22 - National Mortgage news: "Thrift originations rose 22% in second quarter to nearly $200 billion as refinancings pushed production to a new industry record."

August 18 - GMAC: "Residential Funding Corporation (GMAC-RFC) today announced that its total mortgage-backed securities (MBS) and mortgage related asset-backed securities (ABS) issuance reached a record $25.3 billion during the first half of 2003 in the U.S." GMAC-RFC securitized a record $34.5 billion of mortgage-backs during all of 2002, which was up 31% from 2001.

As was widely reported, July Housing Starts jumped to the highest level since August 1986. Single-family starts have not been as strong since November 1978, with Starts on pace for the strongest year since 1986. Compared to July 2002, single-family Starts were up 13.1%, with multi-family starts up 5.5%. By region, single-family Starts were up 31.5% in the Northeast, 7.7% in the Midwest, 17.1% in the South, and 5.3% in the West. Single-building permits held at near record levels.

Broad money supply (M3) added $15.3 billion last week. Demand Deposits declined $22.5 billion, while Savings Deposits surged $36.6 billion. Savings Deposits have increased $305 billion since early March (over 23 weeks), or 24% annualized. Last week, Small Denominated Deposits declined $2.6 billion, while Retail Money Fund deposits added $1.1 billion. Institutional Money Funds declined $7.2 billion, with Large Denominated Deposits increasing $7.5 billion. Repurchase Agreements gained $2.2 billion and Eurodollar deposits dipped $1.1 billion. Foreign (Fed "custody") holdings of U.S. Debt" added $6.4 billion, with three-week gains of $14.4 billion. "Custody" holdings are up $141 billion, or 17.5%, from one year earlier. Commercial Paper outstanding declined $5.0 billion. Non-financial CP increased $2.6 billion, while financial CP declined $7.5 billion.

Following a three-week surge, Total Bank Assets declined $14.4 billion. Securities positions dropped $36.4 billion (down $56.6 billion over two weeks), with Treasury and Agency positions down $44.1 billion. Loans and Leases expanded $17.4 billion ($44.1 billion over two weeks). Commercial and Industrial loans declined $2.1 billion and Real Estate loans dipped $3.6 billion. Securities loans jumped $15.3 billion and Consumer loans added $4.4 billion.

News this week from Intel, the "Philly" Fed, and various sources confirm that our unsound Bubble economy is lurching forward. An economist quoted by Bloomberg captured the growing euphoria: "We have all the classic signs of a burgeoning recovery." The stock market certainly believes so. I would, however, argue that we are instead witnessing classic signs of commencing a dangerous stage of an ill-advised (out of control) Credit Boom. This is neither a rant nor an issue of semantics.

A normal cyclical recovery would experience burgeoning demand throughout the interest rate sensitive sectors, particularly housing and autos. Pent-up demand (especially for durables) would hold the key to accelerating growth. Additionally, a surge in capital spending would be expected to play an instrumental role in propelling the fledgling expansion. And, importantly, unfolding recovery would be stoked by easing Credit conditions, with lenders loosening Credit availability after an extended period of caution. Logical and historically relevant yes, but all of this has virtually nothing to do with today's financial and economic landscape.

Indeed, there's little normal about the current environment; it's categorically abnormal and it's surely not a "recovery." Rate sensitive sectors have enjoyed booming demand for several years now - powering into overdrive since the Fed began cutting rates aggressively back in late 2000. Capital spending is playing a trivial at best role in the current expansion, as we continue to gut our nation's manufacturing base. And instead of a cyclical easing of Credit conditions and a resulting up-tick in borrowings, we are witnessing a blow-off surge after years of unprecedented excess. Rather than a typical cyclical housing recovery, we are witnessing the late stage of parabolic excess and distortion.

There are two fundamental aspects of Credit-induced booms that are today very much in play. First, for the real economy, Credit excess begets only greater excess. The more Credit excesses stoke spending and economic "output," the greater will be the demand for additional borrowings. Credit inflation begets self-reinforcing inflation of varying manifestations. This is the very essence of Credit booms, and once heated up they become only increasingly unwieldy. Ours has turned white-hot.

Conspicuously, the monetary/services U.S. (maladjusted) economy is being driven by extreme Credit excess (household, federal, financial, and state and local borrowings). And while some hold the view that today's "recovery" is weak and unsustainable, Credit Bubble analysis would approach this debate differently: as long as financial market liquidity and the current ultra-easy Credit environment are sustained, the economy is likely to surprise on the upside. In the process things become only more "unwieldy," as we have been witnessing of late. This is why I incessantly argue that a stable and manageable Credit system should be central bankers' top priority. The Fed ignores the issue completely.

The second fundamental aspect of Credit booms is the critical role played by self-reinforcing asset inflation. Credit excess begets rising asset prices that beget additional borrowing demands and higher asset prices. Overheated Credit systems and rising asset prices create their own liquidity, fomenting seductive Bubble market dynamics. This is why contemporary central bankers must recognize and guard against asset Bubbles (also a top priority).

Inarguably, the contemporary U.S. Bubble economy is married to inflating real estate prices and inflating securities values (expanding quantities, as well as rising prices) like never before. The "good" news is that a strong inflationary bias is maintained throughout mortgage finance and the Credit system generally. Current inflationary momentum likely dictates that there is some time remaining for the overheated national housing market, as well as a bit more life left for many dangerous housing Bubbles, including California. But we are in the dangerous, very late stages of an historic housing boom and mortgage finance Bubble. One percent Fed funds is grossly inappropriate for this stage of the Credit cycle.

Importantly, there is today The Great Misinterpretation: Most see Promising Nascent Recovery when the reality is Precarious Late Stage Credit Boom. And while I may concur with the optimists regarding near-term GDP acceleration, that's the extent of our "meeting of the minds." They relish in the perceived opportunities afforded by cyclical upturns, giddy with the belief that we've seen the worst (and it really wasn't half bad). We see a very different world: the perpetuation of Bubble excess, inducing a compounding of serious mistakes that occur at the manic final stage of the cycle.

First of all, considering the fundamental backdrop, current stock market sentiment is truly extraordinary. (Over) Liquidity has worked its seductive magic, with investor optimism having returned to extreme levels. The hedge funds have been forced to reduce short positions, derivative players have unwound bearish trades, and money is again aggressively chasing performance. All of this sets the stage for yet another round of disappointment. And, as always, the "news" follows the general direction of stock prices. Good news is today accentuated (i.e. Intel's announcement), while negative developments are downplayed or completely ignored. When stock prices commence their decline, we will be hearing and reading much more about the unfolding quagmire in Iraq (as well as Afghanistan and the faltering Mid-East peace process) and the festering energy crisis. There are some serious unfolding problems that are today being whitewashed.

And when it comes to Late Cycle Errors, the Fed is absolutely making a mockery out of sound central banking. The economy is quickly heading toward 4% growth, there's double-digit mortgage debt expansion and a buyers' panic in some key housing markets, energy (and other) prices are surging, general Credit conditions could not be easier, and our trade deficits are out of control. Meanwhile, this week saw a parade of central bankers assuring the markets that they would keep rates at 1% for "a considerable time". The Fed is committing an additional huge mistake. They are playing this as Accommodating Nascent Recovery, when they should be Clamping Down on Late Stage Unruly Credit Boom. In the process, our central bank is bringing new meaning to the term "Behind the Curve." The Credit market has much reason to worry.

Curiously, amid this week's stock market euphoria, the financial stocks quietly traded unimpressively. Apparently our central bankers believe they are doing the bond market another favor by promising not to raise rates. Yet, so aggressively accommodating Post-boom Boom is doing only further disservice to financial stability. If this were Nascent Recovery fueled by capital investment and pent-up demand for durables, moderate Fed accommodation would be appropriate. To maintain unprecedented accommodation in today's Late Stage Bubble Environment is reckless.

Today's dilemma - our system's Achilles heel - is that the financial sector has no alternative than to aggressively expand holdings of risky assets (securities and mortgages). The Fed is on a futile crusade to sustain an unsustainable Bubble that must be financed by a ballooning financial system. There is simply no way around this fact of life. This brings us to the issue of Fed credibility. To read and listen to what our central bankers are thinking these days is not comforting (ok, it's disturbing). They simply could not be more lost in flawed analysis and oblivious to critical issues. It certainly appears to me that the Greenspan Fed is today the proverbial deer caught in the headlights. I would expect this to be a seething issue for the vulnerable bond market over the coming weeks. As always, the risk of being Behind the Curve is that, after waiting too long, more drastic measures are necessary to get things under control. While comfortable that they have the Fed in their back pocket, the Credit market will nonetheless be haunted by nightmares of an unchecked Credit boom and an endless flood of risky loans and securities.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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