Reflation Contemplation

By: Doug Noland | Fri, Feb 1, 2008
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For the week, the S&P Homebuilding index gained 16.8% (up 28.7% y-t-d), the Morgan Stanley Retail index rose 11.4% (up 5.0%), the Broker/Dealers gained 11.6% (up 2.2%), the Banks jumped 11.2% (up 8.5%), the Transports increased 7.4% (down 5.2%), and the Morgan Stanley Cyclicals advanced 7.2% (down 1.8%). The Dow rose 4.4% (down 3.9%) and the S&P500 4.9% (down 5.0%). The Morgan Stanley Consumer index gained 3.8% (down 5.5%) and the Utilities 5.2% (down 5.4%). The Russell 2000 jumped 6.1% (down 4.6%) and the S&P400 Mid-Caps 6.7% (down 4.1%). The NASDAQ100 gained 3.7% (down 11%) and the Morgan Stanley High Tech index 4.7% (down 10%). The Semiconductors surged 7.1% (down 6.9%). The Street.com Internet Index rose 4.6% (down 7.3%) and the NASDAQ Telecommunications index gained 4.4% (down 8%). The Biotechs added 2.9% (down 3.3%). With Bullion slipping $8.65, the HUI Gold index declined 2.2% (up 10.3%).

Melt-up week seven. Three-month Treasury bill rates sank another 22 bps the past week to 2.08%. Two-year government yields fell 12 bps to 2.07%. Five-year T-note yields dipped 2 bps to 2.74%, while ten-year yields added 2 bps to 3.59%. Long-bond yields were 3 bps higher at 4.30%. The 2yr/10yr spread ended the week at 152 bps. The implied yield on 3-month December '08 Eurodollars dropped 10 bps to 2.51%. Benchmark Fannie MBS yields added 2 bps to 5.07%, this week performing in line with Treasuries. The spread on Fannie's 5% 2017 note widened 4 to 55 bps and Freddie's 5% 2017 note widened 4 to 55 bps. The 10-year dollar swap spread increased 3.6 to 63.3. Corporate bond spreads were mixed to narrower, with an index of junk bonds 5 narrower this week.

Investment grade issuance included Bear Stearns $3.0bn, AT&T $2.5bn, Merrill Lynch $2.25bn, Union Pacific $750 million, John Deere $425 million, Air Products $300 million, GATX $200 million, and Oklahoma G&E $200 million.

January 29 - Bloomberg (Caroline Salas and Shannon D. Harrington): "The market for high-yield, high-risk bonds shows that a U.S. recession is a foregone conclusion. Junk bonds are off to their worst start since 1990, falling 1.8% and triggering $17 billion in losses this month... Yields relative to Treasuries are rising at the fastest pace in at least 11 years as prices drop. The pain may only get worse. Speculative-grade borrowers made up the majority of U.S. corporate debtors for the first time last year, according to Standard & Poor's. The default rate will soar to more than 8% this year, the highest since Enron Corp.'s collapse..."

Junk issuance included Petroleum Development Co. $200 million.

Foreign dollar debt issuance included Philippines $1.5bn.

German 10-year bund yields declined 5 bps to 3.92%, while the DAX equities index recovered 2.2% (down 13.6% y-t-d). Japanese "JGB" yields fell 5 bps to 1.42%. The Nikkei 225 declined another 1.0% (down 11.8% y-t-d and 23% y-o-y). Emerging equities markets were mostly higher, while debt markets were generally quiet. Brazil's benchmark dollar bond yields dipped 2 bps to 5.69%. Brazil's Bovespa equities index surged 6.3% (down 4.4% y-t-d). The Mexican Bolsa rallied 7.5% (down 0.4% y-t-d). Mexico's 10-year $ yields added 2 bps to 5.15%. Russia's RTS equities index declined 3.1% (down 14% y-t-d). India's Sensex equities index slipped 0.6% (down 10.1% y-t-d). China's Shanghai Exchange sank 9.3%, boosting y-t-d losses to 17.9% (up 55% y-o-y).

Freddie Mac posted 30-year fixed mortgage rates jumped 20 bps this week to 5.68% (down 66bps y-o-y), reversing almost all of last week's decline. Fifteen-year fixed rates surged 22 bps to 5.17% (down 89bps y-o-y). One-year adjustable rates rose 6 bps to 5.05% (down 49bps y-o-y).

Bank Credit surged $71bn during the most recent data week (1/23) to a record $9.372 TN. Bank Credit posted a 27-week surge of $729bn (16.2% annualized) and a 52-week rise of $1.063 TN, or 12.8%. For the week, Securities Credit jumped $46.6bn. Loans & Leases gained $24.3bn to a record $6.866 TN (27-wk gain of $541bn). C&I loans declined $3.8bn, with one-year growth of 21.3%. Real Estate loans rose $10bn (up 7.3% y-o-y). Consumer loans added $1.5bn. Securities loans increased $1.6bn, and Other loans jumped $14.9bn. On the liability side, Deposits jumped $89.5bn.

M2 (narrow) "money" supply jumped $50bn to $7.492 TN (week of 1/21). Narrow "money" expanded $403bn y-o-y, or 5.7%. For the week, Currency added $1.7bn and Demand & Checkable Deposits increased $24.7bn. Savings Deposits rose $7.0bn, while Small Denominated Deposits gained $3.9bn. Retail Money Fund assets increased $13bn.

Total Money Market Fund assets (from Invest. Co Inst) surged another $62.9bn last week (4-wk gain $202bn) to a record $3.314 TN. Money Fund assets have posted a 27-week rise of $731bn (55% annualized) and a one-year increase of $958bn (41%).

Asset-Backed Securities (ABS) issuance increased this week to $4.6bn. Year-to-date total US ABS issuance of $24bn (tallied by JPMorgan) remains less than half of comparable 2007. No Home Equity ABS deals have been sold thus far, compared to almost $33.3bn in comparable 2007. There has been less than $1bn of CDO issuance year-to-date, compared to $12.2bn this time last year.

Total Commercial Paper increased $10bn to an 11-week high $1.857 TN. CP has declined $367bn over the past 25 weeks. Asset-backed CP slipped $1.1bn (25-wk drop of $383bn) last week to $812bn. Over the past year, total CP has contracted $138bn, or 6.9%, with ABCP down $242bn (23%).

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 1/28) increased $14.6bn to a record $2.110 TN. "Custody holdings" were up $320bn year-over-year (17.9%). Federal Reserve Credit gained $3.1bn last week to $861.5bn. Fed Credit expanded $20.4bn y-o-y (2.4%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.315 TN y-o-y, or 26.4%, to a record $6.289 TN.

Global Credit Market Dislocation Watch:

January 31 - Bloomberg (Jody Shenn and David Mildenberg): "Losses from securities linked to subprime mortgages may exceed $265 billion as regional U.S. banks, credit unions and overseas financial institutions write down the value of their holdings, according to Standard & Poor's."

January 30 - Bloomberg (Jody Shenn): "Standard & Poor's said it cut or may reduce ratings of $534 billion of subprime-mortgage securities and collateralized debt obligations as default rates rise. The downgrades may extend losses at the world's banks to more than $265 billion, S&P said. The securities represent $270.1 billion, or 47%, of mortgage bonds rated between January 2006 and June 2007... The...company also said it may cut 572 CDOs valued at $263.9 billion."

January 31 - Bloomberg (Christine Richard): "MBIA Inc....posted its biggest-ever quarterly loss and may raise more capital after a slump in the value of subprime-mortgage securities. The fourth-quarter net loss was $2.3 billion, or $18.61 a share, raising concern that the...company will lose its top credit rating."

February 1 - Bloomberg (Mark Pittman): "Moody's... may downgrade some bond insurers in the next few weeks as it reassesses the extent of losses from subprime mortgage securities. The industry review will be completed by late February and ratings may be cut on some companies earlier if they can't raise capital... 'Our estimate of capital needed to support the mortgage-related risk of some guarantors has risen significantly,' Moody's analysts led by Stanislas Rouyer said..."

January 29 - Bloomberg (Jody Shenn): "The market for U.S. collateralized debt obligations remained shut for a fourth week, according to JPMorgan Chase & Co., on concern that ratings companies haven't adequately assessed the securities. Demand for debt created by slicing pools of assets into securities stalled as some top-rated classes of mortgage-linked CDOs lost all their value amid surging U.S. foreclosures and as bondholders faced unprecedented downgrades on home-loan bonds."

January 31 - Financial Times (Michael Mackenzie): "The US high-yield debt market remains effectively closed for business, with the amount of money borrowed by companies in January the lowest for that month since 1990... The moribund high-yield activity comes at a time when Wall Street has still not placed some $250bn in bank loans and high-yield bonds. An inability to borrow fresh money can lead to liquidity problems for highly indebted companies, and ultimately to higher levels of corporate defaults."

February 1 - Bloomberg (Jeremy R. Cooke): "U.S. state and local governments sold about $17 billion of tax-exempt bonds in January, the least since September 2001, as bond insurers' weakening credit and rising debt costs damped municipal borrowing."

January 30 - Bloomberg (Yalman Onaran and Bradley Keoun): "Merrill Lynch & Co., the world's largest brokerage, plans to exit the business of underwriting collateralized debt obligations and other structured credit products after the securities led to a record loss. 'We are not going to be in the CDO and structured-credit types of businesses,' new Chief Executive Officer John Thain said... The market for CDOs, which repackage assets into new securities with varying degrees of risk, has been frozen since last July when two Bear Stearns Cos. funds that invested in them collapsed."

January 30 - Bloomberg (Christine Richard): "Financial Guaranty Insurance Co., the world's fourth-largest bond insurer, lost its AAA credit rating at Fitch Ratings after missing a deadline to raise capital... The loss of the AAA stamp jeopardizes ratings on bonds Financial Guaranty insured and limits the company's ability to generate new business."

January 28 - Bloomberg (John Glover): "A default by bond insurers such as ACA Capital Holdings Inc. may trigger a 'disaster' in the credit-default swaps market, according to Bank of America... ACA Capital, which guarantees more than $75 billion of debt, may face delinquency proceedings from Maryland Insurance Administration because it can't pay $60 billion of credit-default swaps. The contracts, based on bonds and loans, are used to speculate on a company's ability to repay debt and the buyergets face value in exchange for the underlying securities or the cash equivalent should a borrower default. 'We see huge potential problems for settling CDS contracts,' ...analyst Glen Taksler wrote...

January 30 - Bloomberg (Adam Haigh and Eric Martin): "Citigroup Inc., Merrill Lynch Co., UBS AG and other banks may be forced to post up to $70 billion in writedowns should bond insurers lose their top credit ratings, according to Oppenheimer & Co. analyst Meredith Whitney... 'The fate of the monoline insurers is of paramount importance to financial stocks,' said New York-based Whitney. 'When it becomes clear, as we expect it will, that more charges are on the horizon, we believe the market will take another turn for the worse.'"

January 30 - Bloomberg (Warren Giles): "UBS AG, Europe's largest bank by assets, reported a record loss after about $14 billion of writedowns on assets infected by subprime mortgages in the U.S."

January 30 - Bloomberg (Neil Unmack): "Morgan Stanley, the second-biggest U.S. securities firm, wrote down $169 million after helping its money funds by taking on bonds issued by structured investment vehicles. Morgan Stanley bought $1.06 billion of SIV bonds... Banks and money managers bailed out money funds that bought debt from SIVs after losses caused by the collapse of the U.S. subprime mortgage market threatened to push their value below 100 cents on the dollar, known as 'breaking the buck.'"

January 29 - Bloomberg (Mark Pittman): "A collateralized debt obligation backed by subprime mortgages collapsed after a forced sale of assets didn't yield enough to pay back $282 million in notes. Standard & Poor's lowered the rating of Visage CDO II Ltd. notes to D, its lowest rating and signifying a default. Two of the issues totaling $160 million were given an AAA rating a year ago."

Currency Watch:

February 1 - Financial Times (Richard McGregor): "As China's foreign exchange reserves have swelled to unforeseen and uncomfortable levels in recent years, Beijing's policymakers have taken comfort in the thought that they are at least making a paper profit on managing the money. To keep the renminbi stable, the People's Bank of China buys nearly all the incoming foreign currency, invests it, and then tries to 'sterilise' the monetary impact in China by issuing local currency bills to take the funds out of circulation. High interest rates in the US, and lower rates at home, meant that the dollars invested by Beijing in the US earned the central bank more than it was paying out in local currency bills. But the monetary policy cycles have now abruptly reversed. Rates are falling in the US but rising in China, where the government is tightening credit to fight inflation and cool some sectors of the economy. As a result, China's central bank will be paying about 250 bps more on the bills it issues at home than it gets on US Treasuries... Simple mathematics suggests that Beijing is losing billions of dollars as a result, an amount amplified if the impact of China's appreciating currency is taken into account."

January 31 - Bloomberg (Gavin Finch): "The Swiss franc rose to a record high against the dollar as widening financial sector losses and a decline in stocks prompted investors to sell higher-yielding assets... 'We are probably undergoing a drawn-out process of risk reduction and de-leveraging in global markets, and as such the prognosis for carry trades remains poor,' said Ashley Davies, a currency strategist...at UBS AG, the world's second-largest foreign-exchange trader. 'The carry trade will not return in a big way' in 2008."

January 30 - Bloomberg (Bo Nielsen): "UBS AG, the world's second-largest currency trading firm, says investors should stop selling yen to buy higher-yielding assets overseas because rising volatility and financial-market turmoil favor other strategies. Carry trades will be unreliable this year as banks cut financing in the wake of credit market losses and changes to Japanese investment laws..."

January 31 - Financial Times (Simeon Kerr): "Qatar is reviewing its currency policy and could revalue or drop the dollar peg as the booming Gulf state struggles to tame inflation while the US reduces interest rates to kick-start its slowing economy. Officials yesterday confirmed the gas-rich emir-ate is considering revaluing its currency or linking it to a trade-weighted basket of currencies as well as other policy proposals aimed at taming rampant inflation of up to 15%."

The dollar index declined 0.7% this week to 75.46. For the week on the upside, the New Zealand dollar increased 2.2%, the Brazilian real 2.2%, the Australian dollar 1.7%, the Canadian dollar 0.9%, and the Taiwanese dollar 0.9%. On the downside, the South African rand declined 2.2% and the British pound 1.0%.

Commodities Watch:

January 31 - Financial Times (Jonathan Birchall): "Kellogg and Kraft Foods, two of the world's largest food companies, yesterday said the increase in global food commodity prices had hit their quarterly profits. As a result, Kraft said it was planning to pass on 'significant' price increases to consumers... Kellogg, the world's largest breakfast cereal maker, cited 'significantly higher commodity, fuel, energy and benefit cost inflation'... Irene Rosenfeld, chief executive of Kraft, said the company was facing an 'unprecedented input cost environment'... 'We are expecting to see continued record high input costs,' she said. Kraft said a year-on-year increase in dairy costs of more than 40% had halved operating income from the cheese business... Kraft said overall input costs for 2007 had increased by $1.3bn compared with 2006, with costs for wheat, soyabean oil and cocoa now at 'significantly higher levels than the 2007 costs'... David Mackay, chief executive of Kellogg, said his company had increased the impact of input cost on its forecast... 'There's really nothing that's gone down: wheat, edible oils, corn, packaging, the price of oil and diesel - everything is up anywhere between 19 per cent and 30 per cent. I think it's impacting almost everyone within the fast moving consumer goods segment,' he said."

January 31 - Bloomberg (Pham-Duy Nguyen): "Gold rose, capping the biggest monthly gain since April 2006, after lower U.S. borrowing costs weakened the dollar, boosting the appeal of the metal as an alternative investment. Silver jumped to the highest since 1980."

January 30 - Financial Times (Javier Blas): "Prices for top-quality US wheat jumped to a record high yesterday, extending their gains over the past two months to 40% as demand from emerging countries was boosted by weakness in the US dollar and sharp declines in freight costs."

February 1 - Bloomberg (Jason Folkmanis): "World rice prices will probably rise further until at least next month, stoked by a lack of new supply, the United Nations forecasts, exacerbating inflation in leading producers of the grain... Prices for 13 grades of rice, ranging from Thai parboiled to California medium-grain, rose by an average of 28% in January from the same time a year earlier..."

January 28 - Bloomberg (Josh Fineman): "Hershey Co., the largest U.S. chocolate maker, raised prices on one-third of its U.S. candy products as raw material and fuel costs increased. The average 13% price boost on candy bars is effectively immediately..."

For the week, Gold dipped 0.9% to $905, while Silver gained 2.0% to $16.83. March Copper jumped 2.8%. March Crude declined $1.73 to $88.98. March Gasoline fell 3.0%, and March Natural Gas lost 2.9%. March Wheat added 1.1%. The CRB index gained 0.7%, boosting five-week gains to 1.6%. The Goldman Sachs Commodities Index (GSCI) declined 0.7%, with a five-week decline of 2.4% (52-week gain 39%).

China Watch:

January 28 - Financial Times (Richard McGregor and Tom Mitchell): "An acute coal shortage left China suffering its worst power crisis in years as unseasonably large snowfalls saw hundreds of thousands stranded when they tried to travel to their families for the lunar new year holiday. About half of China's 31 provinces and regions have been hit by 'brownouts', or voltage reductions, caused by Beijing's attempt to reimpose and tighten price controls on commodities including coal and oil. Beijing is using old-fashioned price controls in an effort to stop food inflation, which has pushed the consumer price index to an 11-year high, from spreading to the rest of the economy. Power companies insist the brownouts are the result solely of coal shortages."

January 30 - Associated Press: "China's economy was suffering a double blow Tuesday as coal shortages forced power plants to shut down, while prices of meat and vegetables rose as heavy snow hampered deliveries by truck and train, news reports and companies said. The dual crises highlighted the strain on China's power supplies, railways and other infrastructure following five years of 10%-plus annual economic growth. The snows have aggravated power shortages that have been reported since mid-January and that analysts blame on a four-month-old government freeze on electricity prices. The step was meant to curb inflation, but analysts say it also prompted utilities to cut power generation to curb losses as coal prices rose to record levels."

January 30 - Bloomberg (William Bi): "Vegetables prices in southern China have surged since the worst snowstorms in decades disrupted water and electricity and shut highways, the National Development and Reform Commission said. Prices of staples including cabbages, radishes and eggplants have gained more than 50% since mid-January, when the bad weather started, with some prices doubling..."

Japan Watch:

February 1 - Financial Times (Lindsay Whipp and David Pilling): "Japan's wages dropped at their fastest pace in 3½ years in December, fuelling concern that higher corporate profits are not being felt in workers' pockets in spite of six years of growth. Wages fell 1.9% as small and medium-size companies were unable to pay higher winter bonuses because of the increased cost of raw materials and oil."

Asian Bubble Watch:

February 1 - Bloomberg (Shamim Adam): "Inflation is accelerating in Asia as South Korea, Indonesia and Thailand join regional counterparts in reporting rising prices that are making it harder for their central banks to follow the U.S. in cutting interest rates. Consumer price gains in Sri Lanka exceeded 20% in January, while those in Australia reached levels not seen in 16 years. Inflation is accelerating even as China, India and Australia today reported a slowdown in manufacturing in January."

February 1 - Bloomberg (Seyoon Kim): "South Korea's inflation accelerated in January at the fastest pace in more than three years as costs of industrial goods and fuel rose following a surge in crude oil prices. The consumer price index rose 3.9% from a year earlier..."

January 28 - Bloomberg (Yu-huay Sun): "Taipei fruit prices jumped 70% from a year earlier because typhoons reduced supplies by about a fifth, the China Times reported..."

January 28 - Bloomberg (Glenys Sim): "Singapore's overall concern in 2008 is inflation on the back of high oil prices and rising food costs, the Business Times reported, citing Tony Tan, deputy chairman of Government of Singapore Investment Corp."

India Watch:

February 1 - Bloomberg (Kartik Goyal): "India's exports rose to $12.3 billion in December from a year earlier as companies shipped more gems, machinery and fuel products to overseas markets. Shipments increased 16%... Imports advanced 18.1%."

February 1 - Bloomberg (Anil Varma): "Indian banks' loans rose 203.3 billion rupees ($5.2 billion) in the two weeks ended Jan. 18... Credit climbed 22.5% in the 12 months..."

January 31 - Bloomberg (Kartik Goyal): "India's economy expanded 9.6% last fiscal year, the fastest pace since 1989, as rising incomes spurred demand for cars, mobile phones and motor-bikes."

Unbalanced Global Economy Watch:

January 31 - Financial Times (Ralph Atkins): "Eurozone inflation has soared to a 14-year high of 3.2%, adding to the European Central Bank's case a hard-line stance on future interest rate moves. The unexpected rise from 3.1% in December suggests that the 'hump' in inflation caused by higher energy and food prices will prove larger and longer-lasting than anticipated by the ECB. January's rate was the highest since the Frankfurt-institution took responsibility for monetary policy in the region in 1999."

January 28 - Bloomberg (Gabi Thesing): "Money-supply growth in the euro region cooled in December more than economists forecast, led by a slowdown in overnight deposits. M3 money supply...rose 11.5% from a year earlier, after gaining 12.3% in November..."

January 30 - Bloomberg (Peter Woodifield): "Tenant demand for U.K. offices, shops and warehouses is falling at the fastest rate in five years, led by a decline in central London, according to the Royal Institution of Chartered Surveyors."

February 1 - Bloomberg (Fergal O'Brien): "Irish house prices fell for a 10th month in December, capping the property sector's worst performance in at least a decade. Prices fell 1.5% from November... For the full year, prices fell 7.3%..."

January 30 - Bloomberg (Christian Vits): "German retail sales fell for a fourth month in January as surging inflation eroded spending power, according to the Bloomberg purchasing managers' index... 'Pressure on disposable incomes from rising food, fuel and utility bills continued to exert a downward influence on consumer expenditure,' NTC said... German households curbed spending after inflation accelerated last year to the fastest pace since records began in 1996, driven by a higher sales tax and rising energy prices."

January 29 - Bloomberg (Thomas Mulier): "Swiss watch exports increased 16% last year, the fastest pace in 18 years, as a surging Chinese stock market fueled consumption in Hong Kong."

January 28 - Bloomberg (Jonas Bergman): "Swedish household credit growth slowed in December from a five-month high as higher borrowing costs and slipping real estate prices crimped demand. Total household lending grew an annual 10.8% in December, down from 11.9% in November..."

January 29 - Bloomberg (Alex Nicholson): "The cost of goods leaving Russian factories and mines rose at the fastest annual pace in almost three years in December as global energy and metals prices soared. Producer prices in the world's biggest energy exporter increased 25.1%, up from 22.2% in November..."

January 28 - Bloomberg (Massoud A. Derhally): "Jordan's inflation rate will probably jump to the highest in 18 years in 2008 as the government ends oil subsidies and increases expenditure, Finance Minister Hamed al- Kasasbeh said. Inflation will accelerate to between 8% and 9% from 5.4% last year..."

January 30 - Bloomberg (Nasreen Seria): "South African inflation accelerated to an annual 8.6% in December, exceeding forecasts and staying above the central bank's target range for a ninth consecutive month as food and gasoline costs rose."

Central Banker Watch:

January 31 - Bloomberg (Svenja O'Donnell): "Central banks across the world face a 'minor replay' of the stagflation of the 1970s as inflation picks up and economic growth slows, former Bank of England policy maker Charles Goodhart said. 'All the world's main central banks now face a more difficult period,' Goodhart... 'We're going into a sort of a minor replay of the stagflation we had in the 1970s. Growth has been declining, productivity has been falling awkwardly, and there have been supply shocks on the inflationary side.'"

Bursting Bubble Economy Watch:

January 30 - Bloomberg (Bob Ivry): "U.S. spending on housing fell in the fourth quarter by the most in 26 years as the housing slump started to curtail consumer spending. Residential investment, the money spent on construction, renovation and broker fees associated with sales, dropped 24% in the period..."

February 1 - New York Times (David Barboza): "China's latest export is inflation. After falling for years, prices of Chinese goods sold in the United States have risen for the last eight consecutive months. Soaring energy and raw material costs, a falling dollar and new business regulations here are forcing Chinese factories to increase the prices of their exports, according to analysts and Western companies doing business here... Because of new cost pressures here, American consumers could see prices increase by as much as 10% this year on specific products — including toys, clothing, footwear, and other consumer goods — just as the United States faces a possible recession. In the longer term, higher costs in China could spell the end of an era of ultra-cheap goods, as well as the beginning of China's rise from the lowest rungs of global manufacturing."

January 29 - Bloomberg (Cynthia Cotts): "U.S. law firm growth will drop by half in 2008 after six years of double-digit growth, according to a report by a legal consulting firm that cited a 'perfect storm' triggered in part by the subprime mortgage crisis. The report yesterday by Hildebrandt International Inc. and the Law Firm Group of Citigroup Private Bank predicted industry revenue growth of 6 to 8% and net income growth of 3 to 5%. Law firms reported revenue growth of more than 13% in the first half of 2007 and compound annual growth of about 11 percent between 2001 and 2006..." The predicted decline is the result of a 'precipitous drop off in structured finance work triggered by the subprime mortgage crisis, a decline in M&A and transactional work...and a 'continuing softening of the litigation market...'"

January 26 - Financial Times (Daniel Pimlott): "Hard times in the US are benefiting pawnbrokers as beleaguered consumers pledge jewels, electronics and other goods in return for loans with interest rates running as high as 300% a year. Dave Adelman, president of the National Pawnbrokers Association, said the number of loans at US pawn shops had risen 15-20 per cent since October... Pawnbrokers offer loans in return for personal items. Customers can buy back their property for the value of the loan plus a fee... On Manhattan's 47th Street, the New York block through which about 90% of US diamonds are sourced, some merchants report a sharp uptick in the amount of jewellery being brought in for sale. 'It's real sad - they don't want to sell,' said Ruben, a 52-year-old street hawker... 'They might have paid $150,000 for a necklace but they will get back $25,000 or $30,000 at most. But it's either that or lose their house.'"

Latin America Watch:

January 31 - Dow Jones: "Bank loans to Mexico's private sector grew 24.1% last year..., capping a fourth-straight year of double-digit loan growth, the Bank of Mexico said... After lagging consumer and mortgage lending for years, commercial lending to businesses picked up speed in 2007. Direct performing commercial loans rose 30.5% year-on-year... Mortgage loans grew 19.3%..."

January 29 - Bloomberg (Telma Marotto): "Brazilian bank lending expanded at its fastest pace in 12 years in December as record low interest rates encouraged people to buy more items such as cars and home appliances on credit. State and non-state bank lending rose 27.3%...in December from... a year earlier... That's the biggest annual increase since 1995... Personal lending grew 33% last year as record low interest rates and less unemployment made Brazilians more confident about borrowing. Loans to companies rose 29.8%..."

January 29 - Bloomberg (Eliana Raszewski): "Argentina's inflation rate rose at least 22.3% last year, compared with 8.5% as officially reported, according to the union representing the country's National Statistics Institute."

GSE Watch:

January 29 - Bloomberg (Kathleen Hays and James Tyson): "Fannie Mae, the largest source of money for U.S. home loans, would avoid taking on excessive risk under a government plan allowing it to buy home loans as high as $729,500, Chief Executive Officer Daniel Mudd said... 'It's wrong to say, 'There is a magic line between $417,000 and $418,000, one part is not risky, one part is risky,' Mudd said. 'We will follow the same risk policy, the same underwriting criteria, the same conservative philosophy.'"

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

January 31 - Dow Jones (Romy Varghese): "With each day, more data emerge on how deep a problem collateralized debt obligations pose for financial markets. Not only did Standard & Poor's put over $264 billion of U.S. CDOs on notice for possible downgrade, but the ratings agency's latest tally of technical defaults affecting these complex securities has reached $77 billion on 64 transactions, as of Jan. 21."

January 31 - Bloomberg (Jody Shenn): "Moody's Investors Service raised its loss expectations for subprime mortgages that were packaged into bonds in 2006, boosting the odds for further unprecedented downgrades as defaults build and the economy weakens. The ratings company now expects losses to reach 14% to 18%, it said... Under the best and worst scenarios, losses could be as low as 12% or as high as 24%... In October... Moody's said the best-performing quartile of the loans would probably produce 6.7% losses, while the worst would lose 15%."

February 1 - Bloomberg (Matthew Leising): "CME Group Inc., the world's largest futures exchange, said average daily volume in January rose 65%, driven by investors trading more equity index futures and interest-rate contracts."

January 28 - Financial Times (Francesco Guerrera, Ben White and Aline van Duyn): "A boom in the use of derivatives is giving creditors strong incentives to push troubled companies into bankruptcy rather than help rescue them, according to new research and industry experts. A study by academics Henry Hu and Bernard Black concludes that, thanks to explosive growth in credit derivatives, debt-holders such as banks and hedge funds have often more to gain if companies fail than if they survive. The study suggests this development could endanger the stability of the financial system."

Mortgage Finance Bust Watch:

January 29 - Bloomberg (Dan Levy): "The number of U.S. homeowners entering foreclosure climbed 75% in 2007 from a year earlier as mortgages became more difficult to refinance and falling property values made it tougher to sell. More than 1% of U.S. households were in some stage of foreclosure during the year, up from 0.58% in 2006, RealtyTrac Inc. said... A record $375 billion of subprime loans reset to higher payments in 2007 and another $340 billion will reset this year, said Bose George...at Keefe Bruyette & Woods Inc... The number of U.S. homeowners entering foreclosure doubled in December from a year earlier, RealtyTrac said. For the year, more than 2.2 million default notices, auction notices and bank repossessions were reported on about 1.3 million properties. As many as 750,000 homes will go into foreclosure this year, 'coming on at distressed prices' and adding to the supply of available homes, said Rick Sharga, executive vice president...at RealtyTrac."

January 31 - Bloomberg (Josh P. Hamilton): "Defaults on privately insured U.S. mortgages rose 37% in December from the same month a year earlier... The number of insured borrowers falling more than 60 days late on payments jumped to a record 64,384 last month from 46,921 in December 2006, according to... Mortgage Insurance Companies of America. Defaults increased 5.5% from November, the prior high."

Real Estate Bubbles Watch:

January 28 - Bloomberg (Mark Pittman): "Purchases of new homes in the U.S. unexpectedly fell to a 12-year low in December, ending the worst sales year since records began in 1963 and signaling little prospect for a recovery. The median price dropped 10% from December 2006, the most in 37 years."

January 26 - Financial Times (Daniel Pimlott): "Sales of US office property fell by the largest amount since the September 11 2001 terror attacks in the final three months of last year, raising fears that commercial real estate is heading for a meltdown... The volume of office space sold in the final quarter of last year fell 42% to $26.5bn compared with the same period in 2006, according to...Real Capital Analytics..."

January 28 - The Wall Street Journal (T. W. Farnam): "Local governments are scrambling to deal with the rising number of foreclosures that strain city services and soon may take a toll on property-tax revenue. Stemming foreclosures and managing vacant properties so that years of economic development doesn't unravel was a priority as the nation's mayors gathered in Washington... The cities also are bracing for a drop in tax revenue. A report commissioned by the conference in November projects property values across the country will decline $1.2 trillion this year, leading to a drop in property taxes..."

Muni Watch:

January 31 - Financial Times (Saskia Scholtes): "Further uncertainty over the fate of the embattled bond insurers has rocked the normally sedate world of municipal bond investing in recent weeks. Municipal bond yields have spiked sharply higher versus US Treasuries, a sign that long-term investors are selling munis because of a perceived increase in risk - about half of the $2,600bn municipal bond market is guaranteed by bond insurers such as MBIA and Ambac. But it is also a sign of forced selling from a little-known but important group of short-term municipal bond investment vehicles that have run into acute stress in recent weeks, based on suspicions about the quality of bond insurers' guarantees on the paper that they issue. 'For a long time, investors were working on the assumption that the insurers would always be AAA-rated and now they are looking at the world through a different lens,' said Ben Thompson, portfolio manager at Samson Capital Advisors. 'It's a pretty bad scenario for munis and everything hinges on the fate of the bond insurers.'"

January 28 - Bloomberg (Michael Quint): "The University of Cincinnati in Ohio and an Illinois hospital are among borrowers in the $270 billion auction-rate bond market moving out of the securities into other types of debt amid rising interest rates... Rates on auction securities are climbing on waning investor confidence in bond insurers backing the debt, and on concern that dealers who hold auctions to set yields on the securities may not support the market with their own bids."

January 29 - Bloomberg (Jeremy R. Cooke): "The Las Vegas Valley Water District borrowed $363 million... as state and local government bond sales fall to the slowest monthly pace in almost seven years."

Fiscal Watch:

January 28 - Bloomberg (William Selway): "Half of U.S. states are projecting budget deficits next fiscal year as the slowing economy curbs tax collections, forcing local governments to spend savings, cut funding for programs, borrow or raise taxes, a report found. The Center on Budget and Policy Priorities...said that the shortfalls are estimated to total $31.7 billion to $34.5 billion in 19 states, an amount equal to at least 8% of their spending..."

January 30 - Atlanta Journal-Constitution (Eric Stirgus): "The city of Atlanta faces an estimated $70 million budget deficit, Atlanta Mayor Shirley Franklin said... For the first three months of Atlanta's current budget year, revenue was down 27% while spending was up 9% compared with the same time period a year earlier..."

Speculator Watch:

January 28 - Financial Times (James Mackintosh): "Hedge funds are on track for their worst month since the Russian default of 1998 - which brought down Long Term Capital Management - with the average fund losing more than 3% so far in January. Investors say most funds opened the month betting that stock markets would rise, leaving them exposed to the terrible start to the year for equities and the wild swings of last week."

January 31 - Bloomberg (Jenny Strasburg): "Deephaven Capital Management LLC is liquidating a $780 million hedge fund that tries to profit from takeovers after investment returns fell and investors asked for more than two-thirds of their money back. The firm froze redemptions from the Deephaven Event Fund after clients requested to withdraw 70% of capital..."

Crude Liquidity Watch:

January 29 - Bloomberg (Matthew Brown): "Persian Gulf states, including Saudi Arabia and the United Arab Emirates, may create an 'inflationary spiral' as governments boost spending in response to higher prices, Moody's... said. Increased government spending on salaries and subsidies, aimed at alleviating the effects of inflation, may stimulate demand, leading to further price rises, said senior analyst Tristan Cooper... Inflation accelerated to records in all six Gulf Cooperation Council states during the past year... 'The danger is that governments across the GCC may find it increasingly difficult to limit expenditure growth in the face of rising inflation, thereby locking themselves into higher and higher oil prices in order to balance their budgets,' Cooper said..."

January 30 - Bloomberg (Maria Levitov): "Russian government and corporate foreign debt declined to about 33% of economic production in 2007, Finance Minister Alexei Kudrin said. That was down from more than 50% of gross domestic product in 2006..."

January 29 - Bloomberg (Matthew Brown): "Kuwait's annual M3 money supply growth, an indicator of future inflation, slowed to 19% in December from 20% in November. M1 money supply growth increased to 21% in December from 18% in November, while M2, which includes savings and investment instruments, fell to 19% from 20%..."

Reflation Contemplation:

"The same voices that supported tough macroeconomic policies to deal with the excesses of spending and borrowing in east Asia, Russia and Latin America are today pushing for a significant relaxation in the US to deal with the so-called subprime crisis. Interest rates should be slashed quickly and $150bn put into taxpayers' pockets by April at the latest, they say. The goal seems to be to avoid a 2008 recession at all costs. As Larry Summers, former Treasury secretary, put it, failure to act would make Main Street pay for the sins of Wall Street." Ricardo Hausmann, director of Harvard University's Center for International Development, Financial Times, January 31, 2008

There's no free lunch in finance or from inflation. For now, though, Wall Street celebrates the Bernanke Fed's rapid-fire slashing to a 3% funds rate. The Bank index has now rallied 28% off of recent lows, the Homebuilders 59%, Retailers 25%, Transports 19%, and the Broker/Dealers 25%. There is an overwhelming consensus view that aggressive rate cuts are precisely the policy prescription to stem housing prices declines, to hold recessionary forces at bay and to reliquefy the Credit market. Underlying fundamentals are sound; we just need a helping hand to get through this Credit 'rough patch', they say. The Fed finally "gets it," Wall Street pundits assure us.

Over the short run, there are some obvious benefits to inflationary negative real interest rates. Mortgage borrowing costs have fallen sharply, creating a more conducive environment for home sales while inciting yet another refi boom. Stocks benefit from the paltry yields of competing assets, including bonds, deposits, and money market funds. Many top-tier companies will see their cost of funds decline. Markets in general receive a boost of confidence from the belief that the Fed is now attentive and aggressively on the path of supporting higher asset prices.

Only time will tell how this latest "Reflation" eventually plays out. It's my view that Wall Street is taking a typically rather short-sided and shallow analytical approach to the issue. The consensus believes that further significant house price declines would be catastrophic for a highly leveraged household sector and acutely fragile Credit system. Others note the equally obvious fact that this is a particularly inopportune time for the economy to slip into recession. Apparently, the risks of failing to aggressively ease monetary policy greatly outweigh the limited inflationary risks. If it were only that straightforward.

I believe actual risks are altogether different from what Wall Street perceives. First of all, the potential enduring benefits from a sharply lower Fed funds rate are exaggerated. Housing markets will benefit only marginally from what has so far been but a moderate decline in mortgage borrowing costs. Meanwhile, much tighter Credit conditions and negative sentiment will restrain mortgage lending for years come. Remember, "Reflations" notoriously have only minimal impact on the Bubble markets recently having gone bust, generally exerting powerful effects instead on fledgling Bubbles and other Inflationary Biases.

Importantly, we're now in the midst of the first "Wall Street finance Post-Crash" Reflation attempt. It is analytically imperative to recognize that - because of the newfound impotence of "structured finance" - the current Reflation will be Different in Kind from those that preceded it. Wall Street-backed finance was predominately in the business of lending, securitizing, leveraging and "hedging" in asset markets (especially real estate, stocks and debt securities). Therefore, Reflations operating within a backdrop of a Bubbling Wall Street Credit Apparatus demonstrated a very powerful asset market Inflationary Bias. With abundant Reflationary liquidity flowing predictably to U.S. housing and securities markets, inflationary forces were contained with minimal impact on general consumer prices.

Now, however, the bust in the securitization markets will for some time exert a major drag on U.S. asset inflation, while unleashing greater liquidity to play havoc with a vast multitude of prices at home and abroad. Moreover, previous Reflations - where U.S. asset prices demonstrated the prominent Inflationary Bias - worked to create underlying demand for dollars, despite the fact that dollar-denominated Credit was being inflated in excess. Today, in stark contrast, prevailing Inflationary Biases are global in nature, exacerbating dollar selling pressure within a backdrop of ever-increasing dollar oversupply. Again, the point is to contrast unfolding Reflationary ramifications to those from the past.

For years, the "buy the dip" crowd enjoyed a huge if unappreciated advantage: Wall Street finance was itself a major inflating Bubble. And with each bursting "mini" Bubble - bonds 1994, Mexico, SE Asia, LTCM, Tech, Enron, etc. - was garnered a coveted Reflationary response from the Fed. And, in each instance, monetary accommodation and the resulting Easier Monetary Conditions significantly bolstered Wall Street Credit creation. Over and over again, betting with the Fed - buying stocks, homes, junk bonds or other risk assets - was handsomely rewarded. And while the Fed received Credit for successful Reflations, each recovery owed a greater degree of thanks to booming Wall Street finance.

The consensus view will prove much too optimistic when it comes to the household sector's response to this latest Reflation. Housing markets will benefit only marginally from lower mortgage rates. Meanwhile, savers will be hit with a significant drop in income. When the Fed cut rates in 2001, money market fund assets were about $1.8 TN. Last week they surpassed $3.3 TN. The Household sector had about $4.3 TN of deposits to begin 2001, which grew to $7.1 TN by the end of the third quarter. Sharply lower rates will impact consumption and hurt tax revenues.

Granted, previous Reflations saw interest income decline. Yet this drag was more than offset by inflating asset prices coupled with huge windfalls from refi-related equity extraction and mortgage payment reduction. Today, millions of households face an extraordinary confluence of negative home equity, an inability to refinance, and a major decline in investment income. Expect this Reflation to have a greatly subdued impact on Credit Availability - mortgage, consumer, and business. And if, as I suspect, the leveraged speculating community becomes increasingly impaired, the current Reflation will as well prove much less of a mechanism for inciting securities leveraging and resulting Marketplace Liquidity.

A reasonable case can be made that we have commenced what will be the last major "refi" boom in awhile. The short-term stimulus derived will be at the expense of future demand. I'd be surprised if mortgage rates have much room left on the downside (large risk premiums are a new reality), while the amount of available homeowners' equity is being depleted by the combination of declining prices and ongoing equity extractions. On a side note, for the system as a whole, it is a dangerous time to incite a major extraction of home equity. As the housing bust unfolds, reduced homeowners' equity will only further heighten the vulnerability of the mortgage sector and the Credit system more generally.

Worse yet for the American consumer, today's prominent "fledgling" Bubbles and Inflationary Biases encompass global markets for energy, food, minerals and other commodities. The Bric (Brazil, Russia, India and China) and "emerging market" Bubbles are historic in nature and will be only further destabilized by the Fed's actions and resulting dollar weakness. It is worth noting that there is as of yet little indication that the bursting of the U.S. Credit Bubble has had meaningful restraining influence on overheated Bric (and, for that matter, global) Credit systems. And it is this unappreciative 20% or so annualized Bric Credit growth that will continue to foment very powerful inflationary effects on energy, food, and commodities prices. In concert with the weak dollar, the U.S. consumer will be hit even harder by rising prices for an increasing array of products.

Analytical evidence strongly supports the view that the current Reflation will disappoint on the asset inflation front, while undermining the fragile household sector with a double-whammy of reduced income and higher costs. Indeed - and despite the overwhelming view otherwise - rising consumer prices will likely prove a prevailing consequence of the current monetary and fiscal Reflation, only worsening the backdrop and compounding the policy predicament over time. At this stage, the finance-driven U.S. Bubble economy is notably unbalanced, inefficient and dependent on Credit, imports, and foreign finance. Throwing large quantities on inflationary purchasing power at it today will have much different consequences than such efforts would have had during previous asset and investment booms.

As Mr. Hausmann noted above, "The same voices that supported tough macroeconomic policies to deal with the excesses of spending and borrowing in east Asia, Russia and Latin America are today pushing for a significant relaxation in the US..." There is obviously no tolerance for any tough policy medicine in this country today. Regrettably, this only ensures a much more protracted period of economic stagnation, inflation, uncertainty and eventual arduous adjustment.

These days, there is great relief in the markets that our troubled financial institutions enjoy a virtual bottomless pit of "capital" to garner from overseas investors. This dynamic is, however, only an inflationary expedient that forestalls the necessary reallocation of resources away from finance, consumption, and "services" to the goods producing sector. The current fixation on the housing market misses the more important issue that our economy will soon be forced to restrain its Credit creation and significantly bolster the production of tradable goods and services. Policies to promote mortgage Credit and consumption are not only destined to fail, they are inhibiting the necessary adjustment and reallocation process. And low Treasury yields and today's manageable deficits instill false confidence that fiscal policy enjoys great latitude in fostering counter-cyclical stimulation. I fully expect impending massive deficits, inflation concerns and a dollar crisis to hamstring the efforts to buoy the economy when such measures are really needed.

Many economies have been forced into "tough macroeconomic policies" during the fateful 15-year global experiment in Unfettered Contemporary Finance. In many cases, it was a quite tumultuous and wrenching experience. But these episodes also provided examples of the capacity to bounce back after relatively short but deep financial and economic adjustment periods. Perhaps global markets will not impose a severe adjustment upon our system as it did to others that had similarly allowed borrowing and spending imbalances to severely distort the underlying economic structure. Yet that would only ensure years of stagnation, inflation and unrest. The goal of avoiding recession at all cost carries with it enormous costs.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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