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Liquidity, Money and Credit

Definitely UNEDITED this evening! 

A big drop in bond yields offered little encouragement for a tired stock market. For the week, the Dow and S&P500 posted slight declines. The Utilities were about unchanged, while the "defensive" Morgan Stanley Consumer index added 1%. Economically sensitive issues gave up some ground, as the Transports dipped 2% and the Morgan Stanley Cyclical index declined 1%. The broader market reversed recent strong relative performance, with the small cap Russell 2000 declining 2%. The S&P400 Mid-cap index was unchanged. The technology sector suffered mild declines. The NASDAQ100, Morgan Stanley High Tech, and The Street.com Internet indices declined 2%. The Semiconductors and NASDAQ Telecom indices dropped 3%. The Biotechs suffered a 3% decline. Interestingly, the highflying Broker/Dealers were hit for 5%, while the Banks declined 1%. With bullion surging $14.50, the HUI gold index jumped 7%.

The unsettled Treasury market enjoyed a big rally. Two-year government yields sank 20 basis points 1.80%. Five-year Treasury yields dropped 28 basis points to 3.145%, and 10-year yields sank 24 basis points to 4.20 %. The long-bond saw its yield sink 20 basis points to 5.05%. Benchmark Fannie Mae mortgage-backed yields dropped a notable 29 basis points. The spread on Fannie 4 3/8 2013 note narrowed 4 to 36 and Freddies 4 ½% 2013 note narrowed 4 to 36. The 10-year dollar swap spread declined 4.25 to 38.75. With Treasury prices on the fly, corporate spreads generally widened marginally this week. The implied yield on December 2004 Eurodollars sank 35 basis points this week to 2.365%.

Bloomberg tallied a relatively weak $10.8 billion of corporate debt issuance for the week (2003 weekly average of $12.6 billion). Investment grade issuers included Rabobank $1.75 billion, Telefonos Mexico $1 billion, Fortune Brands $600 million, United Energy Distributors $460 million, CSX $400 million, Bottling Group $400 million, Student Loan Marketing $396 million, Alabama Power $350 million, Scanna Corp $200 million, GATX $150 million, Air Products $125 million, and First Midwest Capital Trust $125 million.

Junk bond funds enjoyed $257.9 million of inflows (from AMG). Terex $300 million, Tekni-plex $275 million, Sonic Automotive $275 million, Mandalay Resorts $250 million, Odyssey RE $225 million, Chesapeake Energy $200 million, Steel Dynamics, and Berry Plastics $85 million.

Converts: Valeant Pharm $400 million, Americredit $200 million, Radisys $75 million, and Casual Male $85 million.

A brief rally came to an end, with the dollar index sinking about 2% this week. The Canadian dollar traded to a 10-year high, the Australian dollar to a new 7-year high, and the South African rand to a 3-year high

Commodities Watch:

The CRB surged better than 2% this week to the highest level since May 1996. The CRB is now up 40% from its lows back in last 2001. Crude traded above $32 today to a three-month high.

November 13 - MarketNews: "U.S. lumber prices soared in the third quarter, driven by supply constraints induced by wet weather and forest fires, then fanned by a super-hot housing market and urgent buying in advance of Hurricane Isabel, say industry officials... The composite price for framing lumber shot up to $375 per thousand board feet in September, up from $254 in March, the highest price since May 2001..." November 12 - Bloomberg: "U.S. soybean inventories in 2004 will fall to their lowest levels in 27 years after drought damaged this year's crop and Chinese demand for oilseed imports surged to a record... The price of soybeans, used to make animal feed and cooking oil, has surged 45 percent in the past four months."

Central Bank "Drivel" Watch"

Today from William Poole: "Policy is conditioned by the evidence that stares us in the face, not on the calendar. If we have modest growth, as expected -- with no imbalances, very orderly with no inflation pressures -- that environment (of accommodative policy) could extend well beyond March."

Global Reflation Watch:

Bank for International Settlements (BIS) first-half derivate data were released this week. Total Derivative positions jumped almost $28 Trillion during the six month period, or 39% annualized. Total Derivatives were up $42.1 Trillion, or 33% y-o-y. Interest-rate Derivative positions jumped $20.1 Trillion, or 40% annualized, to $121.8 Trillion. Interest rate swaps jumped $15.4 Trillion to $94.6 Trillion (up 39% annualized), with y-o-y growth of 39%. Notably, Currency Derivatives experienced unprecedented growth. Total Foreign Exchange Derivatives jumped $3.9 Trillion during the first-half (42% annualized) to $22.4 Trillion. Equity-linked Derivatives increased $490 billion to $2.8 Trillion (42% annualized), and Commodity Derivatives increased $117 billion to $1.0 Trillion (25% annualized). Over the past five years, total notional Derivatives have increased more than 140%. Interest-rate Derivatives have increased almost 190%. We find the recent explosion of derivative positions a troubling development that certainly increases already significant financial fragility.

November 12 - Bloomberg: "China's inflation rate rose in October to a six-year high as food costs surged. Consumer prices gained 1.8 percent from a year earlier after posting a 1.1 percent increase in September... That's more than the 1.3 percent median gain forecast in a Bloomberg News survey... Chinese inflation is accelerating as runaway credit growth puts more money in the pockets of consumers, enabling them to bid up prices of food and housing."

November 13 - Europe Wall Street Journal: "China's fast-growing economy has reached such heft that the country has emerged as the largest force driving the world's growing demand for oil, the International Energy Agency said. Faster-than-expected economic growth in the U.S. and Europe is also resulting in more oil use. But the latest data and forecasts by the Paris-based global energy watchdog show China alone accounting for about a third of the world's rise in use of oil this year and in 2004, when China is expected to displace Japan to become the second-largest consumer of oil after the U.S... In its monthly report released Thursday, the IEA revised upward its forecast for oil demand this year and in 2004. The agency said it now expects world oil consumption to rise this year by 1.3 million barrels a day to 78.6 million barrels a day, or some 170,000 barrels a day more than it had previously expected... The data show that China's oil use is expected to rise from 4.95 million barrels a day in 2002 to 5.39 million barrels a day this year, and to 5.70 million barrels a day in 2004. The increasing Chinese demand for petroleum will account for 35% of the rise in world-wide demand this year, and 30% in 2004... 'At this juncture, China is the engine of global oil demand growth with significant room for further expansion in the industrial and transport sectors' the IEA's latest Oil Market Report said." November 13 - Bloomberg: "China, the world's No. 2 energy user after the U.S., said its crude oil imports rose to a record 74.2 million metric tons (545.4 million barrels) in the first 10 months of this year. China's crude oil imports rose 30.3 percent in the January-October period, the customs bureau said..."

November 14 - Bloomberg: "China's power use will rise as much as 15 percent this year to a record as the economy expands..."

November 13 - Bloomberg: "China posted a record trade surplus last month as exports surged at their fastest pace in five months, stoking growth in Asia's second-biggest economy... The trade surplus widened to $5.74 billion... Exports grew 37 percent to $40.9 billion... The nation's imports rose 40 percent last month to $35.2 billion..." "China's iron ore imports jumped 32 percent in the first 10 months of this year, while steel-product imports rose more than half..."

November 13 - Bloomberg: "India's economy may grow more than 7 percent, the fastest in seven years, in the year to March 31, 2004, as heavier rains boost farm production and lift rural incomes, the government said in its quarterly economic review. The government expects farm growth of 8 percent during the year because of heavier than normal rains..."

November 13 - Bloomberg: "Condominiums for sale in Tokyo fell 24.3 percent from a year ago to 6,739 units, according to the Real Estate Economic Research Institute in Tokyo." Average price per square meter was up 10.8% y-o-y.

November 11 - Bloomberg: "Thai consumer confidence rose to a record in October on optimism that surging exports and rising share prices will boost economic growth..."

November 11 - Bloomberg: "Canadian housing starts unexpectedly rose in October, climbing to the second-fastest pace in 12 years..."

November 11 - Bloomberg: "Australian business confidence rose to a nine-year high in October..."

The European economy surprised on the upside this week, with the Italian economy expanding at the quickest pace in two years.

Domestic Credit Inflation Watch:

October Producer Prices were up a much stronger than expected 0.8%, the largest jump since the prewar pickup in March. Food prices had their strongest gain since January 1984 (from Bloomberg). Year-over-year Producer Prices were up 3.4%. Consumer Confidence rose to the highest level since May of last year, with Current Conditions also the highest 18 months.

November 14 - Bloomberg: "U.S. taxpayers will see refund checks increase almost 27 percent to an average $2,500 per family next year, USA Today reported, citing forecasts from tax experts and economists."

November 10 - Bloomberg: "Sotheby's Holdings Inc. sold a Willem de Kooning abstract painting owned by billionaire Mitchell Rales for $11.2 million during a second consecutive night of record-setting contemporary art sales in New York. The postwar and contemporary auction set five records for artists such as Agnes Martin and Brice Marden... The world's two biggest auctioneers by sales, Sotheby's and Christie's International Plc, both have seen increased interest from art collectors during the second week of the fine-art auction season in New York... 'It was the same as last night, a very buoyant market,' said Julian Weissman, a contemporary art dealer... 'The support seems to be wider and more across-the-board than I've seen in a long time.'"

November 14 - California Association of Realtors: "The median price of an existing, single-family detached home in California hit a new record during the third quarter of 2003, rising 20 percent to $386,340."

November 10 - Bloomberg: "Freddie Mac, the second-largest U.S. mortgage buyer, boosted its 2004 and 2005 forecasts for home sales, price gains and loan volume, saying mortgage rates will stay close to historic lows through next year. Freddie Mac said 7 million new and existing single-family homes likely will sell in 2004, 2.9 percent higher than last month's forecast of 6.8 million."

Countrywide's $29 billion of total October fundings were down significantly from record volume enjoyed during the summer. October Total Fundings were down 16% from October 2002. Non-purchase (refi) fundings of $16.6 billion were down 34%. "Year-to-date purchase volume of $108 billion has exceeded the $86 billion produced for all of 2002 by 25 percent." At the same time, Purchase fundings were up 32% (from Oct. 2002) to $12.4 billion. Home Equity fundings jumped 56% to $1.8 billion, while Subprime surged 142% to $2.4 billion. "Adjustable-rate loan production was $11 billion this month, 183 percent greater than October 2002." "Total assets at Countrywide Bank... rose to $17 billion, an increase of 4 percent from last month and 242 percent more than October 2002."

November 13, 2003 - "Almost all metropolitan areas experienced moderate-to-strong price gains during the third quarter with demand for homes continuing to outstrip supply, according to the latest survey by National Association of Realtors (NAR). The association's third-quarter metro area home price report, covering changes in 124 metropolitan statistical areas, shows 41 areas with double-digit annual increases in median existing-home prices and only two areas posting minor declines. David Lereah, NAR's chief economist, said this is a new record for the number of metro areas experiencing double-digit price increases. 'This breaks a record just set in the second quarter of this year when 40 metropolitan areas experienced double-digit gains in their median existing-home price. In fact, this is the strongest price increase since publication of our quarterly metro price series began in 1982... The national median existing-home price was $177,000 during the third quarter, up 10.1 percent from the third quarter of 2002 when the median price was $160,800."  Not surprisingly, the strongest y-o-y price gains are found on the two coasts. Prices were up 26.5% in San Bernardino, 25.4% in Los Angeles, 22.6% in Trenton, NJ, 19.7% in Daytona Beach, FL, 19.4% in Miami, 18.7% in Providence, RI, and 17.8% in Baltimore. Other notable gainers included Portland, ME, up 16.3%, Orange Co., CA up 16.2%, Philadelphia 15.5%, San Diego 15.1%, Sacramento 14.7%, and Washington DC 14.2%. Year-over-year prices were up 16.8% in the Northeast, 5.7% in the Midwest, 11.5% in the South, and 10.4% in the West. National median prices are up 17% over two years, led by gains of 30% in the Northeast and 20% in the West.

Fannie's October Monthly Summary is interesting. After expanding almost $105 billion over three months (52% annualized), Fannie's Retained Mortgage Portfolio declined $4.5 billion (5.7% annualized) to $912.7 billion. Curiously, Average Net Mortgage Balances were actually up $30.3 billion for the month. Fannie's Outstanding MBS (non-retained mortgage-backeds) jumped $28.8 billion, or 32.6% annualized, to $1.24 Trillion. This was the strongest expansion since June. Overall, the company's Book of Business expanded at a 14.6% annual rate to $2.153 Trillion. Year-to-date, Fannie Book of Business is up $332.3 billion, or 22.3% annualized.

Commercial Paper declined $0.5 billion. Non-financial CP added $1.9 billion, while Financial declined $2.4 billion.

Broad money supply (M3) declined $9.6 billion for the week of November 3. Demand and Checkable Deposits added $14.4 billion. Curiously, narrow money (M1) is up $31.5 billion over three weeks to a new all-time high. However, Savings Deposits dropped $15.9 billion and Small Denominated Deposits dipped $2.3 billion. Retail Money Fund deposits declined $2.0 billion, the tenth consecutive decline ($47.1 billion over ten weeks). Institutional Money Fund deposits added $1.4 billion, reducing its 10-week decline to $30.3 billion. Repurchase Agreements added $1.3 billion, while Eurodollars declined $2.6 billion.

And while broad money supply is about unchanged over the past 18 weeks, debt growth has expanded sharply.

The Bond Market Association's Research Quarterly was published this week. "New issuance activity in the U.S. bond markets stayed on its record pace through the first three quarters of 2003 and ahead of the same period in 2002. Issuance totaled $5.38 trillion, up 40.3% from the $3.84 trillion issued during the same period in 2002... Treasury gross coupon issuance totaled $530.3 billion in the three quarters of 2003, increasing 24.9 percent from the $424.6 billion issued in the same period in 2002... Net foreign purchases of U.S. securities is head of 2002, with U.S. Treasury bonds and notes totaling $192.3 billion in the first eight months of the year, compared to $57.6 billion in the same period of 2002... Daily trading volume by primary dealers averaged $438.6 billion during the three quarters of 2002, up 21.4%... Municipal bond issuance stayed on its record pace through the third quarter, totaling $343.1 billion in the first three quarters of 2003, a 13.2 percent increase... New capital issues accounted for the majority of the issuance increase, totaling $196.7 billion in the three quarters of 2003, 18.6 percent above...the same period of 2002... Total new (corporate) issuance volume increased 12.9 percent, to $583.2 billion... Issuance of convertible bonds - including investment-grade and high-yield issues - totaled $67.1 billion in the first three quarters of 2003, more than 2.5 times the issuance volume during the same period last year... New issuance volume of non-convertible high-yield debt more than doubled in the first three quarters of the year, to $93.0 billion... Asset-backed securities issuance continues to be on pace to break last year's record of $485.4 billion... New issue activity totaled $423.4 billion in the first three quarters of the year, up 18.6 percent... The home equity sector maintained its strong performance supported by the resilient housing market... Issuance totaled $175.2 billion in the first three quarters of the year, up 53.1 percent from the $114.5 billion issued during the same period last year... Long-term debt issuance by federal agencies totaled $1.01 trillion during the first three quarters of 2003, up 36.5 percent from the $740.0 billion issued in the same period last year... Long-term issuance by Fannie Mae surged in the first nine months of the year, totaling $272.4 billion, up 57.9 percent from the same period last year... Issuance of mortgage-related securities, which include agency and non-agency pass-throughs and CMOs, totaled $2.58 trillion in the first three quarters of the year, and already surpassed the record of $2.31 trillion set last year with one quarter left in the year. New issue activity was 67.9 percent high than the $1.54 trillion issued during the first three quarters of 2002. On a linked quarter basis, mortgage-related securities issuance was up 6.6 percent, to $920.8 billion in the third quarter... New issue activity of conforming agency mortgage-backed securities increased $1.74 trillion in the first three quarters of 2003, up 82.7 percent... Issuance of agency collateralized mortgage obligations (CMO) increased to $504.2 billion in the first three quarters of the year, up 36.5 percent... New issue activity in the non-agency MBS market surged to a record and totaled $342.2 billion in the first three quarters of the year, up 56.7 percent..., as originations of jumbo mortgages showed significant growth. Issuance volume for the first three quarters of 2003 has already surpassed all issuance of 2002. The average daily volume of total outstanding repurchase (repo) and reverse repo agreement contracts totaled $3.97 trillion for the first three quarters of 2003, an increase of 9.0 percent... Through the third quarter of 2003, over $190.7 trillion in repo trades were submitted by Government Securities Division participants, with an average daily volume of over $1 trillion..."

Over the past 12 weeks, M3 has declined $154.5 billion, or 7.6% annualized. Some have referred to this as the most significant contraction of money supply in 20 years. Many have averred that this is indicative of faltering liquidity. I have read that declining money supply is evidence of a "compounding liquidity problem" for the stock market. Liquidity problem? If we look at indicators of systemic liquidity, we see 1% short-term interest rates and extraordinarily low market rates, especially considering the backdrop. And, importantly, there is continued strong debt issuance (especially for risky credits), exceptionally narrow credit spreads at home and abroad, a record emerging market debt issuance boom, recent near record flows into equity mutual funds, huge y-t-d stock market gains (especially in the speculative areas), surging gold and commodity prices, and a dollar that can't seem to get out of its own way. In the real economy, we see booming spending, record home price inflation, and the strongest quarter of GDP growth in almost two decades.

How is it possible to witness unmistakable signs of liquidity excess in the economy and markets, while money supply indicates faltering liquidity? I think the answer goes right to the heart of what I will call Liquidity, Money and Credit Theory (a "work in progress").

First of all, I believe that it is today a major mistake to associate "money supply" with liquidity. Liquidity and money have become distinct and are definitely not interchangeable. In the past, the banking system operated as essentially the economy's financial system and payment mechanism. Bank liabilities - deposits - along with government issued currency, comprised the "money supply." Bank deposits creation was limited by reserve requirements ("multiplier effect"). The banks created liabilities (deposit "Credits"), and the banking system's cross-trading of these liabilities comprised the financial system's payment mechanism. This money functioned as the primary media for transactions, as well as playing a significant role as a store of value/savings vehicle. In such a financial system, Money Was Liquidity and we could speak of them interchangeably. An expansion of bank balance sheets (increasing loan assets and deposits liabilities) concurrently increased "money" and systemic liquidity.

That was then; this is now. Today, the banking system is only an important part of a greater financial system. Banks no longer have a monopoly on financial sector liability creation. They must also share their previous domination of our nation's payment system with money market funds, the Wall Street firms, the government-sponsored Enterprises, and a vast array of non-bank financial institutions. The contemporary payment system is comprised of a broad range of financial intermediaries today cross-trading myriad financial sector liabilities. There is certainly no problem writing a check on a money fund holding or wiring funds from a brokerage account to buy a car.

As opposed to the old banking and money system, we today operate in a Credit-based economy and financial system. Households and businesses readily use Credit to consummate transactions, with traditional money playing a small and declining role. And, importantly, speculators have used Credit (repos, margin loans, security Credit, etc.) aggressively to accumulate massive securities holdings. Financial Credit - the expansion of financial sector liabilities - created in the process of leveraged speculation has come to play a dangerously instrumental role in systemic liquidity (in both the financial and economic spheres). "Money" growth is no longer reflective of economic transactions nor, I would strongly argue, is it necessarily an indicator of systemic liquidity.

It is helpful to keep in mind that the vast majority of contemporary "money" is really just debit and Credit entries in a massive electronic ledger tabulating the financial assets of myriad "financial wealth-holders" and the liabilities of a broad range of financial institutions. These electronic claims are categorized based on maturity, as well as perceived Credit quality and "liquidity" attributes. "Money" is considered the safest and most liquid of financial assets. Repeating an important analytical point, in the past the vast majority of such "electronic entries" were the deposit liabilities of the banking system.

Today, however, we have Trillions of dollars of (electronic) liabilities ("financial wealth-holder assets) created by the likes of the GSEs, money market funds, equity and bond funds, Wall Street firms, captive finance companies (GE Capital, GMAC, etc.), and (off-balance sheet) "structured finance" (ABS, mortgage-backs, CDOs, etc.) that comprise the contemporary U.S. financial sector. And while agency long-term debt markets are now among the most liquid in the entire world, these long-term liabilities clearly do not meet the traditional attributes of money. Subjectively, M3 broad money supply includes the deposit liabilities of the banks, money fund liabilities, and other "liquid" claims including net repurchase agreements of the and Eurodollar deposits. Yet we must remain cognizant that the majority of non-bank liabilities are not included in the "money" supply, notwithstanding the exceptionally "liquid" markets in GSE, ABS and other debt instruments. More often than not, these non-bank liabilities are being created in excess, while playing an instrumental role in both the economy and financial system.

So, with this background, let's try to dive into the analysis. I argue strongly that it is the expansion of total new claims - Credit creation - that provides the new purchasing power for both the financial markets and economy. Total Credit growth is key, with these new claims the liabilities of the household, corporate, government, and financial sector. Expanding borrowings from the household, corporate and government sectors are relatively straight-forward, easy to tabulate and track, and thus not of too much analytical confusion and grief. The financial sector is a much different story, with multiple levels of lending and intermediation dictating that analysis is at least as much art as science. Not surprisingly, most econometric models disregard financial sector borrowings. This is most unfortunate.

Some financial institutions, such as insurance companies and equity mutual funds, basically function as intermediaries. Others, in the process of lending, expand their liabilities and create additional financial claims. This Credit expansion creates purchasing power and new perceived financial wealth. Curiously, there remains today a stubborn adherence to the doctrine that only banks create money and Credit - that only bank "money" provides liquidity for the system (Some go so far as to claim only the Fed creates liquidity). There is a failure to appreciate that so-called "liquidity" involves the cross-trading of myriad financial sector liabilities throughout the expansive contemporary financial system. Bank debits and Credits today commingle with debits and Credits from non-bank financial players closely linked in the sophisticated contemporary financial network/system.

Nonetheless, this Bank vs. Non-bank Intermediaries debate goes at least back to the late fifties and survives to this day. Conventional thinking still has it that non-banks (including the GSEs and money market funds) are just intermediaries that take money from one lender and give it to a borrower. While such a view seems reasonable on the surface, it is seriously flawed. Especially in the case of the GSEs, they issues new financial claims (increase their liabilities) to expand their holdings of financial assets. This expansion in claims provides the buying power for mortgage purchases, in the process creating systemic liquidity.

In the past, I have used an example of Fannie Mae borrowing funds from a money market fund (MMF) and using this finance to acquire mortgage-backs held by a hedge fund. The hedge fund exchanges mortgage-backs with Fannie for these available funds, and then establishes a MMF deposits with the sales proceeds. Fannie could then issue more short-term liabilities to the MMF, again borrowing available funds to purchase additional mortgage-backs from the hedge fund. And since the MMF is not bound by reserve requirements, these funds can be borrowed again and again ("infinite multiplier"), with Fannie's ballooning balance sheet providing liquidity throughout the mortgage-backed marketplace. Broad money supply (money market fund deposits) expands, in this case indicative of marketplace liquidity.

Well, such Credit expansion dynamics are not limited to money market funds and the issuance of short-term Fannie Mae liabilities. Ponder the example of Fannie issuing long-term debt instruments to a bond fund, and using these funds to acquire mortgage-backs from a hedge fund. In this case, the hedge fund uses the proceeds of the sale to purchase corporate bonds, whereby the seller places the proceeds of the sale directly with a bond fund. Fannie then could immediate issue more long-term debt to the bond fund, obtain additional funds and purchase more mortgage-backs. In this example, the expansion of Fannie's liabilities again provides liquidity to the mortgage-backed and corporate marketplace. But in this example, heightened marketplace liquidity has occurred by an expansion of liabilities outside of the monetary aggregates. Fannie's expansion would increase the price of mortgage-backs and corporate bonds.

Indeed, I will make the bold claim that it is the expansion of the general financial sector - the expansion of liabilities - that primarily creates systemic liquidity. The past decade has been generally a declining interest rates environment. Financial sector expansion has regularly taken place through the aggressive issuance of short-term "monetary" liabilities. In such circumstances, money supply expansion will be indicative of ample systemic liquidity. However, I would argue, this will not always be the case. If, for whatever reason, the financial sector begins financing expansion with heavier long-term debt issuance, money supply will not as accurately reflect systemic liquidity. Moreover, if a scenario unfolds where the financial sector actually issues long-term financial liabilities aggressively, and in the process reduces short-term liabilities, then the relationship between money supply and systemic liquidity changes profoundly: Money, having so accurately indicated systemic liquidity conditions for years, all the sudden gives an absolutely false signal. I have reason to believe such a scenario may have developed over the past few months (specifically, 12 weeks).

Again, broad money supply has declined about $155 billion (7.6% annualized) since the week of August 11th. But before we get too excited about this unusual decline, we must recall that M3 has exploded almost $390 billion (14% annualized) during the preceding 17 weeks going back to the week of April 14. To appreciate the dynamics of recent money supply contraction, we must attempt to discern the nature of the preceding wild expansion. We know that over a 17-week period Bank Total Assets surged $347 billion, or 15% annualized. This was a period of extreme mortgage lending excess, but there are reasons to believe it was also a period of gross speculative excess throughout the leveraged speculating community (with visions of the Fed forever fighting deflation with easy money). This speculative melee was abruptly brought to an end by a spike in long-term rates and near interest-rate marketplace dislocation.

As I have pointed out previously, the GSEs again came to the market's rescue, with Fannie and Freddie's combined Retained Portfolios expanding over a three month period by $160 billion. This unprecedented expansion provided liquidity to the banks and leveraged speculative community that had been caught overexposed to huge mortgage holdings in a suddenly rising rate environment. There was a major transfer of assets to the GSEs, with significant ramifications for the composition of financial sector liabilities. We know as well that the central banks of Japan and China combined to expand foreign reserve holdings by $133 billion in the four month July through October to $1.0 Trillion, or 46% annualized.

So we have an extraordinary environment for which to analyze liquidity, money and Credit. Importantly, an historic refi boom was brought to an abrupt halt with the rise in market rates. Many have mistakenly claimed that this represented a Credit collapse. Sure, extreme mortgage Credit growth was slowed by the end of the refi boom. But with record home sales at record prices, along with unprecedented home equity borrowings, we remain in a period of enormous mortgage Credit growth. And with the historic ballooning of GSE and global central bank balance sheets, the broader financial sector has been expanding aggressively. Financial sector dollar claims have been created great abundance. As such, I would argue that we have been in the midst of a period of extreme dollar liquidity excess. From this analytical framework, there is absolutely no mystery surrounding the stock market's speculative advance, the collapse of Credit spreads, the global bond issuance boom, the surge in gold and commodity prices or, importantly, a faltering dollar.

But what about the unusual decline in the money supply? Well, there are some significant dynamics at play. First, we are in the midst of a major disintermediation out of low-yielding money market funds. The Investment Company Institute tally of money market fund assets is down $180 billion, or 8.5%, so far this year to $2.12 Trillion. Retail fund assets have surely been fleeing in search of higher-yielding assets and to play the stock market rally. Institutional funds have suffered for similar reasons. There is, as well, the reality that many institutions would today prefer to own short-term debt instruments directly rather than to pay a meaningful percent of their paltry yield in management fees. And while investors have been in a desperate search for yield, borrowers are themselves taking advantage of low long-term rates and unprecedented marketplace liquidity. They have been issuing debt, while paying down commercial paper and bank loans. This process has surely only accelerate with the summer's interest rate scare and the recognition of a stronger economy.

Simplistically, one can think of it this way. Investors in a (money market) fund holding short-term IOUs want higher yields. Companies that have issued these debts would prefer to lock in low long-term rates before the Fed begins to tighten. These companies then create new long-term, higher-yielding IOUs and go to the (money market) fund's management. They tear up the old IOUs and replace them with the new ones. Happy investors in the (bond) fund now enjoy higher yields, while pleased management has reduced interest rate risk. Total Credit remains unchanged (an increase in long-term debt offset by a decline in short-term debt), and I would argue that systemic liquidity (the flow of financial sector Credit) has not been impacted. Money supply, however, has declined with the drop in the monetary component "Money Market Fund" assets.

And while this dynamic has certainly restrained the expansion of money supply this year, it is more difficult to argue it has played the instrumental role in the recent money supply contraction. It is, however, worth noting that Bank of America this week issued $1.7 billion in debt and last week JP Morgan issued $750 million of long-term debt. If, looking to reduce interest-rate exposure, they issue long-term liabilities to repay short-term liabilities, the impact of these transactions could similarly see a reduction of money supply. Simplistic example: BofA approaches bank depositors that are not happy with their 0.75% yield, offering them seven year notes at 4.385%. The outcome of this transaction would be a reduction in money supply (bank deposits), again without impacting Total Credit or systemic (flow of financial Credit) liquidity.

And while we won't know for sure until financial statements are released, I am assuming that the GSEs have been issuing debt to reduce short-term borrowings. They clearly must be working diligently to manage rate exposure. The GSEs have also been issuing floating rate debt. So if investors removed assets from an Institutional Money Market Fund to directly acquire newly issued Fannie floaters, then this transaction could impact broad money supply. This again would be a liability management issue not directly impacting Total Credit or systemic liquidity. But there are also other transactions that could have played a major role in the unusual changes in the monetary components over the past few months. I will admit that part of this type of analysis is clear and part is nebulous. But I will throw out some scenarios to ponder.

The financial sector expanded tremendously during the final (April to July) refi and leveraged speculation "blow-off." One the one hand, there was unprecedented mortgage lending excess. On the other, there was the increase in financial sector liabilities associated with speculative leveraging in the securities markets. There was a major expansion of bank liabilities (deposits), as well as other short-term financial sector liabilities including repurchase agreements, "Fed funds," and various Wall Street Credit balances. I would argue that part of the recent decline in money supply can be explained by these short-term liabilities being "converted" to long-term liabilities: The holders of these short-term "liquid" balances used them, over time, to acquire long-term debt instruments issued by the GSEs, the corporate sector, and our governments.

Again simplistically, there was a reclassification of financial sector liabilities - tearing up short-term IOUs and replacing them with long-term IOUs. I argue strongly that there was no contraction in either the financial sector or Total Credit concurrent with the decline in money supply. Indeed, there was continued significant expansion. While this "conversion" may have had a major impact on the monetary aggregates, it definitely did not cause a contraction in the flow of new financial sector Credit (liquidity!).

Well, if that wasn't nebulous enough... We should briefly address ballooning foreign central bank balance sheets and ponder what possible role they could be playing on our monetary aggregates and systemic liquidity.

Let's go back a couple years and have a homeowner borrow against his home equity to purchase a Toyota Camry. Since the dollar was so strong, Toyota placed the proceeds of the sale into an Institutional Money Fund. This borrowing and spending transaction, as one would expect, led to an expansion of broad money supply. Now, let's jump ahead two years: A California homeowner borrows against inflated equity to buy a new Lexus. Toyota, increasingly concerned with the declining dollar, sells its sales proceeds to the Bank of Japan. The Bank of Japan then takes these dollar balances and acquires newly issued Fannie Mae debt. Fannie takes these proceeds and purchases mortgage-backed securities that had been purchased on Credit by a hedge fund. Here, I would argue that we see transactions that add to Total Credit and system liquidity, without necessarily increasing the monetary aggregates. I would then argue that recent significant investment and speculative flows to international markets - recycled by central banks back into U.S. long-term debt markets - may also be playing a role in the recent divergence between abundant marketplace liquidity and declining money supply. While certainly not a definitive piece on this most complex issue (it's getting late and I'm running out of time), I hope these examples provide at least some food for thought.

I would strongly argue today that liquidity - the flow of new Credit created by the expansion of financial sector liabilities - and Total (financial and non-financial) Credit growth are instrumental in sustaining the runaway Credit and economic Bubbles. These two inescapably ambiguous and nearly impossible to quantify factors remain the focal point of our analysis. We have not to this point been overly concerned with the declining monetary aggregates. If, however, we see indication that Total Credit growth is waning or that liquidity faltering, we will be immediately focused on systemic vulnerabilities.

Ironically, in a risk-taking environment such as the one we are witnessing today, "money" takes a backseat role. Investors and speculators clamor for non-monetary financial assets with higher expected returns. The financial sector can easily expand through the issuance of long-term liabilities. In today's environment, traditional analysis of money provides a dangerously distorted picture of true systemic liquidity.

On the other hand, when risk aversion is high and the marketplace is seeking to move away from risk assets, then the creation of perceived safe and liquid "money" balances plays an instrumental role in generating the necessary Credit growth to sustain the system through difficult times. Thus, and as we have witnessed in the not to distant past, money supply may actually accelerate in the face of perceptions of faltering systemic liquidity.

Unfortunately, there is a long history of using the monetary aggregates in economic modeling. "Money supply" is certainly much more quantifiable than Credit and financial sector liabilities. But with our contemporary financial system operating in a most extraordinary environment, these models will likely not be overly useful.

Instead of faltering dollar liquidity, we see today ample evidence of a continued over-abundance. And while such has fueled a major speculative run in the stock market - having in the process captivated the bullish imagination - I remain convinced we move ever closer toward to a serous dollar problem. Up to this point, the weak dollar has ironically meant aggressive foreign central bank ballooning. These operations fuel rampant global liquidity excess, while at the same time recycling liquidity right back to the U.S. financial markets. U.S. (and global) equity and debt markets have become complacently comfortable with the dynamic of the weak dollar's strong liquidity effects. But we fear the scenario of an increasing surge of dollar selling overpowering the bloated foreign central banks. That's the scenario that could quickly open the door to derivative and other financial problems.

There may be today sufficient Total Credit and systemic liquidity to sustain the Great Credit Bubble. After all, Bubble markets, by their very nature, create their own liquidity. The problem arises when they inevitably reverse. As we appreciate, our acutely vulnerable system is sustained only by enormous unrelenting new quantities of both liquidity and Credit.

Last year's reliquefication "successfully" got everything and everyone all revved up. There's now no room for "error." And it would appear this evening that the unfolding mutual fund (Wall Street?) scandal could provide a catalyst for piercing a major liquidity-induced speculative stock market Bubble. Not only would this pull the rug out from under truly amazing bullishness, it would likely prove an especially untimely development for our faltering currency. Moreover, and again ironically, a return to financial fragility and an attendant bond market rally would only throw gas on the mortgage finance Bubble. The consequence may only be greater inflation of dollar claims and more pressure on the dollar. The "dollar problem" scenario is turning less vague.

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