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The Delta-Hedged Economy

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The Dow enjoyed its eighth consecutive week of gains, adding about 1%. The S&P500 and Morgan Stanley consumer indices gained less than 1% this week. The economically sensitive issues caught fire, with the Morgan Stanley Cyclical index jumping 4% and the Transports increasing 2%. The Utilities dipped about 1%. The broader market rally runs unabated, with the small cap Russell 2000 adding almost 2%, and the S&P400 Mid-Cap index gaining 1%. And while the NASDAQ100 was unchanged for the week, the technology stocks generally enjoyed another solid performance. For the week, the Morgan Stanley High Tech index jumped almost 2.5% (q-t-d gain of 43%) and the Semiconductors 3% (q-t-d 59%). After recent heady gains, The Street.com was unchanged this week, while the NASDAQ Telecom index gave up almost 1%. The Biotechs ran into some selling pressure this week, dropping better than 2%. Financial stocks also underperformed, with the Securities Broker/Dealer and Bank indices dipping about 1%. With bullion dropping about $4, the HUI Gold index declined less than 1%.

The Credit market remains unsettled. For the week, two-year yields dipped five basis points to 2.01%, while five-year yields added two basis points to 3.26%. The 10-year Treasury note saw its yield increase three basis points to 4.21%, while long-bond yields increased two basis points to 5.04%. Benchmark mortgage-backs saw yields add two basis points, while the implied yield on agency futures declined two basis points. The benchmark 10-year dollar swap spread increased one to 49, as the spread on Fannie's 5 3/8% 2011 note remained unchanged at 48. The implied yield on March three-month Eurodollars declined three basis points to 1.48%. The dollar index was about unchanged for the week.

Broad money supply (M3) surged an eye-opening $95.7 billion last week, with six-week gains of $216.7 billion. This boosts 31-week M3 annualized growth above 10%. For the week, Demand Deposits increased $4.2 billion, Small Time Deposits $2.2 billion, and Savings Deposits $19.5 billion (and up $66.2 billion over three weeks). Large Time Deposits declined $12.9 billion, Repurchase Agreements dropped $6.3 billion, and Eurodollar Deposits slipped $1.9 billion. Retail Money Fund Deposits increased $4.5 billion. The action, however, was with Institutional Money Fund Deposits. This money supply component surged $86.1 billion, with two-week gains of $110.2 billion. Today from Dow Jones: "It may be less marked than the recent rebound in major stock indexes, but the commercial paper market is staging a comeback of its own." On the surface, this may be true. Commercial paper increased $3.9 billion last week and has jumped $21 billion over the past three weeks. However, we have yet to see any evidence that access to the CP market is improving for most companies. Over the past three weeks, financial Sector CP borrowings have jumped $22 billion, while non-financial CP has actually declined $1 billion. After recent significant gains, Total Bank Assets declined $49.8 billion last week. Total Bank Credit contracted $28.7 billion, with Securities holdings declining $27.3 billion. In what has become seemingly inconsequential to other extraordinary Credit market developments, Bank Loans and Leases dipped $1.4 billion last week. Total Bank Assets have expanded at an almost 9% rate thus far in 2001.

Global dollar balances emanating from Credit excess-induced U.S. current account deficits are necessitating enormous monthly accumulations of U.S. securities. And despite unrelenting propaganda to the contrary, these purchases are not forcing American consumers to run out and purchase foreign goods (while the U.S. economy posts massive and intractable trade deficits). Many analysts have clearly reversed cause and effect. It is instead the creation of additional dollar balances by the U.S. financial sector - Credit creation directed of late at the mortgage and household sector - that are spent and dispersed to financial intermediaries worldwide. These balances must then find a home in dollar denominated assets ("recycling"), and here we get right to the root cause of ballooning U.S. securities held by foreigners.

It is worth noting, however, that recent heightened risk aversion is responsible for the Treasury and Agency arena seeing the preponderance of foreign buying. During September, foreign-sourced purchasers acquired $46 billion of long-term U.S. securities ($49 billion monthly average over the past five months). Treasuries ($26.3B) and Agencies ($21.1B) basically accounted for all of net foreign purchases during the month. Foreigners actually sold almost $6.5 billion of U.S. stocks during the month (compared to 2001's $9.7 billion of monthly average purchases), the largest sales since September 2001. At the same time, they purchased only $4 billion of U.S. corporate bonds (including asset-backed securities), down significantly from 2001's $19 billion monthly average. Over the past five months, foreign purchasers have accumulated $244 billion of long-term U.S. securities (up 35% y-o-y and consistent with escalating current account deficits). Agency purchases over this period account for about $81 billion (33%), Treasuries $59 billion (24%), and corporate bonds (including asset-backs) $70 billion (29%). There were $11.5 billion of net purchases of U.S. stocks (5%) and $24 billion of foreign stocks and bonds (9%). Foreigners were, on average, net sellers of $9 billion of Treasuries during the comparable five-month period last year. Foreigners were also huge purchasers of U.S. corporate bonds last year, to the tune of $86 billion (48% of total U.S. long-term securities purchases) over the five comparable months. Foreign-sourced buyers also acquired $57 billion of agencies (31%) and $35 billion of U.S. stocks. Foreigners made net purchases of $13 billion of non-U.S. stocks and bonds (7%). We'll wait to see if their appetite for U.S. risk assets returns.

The dimension of U.S. securities trading in the Caribbean continues to amaze. A total of $1.04 Trillion of agency securities traded in the Caribbean over the pasts six months, a monthly average of $173 billion. For comparison, total agency trading averaged $59.4 billion during the first six months of 2001. Indeed, the Caribbean has accounted for 62% of total agency trading during the past six months, compared to 36% during the first six months of last year.

The toll from previous Credit excesses is conspicuous and mounting. Weekly bankruptcy filings were reported at 31,461 last week, and the third quarter saw a record 391,873 bankruptcy filings. This was up 11.6% from an elevated level from last year's third quarter. For comparison, there were 308,718 bankruptcies during the third quarter of 2000. And arriving this week in my mailbox: "Owe more than your car's worth? …we have the opportunity to help customers that owe too much on their current car loan. We realized that 75% - 80% of our customers with trade-ins owe much more at the bank than it is worth. So, we asked the Mazda Corporation to help. They did…with CASH!!... and lots of it… So, bottom line is this… if you've been told that you owe too much on your car - RELAX!! Give us a chance to help you own your brand new Mazda TODAY!"

This week, October Personal Income was reported up a weak 0.1%, but remains up 4.1% y-o-y. Disposable Income was actually up 7.5% y-o-y. October Personal Spending was up a stronger than expected 0.4%. Indicative of severe economic imbalances, year-over-year spending on durable goods was down 5.4%, while spending on non-durables was up 4.1%. Continuing to drive spending growth, Services expenditures were up 5.4% y-o-y (almost 60% of total personal spending). The pundits were encouraged by a stronger than expected report on durable goods - up 2.8% (after September's 4.9% decline) versus expectations of up 1.5%. But this number is not impressive. Year-over-year it is unchanged, and October durable goods orders actually remain almost 10% below those of October 1999. Third-quarter GDP had nonresidential investment down 5.1%, with residential fixed investment up 3.7%. Stoked by ultra-easy auto finance, Durable Goods Consumption expanded at a 12% annualized rate during the quarter. With National Defense spending rising at a pace of 10.2%, Federal Government consumption rose at an 8.1% annualized rate. Goods Imports grew at a 7.5% rate during the quarter, with Goods Exports increasing at 1.8%.

November 26 - Standard & Poor's: "Standard & Poor's Ratings Services today affirmed New York City's 'A' GO rating. However, the outlook is changed to negative from table, reflecting the escalating out-year gap estimates and the risks associated with the current plan to balance the fiscal 2004 budget. 'The outline of the plan put forward by Mayor Michael Bloomberg to address the fiscal 2003 and 2004 budget gap of $7.36 billion is a balanced approach to dealing with the sizeable deficit, but it contains significant risk…' The city council has approved an 18.5% property tax increase, which is a positive development, but the increase was less than the 25% increase put forth by the mayor. State legislative approval of the restructured income tax/revenue enhancement represents another major component of a balanced budget for fiscal 2004. State legislative action on this matter will be a significant challenge and progress on this proposal is largely outside of the city's control. These revenue-enhancement proposals account for half of the gap-closing plan and will be critical elements of future structural budget balance for the city."

October Existing Home Sales were reported at an annualized pace of 5.77 million units, the third-highest on record. Sales were up 9.5% y-o-y, while average prices (mean) jumped 11.4% to $202,600 (reportedly the strongest y-o-y gain since 1987!). Calculated transaction volume (average prices multiplied by annualized sales volume) was up 22% y-o-y to $1.17 Trillion. While down moderately from September's record, October new home sales remained above one million units annualized and were 16.4% above year ago levels. The average sales price was up 8.7% y-o-y to $225,100.

This week from the California Association of Realtors: "The median price of existing homes in California in October increased 22.7 percent and sales rose 17.0 percent compared to the same period a year ago… 'Although the median price of a home increased by double digits again last month compared to a year ago, it's held steady in the $320,000 range since May,' said C.A.R. President Toby Bradley. 'Sales are up dramatically in percentage terms compared to a year ago in large part due to the 'wait-and-see' period that followed Sept. 11 last year. The lowest interest rates in more than four decades also contributed to October's sales increase, which was the seventh highest monthly sales volume on record…" The median price was up an eye-opening $59,710 during the past twelve months, a y-o-y increase of 22.7%. The median condo price was up $43,650, or 21%, to $247,980.

From Bloomberg: "Fannie Mae and Freddie Mac raised the limit on the size of single-family home mortgages they buy from banks by 7.3 percent to $322,700, widening the field of homebuyers eligible for lower-cost financing. The new loan ceiling, up from $300,700, matches the increase in the U.S. average home price in October from a year earlier, according to the Federal Housing Finance Board. The government charters for Fannie Mae and Freddie Mac require them to base annual increases in their maximum loan size on the October price increase. 'It will definitely spur more refinancing as people jump from higher cost jumbo loans…'" These rising lending limits will also likely spur additional housing inflation.

November 25 - National Governors Association (NGA): "Saying states face the most dire fiscal situation since World War II, the National Governors Association and the National Association of State Budget Officers released a report today that concludes many states have exhausted budget cuts and drawing down rainy-day funds and that the most difficult decisions still lay ahead. The associations' biannual report, The Fiscal Survey of States, found that despite significantly curtailing state spending, 37 states were forced to reduce their enacted budgets by about $12.8 billion in fiscal 2002. About mid-way through the current fiscal year, 23 states plan to reduce their net enacted budgets by more than $8.3 billion. 'The fiscal crisis is affecting states across the country,' said NGA Executive Director Raymond C. Scheppach. 'This is a result of a convergence of four major factors that have battered almost every state budget to the point where there just are no easy choices left. The combination of long-run deterioration in state tax systems coupled with an explosion of health care costs are creating an imbalance between revenue and spending. To make matters worse we've had a collapse of capital gains tax revenues added to the overall loss of revenue attributable to slow economic growth.'

Today from Bloomberg News: "November was the busiest month for corporate bond sales since June… Investors snapped up more than $44 billion of bonds, almost double the amount sold in October, as signs the U.S. economy is stabilizing encouraged them to move cash into riskier assets, and away from the safety of government debt.

I think it is fair to say that we have never had an economy so tightly linked to the securities markets. Yes, record numbers of Americans have enormous exposure to the equity market. But more importantly, never before has the Credit market so dictated the availability of finance for both U.S. businesses and households. Back in October, the Credit system was under intense stress, with the much of the corporate bond market virtually grinding to a halt. Collapsing stocks and faltering liquidity in the corporate bond market were reinforcing. And with acute financial stress at the brink of impacting the key market for asset-backed securities, systemic risk was escalating rapidly. Bond spreads for many key financial institutions (including Household International, Ford, Sears, and Capital One) were widening significantly, while prices for Credit default protection were surging throughout. Heightened stress was compelling risk-averse investors to reduce exposure, while at the same time forcing the derivative players and Credit insurers to sell/short securities to hedge their ballooning exposures. Moreover, sinking global stock markets were exacerbating heightened stress in various "risk" markets in a self-feeding collapse of confidence that even impacted the previously "safe-haven" U.S. structured finance arena. In short, the U.S. Credit system was in the process of dislocating, with hedging and speculative selling overwhelming buyers throughout the Credit market. There was also the specter of corporate debt woes quickly migrating to the behemoth U.S. consumer sector, with the U.S. consumer Bubble at the precipice. The systemic risk "trade" was being pressed (by hedgers and speculators), and faltering Credit availability was becoming a critical issue for the U.S. economy.

The Credit system went to the edge and has since recoiled. The overwhelming selling afflicting the corporate bond market has receded, and perhaps a sustainable period of accumulation has commenced. For now, pressure has reversed, with those short corporate bonds, stocks, and on the wrong side of sinking Credit default swap prices feeling the heat. Market dynamics have swung to the other direction, and the pressure is now to unwind the systemic risk "trade" (by both dynamic hedgers and speculators). Consequently, liquidity has returned and corporations are again tapping the markets for debt and equity, in dynamics for now as self-reinforcing on the upside as they were for months on the downside.

But before we get too carried away, it is worth noting that we are expecting some strong cross-currents over the coming months. Corporations will likely enjoy greater access to finance in the near-term, while recent stock market gains will likely boost confidence. But at the same time, we should be mindful that the historic expansion in mortgage Credit is at a late stage. Indeed, the timing of the stock and bond market recovery could not have been more fortunate. And with 30-year mortgage rates likely back to near 6.25% next week, it is at this point safe to predict that the peak in mortgage refinancings has been passed. How quickly refis taper off is unknown. Ramifications of this development with respect to the housing markets and consumption are today important but open questions. We continue believe that the fact that auto and retail sales have of late stagnated in the face of a record refi boom offers ominous portents. Again, the stock and corporate bond market recoveries were quite fortunate.

The perception is growing that acutely stressed securities markets have now commenced a financial recovery similar to the post-LTCM and post-9/11 experiences. We're skeptical. Keep in mind that the reliquefied and over-stimulated post-LTCM Credit system hit a U.S. economy poised to fire on all cylinders and a technology/stock market Bubble hankering to go into speculative blow-off. In other words, the expansive NASDAQ Bubble was teed up and the economy momentum-driven on the upside. The reliquefication and over-stimulated post-9/11 Credit system fed perfectly into a financial system and mortgage sector raring to go to unprecedented excess. The expansive mortgage finance Bubble was teed up and the leveraged speculators ready.

We are today at a loss to recognize a new Bubble lying in wait for the latest round of reliquefication. Certainly, there is nothing on the horizon of the dimensions necessary to mollify a receding historic mortgage finance Bubble. It is also our impression that the leveraged speculators are fully loaded. Sure, corporations will line up to borrow and American governments of all shapes and sizes will finance expanding deficits. And in the short-run - while mortgage borrowings remain enormous - combined Credit creation is sufficient to sustain the Great Credit Bubble. Money supply growth is certainly indicative of continued rampant monetary excess and over-liquefied conditions. But looking out past a few months, things are not so clear. Our hunch is that a negative surprise on the consumption side lurks: As goes the mortgage finance Bubble, so goes the consumer spending Bubble. And after years of over-consumption and mal-investment, the consumption/service-sector economy is addicted to household over-borrowing and over-consuming. The vulnerable U.S. economy could easily prove "out of the woods" for now, but we fully expect unrelenting money and Credit excess to prove only more distorting to the fragile U.S. financial system and hopelessly maladjusted economy.

Whether it is mortgage refinancings, auto sales, retail sales, durable goods orders, business confidence, or GDP growth, we have been witnessing extraordinary economic volatility. The pundits would like us to believe that these unsettled conditions are only evidence of a sound although "uneven" recovery. We tend to see things differently. In our view, the economy has become hostage to an unstable securities and speculation-driven U.S. Credit system. When bullishness flows, easy Credit availability stokes spending and economic "output." The relative degree of stimulation is determined by whatever is the hot sector (NASDAQ stocks and telecom debt, or agency and mortgage-backs, for example). But when bullishness ebbs and risk aversion holds sway, the Credit spigot can rather abruptly run dry for many sectors (but apparently never in mortgage finance). With the contemporary Credit system absolutely dominated by leveraged speculation, "structured finance," and sophisticated hedging strategies, weakening Credit market conditions fosters enormous securities selling and a self-reinforcing contraction of Credit availability for many companies and sectors. Faltering Credit conditions incites additional selling ("Delta-Hedging"), with declining bond and asset prices fostering a self-feeding mountain of short-positions. Liquidity then vanishes for most companies and many sectors.

But despite the gross debt overhang and acute financial fragility, market dynamics will necessitate intermittent reversals of these hedging programs. During these periods, the semblance of abundant liquidity will return almost as if by divine intervention. Surging stocks and the return of liquidity to the corporate bond market are reinforcing, especially in over-liquefied financial markets. And most will interpret market action as a confirmation of rapidly improving fundamentals, when in fact rising financial asset prices have almost everything to do with market dynamics. The performance chasing money managers and speculators will jump on board.

We see good reason today to make reference to The U.S. Delta-Hedged Economy. Speculative trading strategies have come to dominate the Credit system, thus assuring a destabilizing roller-coaster ride of speculation, sophisticated hedging-related securities trading, Credit availability, and attendant economic "output." We have no idea how long this upward ride will last this go around, but we are confident that there is a steep and potentially breathless decline waiting on the other side. We have absolutely no doubt that maintaining Credit, speculation, and spending Bubble excesses are simply not going to rectify the problem. It's a roller coaster from here on out. Let's not forget that it takes enormous amounts of unrelenting Credit creation and leveraged speculation to sustain the Great Credit Bubble. And we certainly don't expect rampant excess to all of the sudden turn stabilizing. In fact, we are expecting a rather wild ride from here on out as a confluence of unprecedented monetary and speculative excess - along with an unstable Bubble-impaired economy - creates an especially unpredictable and volatile mix. Going forward will require that we study the intricacies of the maladjusted economy very carefully.

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