It was another week of acutely unsettled financial markets. Despite considerable volatility, the Dow ended the week down 1.5% and the S&P500 about 1%. The Utilities dipped 1%. The Transports, Morgan Stanley Consumer, and Morgan Stanley Cyclical indices declined 2%. The small cap Russell 2000 dipped 1%, while the S&P400 Mid-cap index slipped less than 1%. The technology stocks were mixed. The NASDAQ100, Morgan Stanley High Tech, and The Street.com Internet indices declined 1%. But the Semiconductors added 2% and the NASDAQ Telecommunications index gained 3% (y-t-d gain up to 8%). The Biotech index declined 2%. The Securities Broker/Dealer index ended the week unchanged, while the banks lost about 1%. With bullion down $1.80, the HUI Gold index declined 2%.
The Credit market seemed to go into "melt-up" mode this week, which will surely pump additional fuel into the mortgage finance Bubble. Two-year Treasury yields dropped 12 basis points to 1.48%, with five-year yields sinking 18 basis points to 2.66%. Ten-year Treasuries enjoyed their strongest weekly gain this year, with yields dropping 20 basis points to 3.69%. The long-bond saw its yield drop 17 basis points to 4.67%. Benchmark agency and mortgage-backs performed well, with yields sinking between 17 and 20 basis points. The spread on Fannie's 5 3/8 2011 note was unchanged at 29, while the 10-year dollar swap spread widened 1.5 to 42. Corporate spreads widened moderately. Both the dollar and the CRB index declined slightly. With stockpiles at 20-month lows ("strong Asian demand"), Nickel prices are at the highest level since June 2000. Propane traded to the highest level "in at least 31 years." Crude oil traded to 12-year highs this week. March Heating Oil traded above $1.15 gallon, the highest since heating oil futures began trading on the NY Merc back in 1978.
February 26 - Bloomberg: "Copper prices rose to a 21-month high on signs of strengthening demand from China, which is vying with the U.S. to be the world's biggest user of the metal increased demand from an expanding Chinese economy has contributed to a 14 percent rise in copper prices this year. Chinese demand will rise 12 percent this year to 2.85 million metric tons… 'There is strong consumption coming out of the Far East,' said James Koppel, a managing director at SG Commodities Group… 'If China continues its buying activity, it will be enough to offset some marginal increase, or decrease, in consumption in the U.S.'
This week saw continued robust debt issuance. Wells Fargo sold $1.5 billion of floating rate notes. JC Penney raised its deal to $600 million from $350 million. Healthcare Properties sold $200 million. El Paso Corp. received a $1 billion loan. A unit of Williams Company raised $175 million in the junk bond market. Occidental Petroleum raised $300 million, ANR Pipeline $300 million, Southern Natural Gas $400 million, and Chesapeake Energy $300 million (inflation in the energy sector "fueling" Credit creation?). In regard to the demand for the company's $250 million 10-year notes, Potash Corp.'s CEO was quoted by Bloomberg: "I'm told it was excellent, substantially over-subscribed, north of $1 billion." "Sales the past two months by more than 160 companies and sovereign borrowers… have brought year-to-date issuance in the U.S. to more than $129 billion, some 27 percent higher than in the same period in 2002, according to Bloomberg data." And according to Merrill Lynch, Investment-grade debt returned 1.7% this month (up 6.74% since October 10th). Junk bonds earned 1% during February and are up 4% y-t-d. Junk bond funds were said to have received inflows of $1.5 billion last week, not far from the record $1.6 billion of inflows received in August (from AMG). Year-to-date junk issuance of $20 billion compares to last year's comparable $11 billion.
February 28 - Bloomberg: "Tax-free debt yields close to 35-year lows and New Jersey's $1.65 billion tobacco bond sale made for the largest February ever for municipal bond sales, the second consecutive record month this year. Municipal bonds worth $26.84 billion were sold this month, according to the Bond Buyer newspaper, that's up 28 percent from last year and eclipses the previous February record of $24.55 billion in 1998. January sales set a record of $23.39 billion in bonds for public purposes. Last year, public issuers sold $357 billion in bonds, the most ever."
February 26 - Dow Jones (Stan Rosenberg): "It took record long-term yields Wednesday to sell $1.65 billion of tax-exempt bonds issued by New Jersey's Tobacco Settlement Financing Corporation. The bonds, backed by revenues from a settlement between 46 states and the four largest cigarette manufacturers, represented the largest offering among several major municipal bond issues priced. Those issues totaled about $2.8 billion… The New Jersey issue offered investors tax-exempt returns of up to 7.10% for bonds coming due in 2041, as well as 7.05% yields for securities maturing in 2039 and 2043, both the loftiest yields ever for securities backed by the 1998 pact… The market has been saturated with tobacco offerings, especially since budget-strapped states have turned to the use of non-recurring, or 'one-shot', revenue sources as short-term solutions to long-term problems. New Jersey is facing a $5 billion budget deficit for the fiscal year beginning July 1. All tobacco bonds, however, are backed by the same settlement and are viewed by professionals as essentially the same security… The result has been higher yields with each offering."
Broad money supply (M3) expanded $20.5 billion last week and is up $100.5 billion in five weeks. Since October (19 weeks), "money" has surged $254.3 billion, or 8.4% annualized. Since April (44 weeks), money supply has increased $519.7 billion, or 7.6% annualized. Last week by money supply component, Currency was up $1.4 billion, Demand Deposits $15.5 billion, and Savings Deposits $15.1 billion ($52.5 in two weeks). Savings Deposits are now up 20% y-o-y to $2.863 Trillion. Last week, Small Denominated Deposits declined $1.4 billion and Retail Money Fund deposits were up $0.8. Institutional Money Fund deposits added $3.2 billion, while Large Denominated Deposits were down $9.3 billion. Repurchase Agreements were down $0.9 billion and Eurodollars declined $3.1 billion. Elsewhere, Total Bank Assets jumped $41.4 billion last week. Securities holdings added $13.6 billion, with three-week gains of $58.2 billion. Loans and Leases declined $0.7 billion, with Commercial and Industrial loans up $2.4 billion and Real Estate loans declining $$9.9 billion. Over the past 52 weeks, Total Bank Assets were up 10.2% to $7.03 Trillion. Real Estate loans jumped $16.8% to almost $2.1 Trillion, while Commercial and Industrial (C&I) loans declined 6.6% to about $1 Trillion. Since May (41 weeks), Real Estate loans have expanded at a 20% rate, while C&I loans have declined at an 8% annualized rate.
February 25 - Bloomberg: "Debt secured by credit card, airplane leases and other types of payments had a record amount of downgrades and defaults in 2002, as a slow economy hurt the ability of borrowers to make payments, according to Standard & Poor's. Downgrades of so-called asset-backed debt more than tripled to 356 from 2003, while the number of issues upgraded declined by more than half to 39, S&P said. Defaults rose to 58 from 12 in the previous year."
February 25 - Moody's: "While fewer corporate issuers defaulted on rated bonds in 2002, the total dollar volume of defaulted debt soared to over $163 billion, up from $106 billion in 2001, Moody's Investors Service reported today in its 16th annual study of global defaults and ratings performance."
February 25 - Bloomberg: "Spiegel Inc., the owner of Eddie Bauer stores and the Spiegel catalog, was ordered by the Office of the Comptroller of the Currency to start liquidating its credit-card business. The company won't meet requirements on two of the securities backed by the bankcard debt and is in danger of defaulting on a third that is backed by the credit-card receivables, according to a regulatory filing. The cards are issued by Spiegel's First Consumers National Bank division... About 41 percent of its sales in 2001 were made with its credit cards. Spiegel agreed last year to either sell or liquidate the bankcard portfolio by April 30. Spiegel may not be able to repay the principle on the asset-backed securities that it is required liquidate if it doesn't meet the targets and isn't allowed to borrow more, it said in the Securities and Exchange Commission filing."
Today from St. Louis Federal Reserve President William Poole: "This is the most sound, lowest risk place in the world to place a buck… The Fed stands ready to respond vigorously and dramatically to upsets in the market, whatever they might be."
Keeping in mind our theme that economic imbalances are today a Key Credit Inflation Manifestation, we discern only greater regional disparities going forward. The Chicago Purchasing Manager index came in at a stronger-than-expected 54.9. This index was a 46.1 back in November and was in the upper-thirties during the first half of 2001. Prices Paid increased 0.7 to 54.9 and New Orders added one to 59. Production remains quite strong at 62.4. This report is consistent with the much stronger-than-expected 3.3% increase in Durable Goods Orders. But it's a different story in New York. The February New York City Purchasing Management business activity index sank 17.4 point to 34.5, the weakest reading in 13 months. Curiously, the Non-manufacturing index sank 18.5 points to 33, while the Manufacturing index declined 8.1 points to 47.6. Prices Paid jumped six points to 50 (up nine points in two months). The Milwaukee index added three to 53, the strongest reading since October.
In our attempt to monitor global demand for U.S. securities, we pay close attention to the monthly Foreign Purchases and Sales of U.S. Securities report from the Treasury Department. We see December foreign-sourced purchases of $37.7 billion (down from November's $69.7 billion). Demand for Agency Securities remains strong, accounting for 43% of December purchases. This compares to 6% for U.S. Stocks and 35% for U.S. Corporate Bonds and 38% Treasuries. Agency purchases were also the largest category for the year, with acquisitions of about $190 billion up 16% y-o-y. It is worth noting that Agencies and Treasuries combined for 52% of total foreign net purchases during 2002, up from the previous year's 36%. During the year, U.S. stocks dropped from 23% to 9% and U.S. Corporate Bonds from 45% to 34%. This data is consistent with U.S. financial sector. Lenders remain eager to finance mortgage and government borrowings, with relatively little interest in directing finance to sound investment (outside of the now Bubbling energy sector!). It is also worth noting that 64% of the net acquisition and disposition of Agency securities internationally during December was in the Caribbean.
Existing Home Sales were reported at a stronger-than-expected and record annualized rate of 6.09 million. To put this sales level into perspective, January sales were more than double the level from the dark days of the early nineties recession. January (annualized) sales were also up 40% from the pre-Bubble January 1997 level. And with both sales and average prices up 40%, total Calculated Transaction Value has almost doubled in six years to $1.24 Trillion (4.34 million units at $145,800 versus 6.09 million units at $204,000). January's Calculated Transaction Value is up 8% y-o-y and 34% over two years. Conversely, New Home Sales were reported at a disappointing 914,000 pace. This was the weakest reading in a year, although sales were up 5.1% y-o-y. Notably, the inventory of New Homes continues to "build," increasing 7,000 for the month to 346,000 units. This is the highest inventory since March 2001. Looking at the dollar value of inventories, we see a y-o-y increase of 12.4% and a 30% increase in less than two years.
From the California Association of Realtors: "The robust momentum we witnessed in the California housing market throughout 2002 continued in January. The Median price of a home has increased by double digits for the last 14 months and shows no signs of abatement as we approach the traditional spring selling season." There are two distinct California Housing Bubble stories. First, even the most inflated markets are apparently not giving up any air. Year-over-year, median prices are up 4% in Santa Clara, 6.4% in San Francisco, 7.5% in the Monterey Region, and 10.6% in Santa Barbara County. And while previous Bubble prices are sustained, the lower spectrums gain full Bubble status. Year-over-year, the Central Valley is up 22.2%, High Desert 17.7%, Los Angeles 18%, and Riverside/San Bernardino 20.9%. Prices are up 26.9% in San Diego, 25.6% in Sacramento, 21.9% in Orange County and 27.9% in North Santa Barbara County. For the state as a whole, median prices are up $49,660, or 17.3%, to $336,740. This provides much inflated "equity" to extract during refinance or through a home equity loan, and all the ingredients are in place for an interesting spring and summer for the Great California Housing Bubble.
The mortgage refi application index jumped 10% to the highest level since mid-November, and remain more than double the year ago level. Perhaps weather related, but it is worth noting the Purchase applications dropped 7.5% to the lowest level since February 2002, and is now slightly below the year ago level. There were 28,724 bankruptcy filings during the holiday-shortened week.
After four months of the fiscal year, federal finances could not appear more dismal. Fiscal year-to-date revenues are down a striking 8.1%. Individual Income Tax receipts have declined 9.4% to $306.5 billion, while Corporate Income Tax receipts are down 47% to $34.2 billion. Social Insurance and Retirement receipts are up 4.5% to $167.2 billion. At the same time, fiscal y-t-d Outlays have jumped 7.8%. With receipts and outlays in anomalous divergence, last year's $98 billion y-t-d surplus has evaporated to this year's $8 billion. By largest Outlay category, Health and Human Services expenditures are up 12.6% to $170 billion, Social Security Administration up 6.6% to $168.4 billion, Defense up 19% to $123.4 billion, Agriculture up 4.5% to $33.6 billion, Labor up 27.2% to $23.2 billion, and Veterans Affairs up 22% to $20.3 billion. Noteworthy increases from smaller departments include Emergency Management up 18%, Housing and Urban Development 10.2%, and Civil Defense up 14.6%. Year-to-date Interest payments on Treasury Debt have declined 2% to $131.4 billion.
In last week's Bulletin I made use of a thermostat analogy in describing how the seductive ease of managing Credit inflation can not only suddenly vanish, but quickly spiral out of control. "Then one day, somehow, it's at the same time too hot and too cold; then it's boiling hot in one room and freezing in the next. The small adjustments that always did the trick before have become impotent. Major alterations only exacerbate the extremes; and then things fall into disarray and beyond control." To expand and clarify this analysis, over many years we watched the awe-inspiring power of slight changes in Fed interest rates (or hints of minor adjustments) evolve to the point where even an historic collapse in rates garners only a tepid response from the real economy (and has had no discernable impact on the stock market). During the boom, just the thought of a Fed rate cut would spur a speculative melee in the financial markets and almost instantaneously augment Credit Availability. This was the marvel of the contemporary securities-based Credit system.
But nowadays, after years of Credit and Speculative Abuse, distorted financial and economic systems respond to stimuli much differently. First of all, the previously effective small rate cuts (minor adjustments to the thermostat) no longer incite heightened speculative response (after years of over-stimulation). There is, then, little marginal impact on general Credit Availability. Moreover, major rate cuts (big adjustments to the thermostat) today only tend to exacerbate the inflationary bias for sectors already affected by excess Credit Availability ("Liquidity Loves Inflation" - with thermostat adjustments making the hot rooms only steamier). We see such dynamics at work today throughout the manic mortgage finance super-sector, impacting home values as well as agency and mortgage-backed securities prices. Additionally, mortgage Bubble induced trade deficits are increasingly recycled directly back to agency and mortgage-backed securities in the circular Bubble of Structured Finance.
At the same time, other sectors suffering various degrees of post-Bubble depression (such as the stock market, technology industry or, perhaps, even the goods sector) remain generally numb ("deflationary" bias) to even enormous systemic Credit and speculative stimulus. Much to the detriment of the already distorted system, the amount of Credit necessary to stimulate these despondent sectors exacerbates and tends to grossly disturb the manic sectors. If the operator of the thermostat is fixated only on the cold rooms, there's going to be some awfully sweltering rooms and a very heavy cost to keep the home heated.
After years of Credit inflation and its cumulative distorting affects, enormous and unrelenting Credit excess is required to generally stimulate (stabilize) the maladjusted U.S. economy. Some inflating sectors (the California Housing Bubble or healthcare, for example) ripen into absolute Credit Gluttons, much at the expense of other regions and sectors. Other fledgling inflation beneficiaries (such as the energy sector) spring to life with increasingly crazed appetites for Credit (again at the expense of the post-Bubble depressed). Manifestly, the amount of gross excess necessary to stimulate the imbalanced and generally despondent real economy provides jet fuel to the inflating speculative Bubble in the U.S. Credit market. There is no way around the fact that, at this stage and going forward, Credit inflation will spread quite unevenly through the real economy sphere. It will also surely further exacerbate dangerous excesses and instability throughout the financial sphere. We view Credit Inflation Manifestations in the financial sphere as The Big Unexplored Story.
There is also the critical issue of our authorities (and the U.S. financial sector) striving to sustain inflated boom-time consumer demand, with resulting over-consumption and ballooning trade deficits. Today, an enormous amount of Credit inflation is "exported." We see this as a case of further risky expansion of the U.S. financial sector that provides little benefit to the faltering Bubble economy. That the marginal consumer borrower is today a very weak Credit ensures only poorer U.S. financial asset quality and eventual impairment. Less conspicuous but no less important, we also see this Credit inflation funneling additional finance to the irrepressible global Leveraged Speculating Community. Surging (and hyper-volatile) energy, Gold, and general commodity prices are an obvious Manifestation.
This "funneling" was for some time seductively agreeable, as speculative flows were immediately and painlessly "recycled" back to the inflating U.S. equity and bond Bubbles. Credit surged, the markets rose, the economy boomed and the dollar excelled. Self-reinforcing speculative flows were largely responsible for The Grand Illusion of Immortal King Dollar, impervious to even gross Credit excess and severe economic impairment. But, in the end, this Illusion was dangerous and self-defeating - speculation-induced market distortions coming home to roost. Going forward, we expect the ballooning "export" component of U.S. Credit inflation to provide increasingly unwieldy Inflationary Manifestations.
It is worth repeating that I view the demise of King Dollar as a critical inflection point in financial and economic history. Following a pattern similar to other major bull markets, it is ending in one final wild and destructive period of Credit and speculative "blow-off" excess. Resulting U.S. financial and economic sector impairment will linger for years. At the very minimum, the faltering dollar marks a critical juncture for the nature of Credit Inflation consequences. Namely, it ushers in an environment of only greater financial market and economic instability, as well as erratic prices for things real and financial, at home and globally. And with one eye on the energy markets, we see support for the notion that a faltering currency sets in motion self-reinforcing (Credit-induced) Inflation dynamics.
In a week that saw a 30% one-day spike in natural gas prices and crude surge to 12-year highs, it is fair to say that commodity prices are garnering increased speculative interest ("animal spirits"). We see this as further confirmation of a sea change in inflation psychology, for commodities, currencies, and other things non-dollar. Not only will the speculators be keen to rising prices, evolving market psychology will alter behavior in the real economy. We have read recent reports that the Chinese are considering establishing a petroleum reserve, as well as being aggressive purchasers of cotton and other commodities. Global producers are now keen to the risk of depleted inventories of fuel and basic commodities. Gold producers and speculators will now think twice before shorting the shiny metal. Many will come to see the value of holding real gold, crude oil, natural gas, cotton, platinum, and such, as opposed to futures contracts or derivative hedging instruments. We would expect only heightened interest - speculative and investment - in acquiring things real; and the less elastic the supply the more appealing. As such, we suspect the relative allure of holding (too easily inflated) things financial, especially claims denominated in dollars, will only dim. With such profound changes in market psychology in the works, we should expect great uncertainty and instability, especially following history's greatest Bubble in financial assets.
We must then ponder what this all means for the "fabricators" of and "intermediaries" for the ever-inflating mountain of U.S. financial assets. As often discussed, we have reached the stage where it requires massive and unrelenting Credit excess to maintain the dangerous U.S. financial and economic Bubbles. We also appreciate that "Structured Finance" has come, by necessity, to dominate the Credit creation process. Only this mechanism could today possibly transform the massive quantities of risky loans into highly-rated securities palatable to the marketplace. Structured Finance has won command of the U.S. "money" and Credit system by default - by Bubble necessity - with unknowable but quite disconcerting consequences.
Indeed, a paradoxical and problematic environment for "Structured Finance," hence the U.S. financial sector and dollar, is now coming into clearer focus. Structured finance exists based upon an immutable reliance on historical data, statistical analysis, sophisticated modeling, and the rather predictable forecasts that the future will be much like the past. Uncertainly is basically taken out of the equation. Yet, presuming the arrival of an historic financial and economic inflection point, we see the past as providing only comforting deceptions for an especially uncertain and problematic future. Importantly, the unending Credit excess now required to keep the U.S. financial and economic wheels from seizing up ensures atypical and especially unpredictable outcomes. Uncertainty now reigns supreme. We wouldn't want to be a writer of Credit protection these days…
Similar to the recent spikes in California and New York home values, this week's surge in energy prices should be recognized as evidence we have commenced a period of even greater financial and economic instability. Furthermore, these types of extreme price gyrations are anathema to writers of derivative protection, the Credit insurers, and financial risk intermediaries generally - the very parties directly responsible for fueling the destabilizing Bubble. While not especially unambiguous, Structured Finance and general financial system disarray have become A Key Contemporary Inflationary Manifestation.
It remains my view that Structured Finance and the dollar are now irreversibly linked to each other. They are both hostage to the Credit Bubble. Granted, the dollar has suffered a meaningful decline with little appreciable impact on the U.S. financial sector or securities markets. Interest rates have remained in steady decline, spreads have narrowed sharply, and liquidity flows (overly) abundant. Importantly, inflating prices have thus far considerably offset currency losses for our foreign creditors. But we see all of this as a Bubble anomaly and part of the same issue - and key to an amazing financial puzzle. My analysis leads me to believe that it is actually the massive Credit creation husbanded by Structured Finance that is largely responsible for the flood of liquidity continuing to inflate debt securities prices. It is thus an enormous expansion of financial sector liabilities (financial Credit) fueling the self-reinforcing Ultimate Bubble throughout the U.S. Credit market.
But what would it take for "virtuous cycle" to become "vicious spiral"? Well, we think the combination of a faltering dollar, rising yields and widening spreads would not be well-received by our foreign-sourced financers. With this in mind, we suspect that this gigantic Bubble is today acutely vulnerable to any reduction in U.S. financial sector expansion/liquidity creation. Yet, the amount of unrelenting dollar financial asset Inflation now required to sustain the Bubble is today increasingly fomenting a change in market perceptions - stoking inflationary psychology for things non-dollar. There will come a day when there will be a major adjustment in U.S. debt securities values. This is a major problem- the proverbial Catch22 - that leads us to believe that complacency with respect to the dollar is unjustified.
Today, one need look only to unparalleled mortgage Credit growth for the major source of liquidity creation. This is problematic on many levels. It is simply incredible that the American household sector is taking on record amounts of debt at this very late stage of the Bubble. For the real economy this fosters only greater maladjustment; for the financial sector, only weaker debt structures and acute financial fragility. While the Mortgage Finance Bubble did sustain the system through the bursting of the Technology and stock market Bubbles, it has absolutely buried the consumer sector in debt. And despite an elongated mortgage refi boom, we see increased evidence of cracks in the foundation of consumer finance.
Structured Finance single-handedly transformed subprime (credit cards, auto, mortgages, motor cycles, boats, facelifts, etc.) from an odd peripheral player to the powerful Credit mechanism financing the marginal buyer sustaining the vulnerable U.S. Bubble economy. And despite the predictable serious troubles now asphyxiating subprime Credit cards and auto finance, reckless excess runs out of control in subprime mortgage lending. That the major Credit insurers have significant exposure to subprime is today a developing issue. That subprime mortgage excess is sowing the seeds of its own destruction is also not in doubt. An unparalleled consumer borrowing binge may have mitigated the corporate debt crisis, but there will be no similar expedient to rescue the over-borrowed U.S. consumer. Inflationary manifestations such as surging fuel, healthcare and insurance costs will only play a greater role in hastening unfolding consumer debt problems. General financial and economic instability will also be increasingly debilitating for the household sector. And we do expect the eventual piercing of the consumer debt Bubble to severely impair the Structured Finance Monetary Regime, leading to the "vicious spiral" of faltering Credit availability, reduced Credit creation, faltering systemic liquidity, and perhaps a problematic run on dollar assets. How quickly the market discounts this eventuality is today unknown.
Importantly, it is our view that consumer finance has supplanted corporate finance as the weakest link in the financial daisy chain. Structured Finance is now clearly in the crosshairs, and it difficult to envision a scenario where the dollar does not face severe problems in the not too distant future. Psychology is changing and so are Key Inflationary Manifestations. Instability Abounds.
