For the week, the Dow (down 3.1% y-t-d) and the S&P500 (down 5.3%) each jumped 4.3%. The Transports surged 5.9% (up 11.6%) and the Morgan Stanley Cyclicals 6.2% (down 0.3%). The Morgan Stanley Consumer index gained 1.9% (down 4.9%), and the Utilities rose 3.3% (down 4.8%). The broader market was strong. The small cap Russell 2000 jumped 4.8% (down 5.9%), and the S&P400 Mid-Caps gained 4.4% (down 2.7%). The NASDAQ100 jumped 5.6% (down 8.9%) and the Morgan Stanley High Tech index 5.5% (down 9.1%). The Semiconductors increased 5.2% (down 7.5%), The Street.com Internet Index surged 7.4% (down 5.4%), and the NASDAQ Telecommunications index jumped 4.9% (down 7.5%). The Biotechs declined 0.7% (down 3.0%). The Broker/Dealers surged 7.2% (down 21%), and the Banks rallied 3.4% (down 7.9%). Although Bullion declined $6.90, the HUI Gold index increased 2.9% (up 11.4%). CREDIT BUBBLE BULLETIN
Crisis intermission - now for stage two
Commentary and weekly watch by Doug Noland
Martin Feldstein, Harvard professor and former chairman of the US President's Council of Economic Advisors, wrote an op-ed piece in last Wednesday's Wall Street Journal - "Enough with Interest Rate Cuts" - worthy of comment.
"It's time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage. Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries. In order to offset the inflationary impact of higher imported commodity prices, central banks in those countries may raise interest rates. Such contractionary policies would reduce real incomes and exacerbate political instability.
"The impact of low interest rates on commodity-price inflation is different from the traditional inflationary effect of easy money. The usual concern is that lowering interest rates stimulates economic activity to a point at which labor and product markets cause wages and prices to rise. That is unlikely to happen in the US in the coming year. The general weakness of the economy will keep most wages and prices from rising more rapidly. But high unemployment and low capacity utilization would not prevent lower interest rates from driving up commodity prices.
"Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates also add to the upward pressure on these commodity prices, by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains. Lower interest rates induce investors to add commodities to their portfolios. When rates are low, portfolio investors will bid up the prices of oil and other commodities to levels at which the expected future returns are in line with the lower rates. An interest rate-induced rise in the price of oil also contributes indirectly to higher prices of food grains. It does so by making it profitable for farmers to devote more farm land to growing corn for ethanol."
While I concur with the basic premise of the article (stop the cuts!), the substance of Mr Feldstein's analysis leaves much to be desired. First of all, I find it strange than he would address the issues of overly accommodative Federal Reserve policy, commodity price risk, and inflationary pressures without so much as a cursory mention of our weak currency. The word "dollar" is nowhere to be found; not a mention of our current account deficits. The focus is only on interest rates, and such one-dimensional analysis just doesn't pass muster in our complex world.
Most people remain comfortably oblivious to today's inflation dynamics. Mr Feldstein mentions increased demand from China and India. He seems to imply, however, that portfolio buying (financed by low interest rates) by "commodity investors and speculators" is providing the major impetus to rising inflationary pressures generally. Perhaps price gains could have something to do with the US$2.5 trillion increase in global official reserve positions over the past two years (85% growth). I would also counter that destabilizing speculative activity is an inevitable consequence, rather than a cause, of an alarmingly inflationary global backdrop.
I'll remind readers that we live in a unique world of unregulated credit. Excess has evolved to the point of being endemic to an apparatus that operates without any mechanism for adjustment or self-correction. There is, of course, no gold reserve system to restrain domestic monetary expansions. Some years back, the dollar-based Bretton Woods global monetary regime lost its relevance. And, importantly, the market-based disciplining mechanism ("king dollar") that emerged at times to ruthlessly punish financial profligacy around the globe throughout the nineties has morphed into a dysfunctional dynamic that these days nurtures self-reinforcing excesses.
The "recycling" of our "bubble dollars" (in the process inflating local credit systems, asset markets, commodities and economies across the globe) directly back into our securities markets rests at the epicenter of global monetary dysfunction.
A historic inflation in dollar financial claims was the undoing of anything resembling a global monetary system, and now this anchorless "system" of wildcat finance is the bane of financial and economic stability. To be sure, massive and unrelenting US current account deficits and resulting dollar impairment have unleashed domestic credit systems around the globe to expand uncontrollably. Today, virtually any major credit system can and does inflate domestic credit to create the purchasing power to procure inflating global food, energy, and commodities prices.
The long-overdue US credit contraction and economic adjustment could change this dynamic. But for now there are reasons to expect this uninhibited global credit bubble to instead run to precarious extremes, and for resulting monetary disorder to become increasingly problematic. Destabilizing price movements and myriad inflationary effects are poised to worsen. The specter of yet another year of near $800 billion current account deficits coupled with huge speculative outflows of dollars is just too much for an acutely overheated and unstable global currency and economic system to cope with.
I hear pundits still referring to a "deflationary credit collapse". Well, the US credit system implosion was largely stopped in its tracks last month. The Fed bailed out Bear Stearns, opened wide the Fed discount window to Wall Street; and implemented unprecedented liquidity facilities for the benefit of the marketplace overall. Central banks around the globe executed unparalleled concerted market liquidity operations.
Here at home, the GSEs' regulator spoke publicly about Fannie and Freddie (mortgage agencies) having the capacity to add $200 billion of mortgages to their balances sheets, with the possibility of increasing their guarantee business as much as $2 trillion this year (certainly including "jumbo" mortgages, that is, larger than the present limits set by Fannie Mae and Freddie Mac). The Federal Home Loan Bank system was given the OK to continue aggressive liquidity injections and balloon its balance sheet in the process. And now (see "GSE Watch" below) we see that the Federal Housing Administration (with its new mandate and $729,550 loan limit) is likely to increase federal government mortgage insurance by as much as $200 billion this year, while Washington’s Ginnie Mae (Government National Mortgage Association) is in the midst of a securitization boom.
Together, the Fed and Washington have effectively nationalized a large portion of both mortgage and market liquidity risk. It is, as well, worth noting that JPMorgan Chase expanded assets by $80.7 billion during the first quarter (20.7% annualized) to $1.642 trillion, with six-month growth of $163.3 billion (22.1% annualized). Goldman Sachs expanded its balance sheets by $69.2 billion during Q1 (24.7% annualized) to $1.189 trillion, with half-year growth of $143.2 billion (27.4%). Even Wells Fargo grew assets at an almost 14% pace this past quarter. And we know that bank credit overall has expanded at a 12.6% rate over the past 38 weeks.
Meanwhile, mortgage-backed securities (MBS) issuance by government-sponsored enterprises (such as Fannie Mae and Freddie Mac) issuance has been ramped up to a record pace. And let’s not forget the credit intermediation function now being carried out by the money fund complex, with assets having increased an unprecedented $371 billion year to date (41.3% annualized) and $900 billion over the past 38 weeks (47.7% annualized). It is also worth noting the $184 billion y-t-d increase (29% annualized) in foreign "custody" holdings held at the Fed.
Sure, the credit system remains under significant stress, with additional mortgage and corporate credit deterioration in the offing. But, at least for now, policymakers have successfully stemmed systemic deleveraging. The credit system is simply not in deflationary collapse mode.
I could not be more pessimistic with regard to our economy's prognosis. And certainly much more severe credit problems lay ahead. I could argue further that recent credit system developments are indeed consistent with the unfolding "worst-case scenario". Yet I tend right now to see benefits from analyzing the current backdrop in terms of the conclusion of the first stage of the crisis.
The key aspect of this first stage was a breakdown in Wall Street's highly leveraged risk intermediation and securities speculation markets. The speed and force of the unwind was extraordinary and in notable contrast to traditional banking crises that track real economy developments. "Resolution" came only through the Federal Reserve and federal government assuming unprecedented risk, and at a cost of a policymaking mix of interest-rate cuts, marketplace interventions and government guarantees. It is worth pondering some of the near-term ramifications.
First of all, and as the market recognized this past week, yields have been driven to excessively low levels. Fed funds are today ridiculously priced in comparison both with the inflationary backdrop and with global rates. Mr Feldstein is calling for a halt to rate cuts when it would be more appropriate for the Fed to move immediately to return rates to a more reasonable level. They, of course, would not contemplate as much.
So I will presume that today's non-imploding credit system, replete with government-backed mortgage securitizations, government-guaranteed bank credit, presumed government-backstopped money funds and a recovering debt issuance apparatus, will suffice in the near-term in generating credit sufficient to perpetuate our enormous current account deficits. This is no minor point.
I have in past Bulletins made the case that US credit and economic bubbles had become untenable; the scope of credit and risk intermediation necessary to support the maladjusted economy had become too large. Extraordinary measures to effectively nationalize mortgage and market liquidity risk change somewhat the direction of the analysis. I would today argue that the risk of a precipitous economic downturn has been reduced in the near-term. As a consequence, US credit growth could surprise on the upside with risks to global price instability increasing markedly.
I would argue firmly that, in the face of a rapidly weakening economic backdrop, global inflation dynamics coupled with our highly maladjusted economy ensure intractable trade deficits. I would further argue that the current inflationary backdrop will prove an impetus to credit creation that then begets only more heightened inflationary pressures.
There are certainly indications that the over-liquefied global system is not well situated today to handle more dollar liquidity (akin to throwing gas on a fire). Inflation and its consequences have quickly become major issues around the world.
With crude hitting a record $117 at the end of last week, there is every reason to expect that newly created global liquidity will further inflate energy, food, and commodity prices generally. The Goldman Sachs Commodities index has gained 21% already this year. But when it comes to monetary instability, our financial markets might just prove the unappreciated wildcard.
When the Fed and Washington radically altered the rules of US finance last month, they placed in jeopardy huge positions that had been put in place to hedge against and profit from systemic crisis. With the end of stage one arises a major short squeeze in the credit, equities, and derivatives markets. And when it comes to contemplating the scope and ramifications of today’s hedging activities, we’re clearly in uncharted waters. It is not beyond reason that a disorderly unwind of bearish credit market positions could incite a mini bout of liquidity, speculation, and credit excess that exacerbates global monetary instability while setting the backdrop for stage two of the crisis.