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The Credit Bubble Bulletin

A Completely Different Environment

January 30, 2000

It was a bearish week on Wall Street as dislocations developed in the credit market and the stock market faltered. For the week, the Dow and S&P500 dropped 3%. The economically sensitive issues traded poorly with the Morgan Stanley Cyclical index declining 5% and the Transports 6%. The Morgan Stanley Consumer index dropped 4% and the Utilities fell 1%. The small caps rally came to an abrupt end with the Russell 2000 sinking 5%, wiping out its entire January gain. The big tech stocks were hammered as the NASDAQ100 dropped 10% and the Morgan Stanley High Tech index fell 9%. The NASDAQ100 ended the day at 3446, still 1000 points above where it traded this past October. The Semiconductors declined 7%, reducing their year-to-date gain to 6%. The Internet index also fell 7%, and the NASDAQ Telecommunications index sank 10%. The financial stocks bucked the selling with the S&P Bank index rising 2%, while the Bloomberg Wall Street index was unchanged. Both indices, however, were hit today as tumult unfolded in the credit market.

Not surprisingly, we see that broad money supply has failed to demonstrate any meaningful contraction after the historic expansion during the final four months of 1999. In fact, M3 money supply totaled $6.509 trillion last week, $290 billion greater than on September 6th. For the first three weeks of the New Year, M3 has declined $26 billion, of which the majority was within the narrowest definition of money, M1. More importantly, money market fund assets continue their unrelenting expansion. For the first three weeks of January, fund assets have increased $37 billion. Since the beginning of September, money market fund assets have surged $175 billion, or 12%. This makes for a 30% annualized rate over the past 20-week period. Growth also continues in financial sector commercial paper borrowings as they have increased marginally during the first four weeks of January. Remember, these borrowings increased by $154 billion, or at an annualized rate of 45%, during the final four months of 1999. This has become the heart of the credit bubble.

And while the contraction of money supply so far in January is clearly immaterial compared to the previous huge increase, we do note that the credit market, once again, functions poorly anytime money supply does not expand aggressively. From the beginning, we have been skeptical of the concept of the Fed “mopping up” excess Y2K liquidity because we believed the vast amount of the excessive money and credit creation during last year’s second-half had less to do with Fed Y2K operations than it did with a credit system spinning out of control. It is our view that money supply growth was fueled by overzealous borrowing by the household and financial sectors, as well as being augmented by unappreciated leverage created concomitant with the historic speculative run in the stock market. Now, however, it looks like we could be in the early stage of a deleveraging process. Such excess doesn’t work well in reverse.

Last week we made the case that the Federal Reserve has lost control of the money and credit creation mechanism. This, of course, is not a popular view in a world of over-optimism and a strange reverence for Alan Greenspan. But the fact remains that broad money has expanded by an unprecedented $860 billion during the past 18 months. Interestingly, many within the bullish camp argue that money supply growth is in no way excessive, especially when compared to GDP growth. Well, let’s take a look at the numbers. Comparing 4th quarter 1999 GDP growth to 4th quarter 1997, we see GDP has increased about 12%. Broad money supply, on the other hand, has expanded by an astonishing 20%. Sometimes we wonder if the bulls even look at the data. Recently, in at least a couple of places, we have read bullish analysis that the Fed has been following a “Price Rule,” steering money supply growth with incredible brilliance while maintaining price stability. Well, we think this is giving the Fed way too much credit and actually looks much more like justification than sound analysis. Besides, we look at inflation as manifesting in three ways: rising goods and services prices, higher asset prices and expanding trade deficits. Inarguably, at least two of the three are flashing dangerous inflation.

It is also now irrefutable that the economy is dangerously overheated. The bulls have been fighting the acceptance of this view, with increasing difficulty. Problematic overheating was again confirmed by truly extraordinary economic data. Today’s stronger than expected 5.8% 4th quarter GDP growth was led by 6.3% growth in real domestic purchases. Consumer spending rose 5.8% and government spending accelerated 8.4%, the largest increase since 1986. And with an election year ahead of us, and ridiculous talk of a coming $4 trillion budget surplus, even greater government expenditures are on the way. In addition, earlier in the week we had December Durable Goods growing at 4.1%, compared to estimates of 1%. We also had an absolutely booming report on Consumer Confidence. And, most troubling, there are various reports indicating that economic activity has actually accelerated in January, particularly in the key housing and auto sectors. Well, after record money growth and stock market gains, a surge in spending was inevitable. As such, it is simply difficult to comprehend why the Federal Reserve did not move long ago to take the punch bowl away. But, then again, key Fed officials are clearly more focused on lasers, broadband, computers and the Internet than they are on money and credit excess, unprecedented stock market speculation and endemic distortions to the real economy. Having so missed its timing, it is going to be a very difficult task to get this wild party under control - very difficult, indeed.

We saw hints of this in today’s near chaos in the credit market. The 10-year Treasury yields spiked to almost 6.85% this morning, only to abruptly reverse course and close at 6.64%. The bellwether long-bond contract dropped more than a full point this morning to 91, then rallied to as high as 93 ½. Yields had an almost 25 basis point intraday swing. For the week, the front part of the curve was hit the hardest as 2-year Treasury yields rose 12 basis points to 6.58%, after ending 1999 at 6.24%. The 5-year rose 3 basis points to 6.66%, a rise of more than 30 basis points for the month. 10-year yields actually declined 10 basis points this week to 6.66%, while 30-year yields dropped a stunning 25 basis points to 6.45%. As you can see, the 2-year now yields 10 basis points more than the long-bond, an inversion that has not occurred in more than 10 years.

It is difficult to know exactly what is going on here. Our hunch, however, is that it looks increasingly like an unfolding dislocation in the derivatives market. Keep in mind that the large US banks have more than $28 trillion of interest rate derivatives on the books. Clearly, there were those within the leveraged speculating community that had made a seemingly reasonable bet on a steepening yield curve. This trade has been a big loser. It also is quite likely that the speculators have been shorting or buying put options on the long bond to hedge leveraged positions in mortgages, corporates and agency securities. These trades, as well, have not worked. Not much has worked in the credit markets over the past few months accept narrowing spread trades. Now these trades look vulnerable. We see that the generic 10-year swap spread widened 9 basis points over the past two days. Mortgages, in particular, performed very poorly as the spread between mortgages and 10-year Treasuries surged 10 basis points today and 14 basis points for the week. The spread on Fannie Mae, Freddie Mac and other agency paper also expanded this week. Importantly, these are all indications of less liquidity and increased systemic stress – stress that has been inevitable with the combination of a desperately overheated economy and highly overleveraged financial system. Going forward, spreads on mortgages and agency securities should be followed closely. This is likely where the most leverage and speculation has developed, hence the area most prone to dislocation.

There is just no way around the fact that highly leveraged financial systems are precarious. Yet, highly leveraged financial institutions and, unfortunately, an aggressive speculating community have come to dominate our entire credit creation process. And, as has been the case repeatedly, various markets become tightly entwined because of the heavy involvement of the leveraged speculating community. Today there is unprecedented leverage and vulnerability in the US credit market, and we believe the stock market. If the leveraged community begins to unwind positions in the credit market, liquidity could falter quickly. Any liquidity problem would quickly transmit to the stock market. And if stocks have commenced a meaningful decline, we would expect considerable deleveraging here as well. In both cases, however, we are not sure where the buyers will be found if the leveraged speculating community becomes aggressive sellers. Markets function well when the leveraged speculating community is buying, not well at all when they are liquidating.

As for a catalyst, we certainly sense an important inflection point in regard to perceptions of pricing pressures. Both of today’s inflation indicators, the GDP deflator and the Employment Cost Index, were stronger than expected. Meanwhile, the bulls, and possibly even the Federal Reserve, have been kidding themselves into believing that unprecedented money and credit creation were somehow being offset by increased productivity and the Internet to maintain price stability. Instead, we are of the opinion that two factors were largely responsible for dampening patently inflationary money and credit growth over the past 15 months. First, the global backdrop, particularly with the Asian and emerging market crises, was one of strong deflationary forces. With demand faltering badly overseas, there was considerable unused capacity available to satisfy excessive US demand. Second, there was the usual economic slack at home. As one would expect, factories weren’t running at full capacity, there were some available workers, and inflationary pressures and bottlenecks had not yet developed.

Today, however, we have a much different picture developing. The global economies have bounced back strongly, with demand sure to expand as long as the global boom continues. And here at home, well, the labor pool has been effectively reduced to zero, factories are running hard, bottlenecks are developing and asset prices have been in an historical rise. Economic distortions and imbalances have grown exponentially, and inflationary psychology has returned for wage earners, homebuyers and stock market participants. And, significantly, money and credit excesses run unabated as higher asset prices spur more money and credit excess and only higher prices. Such excesses may have not been immediately problematic 15 months ago, but they fuel extremely dangerous bubble excesses today. In short, today is a completely different environment. As such, the Fed made a momentous error in accommodating and virtually condoning money and credit excesses before, but now are trapped in a policy of watching and hoping. For good reason, the Fed is likely confused as to what policy action would be most market friendly. Does it raise rates aggressively in an effort to cool an overheated economy and quash budding inflation? Or do they add liquidity and accommodate credit excesses as they have in the past at any sign of faltering financial markets? In the past it was always an easy decision for Greenspan – add liquidity and accommodate excess. Easy for him to do and easy for Wall Street to love him for doing it. Today, however, it’s a completely different environment. The Fed failed to do its job, now we will see how long it takes the markets to do it for them.

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