Saturday, January 29, 2005 6:12:09 PM
*** Doug Noland Commentary ***
Credit Bubble Bulletin, by Doug Noland
The Great Dilemma
January 28, 2005
(excerpted)
The Great Dilemma
It was another interesting week. The Administration released its estimate for a record $427 billion federal deficit. A leading Chinese economist was speaking publicly in Davos about losing confidence in a perpetually “devaluating” U.S. dollar. There was a disappointing two-year Treasury auction, with a notable decline in in-direct bidders – read Asian central banks. Yet ten-year Treasury yields actually declined a little, and the spread between 3-month Treasury bills and benchmark Fannie MBS narrowed 10 basis points to the lowest level since early 2001. Meanwhile, in response to a question about the risk higher home prices pose to the U.S. economy, Freddie Mac’s CEO Richard Syron stated, “Is this a major economic question? No.”
Well, U.S. home prices are a major economic “question,” right along with the “price” of the dollar and the “price” of U.S. Treasuries and mortgage Credit. All are closely interrelated and arguably problematic. Credit is too cheap and assets too dear, and the dear assets seem to make Credit only cheaper. And it is worth noting that the government’s fiscal position is especially alarming when one considers that we are in a period characterized by the robust expansion of Credit, spending and asset inflation. One doesn’t have to be a crazyman to envisage a scenario where a faltering dollar, rising inflation, significantly higher interest rates, a bursting Mortgage Finance Bubble, and a deep recession manifest into Trillion dollar deficits. I wouldn’t bet against it.
Yet I do believe it is somewhat antiquated analysis to focus the blame for dollar woes on spendthrift Washington. In the “old days,” the government “printing press” was the marginal creator of the excess purchasing power that would fuel over-consumption and an escalation in U.S. current account deficits. Stabilizing a lot of things – inflation and the dollar, for two - was largely a matter of reining in federal discretionary spending. The rising price of Credit would force the issue (remember “crowding out”?). But times have changed – the financial system and economy are quite different now.
First of all, The Great Mortgage Finance Bubble is today’s creator of “marginal” purchasing power, as well as marginal global financial market liquidity. This has momentous ramifications that I think are only now just beginning to resonate in the marketplace. For one, the nature of ensuing Inflationary Manifestations is notably non-conducive to Federal government receipts. This is quite a contrast to the late-nineties equities boom and flood of capital gains taxes to federal and state coffers. Not only does home price inflation receive quite favorable tax treatment, (the Inflationary Manifestation) excess consumption of imported goods does a better job lining foreign government pockets than Uncle Sam’s. And a strong case can also be made that the resulting faltering dollar – with rising energy and other costs, as well as stubborn unemployment – will tend to inflate government expenditures.
The wishful consensus view seems to hold that the dollar will recover when fiscal restraint belatedly returns to Washington. Such a view does a complex world injustice. I would argue that the financial markets now dictate the U.S. current account deficit. Here we find dysfunctional Bubble and Speculative Dynamics in full command. The U.S. Financial Complex lends and speculates aggressively – chiefly in mortgages and related instruments – and this purchasing power fuels massive and endemic current account deficits. These deficits are exacerbated by the reality that the financial sector prefers asset and consumption-based lending to financing goods-producing investment. The speculators likewise fancy liquid agency and mortgage securities, while the “industrialists” favor easy financial profits to slugging out in the goods markets.
Trade deficits have become a deep structural malady disguised as somewhat of an annoyance, at worst. Global dollar over-liquidity is “recycled” right back into U.S. securities markets, and the tussle for limited quantities of coveted securities pressures market rates lower. The New Age Bond Market relegates the “permabears” to “permabeatenups.” Meanwhile, pickled notions of permanently low rates and limitless liquidity stoke the Finance and Asset Mania.
It is the nature of Bubbles – not unlike bureaucracies - that dynamics evolve to ensure that they are bolstered and perpetuated. Left to their own devices (which they have been), they will prove powerfully self-reinforcing; Bubbles will inflate, propagate and disperse. And I have argued that the U.S. financial sector has turned dysfunctional and that financial crisis is unfortunately the likely catalyst to contain excess and redirect the flow of resources away from asset markets and to productive investment. Today, years of mortgage lending excess incite further Credit inflation, over-consumption, excess global liquidity, a weak dollar, more central bank purchases, enticing market rates, more borrowing and speculating, deeper economic distortions, and higher home and asset prices.
Interestingly, the GSEs have markedly slowed their expansion and attendant debt issuance. Banking system real estate lending, however, has more than filled the void. So we now have a strange dynamic where U.S. bank Credit expansion is a leading source of global liquidity that is then “recycled” directly back to U.S. securities markets. This bank Credit is created primarily through the issuance of short-term “monetary liabilities” (deposits and “repos”). The upshot is only greater supply/demand imbalance between the virtually endless supply of liquidity creation and the limited issuance of (perceived safe and liquid) longer maturity U.S. securities to be purchased by foreign central banks. This imbalance is complicated by the proliferation of variable-rate mortgages – a prime example of how financial sector “evolution” sustains Bubbles. Here again, there is a creation of liquidity that stokes over-consumption and trade deficits that is then accumulated by Asian central banks and others - and immediately “recycled” back to a confined quantity of long-term U.S. securities.
The pricing of finance (or, traditionally speaking, “capital”) resides at the very heart of Capitalism. Only an operative pricing mechanism will effectively allocate limited resources. And only through the interaction of supply and demand can a pricing mechanism function properly. A functional pricing mechanism would tend toward self-adjustment, limiting imbalances rather than augmenting them. The Great Dilemma of contemporary finance and economics is the limitless nature of the supply of finance/Credit/liquidity (“Global Wildcat Finance”). With no gold anchor or any restriction on the quantity of issuance, Credit will be issued in excess and the resulting liquidity will generally under-price finance (the cost of borrowing/market interest rates). Imbalances will be exacerbated – with extended booms validating mispriced Credit - and the system will become only more unstable over time (and why I use “dysfunctional”).
I would argue (as Master of the Obvious) that the Treasury and agency (and the intricately linked “swaps”) markets have developed into the “anchor” for the global price of finance. And The Great Dilemma today is one of Way Too Many Dollar Balances Chasing Too Few Treasury and Agency Securities. This has led to a seductive dislocation in the pricing of Treasuries/agencies, with extraordinary demand at the “anchor” fixing rates artificially low throughout.
The dislocation in the price of finance is most conspicuous in the market for U.S. mortgage Credit. Just hankering for trouble, our system today basically offers an unlimited supply of cheap (mispriced) real estate finance to virtually any borrower (reminiscent of telecom finance during 1999/2000). And the resulting liquidity creation and housing inflation keep transaction volume high and the average life (“duration”) of mortgage securities relatively short (and the hedgers on their heels!). Increasingly distended home prices and Fed policies contribute to the proliferation of variable-rate mortgages – again limiting the quantity of longer-dated, higher-yielding securities in the marketplace (pasting the hedgers firmly on their heels!). And, importantly, these shorter-maturity securities are easier to leverage and to hedge – thus prime product for the speculating community (including the REITs) desperate for strong returns. Why not aggressively “repo” variable-rate mortgages? And (mispriced) Credit inflation begets only greater inflation.
The Great Dilemma is that the finance pricing mechanism is busted and there is no hope for its repair. There is no self-adjustment or correction – only augmentation. Seemingly endless cheap finance spurs massive government and mortgage borrowings – the greatest explosion of non-productive Credit creation in history. The perpetually “devaluating” dollar, ironically, incites financial market liquidity excess in the U.S. and globally, while at the same time forcing our trading partners into artificially low rates. The U.S. Credit Bubble begets a global Bubble.
At this point, there remains a strong inflationary bias throughout the bond market. Each time when it appears that rates are finally commencing the much needed upward adjustment – they instead stubbornly reverse. There certainly remains a strong inflationary bias in housing prices; if rates don’t go higher, prices will. And the danger lies in the reality that this locomotive of a Credit and Asset Bubble will burst at some point. Asset prices don’t grow to the moon, and it is the final “parabolic” price rise that sets the stage. And as much as Credit excess stokes higher asset prices and only greater marketplace liquidity, the downside will also be self-reinforcing. Recall the telecom debt bust.
The Great Dilemma is that inflating U.S. home prices have developed into the most important issue in global finance. And the tightening link between inflated American real estate prices, mispriced global finance, massive U.S. current account deficits, deteriorating government finance, a faltering dollar, endemic speculative leveraging, and deepening economic distortions is emerging as the crucial facet of latent financial fragility. The Great Dilemma is that an effort to rein in excess would begin with piercing the Mortgage Finance Bubble, something policymakers are not willing to do.
http://www.prudentbear.com/creditbubblebulletin.asp
Credit Bubble Bulletin, by Doug Noland
The Great Dilemma
January 28, 2005
(excerpted)
The Great Dilemma
It was another interesting week. The Administration released its estimate for a record $427 billion federal deficit. A leading Chinese economist was speaking publicly in Davos about losing confidence in a perpetually “devaluating” U.S. dollar. There was a disappointing two-year Treasury auction, with a notable decline in in-direct bidders – read Asian central banks. Yet ten-year Treasury yields actually declined a little, and the spread between 3-month Treasury bills and benchmark Fannie MBS narrowed 10 basis points to the lowest level since early 2001. Meanwhile, in response to a question about the risk higher home prices pose to the U.S. economy, Freddie Mac’s CEO Richard Syron stated, “Is this a major economic question? No.”
Well, U.S. home prices are a major economic “question,” right along with the “price” of the dollar and the “price” of U.S. Treasuries and mortgage Credit. All are closely interrelated and arguably problematic. Credit is too cheap and assets too dear, and the dear assets seem to make Credit only cheaper. And it is worth noting that the government’s fiscal position is especially alarming when one considers that we are in a period characterized by the robust expansion of Credit, spending and asset inflation. One doesn’t have to be a crazyman to envisage a scenario where a faltering dollar, rising inflation, significantly higher interest rates, a bursting Mortgage Finance Bubble, and a deep recession manifest into Trillion dollar deficits. I wouldn’t bet against it.
Yet I do believe it is somewhat antiquated analysis to focus the blame for dollar woes on spendthrift Washington. In the “old days,” the government “printing press” was the marginal creator of the excess purchasing power that would fuel over-consumption and an escalation in U.S. current account deficits. Stabilizing a lot of things – inflation and the dollar, for two - was largely a matter of reining in federal discretionary spending. The rising price of Credit would force the issue (remember “crowding out”?). But times have changed – the financial system and economy are quite different now.
First of all, The Great Mortgage Finance Bubble is today’s creator of “marginal” purchasing power, as well as marginal global financial market liquidity. This has momentous ramifications that I think are only now just beginning to resonate in the marketplace. For one, the nature of ensuing Inflationary Manifestations is notably non-conducive to Federal government receipts. This is quite a contrast to the late-nineties equities boom and flood of capital gains taxes to federal and state coffers. Not only does home price inflation receive quite favorable tax treatment, (the Inflationary Manifestation) excess consumption of imported goods does a better job lining foreign government pockets than Uncle Sam’s. And a strong case can also be made that the resulting faltering dollar – with rising energy and other costs, as well as stubborn unemployment – will tend to inflate government expenditures.
The wishful consensus view seems to hold that the dollar will recover when fiscal restraint belatedly returns to Washington. Such a view does a complex world injustice. I would argue that the financial markets now dictate the U.S. current account deficit. Here we find dysfunctional Bubble and Speculative Dynamics in full command. The U.S. Financial Complex lends and speculates aggressively – chiefly in mortgages and related instruments – and this purchasing power fuels massive and endemic current account deficits. These deficits are exacerbated by the reality that the financial sector prefers asset and consumption-based lending to financing goods-producing investment. The speculators likewise fancy liquid agency and mortgage securities, while the “industrialists” favor easy financial profits to slugging out in the goods markets.
Trade deficits have become a deep structural malady disguised as somewhat of an annoyance, at worst. Global dollar over-liquidity is “recycled” right back into U.S. securities markets, and the tussle for limited quantities of coveted securities pressures market rates lower. The New Age Bond Market relegates the “permabears” to “permabeatenups.” Meanwhile, pickled notions of permanently low rates and limitless liquidity stoke the Finance and Asset Mania.
It is the nature of Bubbles – not unlike bureaucracies - that dynamics evolve to ensure that they are bolstered and perpetuated. Left to their own devices (which they have been), they will prove powerfully self-reinforcing; Bubbles will inflate, propagate and disperse. And I have argued that the U.S. financial sector has turned dysfunctional and that financial crisis is unfortunately the likely catalyst to contain excess and redirect the flow of resources away from asset markets and to productive investment. Today, years of mortgage lending excess incite further Credit inflation, over-consumption, excess global liquidity, a weak dollar, more central bank purchases, enticing market rates, more borrowing and speculating, deeper economic distortions, and higher home and asset prices.
Interestingly, the GSEs have markedly slowed their expansion and attendant debt issuance. Banking system real estate lending, however, has more than filled the void. So we now have a strange dynamic where U.S. bank Credit expansion is a leading source of global liquidity that is then “recycled” directly back to U.S. securities markets. This bank Credit is created primarily through the issuance of short-term “monetary liabilities” (deposits and “repos”). The upshot is only greater supply/demand imbalance between the virtually endless supply of liquidity creation and the limited issuance of (perceived safe and liquid) longer maturity U.S. securities to be purchased by foreign central banks. This imbalance is complicated by the proliferation of variable-rate mortgages – a prime example of how financial sector “evolution” sustains Bubbles. Here again, there is a creation of liquidity that stokes over-consumption and trade deficits that is then accumulated by Asian central banks and others - and immediately “recycled” back to a confined quantity of long-term U.S. securities.
The pricing of finance (or, traditionally speaking, “capital”) resides at the very heart of Capitalism. Only an operative pricing mechanism will effectively allocate limited resources. And only through the interaction of supply and demand can a pricing mechanism function properly. A functional pricing mechanism would tend toward self-adjustment, limiting imbalances rather than augmenting them. The Great Dilemma of contemporary finance and economics is the limitless nature of the supply of finance/Credit/liquidity (“Global Wildcat Finance”). With no gold anchor or any restriction on the quantity of issuance, Credit will be issued in excess and the resulting liquidity will generally under-price finance (the cost of borrowing/market interest rates). Imbalances will be exacerbated – with extended booms validating mispriced Credit - and the system will become only more unstable over time (and why I use “dysfunctional”).
I would argue (as Master of the Obvious) that the Treasury and agency (and the intricately linked “swaps”) markets have developed into the “anchor” for the global price of finance. And The Great Dilemma today is one of Way Too Many Dollar Balances Chasing Too Few Treasury and Agency Securities. This has led to a seductive dislocation in the pricing of Treasuries/agencies, with extraordinary demand at the “anchor” fixing rates artificially low throughout.
The dislocation in the price of finance is most conspicuous in the market for U.S. mortgage Credit. Just hankering for trouble, our system today basically offers an unlimited supply of cheap (mispriced) real estate finance to virtually any borrower (reminiscent of telecom finance during 1999/2000). And the resulting liquidity creation and housing inflation keep transaction volume high and the average life (“duration”) of mortgage securities relatively short (and the hedgers on their heels!). Increasingly distended home prices and Fed policies contribute to the proliferation of variable-rate mortgages – again limiting the quantity of longer-dated, higher-yielding securities in the marketplace (pasting the hedgers firmly on their heels!). And, importantly, these shorter-maturity securities are easier to leverage and to hedge – thus prime product for the speculating community (including the REITs) desperate for strong returns. Why not aggressively “repo” variable-rate mortgages? And (mispriced) Credit inflation begets only greater inflation.
The Great Dilemma is that the finance pricing mechanism is busted and there is no hope for its repair. There is no self-adjustment or correction – only augmentation. Seemingly endless cheap finance spurs massive government and mortgage borrowings – the greatest explosion of non-productive Credit creation in history. The perpetually “devaluating” dollar, ironically, incites financial market liquidity excess in the U.S. and globally, while at the same time forcing our trading partners into artificially low rates. The U.S. Credit Bubble begets a global Bubble.
At this point, there remains a strong inflationary bias throughout the bond market. Each time when it appears that rates are finally commencing the much needed upward adjustment – they instead stubbornly reverse. There certainly remains a strong inflationary bias in housing prices; if rates don’t go higher, prices will. And the danger lies in the reality that this locomotive of a Credit and Asset Bubble will burst at some point. Asset prices don’t grow to the moon, and it is the final “parabolic” price rise that sets the stage. And as much as Credit excess stokes higher asset prices and only greater marketplace liquidity, the downside will also be self-reinforcing. Recall the telecom debt bust.
The Great Dilemma is that inflating U.S. home prices have developed into the most important issue in global finance. And the tightening link between inflated American real estate prices, mispriced global finance, massive U.S. current account deficits, deteriorating government finance, a faltering dollar, endemic speculative leveraging, and deepening economic distortions is emerging as the crucial facet of latent financial fragility. The Great Dilemma is that an effort to rein in excess would begin with piercing the Mortgage Finance Bubble, something policymakers are not willing to do.
http://www.prudentbear.com/creditbubblebulletin.asp
Dan 
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