The high priests of each of these risky asset classes all have very persuasive arguments as to why the fundamentals have changed -- in effect, why the current assessment of risk is far more benign than in the past. Call me a cynic, but I don't buy the theory of 'riskless coincidence'--that the fundamental underpinnings have simultaneously improved for all risky assets at precisely the same point in time. If there's ever been a visible manifestation of the excesses of the stock of global liquidity -- despite an adverse shift in the flow--this is it. Like it or not, the excesses of global liquidity have created a profusion of 'this time it's different' stories. I might be persuaded that one or two of them are intriguing--it's the profusion that kills me.
In a myopic rush to celebrate the immediate dividends of faster economic growth, the costs of what it has taken to achieve that outcome have all but been ignored. As long as global growth remains strong and the liquidity cycle remains accommodative, I suspect those costs will continue to be finessed. But when the tide goes out and the global growth engine slows for any one of a number of reasons, an increasingly integrated global economy and its tightly interdependent financial markets could well have to come to grips with these costs head on. That remains the biggest potential pitfall of 2007, in my view.
- Stephen Roach, 'Global Resilience', 10/09/2006
The infusion of ample liquidity since the start of the decade to bring us out of the 2001 recession, cushion the economy and markets after the September 11th attack, and the continuation of the Yen Carry trade have put a bid under financial markets and have reduced volatility to an extreme. The Volatility Index (VIX) has been compressed to the lowest levels seen in the index's history.
Figure 1
Source: StockCharts.com
The explosion of debt has compressed volatility and reduced risk spreads to historically low levels. According to the Bank for International Settlements (BIS), the notional value on credit default swaps (CDS) has risen from .4 trillion at the end of 2004 to .4 trillion by the end of June 2006, an increase of nearly 220%. BIS data also showed the notional value of global over-the-counter derivatives markets at US5 trillion in December 2005, representing an increase of more than 40% from 2003. The following chart shows the relation of rising debt and falling volatility.
Figure 2
Source: The Bank Credit Analyst (BCA), December 2006 Executive Summary
Stephen Roach from Morgan Stanley isn't the only one who feels volatility, and a financial crisis could emerge in 2007 or within the next few years as The Bank Credit Analyst (BCA) echoes the same concern with editors from BCA making the following comments (December 2006 Executive Summary):
It is almost impossible to predict the timing of, or the trigger for, financial accidents. The blow-up of Long-Term Capital in the fall of 1998 came out of the blue, and it would not be a surprise for similar events to occur in the coming year. Many new market participants have little experience of dealing with financial turmoil, and the fact that firms are all using similar risk-management models could amplify any upheavals that occur.
The general assumption is that as long as the economy stays on track for a soft landing, then there is no need to fear any further increases in interest rates, and the Federal Reserve may even ease policy a notch next year. And if interest rates do not rise, then there is little reason to expect any blow-ups in the markets, so it is OK to take on more risk. This is the kind of mindset and process that leads to bubbles.
We have already seen what leverage in the hedge fund industry can do when speculation turns against the speculator with the blow-up of hedge fund Amaranth Advisors who lost billion in September 2006 on natural gas trading. More financial blow-ups might result if the Fed doesn't lower interest rates where many investors are betting it will. Economic forecasters such as Paul Kasriel from The Northern Trust Company are revising their 2007 economic forecasts upwards and delaying their time frame for a Fed rate cut. Interestingly enough, the weather is playing a role in GDP estimates being revised upward as Mr. Kasriel points out as the reason for Northern Trust's revised estimates in his article, 'Want to Improve Your Economic Forecasting? Watch the Weather Channel.'
Although we continue to believe that economic growth in 2007 will be sub-par, recent incoming information has induced us to modify the forecast a bit. For the five quarters ended the second quarter of 2007 we now are forecasting average growth of 2.3% -- almost 20 basis points higher than our forecast of last month. More importantly with regard to our view of 2007 Federal Reserve policy, we have revised the quarterly pattern of our growth forecast, and now see stronger-than-expected growth for the fourth quarter 2006 and the first quarter 2007 followed by weaker-than-previously forecast growth in the remaining three quarters of 2007.
This combination of marginally faster economic growth over the forecast period, along with some 'front-loaded' growth, leads us to believe that the Federal Open Market Committee (FOMC) will wait a little longer in 2007 to lower the federal funds rate and will limit its cumulative decline to 75 basis points rather than the 100 basis points we were projecting last month.
With economic activity supported in recent months by unseasonably warm weather, core CPI remaining elevated, the unemployment rate continuing to fall, and capacity utilization holding steady, reasons for lowering the interest rates remains absent.
Figure 3
Source: The Bank Credit Analyst (BCA), December 2006 Executive Summary
The readjustment process by the market for a delayed Fed reduction in interest rates may prove to be painful as was the process for the readjustment of expectations for a Fed pause back in May of 2006, when the Fed raised rates instead of pausing as many were expecting. The S&P 500 fall over 8% from its May high to the June lows and the average International iShare ETF corrected 18.4%. I commented on this and the tendency of the markets to correct 3.5 months before a peak in the Fed Funds rate last April (Caution is Warranted). The action of the markets did in fact correct roughly 3.5 months before the peak in the interest rate cycle with the Fed going on pause in August 2006.
The increased leverage seen in the derivatives market in Figure 2 increases the likelihood of a financial crisis causing the markets to implode as Yen Carry Trades unwind (May 2006 with Bank of Japan contraction in its monetary base led to large emerging markets correction) and derivative contract bets go against hedge funds. The unwinding of debt used in financial speculation can lead to prolonged bear markets as the contraction in margin credit (total and rate of change) shows below and its relation to the S&P 500.
Source: Moody's Economy.com
Data: Board of Governors of the Federal Reserve
This increase in the risk for a financial crisis may be the reason behind Henry Paulson taking the reigns as U.S. Treasury Secretary. An October 23rd Wall Street Journal article entitled, 'Paulson Pulls for U.S. Markets,' had the following comments referring to Paulson.
Since taking the reins in July, the Wall Street veteran has reinvigorated the President's Working Group (AKA: Plunge Protection Team) on Financial Markets, which had languished...
Mr. Paulson is chairman of the Working Group, which coordinates government policy on financial markets and includes the heads of the Federal Reserve, Securities and Exchange Commission, and Commodity Futures Trading Commission. Mr. Paulson has insisted that they meet about every six weeks. Before his arrival, the group met every few months and sometimes as infrequently as once a quarter.
Mr. Paulson is having the Working Group look at the systemic risk posed by hedge funds and derivatives, and the government's ability to respond to a financial crisis, officials said. He has ordered his chief of staff, Jim Wilkinson, to oversee the creation of a Treasury command center to track markets world-wide and serve as an operations base in a crisis. The center would revive a market-monitoring room closed in a 2003 budget cut.
Not only does the short-term picture reflect the potential for a financial crisis due to the leverage in the derivatives market, but also the long-term picture with run-away deficits and a surge in forecasted Medicare and Medicaid benefits.
Jim Jubak from MSN Money wrote a recent article entitled, 'State of the nation? Broke,'and I would like to include below some of his main points which are insightful.
The upcoming crisis is absolutely predictable
It's caused, surprise, surprise, by the aging of the baby boomers. The first official baby boomer will become eligible for early retirement under Social Security on Jan. 1, 2008, and for Medicare benefits in 2011. Social Security surpluses -- the surplus of tax receipts versus benefit payouts -- will begin its decline in 2009 and by 2017, unless benefits are cut or taxes increased, Social Security cash flow will have moved into deficit and begun to add to the unified budget deficit rather than diminishing it, as at present.
Don't forget Medicare and Medicaid
According to the Congressional Budget Office, spending for Social Security will reach 4.7% of U.S. gross domestic product (GDP), up from 4.2% in fiscal 2007. But pile the growth in Medicare and Medicaid spending on that relatively modest increase and you've got a backbreaker for the federal budget. According to the Congressional Budget Office, combined Medicare and Medicaid spending will add up to 6.3% of GDP in 2016, up from 4.6% in 2007. By 2030, federal spending for these three entitlement programs will add up to 15.5% of GDP, up from 8.8% in 2007.
The government is digging a huge hole
By 2030, if you assume that discretionary spending (on things like student loans and aircraft carriers) grows at the same rate as the economy and the Bush tax cuts are made permanent, Walker (Comptroller General) testified, government spending on interest on the national debt, Social Security, Medicare and Medicaid would eat up all -- yes, 100% -- government revenue.
Walker finished his testimony by noting that if we do nothing until 2040, balancing the budget in that year would require cutting total federal spending by 60% or raising federal taxes to two times today's level.
Or I suppose the government could just run the printing presses. Printing new currency is one thing Washington is good at.
I found it mind boggling in the Jubak article where Walker estimates that if growth rates on spending continue, government spending on interest would eat up 100% of government revenue by 2030! The path of least resistance and the likely path of the U.S. government is to continue to print dollars to pay for its spending programs and interest payments. If this is indeed the long-term picture, gold will be the safe harbor of wealth while the stock markets may soar due to asset inflation; when priced in gold they may indeed crash dramatically as they did in the 1970s. When priced in gold, the S&P 500 and DJIA are nowhere close to the 2000 highs as the charts below illustrate.
Figure 5
Figure 6
Source: The Chart Store: Weekly Chart Blog, December 29, 2006
This year may see a return to volatility and a contraction in the levels of derivative speculation, or the present condition of rising debt and decreasing volatility may contain its trend. At either rate, the time tested theme of reversion to the mean will surface, and when it does it won't be pretty. Caution is warranted.
TODAY'S MARKET - Economic Reports
MBA Mortgage Applications Survey
Mortgage demand fell for the second straight week, falling 8.4% last week with both purchase applications and refinance applications falling 8.4% and 9.6% respectively. The decrease in mortgage demand continues as mortgage rates rose for a second week. The contract rate on the 30-yr FRM increased 4 basis points to 6.22% with the 1-yr ARM also rising, up 7 basis points to 5.91%.
Source: Dismal Scientist
Data: Mortgage Bankers Association of America
Oil & Gas Inventories
Crude oil inventories rose 0.7 million barrels last week, below expectations for a 1.1 million barrel build. Distillates rose 700,000 barrels while expectations were in the opposite direction, calling for an 800,000 barrel drawdown. Also surprising on the upside was a strong build in gasoline inventories that rose 4.0 million barrels against expectations for a 1.3 million barrel increase.
Petroleum Inventory Changes
Source: Energy Information Agency (EIA)
Source: Energy Information Agency (EIA)
The Markets
The markets opened up higher boosted by tech profit reports from Yahoo Inc. and Sun Microsystems Inc., with Yahoo's 4th quarter profit beating Wall Street's estimates and Sun Microsystems 1st quarter earnings beating Wall Street's estimates. The boost from both stocks helped reverse the declining trend in the NASDAQ which has fallen from its high of 2508.93.
The Dow posted a gain of 87.97 points to close at 12621.77. The S&P 500 was up 12.14 points to close at 1440.13, and the NASDAQ put in the largest gain, rising 34.87 points to close at 2466.28. Investors sold Treasuries today with the 10-year note yield rising to 4.810%, rising 0.6 basis points. The dollar index was also up on the day, rising 0.31 points to close at 84.98. Advancing issues represented 66% and 65% for the NYSE and NASDAQ respectively, with up volume representing 73% and 82% of total volume on the NYSE and NASDAQ.
Energy commodities were up despite the rise in distillate and gasoline inventories that came in higher than expected, with spot Henry Hub natural gas rising 2.78% on the day and up 34.36% for the year. Precious metals were mixed with gold rising .90/oz to 8.60/oz and silver falling __spamspan_img_placeholder__.01/oz to close at .235/oz. Base metals were mostly up on the day with lead leading the pack up, rising 2.21%.
Overseas markets were predominantly up with Mexico's Bolsa and Korea's Kospi indices putting in the strongest showing, up 1.97% and 1.47% respectively. The weakest markets were China's Hang Seng and Japan's Nikkei indices, up 0.25% and 0.57% respectively.
The advancement in the markets today was broad based as all ten S&P sectors were up. The telecommunication sector put in the greatest performances today with help from a 4.27% advance by AT&T stemming from Cingular's 4th quarter profit that more than tripled on the back of an industry record by adding 2.4 million net subscribers. The technology sector put in a strong showing on several positive technology company earnings reports, advancing 1.75%. The weakest sector of the day was the industrial sector which was weighed down by a 5.81% decline in Norfolk Southern Corp, rising only 0.08%.
