Year in Review: Reflation to Gross Over-Liquefication
prudentbear.com
From my analytical framework, liquidity excess is having profound and all-encompassing effects on the financial markets and real economy. Never has over-liquidity been so conspicuous, not even with the technology boom. Crude oil prices rose 34% and energy prices surged during the year; import prices are now up 9.5% from one year ago; CPI and PPI moved solidly higher; and home prices inflated at a pace last seen in the late-70s. Accordingly, a strong case can be made that 2004 deserves the designation "The Year of Inflation's Serious Reemergence." Inflation expectations have certainly returned with a vengeance. Speculative interest in a wide range of hard assets – including real estate, commodities, art, myriad collectables, and precious metals - took firm hold during the past year. And, importantly, once such market psychology manifests, signficantly tighter monetary conditions are required to quell the resulting Monetary Disorder.
Throughout the financial markets, liquidity excess incited The Year of the Blow-off. Junk bond spreads collapsed. Emerging bond spreads collapsed. Credit spreads collapsed. Credit default swap premiums collapsed. Equity option volatilities collapsed. And especially after President Bush secured a second term, the unwind of “bearish” bets and hedges incited virtual melt-up conditions in some sectors of the equity market and speculation throughout. M&A activity went to frothy extremes, inciting only greater Credit and speculative excess.
And over-liquidity also can also take Credit for inspiriting The Year it Didn't Matter. Crude prices ran to $55, but it didn't matter to the bond market. Commodity markets on fire – didn't matter. Sinking dollar – nope, didn't matter. Heightened inflationary pressures – didn't matter. Fed raising rates – didn't matter. Fannie and Freddie with major accounting irregularities – didn't matter. And that was the kind of year it was: major fundamental developments developed with respect to the dollar, inflation, and the integrity of our financial system but all were trumped by rampant system liquidity excess.
To wrap this up this brief and incomplete “review,” we are now 25 months into historic “reliquefication.” As students of inflation would expect, the nature of Inflationary Manifestations has evolved and intensified over time. I would strongly argue that the powerful strain of inflation that has taken hold during 2004 is of the most precarious variety. “Animal spirits” and speculative impulses have been unleashed everywhere. And the problem with extended periods of rampant over-liquidity is that it becomes only more difficult to wean the levitated financial markets, inflated asset markets, and distorted economy off the stimulant. I expect that The Year it Didn't Matter will be followed by The Year it Does. |
