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June 06, 2008

Q1 2008 Flow of Funds
by Doug Noland

Volatility, "Monetary Disorder", and, seemingly, systemic risk have returned. For the week, the Dow dropped 3.4% (down 8.0% y-t-d), and the S&P500 was hit for 2.8% (down 7.3%). The Economically-sensitive issues were under pressure. The Transports declined 3.4% (up 14.9%) and the Morgan Stanley Cyclicals dropped 4.1% (down 6.0%). The Utilities fell 2.0% (down 5.8%), and the Morgan Stanley Consumer index declined 2.4% (down 6.8%). The broader market performed better. The small cap Russell 2000 declined 1.1% (down 3.4%), and the S&P400 Mid-Caps dipped 0.9% (up 1.8%). Technology stocks held their own. The NASDAQ100 declined 2.1% (down 4.5%), and the Morgan Stanley High Tech index fell 2.4% (down 3.1%). The Semiconductors declined 2.3% (down 0.6%), the Street.com Internet Index 2.1% (down 2.5%), and the NASDAQ Telecommunications index 1.6% (up 1.8%). The Biotechs gained 1.1% (down 2.4%). Financial stocks were under heavy selling pressure. The Broker/Dealers dropped 3.6% (down 21.9%) and the Banks 8.2% (down 21.4%). With bullion jumping $15.70, the HUI Gold index increased a modest 2.3% (up 5.4%).

One-month Treasury bill rates dropped 21 bps this week to 1.75%, and 3-month yields declined 8 bps to 1.83%. Two-year government yields fell 37 bps to 2.38%. Five-year T-note yields sank 25 bps to 3.18%, and 10-year yields fell 10 bps to 3.92%. Long-bond yields declined 9 bps to 4.63%. The 2yr/10yr spread widened 12 to 154 bps. The implied yield on 3-month December '08 Eurodollars declined 8.5 bps to 3.025%. Benchmark Fannie MBS yields were little changed at 5.70%. The spread between benchmark MBS and 10-year Treasuries widened a notable 14 to 179 bps. The spread on Fannie's 5% 2017 note widened 15 bps to 72 bps, and the spread on Freddie's 5% 2017 note widened 16 bps to 72 bps. The 10-year dollar swap spread increased 10 to 75. Corporate bond spreads were wider. An index of investment grade bond spreads widened 10 to 110 bps, and an index of junk bond spreads widened 26 to 612 bps.

Investment grade issuance included Kinder-Morgan $2.15bn, Suncor $2.0bn, Humana $750 million, Ply Gem Industries $700 million, Hartford Financial $500 million, Southwestern Electric Power $400 million, Panhandle Eastern $400 million, Detroit Edison $300 million, and Northeast Utilities $250 million.

Junk issuers included Airgas $400 million, Iron Mountain $300 million, Scientific Games $200 million, Cenveo $175 million, and TTM Technologies $175 million.

Convert issuance this week included Netapp $1.1bn, Jetblue $200 million, and Palm Harbor $75 million.

International dollar bond issuance included KFW $3.0bn, National Australia Bank $2.0bn, and Panama $1.15bn.

German 10-year bund yields dipped 2 bps to 4.42%. The German DAX equities index has hit for 4.1% (down 15.7% y-t-d). Japanese 10-year "JGB" yields rose 3.5 bps to 1.785%. The Nikkei 225 gained 1.1% (down 5.3% y-t-d and 19.7% y-o-y). Emerging equities were mostly lower, while debt markets performed better. Brazil's benchmark dollar bond yields were little changed at 6.05%. Brazil's Bovespa equities index fell 3.9% (up 9.2% y-t-d and 34.1% y-o-y). The Mexican Bolsa dropped 2.6% (up 5.5% y-t-d). Mexico's 10-year $ yields sank 15 bps to 5.05%. Russia's RTS equities index fell 3.3% (up 3.8% y-t-d). India's Sensex equities index sank 5.1%, boosting y-t-d losses to 23.2%. China's Shanghai Exchange declined 3.0%, with 2008 losses at 36.7%.

Freddie Mac 30-year fixed mortgage rates added one basis point to 6.09% (down 44bps y-o-y). Fifteen-year fixed rates slipped one basis point to 5.65% (down 57bps y-o-y). One-year adjustable rates dropped 16 bps to 5.06% (down 59 bps y-o-y).

Bank Credit dropped $24.9bn to $9.380 TN (week of 5/28). Bank Credit has expanded $167bn y-t-d, or 4.3% annualized. Bank Credit posted a 52-week rise of $806bn, or 9.4%. For the week, Securities Credit dropped $25.2bn. Loans & Leases were little changed at $6.911 TN (45-wk gain of $586bn, or 10.7% annualized). C&I loans added $1.1bn, with one-year growth of 20.5%. Real Estate loans fell $5.7bn (up 3.6% y-t-d). Consumer loans increased $1.5bn, and Securities loans gained $4.4bn. Other loans slipped $1.0bn. Examining the liability side, "Other Liabilities" dropped $22.4bn.

M2 (narrow) "money" supply jumped $14.4bn to a record $7.704 TN (week of 5/26). Narrow "money" has expanded $241bn y-t-d, or 8.0% annualized, with a y-o-y rise of $475bn, or 6.6%. For the week, Currency gained $2.7bn, and Demand & Checkable Deposits rose $8.5bn. Savings Deposits increased $15.7bn, while Small Denominated Deposits declined $1.8bn. Retail Money Funds dropped $10.7bn.

Total Money Market Fund assets (from Invest Co Inst) dropped $31.5bn last week to $3.448 TN, reducing the y-t-d rise to $335bn, or 25.4% annualized. Money Fund assets have posted a one-year increase of $922bn (36.5%).

Total Commercial Paper increased $1.4bn to $1.755 TN. CP has declined $470bn over the past 43 weeks. Asset-backed CP declined $1.0bn last week (43-wk drop of $442bn) to $753bn. Over the past year, total CP has contracted $360bn, or 17%, with ABCP down $392bn, or 34%.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 6/4) gained $8.6bn to a record $2.301 TN. "Custody holdings" were up $245bn y-t-d, or 27% annualized, and $346bn year-over-year (18%). Federal Reserve Credit slipped $0.3bn to $877.7bn. Fed Credit has expanded $4.2bn y-t-d, while having increased $27.4bn y-o-y (2.3%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.426 TN y-o-y, or 26%, to a record $6.836 TN.

Global Credit Market Dislocation Watch:

June 6 - Dow Jones (Romy Varghese): "Credit derivatives investors reeled at the renewed prospect of ratings downgrades to bond insurers Wednesday, sending the cost of credit protection on MBIA Inc. and Ambac Financial Group deeper into levels typically seen for distressed companies. Moody's... said it would likely strip the two largest bond insurers of their top triple-A credit rating, which would further weaken the companies' already battered business... Meanwhile, the $2.6 trillion municipal bond market held steady, but participants noted that the possibility of a deep downgrade to MBIA and Ambac, or cuts to other firms considered more stable, may hurt the market."

June 2 - Bloomberg (Jody Shenn): "Issuance of collateralized loan obligations has fallen 73% this year as investors avoid securities that can't easily be resold, according to JPMorgan Chase & Co. Creation of CLOs, which package high-yield company loans into securities with varying risks, totaled $13 billion this year through May, compared with $49 billion in the same period of 2007, according to...Chris Flanagan. The market for other types of collateralized debt obligations remains 'entirely shut down,' they wrote."

June 4 - Financial Times (David Oakley and Martin Arnold): "The standards of leveraged loans used to fund private equity buy-outs have loosened in Europe this year in spite of the credit crisis, sharply raising the risk of corporate defaults, Standard & Poor's warned... Record levels of leverage in deals, rising purchase price multiples and the falling ratio of cash that companies have available to cover debt will make it harder for them to repay their loans and put pressure on default rates, the ratings agency said. 'Just because investors are demanding more conservative structures does not mean they are getting them, it said. The ratings agency said this was surprising, given that defaults are expected to rise sharply this year."

June 5 - Bloomberg (Lukanyo Mnyanda): "The cost of borrowing in euros for three months rose to match the highest level since Dec. 18, according to the European Banking Federation. The euro interbank offered rate... rose 1 basis point to 4.87%..."

June 6 - Bloomberg (Darrell Preston): "Franklin Biddar wants his money, and says Bank of America Corp. won't let him have it. The 65-year-old real estate investor... said he hasn't had access to money the bank invested for him in auction-rate preferred shares ever since the market seized up in mid-February. Even when Biddar agreed to sell $100,000 worth of the securities to Fieldstone Capital Group, ... Bank of America wouldn't release the bonds, saying the transaction wasn't in his interest, he said."

Global Inflation Turmoil Watch:

June 5 - Bloomberg (Simon Kennedy): "Asian governments are falling behind in their battle against record oil prices, risking public protests, higher interest rates and slower growth. Indian Prime Minister Manmohan Singh and his Malaysian counterpart, Abdullah Ahmad Badawi, relaxed fuel price controls yesterday, joining Indonesia, Taiwan, Pakistan and Sri Lanka in boosting costs for business and consumers. The moves will drive India's inflation to 8.5%, a 13-year high... Malaysia's consumer-price growth may double to more than 7% this month... Central banks in the region may also follow Pakistan in raising rates, as policy makers lose bets that a global slowdown would temper price increases... This is going to cost these governments politically,' Michael Spencer, Hong Kong-based chief economist for Asia at Deutsche Bank AG, said... 'The governments are basically saying they can't keep subsidizing fuel.'"

June 4 - Financial Times (John Burton): "Malaysia will raise petrol prices by more than 40% from Thursday as it seeks to rein in government spending on fuel subsidies at the cost of ending a low inflation policy. Government officials said Malaysia was in danger of spending M$50bn ($15bn) on fuel subsidies this year if government-set prices for petrol and diesel were not raised... Before today's increase, Malaysia's fuel subsidy accounted for nearly a third of total government spending and was equivalent to about 7% of gross domestic product... The fuel price increase was bigger than those recently announced by Taiwan, Indonesia and India, which raises its fuel prices by 10% from Thursday."

June 4 - Bloomberg (Kartik Goyal and Soraya Permatasari): "India and Malaysia were forced to raise fuel prices after crude oil almost doubled in a year, risking fanning inflation and social unrest. Gasoline will rise 11% in India's capital New Delhi... Pump prices in Malaysia will increase 41%... Asian nations are grappling with record crude prices that have raised the cost of subsidies and caused losses for refineries... 'The countries in Asia, which are dependent on imports, will have to live with the specter of accelerating inflation and slowing economic growth this year,' said Kaushik Das, an economist with Mumbai-based Kotak Mahindra Bank Ltd."

June 3 - Bloomberg (Sungwoo Park): "South Korea, struggling to rein in the highest inflation in seven years stoked by surging oil and food costs, may release rice and frozen fish from state reserves and intensify a crackdown on steel hoarding to cool prices."

June 3 - The Wall Street Journal (James Hookway): "A proliferation of labor strikes in Vietnam is dragging foreign manufacturers into the country's worsening inflation crisis, while Hanoi's Communist leaders struggle to keep rising prices under control... The strikes reflect the anger of the tens of thousands of Vietnamese who have left rural farming communities to seek work in the new industrial zones around Hanoi and Ho Chi Minh City, only to see the buying power of their wage packets dwindle amid rising food and fuel costs. According to government statistics, about 300 strikes took place in the first quarter, up from 103 strikes recorded in the first quarter of last year."

June 6 - Financial Times (Simeon Kerr): "The sovereign ratings of Middle Eastern states could be hit by the political and economic risks caused by soaring inflation across the region, Moody's...said... Poorer regional states, such as Egypt and Jordan, are most likely to be affected in the short term, as inflation prompts strikes and fiscal loosening by governments under pressure... 'Given enhanced sensitivities to the risk of social unrest, some governments in the Middle East are finding it difficult to maintain fiscal discipline,' said Tristan Cooper, Moody's senior sovereign analyst..."

June 3 - Bloomberg (Fiona MacDonald): "Kuwait will tighten controls on prices and increase subsidies on staple consumer goods, the state-run news agency KUNA reported... Inflation in Kuwait accelerated to a record 10.1% in February..."

June 2 - Gulf Times: "Though the Arabian Gulf is reaping a windfall from sky-high oil prices, soaring food prices have hit countries such as Saudi Arabia, Abu Dhabi and Qatar hard. The Gulf nations have to import more than 80% of the food needed for their rapidly growing populations. To brake the runaway inflation that is fuelled by high food costs, Gulf rulers have a new strategy. They are buying unused agricultural land in countries such as Pakistan, Thailand, and Sudan and turn to large-scale farming."

June 3 - Bloomberg (Matthew Brown): "Abu Dhabi plans new measures to control price and salary increases as it seeks to curb inflation, Emirates Business 24/7 reported, citing a government report."

June 5 - Bloomberg (Mike Cohen): "Rising food prices could fuel political instability that African governments will be unable to contain, said Jacob Zuma, leader of South Africa's ruling African National Congress. 'The issue of food prices is actually a time bomb,' Zuma said at a World Economic Forum meeting... 'An uprising could emerge. I don't think there is lots that governments could do.' Rising food prices have sparked protests across the continent in countries including Kenya, Ivory Coast, Cameroon and South Africa... 'Oil prices are driving up food in a way we cannot deal with,' South African Finance Minister Trevor Manuel said... Governments in rich nations must to do more to contain food demand or 'the wealthy are going to take everything, leaving the poor destitute."

June 5 - Financial Times (Barney Jopson): "Food prices in Kenya rose 44% in the year to May reflecting a combination of global trends and the after-effects of the country's post-election turmoil earlier this year. Overall inflation in Kenya rose to 31.5% year-on-year, the highest rate since the early 1990s... Kenya experienced its first small-scale protests over soaring food costs in Nairobi at the weekend, but analysts fear that continued inflation in months to come could stoke more serious unrest among the urban poor."

Currency Watch:

The dollar index declined 0.7% to 72.39. For the week on the upside, the Swedish krona increased 2.1%, the Norwegian krone 2.1%, the Swiss franc 1.9%, the Euro 1.6%, the Danish krone 1.6%, and the Australian dollar 0.8%. On the downside, the New Zealand dollar declined 2.2%, the South African rand 2.2%, the Canadian dollar 1.8%, the South Korean won 0.9%, and the Taiwanese dollar 0.9%.

Commodities Watch:

A week for the commodities history book. Gold gained 1.8% to $902.25, and Silver 3.4% to $17.43 - although the metals were the relatively quiet sector. July Crude surged $10.81 to a record $138.16. July Gasoline jumped 5.4% (up 38% y-t-d), and July Natural Gas surged 8.2% (up 69% y-t-d). August heating oil traded limit up today, posting a one week gain of 8.2%. July Copper added 0.5%. July Wheat jumped 6.5%. The CRB index surged 4.6% to a new record high (up 23.1% y-t-d). The Goldman Sachs Commodities Index (GSCI) jumped 7.1% (up 38% y-t-d and 79% y-o-y).

China Watch:

June 6 - Bloomberg (Tian Ying): "China's passenger-car sales grew a faster-than-expected 16% last month, as demand spurred by economic growth withstood the effects of the country's deadliest earthquake in 32 years."

June 5 - Bloomberg (Nipa Piboontanasawat): "China's current-account surplus grew 49% in 2007 as exports increased, injecting cash into the world's fastest-growing major economy. The gap for trade in goods and services widened to $371.8 billion from $250 billion a year earlier..."

June 2 - Bloomberg (Nipa Piboontanasawat): "Hong Kong's retail sales rose 18.7% in April after the economy accelerated and more tourists shopped in the city."

Japan Watch:

June 4 - Bloomberg (Jason Clenfield): "Japanese businesses cut investment in the first quarter as a global slowdown and waning profits dissuaded companies from building factories and buying equipment. Capital spending... fell 5.3% in the three months ended March 31 from a year earlier... Profits plunged 17.5%."

June 5 - Nikkei: "Sharp wage increases in emerging countries, such as China, India and Poland, are forcing Japanese companies to review their global manufacturing operations, with some laying off workers and others moving operations to lesser developed countries, The Nikkei reported in its Thursday morning edition."

India Watch:

June 6 - Bloomberg (Cherian Thomas): "India's inflation jumped to 8.24%, the fastest since August 2004, adding pressure on the central bank to raise interest rates."

June 2 - Bloomberg (Kartik Goyal): "India's export growth accelerated in April as companies shipped more gems, jewelry, oil and other manufactured products to overseas markets. Shipments jumped 31.5% to $14.4 billion from a year earlier... Imports in April rose 36.6% to $24.3 billion, widening the trade deficit to an all-time high of $9.87 billion."

Asia Watch:

June 5 - Bloomberg (Aloysius Unditu and Clarissa Batino): "Indonesia and the Philippines raised interest rates as surging food and energy prices prompt policy makers across Asia to tackle inflation even as growth slows. Bank Indonesia increased borrowing costs for the second straight month today, raising the rate used as an indication for bill sales to 8.5% from 8.25%."

June 3 - The Wall Street Journal (Reuben Carder, Farida Husna, and Supunnabul Suwannakij): "Record fuel prices drove inflation higher in Indonesia and Thailand in May, with Indonesia's year-to-year inflation rate hitting double digits for the first time in nearly two years... The rise in Thailand's consumer-price index notched a 10-year high."

June 2 - Bloomberg (Suttinee Yuvejwattana): " Thailand's inflation rate was the highest in close to a decade in May amid record oil prices... Consumer prices gained 7.6% last month from a year earlier..."

June 6 - Reuters: "Philippine annual inflation soared to a nine-year high of 9.6% in May... pressuring the central bank to boost interest rates on Thursday for the first time in nearly three years."

June 6 - Bloomberg (Aloysius Unditu): "Indonesia's central bank forecasts inflation will accelerate to 12.7% this month because of the government's move to raise fuel prices in May."

Latin America Watch:

June 5 - Bloomberg (Joe Carroll): "Brazil's oil discoveries, including the Western Hemisphere's largest in three decades, may cost $100 billion more to develop than the industry's most costly field. The Tupi deposit and nearby offshore prospects probably will cost $240 billion to exploit, said Peter Wells, director of U.K. research firm Neftex Petroleum Consultants Ltd."

June 4 - Bloomberg (Eliana Raszewski): "Argentina's tax revenue rose 28.5% in May from a year earlier, the tax agency said in an e- mailed statement."

June 2 - Bloomberg (Eliana Raszewski): "Argentines' confidence in their government fell to the lowest level in five years, according to a survey by Torcuato Di Tella University."

Unbalanced Global Economy Watch:

June 2 - MarketNews International: "Eurozone inflation is a 'real problem' resulting not from monetary union but from a number of external price shocks, European Central Bank President Jean-Claude Trichet said... 'Our citizens demand that we assure price stability in a period when there are a number of inflationary challenges from abroad,' he said, citing the oil shock and more recently agricultural prices."

June 3 - Bloomberg (Brian Swint): "The U.K.'s construction industry... shrank in April at the fastest pace in at least 11 years as homebuilding slumped, a survey showed."

June 3 - Bloomberg (Simone Meier and Joshua Gallu): "Swiss inflation accelerated more than economists forecast to the fastest pace in almost 15 years... Swiss consumer prices rose 2.9% from a year earlier after increasing 2.3% in April..."

June 2 - Bloomberg (Robin Wigglesworth): "Norway's domestic credit growth unexpectedly accelerated to 14.3% in April as companies turned to banks for their funding needs, rather than turbulent international debt markets. Credit growth for households, companies and municipalities quickened from 13.9% in March... Borrowing by non-financial companies rose to an annual 21.7%..., while household credit growth slowed to 10.9% from 11.1%."

June 5 - Bloomberg (Alex Nicholson): "Russian inflation accelerated quicker than economists expected in May to the fastest pace for five and a half years as food prices soared. The inflation rate rose to 15.1% from 14.3%..."

June 3 - Bloomberg (Mark Bentley): "Turkey's inflation rate returned to double digits in May for the first time in 13 months, beating economists' forecasts and adding to pressure on the central bank to lift interest rates. Inflation accelerated to 10.7% from 9.7% in April..."

June 4 - Bloomberg (Mark Bentley): "Turkey revised next year's inflation target to 7.5% from 4% after an increase in energy and food costs pushed the inflation rate into double digits..."

Bursting Bubble Economy Watch:

June 6 - Boston Globe (Ross Kerber): "Record numbers of Americans are raiding their retirement savings as the economy has soured, threatening their long-term financial security to make their mortgage payments, pay medical bills, and cope with rising food and fuel costs. Three decades ago, individually controlled retirement plans like 401(k)s barely existed. Most Americans counted on a pension, with funds contributed and managed by their employer, to provide for retirement along with Social Security payments. But today, workers have accumulated $3 trillion in 401(k) accounts - up from $1.6 trillion in 2002 - making them a tempting target for households looking to get through tough times. The three largest administrators of 401(k)s - Fidelity Investments, CitiStreet, and Vanguard Group Inc. - report a growing number of early withdrawals from the plans in the past year as saving for retirement has taken a backseat to mortgage payments, medical bills, and rising food and fuel costs."

Central Banker Watch:

June 6 - Bloomberg (Simon Kennedy): "European Central Bank President Jean- Claude Trichet is leading the way as the world's most powerful monetary-policy makers turn their attention from protecting economic growth to fighting inflation. Trichet yesterday said the ECB may raise interest rates as soon as next month, two days after Federal Reserve Chairman Ben S. Bernanke indicated he's finished cutting for now. A near doubling in the price of oil in a year and record food costs are forcing central bankers to look beyond weaker consumer spending and focus more on restraining inflation expectations."

June 5 - The Wall Street Journal (Sudeep Reddy): "Federal Reserve Chairman Ben Bernanke... drew sharp distinctions between the inflation problem of the 1970s and price surges today. The economic environment of 1975, when Mr. Bernanke received his undergraduate degree at Harvard, featured some of today's worries, but on a different scale. Among the prime concerns: weakening growth, rising unemployment and a 10% inflation rate as oil prices quadrupled. But Mr. Bernanke emphasized differences between the two eras: Overall inflation over the last four quarters, averaging 3.5%, is 'significantly higher than we would like,' but far from the double-digit pace of inflation in the mid-1970s, he said... 'Importantly, we see little indication today of the beginnings of a 1970s-style wage-price spiral, in which wages and prices chased each other ever upward,' he said."

Mortgage Finance Bubble Watch:

June 5 - New York Times (Michael M. Grynbaum): "Nearly 1 in 10 American homeowners with a mortgage faced foreclosure or fell behind in their payments in the first three months of the year..., a figure that offers a look into the toll caused by the collapse of the housing market. The period from January to March marked the worst quarter for American homeowners in nearly a quarter-century, according to a... report by the Mortgage Bankers Association... Both the rate of new foreclosures and late payments surged to the highest levels since 1979... Of the 45 million home loans included in the survey, 6.35% were at least one payment past due, up from 5.82% for the fourth quarter of 2007. Foreclosure proceedings began on 0.99% of loans... Over all, the percentage of loans being foreclosed on reached 2.47% in the first quarter, rising from 2.04% at the end of December 2007."

June 4 - Bloomberg (Kathleen M. Howley): "Most of the 5.85 million subprime mortgages in the U.S. are in danger of defaulting in the next 12 months because of restrictions on changing terms of the loans, according to Offit Capital Advisors. About 80% of the loans are in bonds that 'slice and dice' rights to a mortgage's interest or principal in multiyear segments, said Todd Petzel, chief investment officer for the New York-based firm, which manages $5 billion. Lifting restrictions on loan modifications spelled out in the securities requires the agreement of everyone who has invested in them, Petzel said."

June 6 - The Wall Street Journal (Ruth Simon): "Mortgage delinquencies and foreclosures continued to surpass record levels in the first quarter, as the prolonged decline in home prices and shifting economic conditions trapped a growing number of prime borrowers. Delinquencies and foreclosures increased at the fastest pace for borrowers with prime adjustable-rate mortgages, according to the Mortgage Bankers Association... The number of new prime ARM foreclosures increased by 29,000 to 117,000 in the first quarter..."

Real Estate Bubble Watch:

June 4 - Bloomberg (Peter Woodifield): "Luxury-home prices in central London, the world's most expensive location for prime real estate, fell the most since the early 1990s as sales slumped, Knight Frank LLP said. The average price of houses and apartments costing more than 2 million pounds ($3.9 million) fell 1.5% in May from a month earlier... That cut the annual increase to 13%, down from a peak of 38% in August."

California Watch:

June 5 - Associated Press (Don Thompson): "Gov. Arnold Schwarzenegger has declared a statewide drought after two years of below-average rainfall, low snowmelt runoff and a court-ordered restriction on water transfers. Schwarzenegger warned that residents and water managers must immediately cut their water use or face the possibility of rationing next year if there is another dry winter. 'We must recognize the severity of the crisis that we face,' the... governor said... California depends on winter snow accumulating in the Sierra Nevada for much of its summer water supply. But March, April and May were the driest winter months on record... The Western Regional Climate Center in Reno, Nev., reported that precipitation in California during that period was 1.2 inches, or 22% of the average for the 114 years since record-keeping began."

Speculator Watch:

June 6 - Bloomberg (Jason Kelly): "Sovereign wealth funds, state- sponsored pools from governments including the United Arab Emirates, invested $58 billion in the first quarter, more than they spent from 2000 to 2005, according to a new report. First-quarter outlays were more than half of 2007's $92 billion, according to...Grail Research, a unit of consulting firm Monitor Group. The funds have as much as $2.9 trillion in capital..."

Crude Liquidity Watch:

June 2 - Bloomberg (Matthew Brown and Fiona MacDonald): "Kuwait became the fourth Gulf state to report inflation above 10% as the cost of housing soared, even after it allowed the dinar to appreciate against the dollar. Consumer prices rose an annual 10.1% in February from 9.5% in January as housing costs surged 16% and food rose 9.2%, the central bank said..."

June 2 - Bloomberg (Matthew Brown): "Qatari inflation accelerated to a record 14.8% in the first quarter from 13.7% in the previous three months as the cost of food and beverages surged. Food costs rose an annual 18.5%..."

Q1 2008 Flow of Funds:

I've been eagerly awaiting the Q1 2008 Federal Reserve "flow of funds" report. In particular, I have been keen to explore two key first quarter dynamics. First, Q1 was historic for the breakdown in "Wall Street finance" and the freezing up of most securitization markets. Second, the U.S. Bubble economy was notably resilient in the face of extreme Credit market tumult. The question then becomes: What types and sources of Credit took up the slack?

To begin with, Non-Financial Debt Growth (NFDG) expanded during the quarter at a respectable 6.5% annualized rate - a rate sufficient to at least keep the general economy from sinking into negative "output" growth. And while 6.5% was a meaningful decline from Q4's 7.5%, I'll note that it compares to an annual average of 5.4% NFDG growth throughout the decade of the nineties.

Examining Q1 Non-Financial Credit growth in somewhat more detail, Total Household Debt Growth slowed sharply to 3.5% from Q4's 6.1%, as Household Mortgage Borrowing growth was cut almost in half from Q4's 5.8% to 3.0%. Yet this was largely offset by a notable 9.2% annualized expansion in total Business Debt Growth (down from Q4's 10.8%), along with a 9.5% rate of federal debt expansion (up from Q4's 5.1%). At the same time, state & local debt expanded 6.4% annualized during Q1 (down from Q4's 7.7%) - this despite turmoil throughout the muni debt markets.

Not surprisingly, Financial Sector Debt Growth (FDG) slowed sharply. After expanding 15.8% annualized during 2007's Q3 and 8.8% in Q4, FDG slowed to a 5.1% pace during the first quarter. This is largely explained by the contraction in both Asset-backed Securities (ABS) and "Open Market Paper"/commercial paper.

These days, in particular, useful perspective is garnered from examining Credit data at "seasonally-adjusted and annualized rates" (SAAR). "Total Net Borrowing" (non-financial and financial) expanded at a SAAR $3.115 TN during Q1. This was down meaningfully from Q4's $3.693 TN and 2007's annual $4.055 TN. For perspective, however, one can compare Q1's rate of Credit expansion to 2006's $3.875 TN, 2005's $3.414 TN, 2004's $3.057 TN, 2003's $2.771 TN, and 2002's $2.362 TN.

Non-Financial Credit Market Borrowings slowed moderately to $2.036 TN during Q1 (down from Q4's $2.316 TN and 2007's annual $2.367 TN), although this should be noted as significant growth in the face of the period's severe Credit market stains. It is worth noting that annual Non-Financial Credit Growth surpassed $1.0 TN for the first time in 1998 and $2.0 TN in 2005. Non-Financial debt growth averaged $701bn annually during the nineties.

A key theme of Q1 analysis is the divergence between the marked slowdown in asset-based lending and the continued readily available finance for much of the real economy. Total Mortgage Debt (TMD) expanded SAAR $581bn, down from Q4's SAAR $988bn and 2007's growth of $1.092 TN. In percentage terms, TMD expanded at a 3.6% pace, with Household Mortgage Debt increasing at a 2.4% rate and Commercial at 6.8%. Over the past year, TMD expanded 6.9%, with Household Mortgage Debt expanding 5.4% and Commercial 12.2%.

The breakdown in the market for Wall Street "private-label" mortgages is evident in Q1's contraction in ABS. Through the first eight years of this decade, the ABS market had almost doubled in size. The greatest excesses were in 2005 and 2006, years of 25.7% and 23.6% growth, respectively. Growth slowed markedly to 4.4% last year, with Q4 posting an actual decline. The ABS market contracted at a 7.4% rate during Q1, or SAAR $305bn to $4.148 TN - reflecting the profound tightening of Credit for non-"conventional" mortgages. The ABS market has posted no growth over the past year (to $4.148 TN).

The expansion of GSE guarantees and balance sheets certainly took up considerable slack. Growth in the (conventional) Agency MBS market slowed as well, from Q4's overheated 20.8% rate to Q1's still strong 11.7%. This placed one-year growth at a notable $639bn, or 16.2%, to $4.595 TN. GSE (holdings) growth slowed from Q4's 11.7% to 5.8%. GSE holdings have expanded $332bn, or 11.5%, over the past year to $3.220 TN.

Interestingly, Broker/Dealer assets posted double-digit growth during the quarter (by choice?). After contracting at a 13.7% annualized rate during Q4, the Broker/Dealers expanded at an 11.8% rate during Q1 to $3.183 TN. One year growth has been reduced to 5.4%, although 2-year Broker/Dealer growth remains a notable (and problematic) 39%. During the quarter, Credit Market Instruments expanded at a 33% annualized rate to $869bn, and the asset Securities Credit grew at a 45% rate to $363bn. On the liabilities side, "Securities Repo" expanded at a 20% rate to $1.205 TN.

Money Fund Assets expanded at a 46% annual rate during the quarter to $3.408 TN. In SAAR terms, Assets expanded at an unprecedented $1.549 TN, up from Q4's SAAR $820bn. By Asset category, Agency & GSE securities expanded SAAR $463bn, Treasury Securities SAAR $374bn, Open Market Paper SAAR $270bn, and Corporate Bonds SAAR $114bn. Over the past year, Money Fund Assets ballooned $1.018 TN, or 42.6% (2-yr growth 69%).

It was, as well, an interesting quarter for the Banking sector. Bank Assets expanded at a 10.0% rate during the quarter, down somewhat from Q4's 11.3%. In SAAR terms, Bank Assets increased $710bn during the quarter, to $11.474 TN. Bank Assets posted a one-year gain of 12.6% ($1.285 TN) and 2-year rise of 20.7% ($1.970 TN). During Q1, Total Loans expanded SAAR $336bn and Miscellaneous Assets SAAR $324bn. Mortgages expanded SAAR $299bn, down from Q4's SAAR $518bn. Securities Credit dropped SAAR $203bn, after increasing SAAR $103bn during Q4. Holdings of both Treasuries and Agencies declined modestly during the quarter, offset by increases in municipal and corporate bonds.

Clearly, the breakdown of key securitization markets was mitigated during the quarter by double-digit growth in Bank Assets, agency MBS, Broker/Dealer Assets and Money Fund Assets. One can also safely assume that such strong growth in key financial sectors goes far in explaining the resiliency of the U.S. Bubble economy in the face of imploding Wall Street finance. Yet there are obvious questions revolving around the sustainability and consequences of such expansion.

First quarter data provide important corroboration for my contention that the U.S. Bubble Economy is sustained only by huge ongoing Credit growth - risky Credit that must increasingly be intermediated by the Banking system, the GSEs and the Money Fund complex. With Wall Street finance having lost its perceived "moneyness," the ongoing U.S. Credit expansion will only be sustained by rampant growth of instruments that retain the perception of safety and liquidity - namely, Treasuries, agency debt and MBS, Bank Liabilities and Money Fund "deposits." And at least for the first quarter, double-digit growth virtually across all these key sectors generated the necessary SAAR $2.036 TN of Non-financial Credit and SAAR $3.115 TN of total system Credit to prop up an acutely vulnerable economic Bubble. But at what cost?

The "Rest of World" (ROW) page of the Fed's Z.1 report always provides a good place to start when it comes to trying to gauge the scope of the global "recycling" effort required to redirect excess dollar liquidity back to the U.S. financial sector. On average, ROW acquired $166bn of our Credit Market Instruments annually during the nineties to "recycle" our Current Account Deficits and speculative dollar outflows. These purchases jumped to $467bn in 2002, to $583bn in 2003, $854bn in 2004, $749bn in 2005, $855bn in 2006, and $827bn in 2007. And despite the weak dollar, a rapidly slowing economy, and severe U.S. Credit tumult, the intractable dollar "recycling" requirement had ROW acquiring U.S. Credit instruments at a stunning SAAR $996bn during the quarter. This is an enormous problem.

Total ROW holdings of U.S. Financial Assets have expanded $1.383 TN over the past year to $15.507 TN. It is no coincidence that this growth closely matches the increase in International Reserve Assets over the past year ($1.426 TN). And the various forms of Acute Global Monetary Disorder that have taken root are certainly a consequence of this increasingly Unwieldy Pool of Excess Global Finance. Crude oil and energy prices have surged better than 40% so far this year (natural gas up 70%), with the Goldman Sachs Commodities index sporting a y-t-d gain of 38%. Moreover, today's moon shot in crude and commodities provides further warning as to the newfound degree of Global Price Instability that has emerged from a dysfunctional U.S. Credit mechanism and global financial "system."

It was a week where Mr. Trichet warned that inflationary pressure may force the ECB to raise rates again. Central banks around the world are feeling increasing pressure to tighten. Here at home, chairman Bernanke voiced the Fed's concern with the inflation backdrop, while making notable comments to support of the dollar. The markets took Mr. Trichet's comments seriously and, not surprisingly, essentially disregarded Mr. Bernanke. The Fed has left itself no leeway - and little credibility.

Bernanke also suggested that sustainable U.S. economic growth would be the most important factor supporting the dollar. I'll continue to argue passionately that the current trajectory of U.S. Credit expansion and today's unsound Economic Structure are highly inflationary and a dollar disaster. Importantly, today's dollar outflows hit a world already inundated with excess dollar balances - not to mention domestic Credit excesses almost across the globe. It is also my view that current Monetary Processes and the trajectory of U.S. and global imbalances ensure further ballooning of the massive Global Pool of Speculative Finance. Indeed, this "Pool" is at the epicenter of today's most intense inflationary and speculative biases - biases that are being thrust to blow-off extremes by the latest round of aggressive Fed reflation (think NASDAQ1999 or U.S. mortgages 2006).

There were important developments this week that seemed to indicate an important inflection point may have been reached. Energy price instability took a decided turn for the worst; global inflationary concerns ratcheted higher; dollar vulnerability reemerged; financial stocks were crushed; and, importantly, the U.S. Credit system demonstrated its greatest instability in a couple of months. And while the U.S. Bubble Economy has proved relatively resilient thus far, sinking stock prices and a further tightening of Financial Conditions would at this point prove too much to bear. I'll also venture a presumption that all the excitement - along with the unwind of hedges - instigated by the Fed's bailouts could now be a source of added instability. Rampant speculation has taken hold and will remain well-embedded until the bust.

To be sure, there are huge costs associated with endeavors to sustain a Bubble Economy. Some are now readily apparent.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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