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June 14, 2008

Stage II Predicaments
by Doug Noland

For the week, the Dow added 0.8% (down 7.2% y-t-d), while the S&P500 was little changed (down 7.4%). The Transports were down 1.9% (up 12.7%), while the Utilities rose 2.4% (down 3.6%). The Morgan Stanley Cyclicals added 0.2% (down 5.7%), and the Morgan Stanley Consumer index gained 0.5% (down 6.3%). The broader market gave back some recent out-performance. Both the small cap Russell 2000 (down 4.2%) and the S&P400 Mid-Caps (up 0.9%) declined 0.9%. The NASDAQ100 declined 1.2% (down 5.7%) and the Morgan Stanley High Tech index fell 1.1% (down 4.2%). The Semiconductors dropped 2.9% (down 3.5%). The Street.com Internet Index dipped 0.2% (down 2.7%), while the NASDAQ Telecommunications index added 0.2% (up 2.0%). The Biotechs lost 2.2% (down 4.6%). The Broker/Dealers added 0.4% (down 21.6%), while the Banks sank another 4.2% (down 24.8%). With Bullion sinking $32.30, the HUI Gold index was clobbered for 7.7% (down 2.7%).

One-month Treasury bill rates increased 13 bps this week to 1.86%, and 3-month yields rose 14 bps to 1.97%. Two-year government yields surged 66 bps to 3.03%, according to Bloomberg the largest weekly gain in yields in 26 years. Five-year T-note yields surged 55 bps to 3.73%, and 10-year yields jumped 34 bps to 4.26%. Long-bond yields gained 18 bps to 4.79%. The 2yr/10yr spread narrowed 22 to 123 bps. The implied yield on 3-month December '09 Eurodollars shot 72.5 bps higher to 4.555%. Benchmark Fannie MBS yields rose 36 bps to 6.07% (high since Aug 20). The spread between benchmark MBS and 10-year Treasuries widened 2 bps to 181. The spread on Fannie's 5% 2017 note narrowed 3 bps to 70.5 bps, and the spread on Freddie's 5% 2017 note narrowed 2 bps to 71 bps. The 10-year dollar swap spread declined 4.5 to 70. Corporate bond spreads were mixed to wider. An index of investment grade bond spreads widened 1 to 111 bps, and an index of junk bond spreads narrowed 15 to 579 bps.

Investment grade issuance included SLM $2.5bn, Florida Power $1.5bn, American Express $500 million, Duke Energy $500 million, FPL Group $500 million, Sotheby's $500 million, Sempra Energy $500 million, and Union Electric $450 million.

Junk issuers included Sequa Corp $500 million, and Targa Resources $250 million.

Convert issuance this week included Sotheby's $175 million.

International dollar bond issuance included Rabobank $3.4bn and Arantes International $150 million.

German 10-year bund yields jumped 22 bps to an 11-month high 4.64%. The German DAX equities index dipped 0.6% (down 16.1% y-t-d). Japanese 10-year "JGB" yields gained 7.5 bps to an 11-month high 1.86%. The Nikkei 225 dropped 3.6% (down 8.7% y-t-d and 21.2% y-o-y). Emerging debt markets were under pressure and equities were mostly lower. Brazil's benchmark dollar bond yields surged 27 bps to 6.33%. Brazil's Bovespa equities index dropped 3.7% (up 5.2% y-t-d and 26.8% y-o-y). The Mexican Bolsa fell 2.4% (up 3.0% y-t-d). Mexico's 10-year $ yields jumped 23 bps to 5.33%. Russia's RTS equities index added 0.2% (up 2.9% y-t-d). India's Sensex equities index fell 2.5%, boosting y-t-d losses to 25.1%. China's Shanghai Exchange index was clobbered for 14.4%, pushing 2008 losses to 45.5%.

Freddie Mac 30-year fixed mortgage rates surged 23 bps to a 7-month high 6.32% (down 42bps y-o-y). Fifteen-year fixed rates jumped 28 bps to 5.93% (down 50bps y-o-y). One-year adjustable rates increased 3 bps to 5.09% (down 66 bps y-o-y).

Bank Credit declined $4.2bn to $9.376 TN (week of 6/4). Bank Credit has expanded $163bn y-t-d, or 4.0% annualized. Bank Credit posted a 52-week rise of $821bn, or 9.6%. For the week, Securities Credit increased $7.9bn. Loans & Leases declined $12.1bn to $6.899 TN (46-wk gain of $574bn, or 10.% annualized). C&I loans fell $7.1bn, with one-year growth of 18.7%. Real Estate loans dipped $1.6bn (up 3.4% y-t-d). Consumer loans were little changed, and Securities loans declined $2.2bn. Other loans decreased $1.0bn. Examining the liability side, Deposits sank $36.4bn and "Borrowings" rose $11.6bn.

M2 (narrow) "money" supply declined $11bn to $7.694 TN (week of 6/2). Narrow "money" has expanded $231bn y-t-d, or 7.3% annualized, with a y-o-y rise of $466bn, or 6.4%. For the week, Currency added $1.1bn, and Demand & Checkable Deposits increased $17.8bn. Savings Deposits dropped $26.2bn, and Small Denominated Deposits declined $2.4bn. Retail Money Funds slipped $1.2bn.

Total Money Market Fund assets (from Invest Co Inst) declined $5.0bn last week to $3.515 TN, reducing the y-t-d rise to $402bn, or 29% annualized. Money Fund assets have posted a one-year increase of $985bn (38.9%).

Asset-Backed Securities (ABS) issuance increased this week to $6.3bn. Year-to-date total US ABS issuance of $100bn (tallied by JPMorgan's Christopher Flanagan) is running at 27% of the comparable level from 2007. Home Equity ABS issuance of $303 million compares with 2007's $184bn. Year-to-date CDO issuance of $13.8bn compares to the year ago $208bn.

Total Commercial Paper jumped $16.4bn to $1.772 TN. CP has declined $452bn over the past 44 weeks. Asset-backed CP rose $8.5bn last week (44-wk drop of $434bn) to $761bn. Over the past year, total CP has contracted $349bn, or 16.5%, with ABCP down $394bn, or 34%.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 6/11) increased $2.7bn to a record $2.304 TN. "Custody holdings" were up $248bn y-t-d, or 26% annualized, and $349bn year-over-year (17.8%). Federal Reserve Credit declined $4.2bn to $873.5bn. Fed Credit is little changed y-t-d, while having increased $23.5bn y-o-y (2.8%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.405 TN y-o-y, or 26%, to $6.822 TN.

Global Credit Market Dislocation Watch:

June 9 - Bloomberg (John Glover): "Governments and companies sold 26% fewer bonds in the first quarter as losses on debt securities forced financial institutions to restrict credit, the Bank for International Settlements said. Global issuance fell to a net $360 billion from $487 billion in the last three months of 2007... European borrowers led the decline, as sales shrunk almost 50% to $105 billion... 'The process of disorderly deleveraging which had started in 2007 intensified from end-February, with asset markets becoming increasingly illiquid and valuations plunging to levels implying severe stress,' BIS analysts Ingo Fender and Peter Hordahl wrote..."

June 12 - Financial Times (Daniel Pimlott): "When grandees from the world of commercial mortgage-backed securities gathered for their annual conference in June 2007, the mood of optimism was almost tangible. In the first five months of the year, a record $100bn of mortgages were repackaged and sold as bonds, as real estate makers rushed to take advantage of cheap credit. A year on and the market for CMBS looks worse than chastened. The amount issued in the first five months of this year fell 89% to $10.8bn, the lowest level since the late 1990s... Sales of office property in the US fell 81% in the first four months of the year..."

June 11 - Bloomberg (Bryan Keogh and Gabrielle Coppola): "Investors are demanding the highest yields in almost six years to own U.S. investment-grade corporate bonds... Average yields on the securities rose 14 bps yesterday to 6.32%..."

June 10 - Bloomberg (Cecile Gutscher): "Banks are concerned that companies may draw on $6 trillion of loan commitments they made before the credit crunch, adding to pressure on their balance sheets, Citigroup Inc. analysts said... 'We suspect many banks remain uneasy about their committed loan facilities,' Citigroup analysts led by Hans Lorenzen... wrote..."

June 12 - Financial Times (Nicole Bullock): "The financial health of the large number of US leveraged buy-outs is deteriorating more than other parts of the debt market as the economy slows and the credit markets remain shut to debt-laden companies, Fitch Ratings says... Weak performance is already hurting loan-financed LBOs done in the boom years of 2004 to 2007... Of the 209 LBOs and nearly $300bn in accompanying loans that Fitch studied, credit rating downgrades have surpassed upgrades by a ratio of three to one from the time of the LBO until the end of May."

June 9 - Financial Times (Gillian Tett): "A dramatic imbalance between the funding patterns of US and European banks might be fuelling tensions in money markets, new research conducted by central bank officials has found. European banks had secretly increased their dependence on dollar funding by about $500bn in the past four years to about $800bn by the middle of last year... Much of the funding was apparently borrowed from US banks. US banks, by contrast, have been raising most of their US dollar funding from money market funds... This dramatic difference in the funding patterns may help to explain why Libor - the benchmark rate for interbank money markets - has continued to stay so high in recent weeks in spite of the emergency measures introduced by the US Federal Reserve, central bank officials believe."

June 11 - Financial Times (Ben White, Francesco Guerrera and Peter Thal Larsen): "Shares in Lehman Brothers plunged yesterday as the bank disclosed a worse-than-expected $2.8bn second-quarter loss and said it would raise $6bn in common and preferred shares to bolster its financial position. The embarrassing second quarter loss, Lehman's first since going public in 1994, followed a decline in the value of its mortgage assets and losses on proprietary trading positions... The investment bank said it had reduced its net leverage ratio to 12.5 times shareholders' equity..."

June 11 - Financial Times (Aline van Duyn and Francesco Guerrera): "Citigroup, Merrill Lynch and UBS, the banks most exposed to Ambac and MBIA, could face further writedowns of up to $10bn after the bond insurers last week lost their fight to retain their triple A credit ratings. Wall Street executives said they had been wrong-footed by the timing of the downgrades by Moody's and Standard & Poor's, saying they had not expected the rating agencies to take action for several months..."

June 9 - Financial Times (Saskia Scholtes and Francesco Guerrera): "Home equity loans are emerging as the next front of the credit crunch as falling house prices and lax underwriting lead to growing losses for US regional banks that have huge portfolios of such loans on their balance sheets. The rising defaults on home equity loans... underscore how the financial crisis is shifting from big banks' writedowns on complex derivatives to consumer-related problems for smaller banks. Mounting losses on home equity loans are likely to deepen the financial woes of many US regional lenders... Losses on home equity loans have more than tripled in the past six months to 1.54% of outstanding loan volumes."

June 12 - Bloomberg (Joyce Moullakis and Josh Fineman): "Citigroup Inc. Chief Executive Officer Vikram Pandit plans to shut down Old Lane Partners, the hedge-fund group he co-founded and sold to the bank last year for more than $800 million. Citigroup will purchase most of Old Lane's assets, and clients can begin withdrawing their investments beginning July 31... The wind- down is at least the fourth failure for Citigroup's hedge-fund management unit this year."

Global Inflation Turmoil Watch:

June 11 - Bloomberg (Paul Tobin): "Spanish truckers blocked highways near Madrid and in other parts of the country in the third day of protests against the surge in fuel prices."

June 13 - Bloomberg (Ranjeetha Pakiam): "At least 2,000 Malaysian protesters marched through the center of the capital Kuala Lumpur to protest this month's 41% surge in fuel prices."

Currency Watch:

June 10 - Bloomberg (Kim Kyoungwha): "The U.S. should stabilize the dollar as its weakness is contributing to global inflation, Xinhua News Agency reported, citing China's ambassador to the World Trade Organization Sun Zhenyu. The dollar's depreciation has 'further added fuel' to rapid increases of crude oil and food prices and hurt the exports of developing countries, Sun said..."

The dollar index rallied 2.4% to an almost 4-month high 74.15. For the week on the upside, the Pakistani Rupee increased 1.7%, the Uruguayan peso 1.0%, and the Argentine peso 0.8%. On the downside, the Norwegian krone declined 3.0%, the South African rand 2.5%, the Swedish krona 1.9%, the Swiss franc 1.8%, the Japanese yen 1.7%, the Euro 1.7%, the Danish krone 1.7%, and the British pound 1.4%.

Commodities Watch:

June 11 - Bloomberg (Winnie Zhu): "China's crude oil imports jumped 25% last month from a year earlier as state refiners boosted fuel production to meet higher demand... Crude imports rose to 16.2 million metric tons in May..."

June 13 - Bloomberg (Jeff Wilson): "Corn rose to a record, extending its rally to an eighth straight session, as floods in the Midwest threatened production in the U.S., the world's largest grower and exporter. Soybeans rose to a three-month high... U.S. corn stockpiles before the 2009 harvest will fall 53% to a 13-year low, and soybean supply as a percentage of use will drop to a record this year... The December contract has gained 11% this week. The most-active contract has jumped almost 86% in the past year... Global inventories may shrink to a 24-year low, the U.S. Department of Agriculture has said."

June 12 - Bloomberg (Ron Day): "Cocoa rose to its highest price since March 1980 in New York on speculation that supplies may be trimmed by bugs and disease in West Africa, the world's main production area."

June 11 - Financial Times (Javier Blas): "Food aid volumes sank last year to their lowest level in almost 50 years as rising agricultural commodity prices - particularly for wheat, corn and rice - hit donors' budgets, a United Nations report will say today. The Food Aid Flows report estimates global deliveries dropped last year to 5.9m tonnes - the lowest level since records began in 1961 and 15% below the figure for 2006."

Gold sank 3.6% to $870, and Silver fell 5% to $16.56. July Crude declined $4.09 to $134.45. July Gasoline fell 2.4% (up 40% y-t-d), and July Natural Gas slipped 0.6% (up 69% y-t-d). July Copper declined 0.9%. July Wheat surged 8.8% and Corn 12.4%. The CRB index gained 1.0% to a new record high (up 24.3% y-t-d). The Goldman Sachs Commodities Index (GSCI) declined 0.3% (up 37.7% y-t-d and 70% y-o-y).

China Watch:

June 11 - Bloomberg (Li Yanping and Nipa Piboontanasawat): "China's export growth unexpectedly accelerated in May... Overseas sales rose 28.1% from a year earlier, after gaining a revised 21.9% in April..."

June 12 - Bloomberg (Nipa Piboontanasawat): "China's money-supply growth accelerated to the fastest pace in four months in May... M2... rose 18.1% from a year earlier to 43.6 trillion yuan ($6.3 trillion)..."

June 13 - Bloomberg (Paul Panckhurst): "China's retail sales rose 21.6% in May, close to the fastest pace in nine years..."

June 12 - Bloomberg (Kevin Hamlin and Nipa Piboontanasawat): "China's food inflation slowed last month... The increase of 19.9% from a year earlier compared with a 22.1% gain in April..."

June 10 - Bloomberg (Madelene Pearson): "China, the world's fastest growing major economy, may invest more than A$30 billion ($28.5 billion) in Australia in fiscal 2008, Treasurer Wayne Swan said..."

Japan Watch:

June 11 - Bloomberg (Mayumi Otsuma and Keiko Ujikane): "Japan's wholesale prices rose at the fastest pace in 27 years and the current-account surplus narrowed... Producer-price inflation accelerated to 4.7% in May from 3.9% in April..."

India Watch:

June 13 - Bloomberg (Anoop Agrawal): "India's foreign-exchange reserves increased $1.05 billion to $315.7 billion in the week ended June 6..."

June 13 - Bloomberg (Kartik Goyal): "India's inflation accelerated to a seven-year high on soaring commodities and energy prices, stoking speculation the central bank will increase interest rates next month. Wholesale prices jumped 8.75% in the week..."

June 11 - Bloomberg (Cherian Thomas and Shobhana Chandra): "India joined Brazil, China and Russia in raising borrowing costs to combat inflation... The Reserve Bank of India yesterday unexpectedly increased the repurchase rate to 8% from 7.75%..."

Asia Watch:

June 10 - Bloomberg (Nguyen Kieu Giang): "Vietnam increased the benchmark interest rate for a third time this year to rein in the fastest inflation since at least 1992... The State Bank of Vietnam raised the base rate to 14%..."

June 9 - Bloomberg (William Sim): "South Korea's household debt rose to a record last quarter as consumers borrowed more to buy homes and settle credit-card bills. Household credit, the sum of loans and credit card installments, surged 9.2%... Rising debt and accelerating inflation are driving up costs and sapping consumers' buying power and corporate profit margins."

June 13 - Bloomberg (William Sim): "South Korea's import prices rose the most in more than 10 years... Prices of imported goods surged 44.6% in May after a 31.3% gain in April..."

June 9 - Bloomberg (James Peng): "Taiwan's export growth accelerated in May as demand from China, India and Southeast Asia countered weakening sales to the U.S. Overseas shipments increased 20.5% from a year earlier..."

June 12 - Bloomberg (Simeon Bennett): "Inflation in Singapore will peak at more than 8% in May or June as higher oil prices increase the cost of food, the Business Times reported..., citing Credit Suisse economist Cem Karacadag."

June 10 - Bloomberg (Khalid Qayum): "Pakistan's budget deficit widened to a 10-year high... The budget shortfall increased to 'close to' 7%..."

June 11 - Bloomberg (Farhan Sharif): "Pakistan's consumer prices rose at the fastest pace in at least 30 years in May as food costs jumped and record government borrowing to fund a widening budget deficit flooded the economy with cash. Inflation in South Asia's second-largest economy accelerated to 19.27%..."

Latin America Watch:

June 9 - Financial Times (Jude Webber): "Inflation is a touchy subject for Argentines. Many can remember surreal shopping trips at the height of hyperinflation nearly 20 years ago, when prices were rising so fast that supermarkets had to announce the increases over loudspeakers. Those days are long gone. Alberto Fernández, cabinet chief, calls Argentina a 'recovered alcoholic' whose reckless old ways have changed for good. But a survey last month for Torcuato di Tella University's Centre for Financial Research found average inflation expectations for the coming year accelerating to 36.5%, more than four times the official 2007 rate of 8.5%. Some economists believe Argentina is heading for 2008 inflation of 25 to 30%."

June 13 - Financial Times (Jude Webber): "Argentina's debt levels are higher than when in 2001 it crashed into the biggest sovereign debt default in history, while a crisis of confidence in the government brings the spectre of a default closer, a report to be issued next week says. Despite a radical restructuring three years ago, public debt is $114.7bn (£59bn) or 56 per cent of gross domestic product, compared with $144.2bn, or 54 per cent of GDP, in 2001 when Argentina's economy was much larger, the paper says."

June 12 - Bloomberg (Sebastian Boyd): "Chile's central bank raised its benchmark interest rate half a percentage point to help contain the fastest inflation in more than 13 years... Chile's inflation rate has tripled during the past year and reached 8.9% last month... Food prices have risen 19.4%..."

Unbalanced Global Economy Watch:

June 11 - Bloomberg (Theophilos Argitis): "Canadian industrial companies used less of their production capacity last quarter than at any time in the past 15 years, as auto manufacturers and lumber mills slowed production. The proportion of plants in use fell to 79.8%..."

June 11 - Bloomberg (Jennifer Ryan): "U.K. economic growth weakened to a three-year low in the quarter through May... Gross domestic product rose 0.2%..."

June 9 - Bloomberg (Brian Swint): "U.K. producer prices increased at the quickest pace in two decades in May... Prices charged by factories rose 1.6% from April..."

June 12 - Bloomberg (Fergal O'Brien and Louisa Nesbitt): "Irish inflation accelerated in May as food prices soared and crude oil rose... The annual inflation rate... climbed to 3.7% from 3.3% in April..."

June 10 - Bloomberg (Tasneem Brogger): "Sweden's inflation rate rose to 2.9% in May, the highest in more than five years..."

June 10 - Bloomberg (Tasneem Brogger): "Danish inflation accelerated to the fastest pace for 18 years... The inflation rate rose to 3.4%..."

June 13 - Associated Press: "Finland's annual inflation rate climbed to 4.2% in May, the highest figure in almost eight years..."

June 12 - Financial Times (Jan Cienski, Thomas Escritt and Robert Anderson): "Hungary and Slovakia... announced unexpectedly high inflation figures, reinforcing concerns about rising costs driven by wage growth and high commodity prices. The inflation rate in Hungary accelerated to 7% in May from 6.6% a month earlier. The rate in Slovakia hit an annualised 4.6%... while the Czech Republic remained high at 6.8%... The Baltic state of Latvia saw its year-on-year rate hitting 17.9% in May. Neil Shearing, emerging Europe economist at... Capital Economics, said: 'Pretty much without exception, inflation is going to remain above target in every country in central Europe until 2010 at the earliest.'

June 12 - Bloomberg (Elizabeth Konstantinova): "Bulgarian inflation accelerated in May to the fastest pace in a decade... The inflation rate rose to 15%..."

June 9 - Bloomberg (Emma O'Brien): "Russia's economy is showing 'serious signs' of overheating as consumer demand outpaces economic growth, Finance Minister Alexei Kudrin said. Demand is increasing 15% a year while gross domestic product is expanding 8%, Kudrin said... Imports are rising 30% to 40% a year, a pace that 'is very dangerous,' Kudrin said..."

June 10 - Bloomberg (Abeer Allam): "Egyptian inflation accelerated to a record 19.7% in May... Urban inflation accelerated from 16.4% in April..."

June 10 - Dow Jones (James Glynn): "Australian housing finance continued to fall in April, reaching its lowest level since August 2005 as higher interest rates and soaring fuel prices flayed demand. Housing finance fell for the third straight month..."

June 11 - Bloomberg (Jacob Greber): "Australian consumer confidence slumped to the lowest level in almost 16 years in June after oil prices climbed to a record and the central bank signaled it may increase interest rates."

June 11 - Bloomberg (Tracy Withers): "Sales of New Zealand houses slumped to a 16-year low in May as record-high interest rates curtailed demand... The number of homes sold dropped 52.9%..."

Bursting Bubble Economy Watch:

June 13 - Bloomberg (Shobhana Chandra): "U.S. consumer prices rose more than forecast in May as record oil prices reduced American confidence to the lowest level since Jimmy Carter was in the White House."

June 10 - Wall Street Journal (Kelly Evans): "Rising fuel prices pushed the U.S. trade deficit wider in April... The deficit widened 7.8% in April to a seasonally adjusted $60.9bn from $56.5bn in March, the largest one-month gain in nearly three years... The value of crude-oil imports rose by $4.2bn to $29.3bn... Imports overall rose 4.5% in April to $216.4 billion, while exports rose 3.3% to $155.5 billion."

June 9 - Bloomberg (Rich Miller and Matthew Benjamin): "Sky-high gasoline prices aren't just raising the cost of Eugene Marino's 120-mile round-trip to his job in the Washington area. They're reducing his wealth, too. House prices in his rural subdivision beyond the Blue Ridge Mountains in Charles Town, West Virginia, have plunged as commuting expenses have soared..."

June 13 - Bloomberg (Josh Fineman): "Lehman Brothers'... employees lost at least $10 billion as shares of the fourth- largest U.S. securities firm plummeted 74% from the high last year."

Fiscal Watch:

June 11 - Bloomberg (Rebecca Christie): "The U.S. budget deficit for May widened to $165.9 billion, bigger than the shortfall for all of fiscal 2007, as the Treasury issued tax rebates and a slowing economy cut revenue... Government spending since the fiscal year started Oct. 1 was up 9.7% to $1.993 trillion through May, while revenue increased 0.3% to $1.674 trillion. That left the year-to-date deficit at a $319.4 billion, more than double the eighth- month cumulative $148.5 billion shortage reported a year earlier..."

Central Banker Watch:

June 12 - Financial Times (Michael Mackenzie): "When central bankers aggressively bang the drum on inflation, bond investors quickly head for the exits. So it is not surprising that waves of selling have engulfed global government debt markets. The catalyst has been a recognition among traders that central banks, notably the European Central Bank, the US Federal Reserve and the Bank of England may have to raise interest rates this year to arrest the threat of higher inflation. Jim Caron, head of US interest rate strategy at Morgan Stanley said: 'You are not supposed to fight either the Fed or the ECB and certainly not both of them at the same time.'"

June 10 - Reuters: "A steady rise in energy prices has fueled an inflationary psychology in the United States and could be a problem if it does not reverse, Federal Reserve Vice Chairman Donald Kohn said... 'Repeated increases in energy prices and their effect on overall inflation have contributed to a rise in the year-ahead inflation expectation of households,' Kohn said... 'Any tendency for these longer-term inflation expectations to drift higher or even fail to reverse over time would have troublesome implications for the outlook for inflation,' he said."

"If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time the parties will become wilder and wilder. That might not matter were the consequences limited to the partygoers. But they are not." Governer of the Bank of England, Mervyn King

June 12 - Financial Times (Delphine Strauss): "Public expectations of inflation have risen dramatically in the last few months... The Bank's own quarterly survey of inflation expectations found people on average thought prices had risen 4.9% in the last year, much higher than the latest reading of 3% on the consumer price index... The average expectation for inflation over the next year rose from 3.3% in February to 4.3% in May..."

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

June 9 - Bloomberg (Liz Capo McCormick): "Trading in derivatives, led by short- term interest-rate futures, climbed 30% to a record $692 trillion in the first quarter... the Bank for International Settlements said. The value of short-term interest-rate futures traded on exchanges rose to $548 trillion..."

June 12 - Bloomberg (Nasreen Seria and Mike Cohen): "South Africa's central bank raised its benchmark interest rate by half a percentage point, the sixth increase in a year, forecasting that rising food and energy costs will keep inflation outside of the target until 2010."

Mortgage Finance Bubble Watch:

June 13 - Dow Jones: "Property foreclosure filings for May rose 7% from April and 48% from a year earlier as credit woes and tumbling home values continue to hit homeowners, said... RealtyTrac. The firm said there were foreclosure filings on 261,255 properties last month... California... had the highest number of filings at 71,930 properties, followed by Florida, Arizona, Michigan and Ohio."

GSE Watch:

June 10 - Bloomberg (Dawn Kopecki): "Fannie Mae and Freddie Mac, the largest U.S. mortgage-finance companies, will have to change the way they account for foreclosed property costs under a new rule adopted by regulators today. Fannie Mae and Freddie Mac have been booking profits when they should be recording losses on some single-family and federally backed mortgages, the Office of Federal Housing Enterprise Oversight... said..."

June 12 - Bloomberg (Dawn Kopecki): "Fannie Mae and Freddie Mac will pay at least $9 billion in new fees over 10 years to U.S. mortgage- insurance and affordable-housing programs contained in a Senate anti-foreclosure bill... The legislation requires Fannie Mae and Freddie Mac, the largest U.S. mortgage-finance companies, to pay fees equal to 4.2 bps of their new business volume... The numbers are higher than the 'manageable' amount of $175 million a year Freddie Mac Chief Financial Officer Anthony Piszel told investors last month that the company expected to pay."

Muni Watch:

June 12 - Bloomberg (William Selway): "Almost $70 million of tax-exempt bonds were sold in June 2007 to build roads and sewers for thousands of new homes planned for Elk Grove, California, once the fastest growing city in the U.S. A year later, the lots are largely vacant and the bonds lost 41% of their value. The debt plummeted as construction all but ceased after the biggest developer on the Laguna Ridge project fell behind on the property taxes... The $2.66 trillion municipal bond market, a traditional haven in times of financial turmoil, is becoming perilous."

California Watch:

June 13 - Bloomberg (Bob Ivry): "Bank repossessions more than doubled in May and foreclosure filings rose 48 percent from a year earlier as previously foreclosed properties dragged down housing prices... Metropolitan areas in California and Florida accounted for nine out of the top 10 metro foreclosure rates... Seven California metro areas were in the top 10: Stockton, Merced, Modesto, Riverside-San Bernardino, Vallejo-Fairfield, Bakersfield and Sacramento. Stockton's rate, one in every 75 households, was more than six times the national average..."

Speculator Watch:

June 10 - Bloomberg (David Papadopoulos): "Nick Zito, Bob Baffert and D. Wayne Lukas, thoroughbred trainers who have won a combined 26 Triple Crown races, will help manage a venture capital fund that plans to raise $75 million to buy racehorses."

Crude Liquidity Watch:

June 11 - Bloomberg (Will McSheehy): "Gulf states including Saudi Arabia and the United Arab Emirates amassed a combined current account surplus of almost $1 trillion in six years of soaring oil prices, boosting their sovereign wealth funds, S&P said."

June 11 - Bloomberg (Arif Sharif): "Gulf Arab banks' assets are growing more than 20% a year, more than twice the rate of nominal GDP growth, Gulf News reported..."

June 12 - Financial Times (Simeon Kerr): "Productivity outside the oil and gas sectors has decreased across the Gulf states during the petrodollar windfalls this decade, threatening sustainable economic growth, research reveals. Soaring oil prices have sparked average growth of 5.1% since 2000, but the oil boom has only triggered employment growth at the expense of productivity... 'Currently, much of the oil and gas revenues are being spent on low-productivity construction and real estate which give only a superficial impression of affluence,' says the report by the Conference Board, a business research organisation, and the Gulf Investment Corporation."

June 11 - Bloomberg (Will McSheehy): "Saudi Arabia, the world's biggest oil exporter, needs to spend $180 billion by 2015 to build homes and will soon enact a new mortgage law to help finance them, National Commercial Bank said. Saudi Arabia must build 1.3 million new homes over the next seven years to address an 'acute housing shortage'... About 70% of the kingdom's 24 million inhabitants are below the age of 30, it said."

June 11 - Bloomberg (Abdulla Fardan): "Economic growth in the Persian Gulf state of Qatar was 12.5% in the first quarter... The Qatari government has frozen the prices of building materials, including sand, steel and cement, to protect contractors from rising inflation..."

Stage II Predicaments:

"Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so." Chairman Ben Bernanke, June 9, 2008

I'll make just some brief comments as to why I believe Dr. Bernanke's view is too optimistic. First, since March the Fed's Wall Street bailout and the concurrent collapse in market yields played a significant role in artificially bolstering the U.S. economy. The unwind of market hedges also worked to support marketplace liquidity and likely artificially boosted Credit Availability - especially for conventional mortgages and the investment grade corporate sector. I believe these forces have by now likely run their course.

The risk that our economy has entered a substantial downturn has actually increased markedly over the past several weeks. Importantly, energy costs have risen significantly to the point of being economically destabilizing. The combination of spiking energy and food costs has created the worst global inflationary backdrop since the seventies - a dangerous predicament only belatedly appreciated by global policymakers. Central banks across the globe have begun to react, and vulnerable global bond markets are under heavy selling pressure. There is today great uncertainty as to the consequences of a global spike in bond yields.

Importantly, the Fed's aggressive "reflation" is being stopped dead in its tracks by market forces. U.S. market yields are moving sharply higher, with benchmark MBS yields now all the way back to last summer's levels. This is forcing another round of speculative de-leveraging in the highly leveraged mortgage Credit market, which is tantamount to a further tightening of already tight mortgage finance conditions. This is another huge blow for the vulnerable Bubble Economy.

The University of Michigan Consumer Confidence index posted its high of 112 back in the first month of 2000. By the beginning of 2003, it had sunk all the way down to 78. Yet during this period of weakening consumer sentiment and general economic conditions, benchmark MBS yields dropped from over 8.0% in mid-2000 all the way down to 4.2% by June 2003. Repeatedly over the past ("dis-inflationary") 20 years, waning economic activity has been bolstered by sinking mortgage yields and resulting stimulus to housing and home-equity withdrawal. It was like clockwork, but now this important cycle has been broken. Since January, Consumer Confidence has plunged from 78.4 to 56.7, while MBS yields have jumped from 5% or so to above 6%.

I have argued that the Fed's latest reflation would prove problematic. On the one hand, reflationary forces would bypass burst Bubbles in Wall Street finance and U.S. real estate markets. On the other, an over abundance of cheap U.S. and global liquidity would further destabilize heightened inflationary pressures globally and stoke Acute Monetary Disorder. As has become clear of late, the upshot is intensifying inflationary pressures in the face of a weakening U.S. economy. Indeed, one can look to spiking energy, food and borrowing costs and make a strong case that Fed reflationary policies have become dangerous and counterproductive.

From examining Q1 "Flow of Funds," one could identify how double-digit growth in Bank Credit, agency MBS, and the Money Fund Complex was carrying the load for a busted Wall Street securitization Credit apparatus. Recent developments, however, have the sustainability of robust Bank Credit and MBS in serious doubt. And while 9.7% fiscal y-t-d federal spending growth (see "Fiscal Watch") has thus far played a meaningful role in supporting the economy, the bond market for the first time in years must come to grips with the confluence of surging yields and the prospect of massive federal deficits. Similar to the Fed's reflation policies, federal government stimulus is not without significant costs and risks. Acute global inflationary pressures ensure the old "free lunch" monetary and fiscal stimulus come these days with a hefty price tag.

It has not taken long for Stage II of this unfolding historic crisis to demonstrate some of the classic old financial and economic headaches. I've always believed the most problematic scenario for the highly leveraged U.S. Credit system and Bubble Economy would be an inflationary surge and resulting spike in market yields. Curiously, just as the possibility of such a dismal scenario gains momentum a bullish consensus develops that the worst of the crisis is behind us.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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