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June 19, 2009

Q1 2009 Flow of Funds
by Doug Noland

For the week, the S&P500 dropped 2.6% (up 2.0% y-t-d), and the Dow fell 2.9% (down 2.7% y-t-d). The Banks lost 3.4% (down 15.8%), and the Broker/Dealers were hit for 5.0% (up 26.8%). Economically-sensitive stocks were under pressure. The Morgan Stanley Cyclicals sank 6.2% (up 16.4%), and the Transports fell 4.2% (down 9.0%). The Morgan Stanley Consumer index slipped only 1.4% (up 1.5%), and the Utilities dipped 1.4% (down 6.5%). The broader market pulled back. The S&P 400 Mid-Caps dropped 3.1% (up 7.4%), and the small cap Russell 2000 lost 2.7% (up 2.7%). The Nasdaq100 declined 1.3% (up 21.4%), and the Morgan Stanley High Tech index fell 2.4% (up 32.3%). The Semiconductors dropped 3.8% (up 24.7%), and the InteractiveWeek Internet index fell 3.5% (up 40.0%). The Biotechs were down only 0.6% (up 4.9%). With Bullion down about $4.0, the HUI gold index fell 2.8% (up 12.4%).

One-month Treasury bill rates ended the week at 11 bps, and three-month bills closed at 18 bps. Two-year government yields declined 7 bps to 1.19%. Five-year T-note yields were little changed at 2.78%. Ten-year yields declined 2 bps to 3.78%. The long-bond saw yields end the week down 14 bps to 4.50%. The implied yield on 3-month December '09 Eurodollars declined 4.5 bps to 1.055%. Benchmark Fannie MBS yields were down 12 bps to 4.79%. The spread between benchmark MBS and 10-year T-notes narrowed 10 bps to 101 bps. Agency 10-yr debt spreads widened 5 to 25 bps. The 2-year dollar swap spread increased 6.25 to 48 bps; the 10-year dollar swap spread declined 2.0 to 25.75 bps; and the 30-year swap spread increased 10 to negative 13.25 bps. Corporate bond spreads were wider. An index of investment grade bond spreads widened 20 to 192 bps, and an index of junk spreads widened 14 to 871 bps.

Investment grade issuers included Pacific Life Insurance $1.0bn, Comcast $1.5bn, General Dynamics $750 million, Lincoln National $500 million, Valspar $300 million, Magellan Midstream $300 million, and Mellon Foundation $230 million.

Junk bond funds saw inflows of $323 million (from AMG), 14 straight weeks of positive flows. The list of junk issuers included Capital One $1.5bn, Lorillard Tobacoo $750 million, RailAmerica $740 million, Quicksilver Resources $600 million, Wendy's/Arby's Group $565 million, Limited Brands $500 million, Cinemark $470 million, CB Richard Ellis $450 million, Terremark Worldwide $420 million, Continental Airlines $390 million, and Paetec $350 million.

I saw no convert issuance this week.

International dollar debt issuers included Commonwealth Bank of Australia $2.5bn, Dexia Credit $4.0bn, Telecom Italia $2.0bn, Swedbank $1.5bn, Deutsche Telekom $1.5bn, Lloyds Bank $635 million, and BNP Paribas $500 million.

U.K. 10-year gilt yields fell 16 bps to 3.81%, while German bund yields dropped 13 bps to 3.50%. The German DAX equities index dropped 4.5% (up 0.6%). Japanese 10-year "JGB" yields declined 7 bps to 1.44%. The Nikkei 225 lost 3.4% (up 10.5%). Emerging markets were mostly lower. Brazil's benchmark dollar bond yields surged 29 bps to 6.30%. Brazil's Bovespa equities index dropped 4.1% (up 36.8% y-t-d). The Mexican Bolsa sank 4.7% (up 8.5% y-t-d). Mexico's 10-year $ yields added about a basis point to 6.23%. Russia's RTS equities index sank 10.3% (up 60.1%). India's Sensex equities index dropped 4.7% (up 50.5%). China's Shanghai Exchange jumped 5.0% (up 58.2%).

Freddie Mac 30-year fixed mortgage rates sank 21 bps to 5.38% (down 104bps y-o-y), with a 4-week rise of bps. Fifteen-year fixed rates fell 17 bps to 4.89% (down 113bps y-o-y). One-year ARMs declined 9 bps to 4.95% (down 24bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 10 bps to 6.57% (down 83bps y-o-y).

Federal Reserve Credit jumped $29.4bn last week to $2.055TN. Fed Credit has declined $191bn y-t-d, although it expanded $1.178 TN over the past 52 weeks (134%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 6/17) increased $2.1bn to a record $2.752 TN. "Custody holdings" have been expanding at an 20.3% rate y-t-d, and were up $435bn over the past year, or 18.8%.

Bank Credit dropped $59bn to $9.722 TN (week of 6/10). Bank Credit was up $317bn year-over-year, or 3.4%. Bank Credit is now down $191bn y-t-d (4.4% annualized). For the week, Securities Credit sank $32.6bn. Loans & Leases dropped $26.4bn to $7.078 TN (52-wk gain of $180bn, or 2.6%). C&I loans declined $5.9bn, with a one-year decline of 0.9%. Real Estate loans fell $7.4bn (up 6.5% y-o-y). Consumer loans declined $4.3bn, and Securities loans fell $5.5bn. Other loans dipped $3.2bn.

Year-to-date total US ABS issuance of $61bn (tallied by JPMorgan's Christopher Flanagan) compares to the $105bn from the same period of 2008. U.S. CDO issuance of $23.6bn compares to last year's y-t-d $16.5bn.

M2 (narrow) "money" supply gained $4.4bn to $8.354 TN (week of 6/8). Narrow "money" has expanded at a 4.3% rate y-t-d and 9.3% over the past year. For the week, Currency added $1.5bn, and Demand & Checkable Deposits jumped $32.8bn. Savings Deposits fell $15.8bn, and Small Denominated Deposits declined $3.1bn. Retail Money Funds dropped $11.1bn.

Total Money Market Fund assets (from Invest Co Inst) dropped $72.9bn last week to $3.675 TN. Money fund assets have declined $156bn y-t-d, or 8.8% annualized. Money funds grew $199bn, or 5.7%, over the past year.

Total Commercial Paper outstanding dropped $27.8bn this past week to $1.202 TN. CP has declined $479bn y-t-d (62% annualized) and $549bn over the past year (31%). Asset-backed CP sank $22.2bn to $503bn, with a 52-wk drop of $278bn (33%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were down $33bn y-o-y to $6.793 TN. Reserves have increased $28bn year-to-date.

Global Credit Market Dislocation Watch:

June 17 - Bloomberg (Caroline Salas): "Almost two years into the worst financial calamity since the 1930s, companies are doing everything they can to reduce their indebtedness, selling record amounts of equity to pay back bonds and loans. 'Stock buybacks are a thing of the past: It's reducing debt and bond buybacks that are in vogue,' said Kathleen Gaffney, co-manager of the Loomis Sayles Bond Fund ...'Stocks aren't going to move and earnings aren't going to move without a healthier balance sheet,' said Gaffney... More than 165 companies raised a record $87 billion in U.S. secondary share sales this quarter, and 77% of them used the proceeds to slash leverage, according to...Bloomberg."

June 15 - Bloomberg (Frances Robinson): "Commercial banks in the 16-nation euro region may lose a further $283 billion by the end of next year as the financial crisis forces them to write off bad loans, the European Central Bank said. 'Hard-to-value assets have remained on bank balance sheets and the marked deterioration in the economic outlook has created concerns about the potential for sizeable loan losses,' the...ECB said..."

June 16 - Bloomberg (Caroline Hyde): "As many as 14% of investment grade European companies will be unable to meet their cash requirements in the next 12 months even as bond issuance is at record levels, according to Moody's...For high-risk, high-yield companies the situation is worse, with as many as 20% failing to have sufficient cash to meet outflows..."

June 18 - Bloomberg (Denis Maternovsky): "OAO Sberbank, VTB Group and Russia's other lenders are facing a surge in 'troubled assets' that may total $213 billion, S&P said. As much as 38% of all assets held by Russian banks...may become problematic by the end of 2011...'The extent of the damage and its impact on the Russian banking industry will depend, in our view, on government policies to support banks and shore up troubled industrial enterprises, including state-owned companies,' said Scott Bugie, an S&P analyst."

Government Finance Bubble Watch:

June 16 - UPI: "The Chinese government says fiscal revenues in May rose 4.8% to $96.05 billion from the same month last year...The finance ministry said the May numbers represent a reversal of the downward trend of the past few months, China Daily reported...Federal and local government revenues in the first five months of this year totaled 2.71 trillion yuan or about $396 billion, down 6.7% from last year..."

Currency Watch:

June 17 - Associated Press: "Russian President Dmitry Medvedev says the world needs new reserve currencies. Medvedev told a regional summit Tuesday that the creation of new reserve currencies in addition to the dollar is needed to stabilize global finances. Medvedev has made the proposal before. It reflects both the Kremlin's push for greater international clout and a concern shared by other countries that soaring U.S. budget deficits could spur inflation and weaken the dollar. Airing it at a summit meeting underlined the challenge to U.S. clout."

June 17 - Bloomberg (Lyubov Pronina): "China and Russia agreed to promote the use each other's currencies more in bilateral trade, relying less on the U.S. dollar, the presidents of the two countries said."

June 16 - Bloomberg (Lyubov Pronina and Alex Nicholson): "Brazil, Russia, India and China are considering buying each other's bonds and swapping currencies to lessen dependence on the U.S. dollar, Russian President Dmitry Medvedev's top economic adviser said. The leaders of the so-called BRIC countries will discuss measures to promote regional currencies when they meet later today, Arkady Dvorkovich told reporters in the Ural Mountains city of Yekaterinburg before the first BRIC summit. 'There will be talk about increasing the share of mutual trade in national currencies, possibly placing part of reserves in the financial instruments of partner countries,' Dvorkovich said."

June 16 - Bloomberg: "China's purchases of foreign assets including U.S. Treasuries depend on its own needs, Foreign Ministry spokesman Qin Gang told a regular news briefing...'We operate according to the principles of security, liquidity and good value and according to our need...As to how much to buy, when to buy, these all depend on the above," he said..."

June 16 - Wall Street Journal (Riva Froymovich and Deborah Lynn Blumberg): "Foreign and U.S. investors moved capital out of U.S. assets in April, with much of the outflows concentrated in short-term securities...The switch in capital flows reflect investors' greater appetite for risk. Foreign investors sold dollar-denominated assets they had bought to shelter their portfolios from turbulent markets. U.S. investors, meanwhile, bought more foreign securities. Net outflows in April, including short-term securities and changes in bank deposits, totaled $53.2 billion..."

The dollar index added 0.2% this week to 80.30 (down 1.2% y-t-d). For the week on the upside, the Japanese yen increased 2.3%, the British pound 0.4%, the Mexican peso 0.3%, and the New Zealand dollar 0.1%. On the downside, the Swedish krona declined 2.7%, the Brazilian real 2.4%, the Canadian dollar 1.4%., the South African rand 1.2%, the Norwegian krone 1.0%, the Australian dollar 0.8%, and the Euro 0.5%.

Commodities Watch:

Gold ended the week down 0.4% to $935 (up 6.0% y-t-d). Silver fell 4.5% to $14.20 (up 25.7% y-t-d). July Crude slipped $2.45 (5-wk gain of $12.59) to $69.59 (up 56% y-t-d). July Gasoline dropped 5.3% (up 82% y-t-d), while July Natural Gas rose 5.0% (down 28% y-t-d). September Copper fell 5.7% (up 59% y-t-d). July Wheat declined 5.0% (down 9% y-t-d), and July Corn sank 6.2% (down 1.9% y-t-d). The CRB index fell 3.6% (up 10.1% y-t-d). The Goldman Sachs Commodities Index (GSCI) declined 3.2% (up 31% y-t-d).

China Reflation Watch:

June 17 - Bloomberg: "China will stick to its proactive fiscal policy and appropriately loose monetary policy, China Central Television reported...citing Vice Premier Li Keqiang. The nation will focus on boosting domestic demand, particularly individual consumption, to fuel economic growth, the state-run CCTV cited Li..."

Asia Bubble Watch:

June 15 - Bloomberg (Arijit Ghosh): "Indonesia's economic growth may accelerate to 7% starting in 2011, providing a case for its inclusion in the so-called BRIC economies along with Brazil, Russia, India and China, Morgan Stanley said. Political stability and buoyant domestic demand will help boost expansion in the $433 billion economy, Morgan Stanley said...that compares Indonesia with India."

Latin America Watch:

June 15 - Bloomberg (Telma Marotto and Andre Soliani): "Banco do Brasil SA, the nation's largest federally controlled lender, increased lending available for small companies by 11.6 billion reais ($5.93 billion) to help to increase their working capital. The bank also cut interest rates on credit lines to small companies...The loans will benefit as many as 303,000 companies...Aldemir Bendine, who was made Banco do Brasil's president in April, has expanded credit to individuals by 13 billion reais, reduced rates on consumer loans and mortgages and extended the maturity of car loans in a bid to revive consumer spending...The boost to personal loans benefited 10 million clients, about a third of its total, the bank said...'Banco do Brasil is giving an important sign to the market that it's willing to lend more,' said Andre Caminada, a partner at Sao Paulo-based Victoire Brasil Investimentos. 'It's being aggressive in that commercial side and it's marketing itself well.'"

June 19 - Bloomberg (Drew Benson): "Chile's peso is poised to be the world's best performing currency this week after the government announced plans to extend its dollar sales in the foreign-exchange market to fund an additional $4 billion in stimulus...The peso jumped 4.9% this week..."

Unbalanced Global Economy Watch:

June 18 - Bloomberg (Louisa Nesbitt): "Irish retail sales fell 17% during April from the same month last year, the country's Central Statistics Office said...When car sales are excluded, sales fell 7.1%."

June 15 - Bloomberg (Simone Meier): "Europe's economy lost a record 1.22 million jobs in the first quarter...Employment payrolls in the 16-member euro region fell 0.8% from the fourth quarter...The first-quarter drop was the biggest decline since the data series started in 1995."

June 16 - Bloomberg (Simone Meier): "German investor confidence rose more than economists forecast to a three-year high in June after evidence emerged that the recession in Europe's largest economy is bottoming out."

Bursting Bubble Economy Watch:

June 19 - Bloomberg (Shobhana Chandra): "More than one-quarter of American states now have unemployment rates higher than 10%, and all but two saw a further job-market deterioration in May. Tennessee and Indiana joined the rank of states, now 13, that have jobless rates exceeding 10%, and eight states - including California, Florida and Georgia -- reached their highest level of joblessness in May since records began in 1976..."

June 17 - Bloomberg (Bob Willis): "The U.S. current-account deficit narrowed in the first quarter to $101.5 billion, the least since 2001, reflecting a smaller shortfall in trade of goods. The gap, the broadest measure of trade because it includes transfer payments and investment income, was more than forecast and followed a revised $154.9 billion deficit in the previous three months..."

Central Banker Watch:

June 17 - Bloomberg (Toby Alder): "Norway's central bank cut the benchmark interest rate by quarter of a percentage point to 1.25%..."

GSE Watch:

June 18 - Bloomberg (Dawn Kopecki): "Fannie Mae and Freddie Mac will remain in limbo as the U.S. Treasury secretary said the government doesn't have time now to deal with the future of the two mortgage-finance companies it seized in September. 'We did not believe that we could at this time -- in this time frame -- lay out a sensible set of reforms to guide, to determine what their future role should be,' Treasury Secretary Timothy Geithner told the Senate Banking Committee...'We're going to begin a process of looking at broader options for what their future should be...We just didn't think its an essential thing to do just now, but it is an essential thing to do,' Geithner said."

June 18 - Bloomberg (Dawn Kopecki): "Record-high demand for government-backed home loans is overtaxing the Federal Housing Administration and may weaken the integrity of Ginnie Mae mortgage bonds, a U.S. inspector general said. 'FHA will be challenged to handle its expanded workload or new programs that require the agency to take on riskier loans than it historically has had in its portfolio,' Kenneth Donohue, the inspector general for the Housing and Urban Development Department, told lawmakers...'The surge in FHA loans is likely to overtax the oversight resources of FHA, making careful and comprehensive lender monitoring difficult.' The freeze in the mortgage markets has driven FHA's market share to 63% this year, from 24% in the fiscal year ended Sept. 30...The volume of single-family mortgage loans insured by FHA...more than tripled to $180 billion in 2008...FHA has historically been most vulnerable to fraud and exploitation when loan volume is high, Donohue said. He said that Ginnie Mae, the government agency that insures mortgage bonds backed by FHA loans, is also at risk."

Real Estate Bust Watch:

June 18 - Wall Street Journal (Dawn Wotapka): "For home builders, foreclosures and distressed sales remain a problem even after the houses are sold, hanging over other sales like ghosts... For months, builders have complained that foreclosures and short sales -- in which a borrower unloads a house for less than what is owed -- pose stiff competition because such houses can sell for steep discounts. Builders even find themselves competing with nearly new houses that they built, which is pushing several of them, including KB Home, to alter their designs."

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

June 17 - Bloomberg (Jody Shenn): "Standard & Poor's boosted its projections for losses from prime-jumbo U.S. mortgages backing securities. Losses on prime-jumbo loans backing 2006 securities will reach an average of 5.08% of the original balances, while losses for similar 2007 bonds will total 6.97%... In February, S&P said the losses would total an average of 3.65% for 2006 bonds and 4.5% for 2007 securities."

Muni Watch:

June 17 - Wall Street Journal (Stu Woo): "Residents of some affluent cities in this broke state are banding together to make up for cuts in public education, opening rifts between rich and poor school districts. Key to the debate are parcel taxes, flat fees on property that are used by some cities to help fund public schools. A handful of communities...have passed new parcel taxes to compensate for proposed state cutbacks, and others are considering them."

California Watch:

June 19 - Bloomberg (Stacie Servetah and Michael B. Marois): "California's credit rating, already the lowest among U.S. states, may be cut several levels by Moody's...as government leaders seek ways to eliminate a $24 billion budget deficit. The move would affect $72 billion of debt...California's full faith and credit pledge is rated A2 by Moody's, five steps below top investment grade."

June 16 - Bloomberg (Michael B. Marois): "Democrats who control California's legislature said tax increases are needed to help close a $24 billion deficit, setting up a battle with Republicans that could leave the state unable to pay its bills next month."

June 17 - Dow Jones (Ditas Lopez): "Standard & Poor's...warned it may downgrade California's credit ratings, citing concern the U.S.'s most populous state may miss debt payments if it doesn't make a significant revision to its fiscal 2010 budget. In putting California's debt on credit watch with negative implications, S&P said its structural budget gap may lead to acute liquidity strain, payment delays, or issuance of instruments in lieu of cash payments, and warned it may lower California's ratings below the A category..."

New York Watch:

June 17 - Bloomberg (Henry Goldman): "New York Mayor Michael Bloomberg and the City Council agreed on a $59.4 billion budget balanced with federal stimulus funds, a 0.5 percentage-point sales tax increase, union concessions and a reduction in the workforce. The spending plan, ...covers the 2010 fiscal year that begins July 1. It shrinks the city's 300,000-worker payroll by about 4% and requires fewer than 2,000 layoffs, sparing uniformed services and teachers."

Speculator Watch:

June 17 - Bloomberg (Tomoko Yamazaki): "Hedge fund assets rose by $30.3 billion to $1.32 trillion in May, the first increase in 11 months, as the industry outperforms the global stock market rally, Eurekahedge Pte said. The industry had net inflows of $11.3 billion last month while performance-related gains amounted to $19 billion based on preliminary figures..."

Q1 2009 Flow of Funds:

Total Domestic Non-Financial Debt (NFD) expanded at a 4.1% seasonally-adjusted and annualized rate (SAAR) during the first quarter. This was down from Q4 2008's 6.2%, and was below Q1 2008's 5.4%. Total system Credit (non-financial and financial) increased $371.8bn, or 2.8% annualized, to a record $52.904 TN - and was up $2.238 TN over the past year, or 4.4%. Talk of "Credit collapse" has been overdone.

During the first quarter, total Household Sector debt contracted at a 1.1% rate, with household mortgage borrowings unchanged during the quarter. Flat household mortgage debt growth compares to Q4's negative 1.7%, Q3's negative 2.4%, and Q2's negative 0.3%. Home mortgage borrowings declined 1.6% over the past year. Total mortgage debt was down only $67.2bn y-o-y, or 0.5%. Total Business Borrowings declined at a 0.3% rate, although Corporate debt expanded at a 2.0% pace during the quarter. Total Business borrowings were up 3.2% over the past year.

Rapidly expanding government debt more than offset the small first quarter declines in Household and Business borrowings. State & Local debt expanded at a 4.9% rate - a notable bounce back from Q4's 0.4% contraction and the strongest growth since Q4 2007. Yet most of the Credit for Q1's respectable NFD growth goes to our federal government, where borrowings surged at a 22.6% annualized pace.

Treasury debt outstanding increased a nominal $466bn during the quarter to $6.804 TN. Over the past year, Treasury debt expanded an unprecedented $1.505 TN, or 28.4%. But Washington's giant Credit footprint is not confined to the Treasury issuance boom. GSE borrowings expanded SAAR $259bn during the quarter to a record $3.452 TN. In percentage terms, GSE debt expanded at a 7.6% rate during the quarter and was up 7.2% y-o-y. Agency MBS growth was even stronger, expanding SAAR $300bn during Q1 to surpass $5.0 TN ($5.052 TN) for the first time. Agency MBS expanded at a 6.5% rate during the quarter and was up 9.6% from a year earlier. During the past eight quarters, the GSEs have expanded 19.5% and agency MBS 27.5% - a massive and ongoing nationalization of mortgage Credit and interest-rate risk.

First quarter combined Treasury, GSE debt, and agency MBS growth surged to SAAR $2.0 TN. In nominal dollars, total combined Treasury, GSE and MBS expanded $612bn during the quarter, or 16.7% annualized, to $15.298 TN. These "federal" debt obligations ballooned an alarming $2.177 TN over the past year, or 16.6%. This was just below 100% of one-year total system Credit growth, highlighting the most conspicuous aspect of an expanding Government Finance Bubble.

Analyzing the financial sector these days is fraught with challenges. I feel for the staff at the Federal Reserve responsible for aggregating the data. And despite my years of dissecting the "flow of funds," this quarter's financial sector data has me stumped. Examining the "L" (level) pages, Total Financial Sector Credit market borrowings contracted a meager $72bn to $17.015 TN (up 3.7% y-o-y). Yet the "F" (flows) pages show a huge (SAAR $1.792 TN) decline for financial sector borrowings during the quarter. The "level" page has bank Financial Assets up almost $500bn during the quarter (almost $700bn increase in Misc. Assets), while the "flow" page has bank assets contracting. Hopefully we'll have more clarity with Q2 data and revisions.

Securities Broker/Dealer Assets contracted a nominal $305bn during the quarter to $1.913 TN, bringing the one-year drop to $1.332 TN (although some of this has moved to bank and Federal Reserve balance sheets). And Open Market Paper (CP) fell $175bn during the quarter to $1.424 TN, with a one-year decline of $361bn (20.2%). And Fed Funds & Repo contracted $201bn during Q1 to $1.055 TN, with a notable one-year drop of $1.086 TN (50.7%). Federal Reserve assets declined $149bn during the quarter to $2.122 TN, although assets were up $1.190 TN, or 128%, over the past year.

So with recent bank Credit stagnation and contractions experienced by the Wall Street firms, the commercial paper market, and the Fed - some analysts see support for the Credit collapse viewpoint. But this ignores the massive ongoing issuance of Treasuries, GSE debt and agency MBS - not to mention a more recent booms in corporate and muni debt issuance. Again, keep in mind that Non-financial debt did expand at a 4.1% rate during the quarter, a pace of Credit expansion that I expect is being exceeded during the current quarter.

National Income declined a modest $48bn (annualized) during the first quarter to a $12.255 TN pace. This was a slower contraction than Q4's $189bn (annualized), with National Income declining 1.6% y-o-y. Total Compensation was up 0.2% y-o-y to $8.024 TN. From my analytical perspective, the massive - almost $2.2 TN - "federal" Credit boom has for now stabilized system-wide Compensation and Income. Yet the sustainability and consequences of the Government Finance Bubble create - at best - great uncertainty. I'll stick with the analysis that two Trillion-plus of government Credit creation is necessary to hold Bubble Economy implosion at bay - and that this amount of Washington-based finance comes with its own set of serious issues (including exacerbating global financial and economic distortions).

It is a primary theme of current Credit Bubble analysis that the unfolding Government Finance Bubble-driven global reflation will be of an altogether different nature than previous Fed/Wall Street-induced reflations. For one, the major reflationary monetary mechanism has shifted from Wall Street finance (securities firms' balance sheets and securitizations, "repo" finance, hedge funds, etc. - to various avenues of government finance. As such, we are expecting a lasting shift in the flow of finance away from the asset markets, with important ramifications for household wealth and spending. The Flow of Funds provides confirmation of this analysis.

Household Balance Sheet data make for dreadful analysis. Despite incredible government stimulus, Household sector Assets declined a further $1.444 Trillion during the quarter. This brought the one-year drop to an unrivaled $10.075 Trillion (13.5%). At $64.517 TN, Household Assets have returned to year-end 2005 levels. Over the past year, Financial Assets declined $7.869 TN (16.3%) to $40.296 TN and Real Estate dropped $2.279 TN (10.3%) to $19.819 TN. Household Liabilities contracted at a 3.2% rate during the quarter to $14.141 TN, with a one-year drop of 2.1% ($301bn). As such, Household Net Worth contracted $1.330 TN, or at a 10.3% rate, during Q1 to $50.376 TN. Household Net Worth dropped $9.774 TN over the past four quarters, or 16.2%, deflating back to about the Q3 2005 level.

There are also indications of potential trouble from Rest of World (ROW) flow analysis. ROW holdings declined for Agency/GSE-backed securities, Open Market Paper, U.S. Time Deposits, Inter-bank Assets, Corporate Bonds, and Loans to Corporate Business. Meanwhile, Treasury holdings expanded SAAR $636bn during the quarter to $3.341 TN. Our foreign Creditors may be content to recycle dollar flows back into Treasuries, but they are thus far in no mood to return to financing our business or household sectors. This may prove a major factor contributing to an altered flow of finance throughout the U.S. economy. It can also be read as a warning that the crucial process of dollar recycling rests increasingly on market perceptions of the soundness of one single market - U.S. Treasuries.

Financial reform received keen focus this week. Everyone agrees the previous regulatory framework failed profoundly in restraining excesses throughout mortgage and Wall Street finance. So I would like to know which regulator in the new regime is going to protect the system from similar excesses throughout government finance. Same problem as before: No one will step up and reign in a Bubble. There's always an excuse - masterful justifications and rationalizations. And, of course, the intellectual frameworks operating in Washington and elsewhere would adamantly insist that now is the absolute worst time to reign in government borrowing.

So disciplining Washington will be left to the marketplace. On the one hand, the markets were content to accommodate Wall Street's self-destruction for far too long. On the other, the markets were burned and would seemly now be heedful of "Ponzi Finance" dynamics.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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