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November 21, 2009

Reflation Issues Heat Up
by Doug Noland

For the week, the S&P500 slipped 0.2% (up 20.8% y-t-d), while the Dow added 0.5% (up 17.6% y-t-d). The Morgan Stanley Cyclicals dipped 0.5% (up 64.2%), and Transports slipped 0.4% (up 11.5%). The Morgan Stanley Consumer index gained 0.4% (up 21.8%), while the Utilities declined 0.4% (down 1.8%). The Banks rose 1.2% (down 1.5%), while the Broker/Dealers declined 1.6% (up 49.5%). The S&P 400 Mid-Caps fell 1.5% (up 27.7%), and the small cap Russell 2000 declined 0.3% (up 17.1%). The Nasdaq100 gave back 1.4% (up 45.6%), and the Morgan Stanley High Tech index fell 1.7% (up 59.6%). The Semiconductors sank 3.0% (up 45.2%). The InteractiveWeek Internet index declined 1.3% (up 67.1%). The Biotechs fell 2.8% (up 33.9%). With bullion up another $31, the HUI gold index gained 2.6% (up 56.3%).

One-month Treasury bill rates ended the week at 3 bps, and three-month bills closed at 2 bps. Two-year government yields declined 7.5 bps to 0.675%. Five-year T-note yields dropped 8 bps to 2.14%. Ten-year yields were down 6 bps to 3.37%. Long bond yields fell 6 bps to 4.30%. Benchmark Fannie MBS yields dipped one basis point to 4.12%. The spread between 10-year Treasuries and benchmark MBS yields widened 5 to 75 bps. Agency 10-yr debt spreads widened one to 46 bps. The implied yield on December 2010 eurodollar futures sank 17 bps to 1.185%. The 10-year dollar swap spread narrowed 0.5 to 11 bps; and the 30-year swap spread increased 2 to negative 11.5 bps. Corporate bond spreads were somewhat wider. An index of investment grade bond spreads widened 3 bps to 151, and an index of junk spreads widened 4 bps to 573 bps.

The week saw an enormous quantity of debt issuance. Investment grade issuers included Morgan Stanley $2.0bn, Boeing $1.2bn, Progress Energy $950 million, Duke Energy $750 million, Delta Airlines $690 million, Republic Services $600 million, US Bancorp $500 million, Fortune Brands $400 million, Transatlantic Holdings $350 million, Private Export Funding $300 million, Healthsouth $290 million, Public Service E&G $250 million, Kellogg $500 million, Harley-Davidson $500 million, AMB Property $500 million, Amerisourcebergen $400 million, Thomas & Betts $250 million, Oaktree Capital $250 million, Idaho Power $130 million, and Rowan Companies $125 million.

Junk issuers included Clearwire $1.6bn, United Airlines $800 million, Cascades Inc $500 million, Landry's Restaurant $400 million, Johnsondiversey $650 million, Easton-Bell Sports $350 million, TRW Automotive $250 million, Graham Pack $250 million, Altra Holdings $210 million, Alliance Health $190 million, Montana RE $175 million, Stonemore $150 million, and Universal Corp $100 million.

Convert issues this week included TRW Automotive $260 million and Kilroy Realty $150 million.

International dollar-denominated debt issuers included Qatar $7.0bn, CDP Financial $5.0bn, Westpac Banking $4.0bn, Royal Bank of Scotland $7.0bn, Barclays Bank $2.0bn, Total Capital $1.3bn, Commercial Bank of Australia $1.25bn, European Investment Bank $1.0bn, Panama $1.0bn, BBVA $1.0bn, Gerdau Holdings $1.25bn, UPC Germany $845 million, Temasek Financial $500 million, Vodafone $500 million, Opti Canada $425 million, Bahamas $300 million, and Cayman Islands $300 million.

U.K. 10-year gilt yields sank 16 bps to 3.64%, and German bund yields fell 13 bps to 3.25%. The German DAX equities index slipped 0.4% (up 17.7% y-t-d). Japanese 10-year "JGB" yields declined 3 bps to 1.30%. The Nikkei 225 dropped 2.8% (up 7.2%). Emerging markets were mixed. Brazil's Bovespa equities index increased 1.5% (up 76.6%), and Mexico's Bolsa declined 1.1% (up 37.0%). Russia's RTS equities index gave up 2.6% (up 128.5%). India's Sensex equities index increased 1.0% (up 76.4%). China's Shanghai Exchange jumped 3.8%, boosting 2009 gains to 81.7%. Brazil's benchmark dollar bond yields dropped 13 bps to 4.94%, and Mexico's benchmark bond yields sank 39 bps to 4.81%.

Freddie Mac 30-year fixed mortgage rates dropped 8 bps to a 26-wk low 4.83% (down 121bps y-o-y). Fifteen-year fixed rates declined 4 bps to 4.32% (down 141bps y-o-y). One-year ARMs sank 11 bps to a 4-year low 4.35% (down 94bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 4 bps to 5.95% (down 160bps y-o-y).

Federal Reserve Credit jumped $75.7bn last week to $2.191 TN. Fed Credit has declined $55bn y-t-d, although it expanded $12.5bn over the past 52 weeks. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 11/18) increased $11.3bn to a record $2.928 TN. "Custody holdings" have expanded at an 18.5% rate y-t-d, and were up $427bn over the past year, or 17.1%.

M2 (narrow) "money" supply added $1.6bn to $8.389 TN (week of 11/9). Narrow "money" has expanded at a 2.8% rate y-t-d and 5.6% over the past year. For the week, Currency declined $1.7bn, while Demand & Checkable Deposits jumped $24.6bn. Savings Deposits fell $12.4bn, and Small Denominated Deposits declined $7.8bn. Retail Money Funds dipped $1.2bn.

Total Money Market Fund assets (from Invest Co Inst) increased $3.8bn to $3.339 TN. Money fund assets have declined $492bn y-t-d, or 14.5% annualized. Money funds dropped $343bn, or 9.3%, over the past year.

Total Commercial Paper outstanding jumped $28.5bn (14-wk gain of $193bn) to $1.267 TN. CP has declined $414bn y-t-d (27.8% annualized) and $347bn over the past year (21.5%). Asset-backed CP declined $14.0bn last week to $496bn, with a 52-wk drop of $245bn (33.0%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $776bn y-o-y to $7.514 TN. Reserves have increased $749bn year-to-date.

Global Credit Market Watch:

November 18 - New York Times (Zachery Kouwe): "Ten months ago, President Obama said a time would come for Wall Street to make profits and pay bonuses, but 'now's not that time.' But it appears that was exactly when Wall Street began to return to profitability. In a report... by Thomas P. DiNapoli, the comptroller of New York State, Wall Street profits in 2009 are on track to exceed the record set three years ago, at the height of the credit bubble. The report noted that the four largest investment firms in Manhattan...earned $22.5 billion in the first nine months... 'The national economy is slowly improving, but Wall Street has recovered much faster than anyone had envisioned,' Mr. DiNapoli said..."

November 17 - Bloomberg (Caroline Hyde): "Sales of high-yield bonds are surging in Europe as companies... tap investor demand for riskier assets that's driven borrowing costs to the lowest this year. Sales of junk-rated debt more than tripled to 3.4 billion euros ($5.1 billion) last week from the previous seven days... That's taken the year's tally to 21 billion euros, an almost four-fold jump from the same period in 2008. Sales by U.S. companies with sub-investment grade ratings doubled to $132 billion from the previous year."

November 17 - Bloomberg (Linda Shen): "U.S. banks may face defaults on 10% of their $1.1 trillion of commercial property loans, with regional lenders vulnerable to 'significant' cuts in their credit grades, Fitch Ratings said. Commercial mortgages represent as much as half of total loans at banks followed by Fitch... Among the 36 banks with less than $20 billion in assets evaluated by Fitch, commercial property exceeded 25% of total loans, compared with 10% or less at the nation's four biggest lenders."

November 19 - Bloomberg (Sarah McDonald and Yusuke Miyazawa): "Debt sold by Citigroup Inc., Goldman Sachs Group Inc. and JPMorgan Chase & Co. is among the $450 billion of securities that Moody's... said it may downgrade. Some 775 hybrid and subordinated notes issued by 170 'bank families' in 36 countries are on review after Moody's altered the assumptions it uses to rate the debt..."

Global Government Finance Bubble Watch:

November 17 - Bloomberg (Scott Lanman): "Federal Reserve Chairman Ben S. Bernanke's diagnosis of a weak U.S. economy and labor market signaled that the central bank's extended period of low borrowing costs may get even longer. Bernanke said 'significant economic challenges remain,' with lending constrained and the jobless rate above 10%. Speaking in New York... he said U.S. asset prices aren't out of line with underlying values, and central bank policy will ensure that the 'dollar is strong.'"

November 17 - Bloomberg: "Financial officials in Japan and China, Asia's two largest economies, warned the Federal Reserve's interest-rate policy risks spurring speculative capital that may inflate asset prices and derail the global economic recovery. Emerging economies 'might overheat and experience financial turmoil,' Bank of Japan Governor Masaaki Shirakawa said... Low rates and the dollar's depreciation present 'new, real and insurmountable risks to the recovery of the global economy,' Liu Mingkang, China's top banking regulator, said... The comments reflect concern that the Fed's pledge to keep rates near zero for an 'extended period' may lead to a repeat of the financial crisis. MSCI's emerging-markets stock index has risen 71% this year and Asian countries from Singapore to South Korea are trying to rein in surging real-estate prices. 'The continuous depreciation in the dollar, and the U.S. government's indication that, in order to resume growth and maintain public confidence, it basically won't raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation,' Liu, chairman of the China Banking Regulatory Commission, said..."

November 18 - Bloomberg (Sophie Leung and Chia-Peck Wong): "China is among the emerging markets facing risks of property and commodity market bubbles, central bank adviser Fan Gang said, joining officials from the region in expressing concern about surging asset prices. 'The real risk is really asset bubbles,' Fan, who heads the National Institute of Economic Research, said... A 'Chinese asset bubble would be something very dangerous, that would cause the overheating' elsewhere as well, he said. Low interest rates sustained by the Federal Reserve, a weakening dollar and capital inflows to emerging markets have added to the dangers, Fan said. He becomes the latest voice indicating that the seeds of the next financial crisis may be being laid in Asia in the wake of liquidity injections by the world's central banks. 'When there is too much money around looking for good opportunities and emerging markets are the only places where growth is happening, over liquidity will lead to asset bubbles in equities, real estate and commodities,' Fan said. 'That's something we really need to watch.'"

November 19 - Bloomberg (Hanny Wan and Bernard Lo): "Hong Kong Exchanges & Clearing Ltd.'s Chairman Ronald Arculli said asset bubbles may be looming in Asia amid burgeoning stock and property prices. Arculli's comments... were in response to U.S. Federal Reserve Chairman Ben S. Bernanke saying on Nov. 16 that it's 'not obvious' asset prices in the U.S. were out of line with underlying values. 'He doesn't see any asset bubble, sitting where he is, which is correct, but in Asia, we're seeing signs of potential asset bubbles,' Arculli said."

November 19 - Bloomberg (Laura Cochrane): "From Angola to Belarus, emerging- market governments are planning first-time debt offerings to take advantage of the biggest bond rally in at least 11 years... 'It's because of the wall of money that comes from extremely accommodative monetary policy globally," said Edwin Gutierrez, an emerging-market money manager...for Aberdeen... 'There is just absolutely loads of liquidity out there still trying to find a home for that money.'"

November 18 - Bloomberg (Laura Cochrane): "Qatar received $28 billion of orders for its sale of $7 billion of bonds yesterday, the largest offering from an emerging-market government on record, according to JPMorgan Chase & Co."

November 19 - Bloomberg (Svenja O'Donnell and Gonzalo Vina): "Britain's budget deficit in October was the worst for the month since records began in 1993 as the recession hammered tax revenue and welfare costs surged. The 11.4 billion-pound ($19 billion) shortfall compared with a deficit of 130 million pounds a year earlier..."

November 19 - Bloomberg (Alan Ohnsman): "Los Angeles Mayor Antonio Villaraigosa said his goal to speed up construction of 12 transit projects and ease congestion in the second-biggest U.S. city requires 'creative' funding help from Washington. Villaraigosa is pushing a plan to complete about $20 billion of subway and rail-line work by 2019, 20 years sooner than an initial estimate by Los Angeles County's Metropolitan Transportation Authority. The mayor said he'll seek a funding advance from the U.S. government against future local sales tax revenue, along with federal grant money."

Currency Watch:

November 20 - Bloomberg: "China is 'passive' on the value of the U.S. dollar, central bank Governor Zhou Xiaochuan said, signaling that policy makers aren't yet prepared to loosen controls on the yuan. 'It's like watching a tournament,' Zhou said... 'We just watch the game. Regardless who wins or loses, the issue of whether the winner or loser benefits the spectator doesn't arise.'"

November 20 - Bloomberg (Shamim Adam): "Asian policy makers are studying capital controls to limit "hot money" inflows that may stoke asset bubbles and force their currencies to appreciate. Officials from India, South Korea and Indonesia are among those expressing concern over overseas capital stoking stock and real estate prices. Indonesia's central bank is "seriously" studying a limit on inflows to short-term bills, Senior Deputy Governor Darmin Nasution said yesterday. Taiwan last week banned international investors from placing funds in time deposits."

November 20 - Bloomberg (Ian C. Sayson and Chan Tien Hin): "Emerging-market equity and commodity fund inflows surged last week as investors sought protection from a weaker dollar, EPFR Global said. Emerging nations lured 49% of the $5.98 billion invested in all stock funds in the week... Commodity sector funds took $1.34 billion, the most in 3 1/2 years..."

The dollar index rallied 0.4% to 75.60. For the week on the upside, the Japanese yen increased 0.8% and the South Korean won 0.1%. On the downside, the New Zealand dollar declined 2.5%, the South African rand 2.5%, the Australian dollar 1.9%, the Canadian dollar 1.7%, the Swedish krona 1.2%, the British pound 1.0%, the Norwegian krone 0.7%, the Brazilian real 0.5%, the Swiss franc 0.5%, and the Euro 0.3%

Commodities Watch:

November 20 - Bloomberg (Pham-Duy Nguyen): "Gold prices climbed for the sixth straight session on speculation that the dollar will decline, boosting demand for the metal as an alternative investment. The dollar touched a 15-month low against a basket of major currencies on Nov. 16... The metal has climbed 30% this year, heading for a ninth straight annual gain. 'People are still buying gold because they think the dollar hasn't been broken yet," said Marty McNeill, a trader at R.F. Lafferty Inc. in New York. "If the dollar rallies, it's an excuse to sell for profit. Any dip in prices is a buying opportunity.'"

November 19 - Bloomberg (Nicholas Larkin): "Gold demand climbed 10% in the third quarter from the previous three months after investors bought the metal as a currency hedge and jewelry purchases picked up, the World Gold Council said. Global consumption increased to 800.3 metric tons as Chinese demand surged to 120.2 tons... Total demand was 34% lower compared with a year earlier, when investors sought refuge from the economic crisis amid lower gold prices."

November 20 - Bloomberg (Stuart Wallace and Chanyaporn Chanjaroen): "Commodities will likely attract a record $60 billion this year as investors seek to diversify their assets, Barclays Capital said. Inflows so far this year are almost $55 billion, already more than the previous full-year record of $51 billion set in 2006..."

November 18 - Bloomberg (Yi Tian): "The spread of swine flu in the U.S. is helping to fuel the biggest orange-juice rally in three decades, and rising demand may send prices up an additional 25% by February, said Fain Shaffer at Infinity Trading Corp... Orange-juice futures are up 66% this year, the most since 1977."

The CRB index jumped 2.0% this week (up 19.6% y-t-d). The Goldman Sachs Commodities Index (GSCI) increased 1.4% (up 45.7%). Gold rose another 2.8% to close at a record $1,150 (up 30%). Silver surged 6.5% to $18.51 (up 64%). December Crude added 72 cents to $77.75 (up 74%). December Gasoline jumped 3.6% (up 87%), and December Natural Gas increased 0.9% (down 21%). December Copper jumped 6.0% to a 14-month high (up 126%). December Wheat rose 3.8% (down 8%), and December Corn added 0.1% (down 4% y-t-d).

China Bubble Watch:

November 20 - Bloomberg (Hanny Wan and Bernard Lo): "China is sending 'strong signals' that it's concerned the rally in asset prices may be forming a bubble, according to Morgan Stanley Asia Chairman Stephen Roach. Liu Mingkang, China's top banking regulator, said Nov. 15 the dollar's decline and the U.S.'s decision to keep interest rates low have caused 'huge' speculation in foreign exchange trading and hurt global asset prices."

November 20 - Bloomberg: "China's 11 largest publicly-traded banks may need to raise about 300 billion yuan ($44 billion) by selling shares and bonds to ensure they have adequate capital for credit growth, according to BNP Paribas... China's government has encouraged a $1.3 trillion credit boom this year to complement its monetary and fiscal stimulus plans..."

November 20 - Bloomberg (Katrina Nicholas): "Foster's Group Ltd., Australia's biggest brewer, never borrowed from China until this year, when Bank of China Ltd. helped arrange $500 million in loans to refinance debt. Chinese lenders are 'injecting large amounts of liquidity,' said Peter Kopanidis, group treasurer at... Foster's... Industrial & Commercial Bank of China Ltd. and Bank of China underwrote $25.6 billion of syndicated loans in Asia- Pacific outside Japan this year, or 14.5% of the total, up from 4.9% a year earlier..."

November 17 - Bloomberg (Rebecca Keenan): "China, the world's biggest consumer of metals, is experiencing 'powerful' growth in demand for all commodities and will lead the global economic recovery, BlackRock Investment Management Ltd.'s Evy Hambro said."

November 16 - Bloomberg (Zijing Wu): "Steel production growth in China will hold above an annual 10% for the next five years, Chinese research group Steelhome.cn said. 'Steel production in China will increase at the current pace in the next five years at least,' President Wu Wenzhang said... 'A robust economy will continue to spur domestic demand, like it did in the past 10 years.' Growth this year is an annual 14%, he said."

Japan Watch:

November 20 - Financial Times (Robin Harding): "The Bank of Japan moved towards a neutral stance on the risk of inflation on Friday even as the government formally declared that the world's second-largest economy has entered deflation for the first time since 2006. The government's declaration sets the scene for heightened tension with the bank, which has been resisting public calls by politicians for greater aggression in the fight against deflation."

India Watch:

November 18 - Bloomberg (Kartik Goyal and Tushar Dhara): "An increasing inflow of foreign funds into India isn't a 'matter of concern,' and the country's regulatory system will help curb any volatility, Finance Minister Pranab Mukherjee said. 'It is not a matter of concern. We have a system of monitoring it and if there are distortions then we have arrangements to counter it," Mukherjee told reporters... 'Therefore, it's not disturbing.'"

November 19 - Bloomberg (Cherian Thomas): "India's central bank must tighten its monetary policy 'fairly soon' to rein in inflation, the Organization for Economic Cooperation and Development said. 'Given the magnitude of easing and the speed at which inflation has bounced back, monetary policy will need to be tightened fairly soon,' the Paris-based OECD said... Expectations of higher interest rates have sent Indian bond prices down by 5.9% in 2009..."

Asia Bubble Watch:

November 19 - Bloomberg (Shamim Adam and Simeon Bennett): "Singapore said its economy will expand next year after exiting the deepest recession since independence in 1965, adding to evidence of a regional recovery... The economy will grow 3% to 5% in 2010 after shrinking as much as 2.5% this year... Gross domestic product climbed a revised annualized 14.2% last quarter from the previous three months..."

Latin America Bubble Watch:

November 17 - Bloomberg (Laura Price): "Brazil's real may depreciate in an 'orderly' fashion after a world-beating rally this year as a consumer-led recovery fuels imports, widening the current account deficit, former Finance Minister Pedro Malan said. The gap for the current account... will double to a record $34.3 billion next year, according to a Brazilian central bank survey..."

November 18 - Bloomberg (Yusuke Miyazawa and Takashi Ueno): "Mexico and Colombia plan to sell Samurai bonds, joining Poland and the Philippines in turning to Japanese investors for funding as governments grapple with budget deficits... 'The demand for Samurais is strong while the supply is running short,' said Tetsuo Ishihara, a senior credit analyst at at Mizuho Securities... 'These emerging economies with high profile are a good buy.'"

November 17 - Bloomberg (Adriana Lopez Caraveo and Thomas Black): "Mexico's Congress approved the 2010 budget today that includes 3.18 trillion pesos ($244 billion) of spending and the widest deficit in more than two decades... The shortfall including Pemex debt will be 2.75% of GDP, the widest since 1989, according to Gabriel Casillas, chief economist at JPMorgan..."

Unbalanced Global Economy Watch:

November 19 - Bloomberg (Mark Deen and Simon Kennedy): "The Organization for Economic Cooperation and Development doubled its growth forecast for the leading developed economies next year and predicted a further acceleration in 2011 as China powers a global recovery. The economy of the group's 30 member countries will expand 1.9% next year and 2.5% in 2011..."

November 16 - Bloomberg (Greg Quinn): "Canadian home resales rose to a record in October, as low mortgage rates fed a rebound in consumer confidence, a realtor group said. Sales rose 5.1%..."

November 16 - Bloomberg (Laurence Frost): "European car sales jumped 11% in October, the biggest gain in more than three years, led by a recovery in demand from U.K. and Spanish consumers. New car registrations rose to 1.26 million vehicles from 1.14 million a year earlier..."

U.S. Bubble Economy Watch:

November 17 - Bloomberg (Alan Bjerga): "About one in six Americans lived in households that struggled to afford food at some point last year as tight credit and the fastest rate of food inflation since 1980 combined to strain budgets, the government said. About 49.1 million people were "food insecure" in 2008, up 36% from a year earlier, the Department of Agriculture said... That's the most since the USDA conducted its first survey on food insecurity in 1995 and 29% higher than the previous record in 2004."

November 18 - Los Angeles Times (Michael R. Blood): "Hundreds of protesters chanted, marched and took over a building Thursday on the UCLA campus, where University of California regents were scheduled to vote on a 32% student fee increase."

Central Banker Watch:

November 19 - MarketNews International (Heather Scott): "If past recessions are a guide, it is possible the Federal Reserve will continue its low interest rate policy for another two years, St. Louis Federal Reserve Bank President James Bullard said... 'Policy rates are near zero in the U.S. and the rest of G-7 countries, something not seen in postwar economic history,' Bullard said. 'The FOMC did not begin policy rate increases until 2-1/2-3 years after the end of each of the past two recessions.' Assuming the current recession ended this past summer, this could mean the FOMC would not start increasing rates until early 2012, if it behaves in a similar way as in past recessions, Bullard said..."

Fiscal Watch:

November 19 - Bloomberg (Kathleen M. Howley): "Foreclosures on prime mortgages and home loans insured by the Federal Housing Administration rose to three-decade highs in the third quarter... One out of every six FHA mortgages was late by at least one payment and 3.32% were in foreclosure, the highest for both since at least 1979, the Mortgage Bankers Association said... The delinquency rate for prime fixed-rate mortgages, considered home loans with the least risk, rose to 5.8% and the foreclosure inventory rose to 1.95%, the highest since at least 1972."

November 18 - Bloomberg (John Gittelsohn): "The Federal Housing Administration, the agency that insures home purchases made with down payments as small as 3.5%, may create another lending crisis, Toll Brothers Inc. CEO Robert Toll said. 'Yesterday's subprime is today's FHA,' Toll said... 'It's a definite train wreck and the flag will go up in the next couple of months: Bail us out. Give us more money.'"

Muni Watch:

November 16 - Bloomberg (Michael Weiss): "New Jersey Governor-elect Chris Christie and his economic transition team said the budget gap for the year beginning July 1 may exceed the $8 billion state budget officials previously forecast."

California Watch:

November 20 - Los Angeles Times (Alana Semuels): "The California jobless rate hit 12.5%, a post-World War II high, up from a revised 12.3% in September..."

November 18 - Los Angeles Times (Shane Goldmacher): "Less than four months after California leaders stitched together a patchwork budget, a projected deficit of nearly $21 billion already looms over Sacramento, according to a report... by the chief budget analyst. The new figure... threatens to send Sacramento back into budgetary gridlock and force more across-the-board cuts in state programs."

November 19 - Bloomberg (Jeremy R. Cooke): "California, the most indebted U.S. state, is back in the bond market with its sixth billion-dollar sale this quarter after its latest wave of borrowing contributed to rising costs for lower-rated municipal issuers."

Speculation Watch:

November 18 - Bloomberg (Tomoko Yamazaki and Warren Giles): "Hedge-fund assets increased by $7.8 billion in October, a sixth straight monthly gain... Eurekahedge Pte said... The funds have total assets under management of $1.45 trillion."

November 20 - Bloomberg (Jason Kelly): "KKR & Co., the private-equity firm run by Henry Kravis and George Roberts, said it had a third- quarter profit of $656.6 million in its first report after becoming a publicly listed company as buyouts rebounded."

November 19 - Bloomberg (Josh Fineman and Thomas R. Keene): "Meredith Whitney... said Goldman Sachs Group Inc. has lost some of its top-performing employees in recent years as executives left to start their own hedge funds. 'Goldman's lost a tremendous amount of talent going to set up their own hedge funds,' Whitney said... 'It became a scary prospect of having the government determine what you make.'"

November 18 - Bloomberg (Cristina Alesci, Jonathan Keehner and Jason Kelly): "The biggest U.S. pension plan doled out 62% less cash to buyout companies in the first seven months of the year and pressed for fee cuts as firms... The California Public Employees' Retirement System wrote checks for $2.23 billion to the firms through July, compared with $5.93 billion during the same period last year..."

Reflation Issues Heat Up

The Bernanke Fed held tightly to its "extended period" language in their November 4th communication. Global markets took this as a signal that the Fed would not be shifting away from its ultra-loose stance until sometime later in 2010 - at the earliest. Then there were captivating comments this week from St. Louis Federal Reserve Bank President James Bullard: "Policy rates are near zero in the U.S. and the rest of G-7 countries, something not seen in postwar economic history. The FOMC did not begin policy rate increases until 2-1/2-3 years after the end of each of the past two recessions." Markets were quick to ponder the possibility that rates might be on hold all the way into 2012. The Fed should discourage such thinking.

In fairness to Mr. Bullard, he did note that the Fed will be mindful of criticism that it has in the past maintained low interest rates for too long. Interestingly, the world seems to have suddenly woken up to some of the risks posed by prolonged near zero short-term U.S. rates. Throughout Asia, attention has shifted from crisis management to the formidable challenge of dealing with unrelenting "hot money" inflows and associated Bubble risks. Increasingly, there are fears of an extended period of Monetary Disorder.

"Asian policy makers are studying capital controls to limit 'hot money' inflows that may stoke asset bubbles and force their currencies to appreciate,' according to a Bloomberg story (Shamim Adam) that ran this morning. The article noted that policymakers from South Korea, India, and Indonesia are expressing concerns regarding international flows fueling asset inflation. Central bankers in Indonesia are studying placing limits on foreign investment in short-term debt instruments. This follows last week's move by the Taiwanese to restrict international investments in bank term deposits. The Bloomberg article also included an apt comment from the Chief Executive of the Hong Kong Monetary Authority: "These economies could of course raise interest rates to contain inflation and increases in asset prices. But the fear is that once interest rates are raised the carry trade will become even more active, attracting even more fund inflows. Asian economies are therefore facing a dilemma."

Here at home, there is the consensus view that the weak dollar, "hot money" flows, and the reemergence of Asian and global asset Bubbles are predominantly the problem of Asia and the rest of the non-U.S. world. From Bill Gross's latest: "Raise interest rates with 15 million jobless and 25 million part-time working Americans? All because gold is above $1,100? You must be joking or smoking - something."

With a clear head I can argue seriously that U.S. rates were cut much too low and that leaving them at near zero for a prolonged period is another major policy blunder. It is a case of the costs of such a policy greatly outweighing potential benefits.

As my designated "analytical nemeses" for approaching a decade now, I take special interest in the commentaries coming out of Pimco. In my parlance, Messrs. Gross and McCulley are "inflationists." I would have expected inflationism dogma to have been discredited by now. Silly me, as the inflationists remain firmly in control of the Federal Reserve and Treasury - and continue to enjoy renown and riches as our era's "captains of industry." And they stick unbowed with their policy ideologies - government-directed monetary and fiscal stimulus - but in increasingly massive quantities and for longer durations.

The inflationists argued passionately for extraordinary "Keynesian" stimulus after the bursting of the technology Bubble. The "market" demanded and the Fed delivered. Of course, the Fed collapsed rates after the 2000 tech wreck. Rates remained at 1.0% until June 2004 and didn't make it above 3% until mid-2005. At the time, the inflationists argued that some real estate excesses were a small price to pay to protect the system from the scourge of deflation. Their analysis of risk was flawed.

Household mortgage debt expanded 10.6% in 2001, 13.4% in 2002, 14.3% in 2002, 13.6% in 2004 and 13.2% in 2005. Evidence of a Bubble was right there in Fed data. From my perspective, rates were inarguably set inappropriately low for much too long, and higher borrowing costs would have been constructive for a more sound and stable financial and economic system. Would we be better off today had the Fed raised rates earlier and more aggressively?

The inflationists are always keen to downplay (ignore) Bubble risks, while disparaging any analysis suggesting that government market intervention can go too far. I could only chuckle recently when CNBC's Rick Santelli and Steve Liesman were going another round at each other. After criticizing Federal Reserve, Mr. Liesman needled Mr. Santelli's for how he'd set policy if he were leading the Fed. Santelli responded, "I'd start by raising rates to 1.0%." Liesman immediately snapped back, "You're a liquidationist!"

In Mr. Gross's latest, he refers to "mini bubbles." The problem is that the concept of anything "mini" hasn't applied to Bubble analysis for years - and it doesn't apply to the current backdrop either. It is the nature of Credit Bubbles that they tend toward expansion. If accommodated, they will not remain "mini" for long. Considering the unprecedented scope of synchronized global monetary and fiscal stimulus, it should be no surprise that Bubble dynamics have emerged so quickly.

To be sure, the Fed has been accommodating Bubbles for many years now. And with each bursting Bubble came policy reflation and only larger Bubbles. The bursting of bigger Bubbles provoked only more aggressive reflations and Bubbles of historic dimensions. The inflationists fatefully disregarded Bubble dynamics earlier this decade when their aggressive post-tech Bubble policy course fomented a much more dangerous Wall Street/mortgage finance Bubble. They are content these days to make a similar mistake.

Importantly, the unfolding global government finance Bubble is the largest and most precarious Bubble yet. Such a statement may today seem ridiculous to U.S.-centric analysts - but its becoming less so to those following developments in and around China. The unfolding backdrop is particularly dangerous because the Fed is poised to aggressively accommodate global Bubble dynamics for an extended period. Ultra-aggressive U.S. policy stimulus ensures ongoing dollar debasement, which feeds already massive financial flows to "undollar" assets and markets. Only aggressive policy tightening would contain Bubble excesses in China, Asia and the emerging markets. There appears no stomach for such an approach anywhere - and this is no mini predicament.

From Mr. Gross's perspective, the Fed will not back away from its aggressive stimulus until "your cash has recapitalized and revitalized corporate America and homeowners..." And this seems an accurate enough assessment of the Fed's point of view. But Gross then follows with a key sentence: "To date that transition is incomplete, mainly because mortgage refinancing and the purchase of new homes is being thwarted by significant changes in down payment requirements." If I had to speculate, I'd say Mr. Gross struggled with that sentence - and may even wish he could have it back.

It is fundamental to Credit Bubble analysis to appreciate that the unfolding reflation is going to be altogether different than previous reflations. As I've repeatedly tried to explain, the epicenter of reflationary forces have shifted from the Core (U.S.) to the Periphery (China, Asia, and the "emerging" markets). The dollar and sophisticated Wall Street Credit instruments have been supplanted by non-dollar assets and markets as the inflationary asset class of choice. The underlying U.S. economic structure evolved during - and for - a Credit cycle era comprised of massive ongoing U.S. mortgage Credit expansion, resulting asset inflation, over-consumption and mal-investment. Accordingly, the U.S. economy is today especially poorly positioned for the new global reflationary backdrop.

"Down payment requirements" have essentially nothing to do with the lagging U.S. economy. A historic financial Bubble fueled a housing mania. The Bubble collapsed and the mania won't be reappearing anytime soon. As a reminder of the nature of manias, Nasdaq traded above 5,000 in March 2000 and sits at less than half that level almost a decade later. Japan's Nikkei traded to 38,957 on December 29, 1989 and closed today at 9,498. Reflations may create new manias, but they don't rejuvenate the disCredited ones.

Years of steady home price inflation had convinced us that the more we borrowed to buy the biggest house - the wealthier we'd become. And the more we all accumulated debt (and Wall Street piled on leverage) the more home prices and our net worth inflated - and the more mad money we found to spend so freely. Not atypically, this mania was built upon Ponzi Credit and speculative excesses. Today, no amount of cheap mortgage Credit - and Fannie, Freddie, FHA and Treasury largess - is going to bring the housing boom back. Market psychology changed radically and the mania was crushed. The powerful inflationary bias percolating for years throughout U.S. housing and households was squelched. Spending patterns were significantly altered.

It is my thesis that there is no alternative than a major transformation of the underlying structure of the U.S. economy. In simplest terms, we must produce much more, consume much less and do it with a lot less Credit creation. The objective of current policymaking, however, is to quickly rejuvenate housing and asset prices with the intention of sustaining the legacy economic structure. Zero interest-rate policy is key to this strategy. The objective is to push savers out to the risk asset markets, as well as to transfer returns on savings from the savers to be used instead to recapitalize the banking/financial system. If this reflation is unsuccessful, the household sector will find itself with only greater exposure to risky assets.

No only is the current course of policymaking unjust, I believe it is flawed. The nation's housing markets will remain rather impervious to low rates, while the household sector is punished with near zero returns on its savings. At the same time, monetary policy will continue to play a major role in dollar devaluation and higher consumer prices for energy and imports. Financial sector profits have already bounced back strongly, but there is little market incentive to direct new finance in a manner that would fund any semblance of economic transformation. The focus remains on financing the old structure. Indeed, I would argue that the current course of policymaking and market interventions only work to delay the unavoidable economic adjustment process.

I believe the unfolding risks to the U.S. and global economy are enormous. Most seem rather oblivious to the risks, believing both that our asset markets are not overvalued and that economic recovery is only a matter of time. But we are taking an economy that had become dependent on massive mortgage Credit and housing inflation and making it equally addicted to zero interest rates, massive federal deficits, and tenuous global reflationary dynamics. Or let's look at it from a different angle. From the perspective of stock market valuation - massive Credit growth, the resulting flow of finance, and the course of policymaking basically created no additional wealth over the past ten years. We now appear determined to repeat this dismal performance over the next decade. Repeating what I wrote above, I believe the costs associated with prolonged zero rates are much greater than the benefits.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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