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June 04, 2005

This Time it is Different
by Doug Noland

HIGHLY UNEDITED!

Another volatile, interesting week... The Dow declined less than 1%, with the S&P500 about unchanged. The Transports and Morgan Stanley Cyclical index slipped slightly. The Utilities jumped 1.6%, while the Morgan Stanley Consumer index declined about 1%. The broader market rally continued. The small cap Russell 2000 and S&P400 Mid-cap indices gained 1%. Technology stocks were volatile, with the NASDAQ100 and Morgan Stanley High Tech indices about unchanged. The Semiconductors and NASDAQ Telecom indices were slightly positive, while the Street.com Internet Index was up less than 1%. The Biotechs were hit for 2.5%. The financials were mixed. The Broker/dealers were up almost 2%, while the Banks dipped 0.5%. With bullion up $1.85, the HUI gold index jumped 6%.

The Treasury yield collapse was interrupted by today's sharp reversal. For the week, two-year Treasury yields dropped 7 basis points to 3.57%. Five-year government yields declined 8 basis points, ending the week at 3.73%. The 10-year Treasury yield was down 9 basis points for the week to 3.98%, this after trading to as low as 3.825% on this mornings jobs data. Long-bond yields sank 14 basis points to 4.28%. The spread between 2 and 30-year government yields declined 6 to 71. Benchmark Fannie Mae MBS yields dropped 10 basis points. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note narrowed 2 basis points to 31, and the spread on Freddie's 5% 2014 note also narrowed 2 basis points to 31. The 10-year dollar swap spread declined 0.5 to 41.5. Corporate bond yields generally declined to one-year lows. The auto bond and CDS sectors improved, and junk bond spreads narrowed somewhat. The implied yield on 3-month December Eurodollars sank 12 basis points to 3.81%.

With corporate yields falling to a one-year low, there was a solid $16.2 billion of corporate issuance this week (from Bloomberg). Investment grade issuers included Wells Fargo $3.5 billion, Wal-Mart $2.0 billion (increased from $1.5bn), GE Capital $1.75 billion, Barclays Bank $1.0 billion, Simon Group $1.0 billion, DaimlerChrysler $1.0 billion, Sun Life $600 million, Affiliated Computer Services $500 million, Noranda $500 billion, Centex $450 million, Appalachian Power $400 million, Beazer Homes $300 million, Camden Property Trust $250 million, Cascadia $300 million, Florida Power & Light $300 million, Radian $250 million, Kimco Realty $200 million, Prime Property Funding $200 million, and Teco Energy $100 million.

In a noteworthy reversal after 15 weeks of outflows, junk bond funds saw inflows of $976.1 million (from AMG). Junk issuers included M/I Homes $200 million and Petroquest Energy $150 million.

Convert issuers included Cephalon $800 million and Symmetricom $100 million.

Foreign dollar debt issuers included Turkey $1.25 billion, Development Bank of Japan $700 million and El Salvador $375 million.

Japanese 10-year JGB yields declined 0.5 basis points to 1.235%. Emerging debt markets continue to perform well. Brazilian benchmark dollar bond yields dropped another 19 basis points to 7.52%. Mexican govt. yields ended the week down 15 basis points to 5.36%. Russian 10-year dollar Eurobond yields dipped one basis point to 5.98%.

Freddie Mac posted 30-year fixed mortgage rates dipped 3 basis points to 5.62%, (a 15-week low and down 62 basis points from one year ago). Fifteen-year fixed mortgage rates dipped one basis point to 5.21%. One-year adjustable rates rose 5 basis points to 4.26%. The Mortgage Bankers Association Purchase Applications Index declined 4.1%. Purchase applications were up 1% compared to one year ago, with dollar volume up almost 12%. Refi applications dipped 1.2%. The average new Purchase mortgage declined slightly to $238,900. The average ARM declined to $342,300. The percentage of ARMs declined to 33.3% of total applications.

Broad money supply (M3) jumped $21.4 billion to $9.60 Trillion (week of May 23). Year-to-date, M3 has expanded at a 3.1% rate, with M3-less Money Funds growing at 5.3% pace. For the week, Currency added $0.2 billion. Demand & Checkable Deposits rose $20.9 billion. Savings Deposits declined $12.4 billion. Small Denominated Deposits added $4.3 billion. Retail Money Fund deposits declined $1.0 billion, while Institutional Money Fund deposits gained $2.3 billion. Large Denominated Deposits fell $1.5 billion. For the week, Repurchase Agreements increased $4.1 billion (up $47.6bn in 6 wks), and Eurodollar deposits gained $4.4 billion.

In blow-off fashion, Bank Credit surged another $46.1 billion last week, increasing the year-to-date expansion to $388 billion, or 14.2% annualized. Securities Credit is up $143 billion, or 18.5% annualized, year-to-date. Loans & Leases have expanded at a 12.4% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 20.4%. For the week, Securities increased $10.1 billion. C&I loans jumped $9.5 billion. Real Estate loans increased $10.1 billion. Real Estate loans have expanded at a 12.8% rate during the first 21 weeks of 2005 to $2.67 Trillion. Real Estate loans are up $295 billion, or 12.4%, over the past 52 weeks. For the week, consumer loans added $0.5 billion, and Securities loans increased $2.6 billion. Other loans jumped $13.3 billion.

Total Commercial Paper declined $11.0 billion last week to $1.508 Trillion. Total CP has expanded at a 15.8% rate y-t-d (up 13.2% over the past 52 weeks). Financial CP fell $8.5 billion last week to $1.357 Trillion, with a y-t-d gain of $72.4 billion (13.3% ann.). Non-financial CP declined $2.4 billion to $151.5 billion (up 40.2% y-t-d and 26.4% over 52 wks).

ABS issuance slowed to $4 billion (from JPMorgan). Year-to-date issuance of $274 billion is 12% ahead of comparable 2004. At $174 billion, y-t-d home equity ABS issuance is 19% above the year ago level.

Fed Foreign Holdings of Treasury, Agency Debt surged $15.5 billion to $1.426 Trillion for the week ended June 1. "Custody" holdings are up $90.5 billion, or 16.0% annualized, year-to-date (up $206bn, or 16.8%, over 52 weeks). Federal Reserve Credit jumped $5.9 billion to $792.5 billion. Fed Credit has increased 0.6% annualized y-t-d (up $42.9bn, or 5.7%, over 52 weeks).

International reserve assets (excluding gold) - as accumulated by Bloomberg - were up $581.1 billion, or 17.8%, over the past 12 months to $3.839 Trillion. Through the end of the first quarter, Chinese reserves were up 50% to $659 billion. Eurozone M3 was up 6.7% year-over-year during April, accelerating from March's 6.5%. EU "Credit to companies, households expanded 7.7%. Canada's M3 was up 10.7% from April 2004.

Currency Watch:

French and Dutch rejection of the European Union constitution weighed on the euro. The dollar index gained 2% for the week. Yet the Canadian dollar, Mexican peso, Taiwan dollar and Japanese yen all posted small gains against the greenback. On the downside, the South African rand dropped 4%, the euro 2.8%, and Danish Krone 2.8%, and Swedish krona 2.3%.

Commodities Watch:

June 3 - Financial Times (Caroline Daniel): "Henry Kissinger, former US secretary of state, yesterday warned that the global battle for control of energy resources could become the modern equivalent of the 19th century 'great game' - the conflict between the UK and Tsarist Russia for supremacy in central Asia. 'The great game is developing again,' he told a meeting of the US-India Business Council. 'The amount of energy is finite, up to now in relation to demand, and competition for access to energy can become the life and death for many societies. It would be ironic if the direction of pipelines and locations become the modern equivalent of the colonial disputes of the 19th century.'"

May 31 - MktNews: "The idea of buying oil with foreign exchange reserves appears to be gaining momentum in China amidst growing calls within and without the government for its massive reserves to be put to better use. A decision use its reserves to buy oil could meet the government's concerns about energy security, help reduce exposure to the volatility of the global currency markets and even go some way to defusing criticism about the yuan's valuation, analysts said. China's reserves hit $659 bln at the end of March, with the creaking banking system and now oil reserves topping the list of suggested alternate uses for the cash."

June 3 - Bloomberg (Claudia Carpenter): "Copper prices in New York rose to a 16-year high after global inventories fell to the lowest since May 1988 as demand continues to outpace production by miners. Copper futures for July delivery surged 4.1 cents, or 2.7 percent, to $1.5575 a pound on the Comex...the highest close since Jan. 26, 1989. Prices have gained 25 percent in the past year as stockpiles tumbled 67 percent."

June 2 - Bloomberg (Matthew Craze): "Uranium prices will rise to a record in 2006 as governments, particularly in Asia, build nuclear plants to meet energy needs, according to JPMorgan Chase & Co.. The bank raised its 2006 uranium price forecast to $32.5 a pound, from a previous forecast of $29.6 a pound, (said) Anindya Mohinta, a London-based analyst... 'Political will appears to exist for a resurrection of the nuclear option,' Mohinta said. 'We project demand to increase from the East, particularly from China, Japan and India.' Wholesale uranium prices have more than doubled from $14 a pound in January 2004..."

July crude oil jumped $3.18 to $55.03. For the week, the CRB advanced 1.9%, increasing y-t-d gains to 8.0%. The Goldman Sachs Commodities index surged 5.2%, raising the 2005 gain to 20.3%.

China Watch:

June 3 - Bloomberg (Rob Delaney and Amit Prakash): "China doesn't want a large increase in its foreign currency reserves, Commerce Minister Bo Xilai said today at a meeting of Asia-Pacific ministers... 'China does not want to have a large incremental reserve of foreign exchange holdings because it causes problems for the Chinese government,' he said... 'We will handle this matter appropriately in a very responsible way.'"

June 2 - Bloomberg (Koh Chin Ling): "China plans by year-end to draw up a list of companies it aims to shut down by 2010 for causing pollution in a bid to curb a 30 percent annual increase in the number of public complaints about air quality."

June 2 - Bloomberg (Clare Cheung): "Hong Kong property sales, mainly of apartments, surged in May from a year earlier, the third increase in five months... Sales of properties, including factory and office units, more than doubled to HK$54.1 billion ($6.95 billion)... Sales rose 13 percent from April."

Asia Boom Watch:

June 1 - Bloomberg (Lily Nonomiya): "Japan's monthly salaries rose for the first time in more than four years in April as companies passed growing profits on to workers. The average base salary for workers rose 0.3 percent to 255,607 yen ($2,360), the first increase since November 2000... Wages that include bonuses, overtime pay and commuting costs, rose 0.6 percent to 281,935 yen. Rising wages are stoking a rebound in household spending, fueling sales at companies including Toyota Motor Corp.... Consumer spending accounted for more than half of the first quarter's 5.3 percent annual pace of growth, which was twice as fast as economists expected."

June 1 - UPI: "South Korea's exports recovered their double-digit growth in May after a slump in the previous month... Customs-cleared exports increased 11.8 percent in May from a year earlier to $23.3 billion, up from a 6.9 percent gain on last year the previous month, according to the Ministry of Commerce, Industry and Energy. Imports amounted to $21.2 billion last month, up 18.4 percent from a year earlier due to higher oil import prices..."

May 31 - Bloomberg (Seyoon Kim): "South Korea's municipal governments will raise water charges, postage, subway and taxi fares from as early as June 1... Taxi fares in Seoul will rise by 17.5 percent from tomorrow, while cabs in Busan will charge 15 percent more from July or August...Water charges will rise 35 percent from July in Seoul and 9.8 percent in Busan."

June 1 - Bloomberg (Laurent Malespine): "Thailand's unemployment rate in April fell from a year earlier as rising consumption boosted hiring in the retail and housing sectors, the government said today. The jobless rate was 2.2 percent, compared with 2.8 percent in April 2004, the National Statistics Office said... The number of jobless fell to 790,000 from 990,000."

June 1 - Bloomberg (Anuchit Nguyen): "Thailand's inflation rate accelerated in May to a six-year high as fuel prices increased, reinforcing expectations the central bank will raise interest rates for a fifth time in less than a year. Consumer prices rose 3.7 percent from a year earlier, the highest rate since December 1998..."

Unbalanced Global Economy Watch:

June 3 - Bloomberg (Matthew Brockett and Brian Swint): "The European Central Bank said rising asset prices may pose the biggest risk to financial stability in the 12 countries sharing the euro. 'The main source of vulnerability appears to be associated with concerns that an underestimation of risk may have pushed asset prices beyond their intrinsic value, especially in fixed income markets,' the ECB said in its semi-annual report on financial stability..."

May 31 - Bloomberg (Matthew Brockett): "Money supply growth in the 12 countries sharing the euro accelerated for the first time since January last month, adding to pressure on the European Central Bank to increase interest rates. M3, the ECB's measure of money supply, rose 6.7 percent in April from a year earlier after growing 6.5 percent in March... The bank says a rate above 4.5 percent risks fueling inflation."

June 1 - Bloomberg (Sam Fleming): "The number of home loans approved by U.K. mortgage lenders in April increased at the fastest pace in nine months, suggesting the housing market may be picking up following a slowdown that began at the end of 2004."

May 31 - Bloomberg (Francois de Beaupuy): "French housing starts rose 9.7 percent in the three months ended in April from a year earlier as homebuilders kept pace with demand underpinned by tax breaks and borrowing costs at the lowest in France since 1946. Building work began on 32,936 homes in April, taking housing starts in the quarter to 95,779, the Paris-based Housing Ministry said. Housing permits, a gauge of future construction, rose 14 percent in February-April period from a year earlier."

June 2 - Bloomberg (Trygve Meyer): "Norwegian unemployment declined more than expected in May, falling for a fourth consecutive month, as companies stepped up hiring, the country's labor board said. The unemployment rate fell to 3.3 percent, the lowest since November 2002..."

Latin America Watch:

June 2 - Bloomberg (Elzio Barreto and Telma Marotto): "Banco Pactual SA, the top manager of stock offerings in Brazil, expects a surge in initial share sales by yearend as interest rates fall, said Rodolfo Riechert, a partner at the investment bank. 'We continue to be very optimistic for the Brazilian stock market,' Riechert, whose bank managed five of Brazil's seven IPOs in 2004, said... 'A lot of companies have already filed with the securities regulators for IPOs and that gives us a positive outlook from here on.'"

June 2 - Bloomberg (Romina Nicaretta): "Brazilian new vehicle registrations rose in May from a year earlier to a four-year high...citing the Brazil's car dealers federation, Fenabrave. Registrations rose 16 percent to 143,000 units last month from May 2004..."

June 1 - Bloomberg (Charles Penty): "Brazil's imports rose to a record in May as a stronger currency encouraged companies to buy more goods from abroad. Imports jumped 19.5 percent from the previous month to $6.37 billion, causing the country's trade surplus to shrink for the first time since January..."

June 1 - Bloomberg (Eliana Raszewski): "Argentina's tax revenue rose 28.3 percent in May as a surge in consumption and income tax payments boosted collection, the government said."

June 1 - Bloomberg (Alex Kennedy): "Venezuela's inflation rate jumped to a 16-month high in May as a currency devaluation drove up the cost of imports and rising consumer demand gave retailers more room to raise prices. Consumer prices rose 2.5 percent in May, almost double the 1.3 percent increase in April, after the central bank devalued the currency 10.7 percent on March 3... The increase in the monthly inflation rate pushed up the annual inflation rate to 17.4 percent..."

Speculative Financial Bubble Watch:

June 1 - Bloomberg (Brian Swint): "European Central Bank board member Tommaso Padoa-Schioppa said the risks to financial stability from hedge funds has grown, the Financial Times Deutschland newspaper said, citing comments at the ECB's presentation of its financial stability report yesterday. Padoa-Schioppa said the problem with hedge funds, private funds that attract rich and institutional investors, is that they take similar positions, boosting the concentration of risk. That may threaten stability if a crisis leads funds to abandon these investment positions quickly, the paper reported him as saying."

Bubble Economy Watch:

May 31 - New York Times (Motoko Rich): "Earlier this month, Michael Neeley, a real estate broker in this leafy, upscale suburb, closed on the sale of a contemporary ranch house. A few days later, the sellers of that house bought another, larger ranch house. Then, in a chain reaction, the sellers of the larger house closed on a $900,000 four-bedroom new colonial house. Mr. Neeley had a stake in all three deals... In less than two weeks, he said he cleared nearly $98,000 in commissions, after splitting with other brokers and his firm. The real estate boom has been good to agents like Mr. Neeley.... As the housing market has fueled the economy over the last five years, top real estate agents have been among the biggest beneficiaries. Until recently, the neighbors who drove the best cars, wore the best clothes and gave the best dinner parties were doctors, lawyers, bankers and stockbrokers. But now, with house prices skyrocketing and homes in the hottest markets selling in a matter of days, some real estate brokers are enjoying incomes and lifestyles that approach those of their wealthiest clients. Their success is inspiring a new generation of prospective sales agents... In addition to the Bentley, Mr. Neeley's blossoming wealth has allowed him to buy four Mercedeses, two Jaguars and two Range Rovers. He spends lavishly on theater tickets, Tiffany jewelry, Louis Vuitton belts and shoes, and owns 28 pairs of Alain Mikli eyeglasses, which are color-coordinated with his wardrobe... Meanwhile, the volume of homes sold, coupled with increased sale prices, has helped lift total commission revenues over the last few years. Real estate agents in the United States collected $61.1 billion in commissions last year, up 43 percent from $42.6 billion in 2000, said Steve Murray, editor of Real Trends, a real estate industry newsletter. In the most frenzied markets, some are making sums that recall the bonanzas enjoyed by stockbrokers in the late 1990's. In Manhattan, the best real estate agents cleared over $2 million last year, said Pamela Liebman, the chief executive of the Corcoran Group."

June 2 - Bloomberg (John McAuley): "One of the Federal Reserve's most detested economic disturbances is labor cost inflation and recent data show it has suddenly popped onto the scene. On Thursday the Labor Department reported an upward revision to nonfarm productivity growth in the first quarter to a 2.9% annual rate... More remarkable, however, were the much larger revisions to the growth of hourly compensation and unit labor costs... Unit labor costs were revised to a 3.3% rate in the first quarter from 2.2%... Moreover, when the revised data are viewed over a longer time, the emergence of a worrisome - and sudden - inflationary trend emerges. Through all of 2001, unit labor costs only rose by 0.3%, in 2002 these costs fell by 0.6%, while during 2003 they edged 0.1% lower... In the third quarter of last year, however, it moved into positive territory with a 1.5% increase, a 3.0% rise in the fourth quarter and in the first quarter, the rate was 4.3% above the level in the first quarter of 2004."

April Total Construction Spending was up 8.2% from one year ago. Residential expenditures were up 13.2%, with a two-year gain of 30%. April Factory Orders were up 0.9% for the month, the strongest gain since November. Factory Orders were up 6.8% y-o-y.

June 2 - Bloomberg (Kerry Dooley Young): "About 1.3 million adults in the U.S. lose their employer-sponsored health insurance with each 10 percent average rise in premiums, according to a study from the University of California, Berkeley. Companies have been shifting a bigger portion of insurance costs to employees... The average employee contribution for a family insurance plan last year rose to $3,156, or 32 percent of the total cost, from $1,670, or 25 percent, in 2000."

Mortgage Finance Bubble Watch:

June 1 - MktNews: "The following is the statement released...by the Office of Federal Housing Enterprise Oversight... 'Average U.S. home prices increased 12.50% from the first quarter of 2004 through the first quarter of 2005. appreciation for the most recent quarter was 2.21%, or an annualized rate of 8.82%. The new data represent the largest four quarter increase since the third quarter of 2004, when appreciation surpassed any increase in over 25 years... 'The House Price Index shows the rise in house prices continues at an extremely strong pace and raises the potential for declines in some areas later on,' said OFHEO Chief Economist Patrick Lawler. 'House prices grew considerably faster over the past year than did prices of non-housing goods and services reflected in the Consumer Price Index. House prices rose 12.5%, while prices of other goods and services rose only 3.1%."

May 31 - Bloomberg (Alison Fitzgerald): "Low interest rates and rising incomes have made houses more affordable than they were 10 years ago, suggesting talk of a national real estate bubble may be exaggerated, a study by the Federal Reserve Bank of Chicago said. It took less than 16 percent of the median household's income to cover the monthly mortgage payment on a home with the median sale price last year, the study by senior economist Richard Rosen found. That compares with 20 percent in the mid-1980s and 18 percent in the early 1990s. 'The increase in housing has come at the same time as mortgage rates have declined and incomes have increased,' Rosen wrote in the Chicago Fed Letter published today. 'These two factors have kept housing affordability for the United States as a whole roughly constant as housing prices have increased.'"

June 1 - Bloomberg (Victor Epstein): "Contracts to buy previously owned U.S. homes rose in April by the most in 13 months as falling borrowing costs, rising job creation and speculative purchases drove demand. The index of signed purchase agreements, or pending home resales, rose 3.6 percent to 128.2, a record...The index averaged 120.6 last year...Resale contracts rose 9.2 percent in April from the same month a year ago. Pending resales gained in all four U.S. regions. Compared with a year earlier, the index increased 12.5 percent in the South, 10.1 percent in the Northeast, 8 percent in the West and 4.5 percent in the Midwest."

June 2 - Baltimore Sun: "Gains in home prices in the Baltimore area and Maryland continued to outpace those in the nation in the first quarter as low mortgage rates and limited supply further fueled demand in a hot real estate market. Prices in the Baltimore area and the state rose nearly 21 percent since last year's first quarter, the Office of Federal Housing Enterprise Oversight (OFHEO) reported yesterday."

June 1 - NBC (Kevin Tibbles): "For the Rhodes family, a bike ride near their home in Eagle County, Colo., is welcome quality time. But this isn't their real home; it's their second - purchased as a long-term investment. 'It's something that you can actually see, touch, feel, use,' says Jeff Rhodes, [instead of investing in the stock market; that is kind of abstract.' The Rhodeses aren't alone. Second homes accounted for a record 36 percent of all home purchases last year - 23 percent were investments. But how do you know it's a good deal? How do you value something? Many are joining investment clubs that focus on real estate. Rebecca Katzen belongs to one in Long Beach, Calif. 'My tax guy has been bugging me,' says Katzen. "You know, real estate is where it's at!'"

This Time it is Different:

The global marketplace for financial assets - especially bonds and interest-rates - has become circus-like, recalling the fateful exuberance so prominent during the climax of the technology Bubble. And while Richard Fisher may be no Henry Blodget, the new President of the Dallas Fed embodies the current audacious and imprudent environment. Whether it is playing a simple game of basketball, trading securities, or managing monetary policy, blissful complacency welcomes a lack of focus and attendant blunders that will seem almost incomprehensible a that point when the expected positive outcome is seen to have needlessly slipped away. Hopefully, the Fed is not as complacent today as they were in early 1999 - with 4.75% Fed funds and ultra-easy "money" providing ample fuel for the building tech blow-off.

The newest stripe of New Paradigmism envisions a Permanent Plateau of Low Interest Rates, Global Excess Savings, Abundant Marketplace Liquidity, Placid Inflation and General Financial Stability. The latest fads have bonds and houses as one-decision can't lose investments for the long-term. And while I don't hesitate to scoff at silly theories hailing from major market melt-ups, as an analyst I do recognize that This Time It Is Different.

Examining the Economic Sphere, changes to the nature of output over this long boom cycle have been momentous. Inarguably, the U.S. has evolved into primarily a services-based economy. From today's employment data, we see that there were a total of 133.4 million jobs reported by the Labor Department (up 1.5% y-o-y) last month. At 14.3 million, Manufacturing employment declined 0.3% over the past year to now comprise just over 10% of the total workforce. Meanwhile, Service-producing positions increased 1.6% to 111.2 million. Retail Trade employment was up 0.8% y-o-y to 15.2 million, Wholesale Trade up 1.2% to 5.7 million, and Transportation/Warehousing up 3% to 4.4 million. Financial Activities jobs were up 1.8% y-o-y to 8.2 million and Professional/Business were up 2.7% to 16.8 million. Health Care/Social Services employment increased 2.1% over the past year to 14.5 million. Leisure/Hospitality jobs were up 2% to 12.7 million. Government positions were up 0.8% to 21.7 million.

Especially after the major inflation in medical and drug costs, the healthcare sector has ballooned to comprise a major piece of the economic pie. Within the goods-producing arena, computers, high-tech equipment, software and telecom have grown tremendously as a share of output, while more traditional goods output arrives via low-cost foreign manufacturers. And with the proliferation of media and the Internet, the scope of the "digital" and "virtual" economy has expanded to beyond traditional economic comprehensibility. The Bubble Economy expansion of leisure, hospitality and "upscale" has similarly played a major role in the altered state of economic output. And let's not forget the massive distribution infrastructure that evolved to get imported goods from the docks to consumers' garages, cupboards, offices and entertainment centers. Throughout the expansive service sector, there are jobs and output that muddy the water of traditional economic analysis.

This Time Economic Output Is Different. And I do feel comfortable with the insight that the Nature of Inflationary Manifestations is today as Different as the change in the nature of output. If it were today possible to calculate a legitimate consumer price inflation rate, it would still represent only one facet of inflationary processes. And I have no confidence that it is possible to successfully analyze contemporary "output" and worker hours to accurately differentiate "productivity" and quality enhancements from "inflation." Are doctors, attorneys, real estate agents, investment bankers, and hedge fund managers more productive these days, or is it more a case of atypical inflation dynamics prominently at play? As I explained last week, I do not believe there is a "general price level" - hence the notion of "real GDP" is an anachronism from a bygone - tangible GDP - era. "Real GDP" should be downplayed, with the focus on sectoral and nominal outputs.

Recognizing the changing nature of output does not set the analytical world on fire. Things do, however, heat up when the debate moves on to ponder the ramifications as they relate to the Financial Sphere. This Time It Is Different - the nature of economic output (i.e. services, medical, admin, finance, digital, virtual and media) does profoundly impact the capacity of for the economy to "produce" inflated "output" (and income) without engendering traditional inflationary pressures (especially for CPI). Importantly, the New Paradigmers contend (mistakenly crediting the Fed for achieving "price stability") that new inflation backdrop/dynamics grant low Fed and market rates. As they see it, there is little risk associated with extended periods of generally loose monetary conditions. It is my contention that the changing nature of economic output - and the capacity for seemingly non-inflationary expansion - beckoned for judicious monetary caution and restraint.

The financial sector indulges in unrestrained expansion, with basically limitless capacity to create "money" and Credit to fund output and the asset markets. And while contemporary output expands quiescently with each year of rising GDP, the associated Credit creation invariably inflates the Financial Sphere and the available pool of finance. Unconstrained financial sector expansion creates the extraordinary capacity to satisfy heightened borrowing demands without the normal corresponding increase in the cost of finance (higher rates). And while Bank Credit growth has been robust, non-bank "money" and Credit creation has been historic. The ABS market has expanded 185% in seven years to $2.9 Trillion, while MBS almost doubled to $3.5 Trillion. Total GSE Assets have increased 160% over this period to $2.9 Trillion. Broker/Dealer Assets are up 135% to $1.8 Trillion. Outstanding primary dealer repurchase agreements now exceed $3.3 Trillion, while global derivative positions now surpass $220 Trillion. Investments in hedge funds now exceed $1 Trillion.

It is this unprecedented - and unappreciated - Financial Sphere Inflation that has created cheap liquidity to drive both robust "output" expansion and rampant asset price inflation, at home and increasingly abroad. Most prominently, Total US Mortgage Debt has doubled in seven years to $10.5 Trillion. And let there be no doubt, this $5 Trillion inflation in mortgage debt is the flipside (the liability side) of the much trumpeted but misnamed "excess global savings." That it is backed by inflated collateral and, in many cases, has been extended to marginal borrowers on aggressive terms is apparently today a non-issue. It will, however, be a critical factor come the inevitable (during our lifetime!) downside of the mortgage debt boom. Indeed, the New Paradigm notion of "excess savings" will die when the Mortgage Finance Bubble finally succumbs.

This Time Mortgage Finance Is Different. Unconstrained Credit growth has financed an historic borrowing binge at - in contemporary finance-fashion - ultra-low interest rates. This flood of liquidity and resulting inflation (including housing and MBS pricing) has distorted market pricing mechanisms, certainly including the perception of Credit risk and lending profits. The upshot has been a surge in the number and type of mortgage lending institutions, an explosion in mortgage brokers, and the proliferation of progressively aggressive lending products and practices (to today's subprime, no-down, negative amortization ARMs!). It is Different This Time, with households today shopping the Internet for the low-cost variable-rate home equity loans (instead of tech stocks) that will be packaged in an ABS pool, sold to a hedge fund financing the instrument in the low-cost repo market (playing the spread). And this Liquidity Juggernaut will support "output," asset prices, marketplace liquidity and, in the process, generally reduced marketplace volatilities and risk premiums. Voila, the illusion of Financial Nirvana. It is, however, worth recalling that the biggest mistake the technology new paradigmers made was not appreciating the paramount role played by the late-'90s Speculative Bubble in telecom/junk/leveraged lending for the financing of blow-off industry excesses.

This Time Money and Credit Are Different. Over several decades, the Credit system evolved from prudent bank loan officer and her benign bank loan, to aggressive loan originator and investment banker and their coveted marketable security. A large portion of this debt has been accumulated by financial speculators, earning windfall "profits" through heavy leveraging at low rates pegged by the newfound transparent Federal Reserve. You bet This Time it is Different! And this especially unmarket-like arrangement set the stage for an evolving speculative Bubble throughout finance, culminating with today's Credit Bubble Blow-off.

Blow-off U.S. Credit system excesses have ensured that Things are Much Different This Time as well for the Global Financial System. Global central bank reserve assets have inflated by about $1 Trillion over the past 18 months (35%) to surpass $3.8 Trillion. Asian (Japan, China, Hong Kong, Taiwan, Singapore and India) central bank foreign reserves have more than doubled in just three years to $2.3 Trillion. The resulting unprecedented expansion of global liquidity (not "excess savings") has fueled powerful inflationary booms in the U.S. and throughout Asia. But resulting Monetary Disorder has nurtured international currency instability, major oil and commodities inflation, and unprecedented global imbalances.

And while U.S. markets were this week enamored with notions of sinking interest rates and financial and economic nirvana, there were some unsettling developments. French and Dutch voters this week sent a message that they are increasingly impatient with the current economic and financial arrangement. The faltering dollar, rising energy prices and an over-liquefied Asia have taken a toll on Europe. And while a wounded euro will be interpreted by the goldilocks crowd as a positive development for the dollar, as well as the U.S. markets and economy generally, I would be cautious. Any loss of euro confidence is an unwelcome blow to a global currency "system" already tottering over its unsound dollar foundation. Moreover, perceptions of a weakened euro appear to be pressuring global interest rates lower, while taking pressure off the dollar. These are problematic developments in today's profligate environment, certain to only exacerbate U.S. Mortgage Finance and Credit Bubble excesses.

Things were Curiously Different Wednesday. Stocks were strong, bonds were strong, commodities were strong and crude oil jumped 5%. Thursday saw a big jump in gold. For the week, the biggest price gains were found in the commodities markets, even as the dollar index surged higher. Crude oil traded above $55, while copper jumped to a new 16-year high. And this year's impressive commodities price gains are in the face of a stronger dollar. Global slowdown, or is it more a case of rampant global liquidity excess pushing global bonds, equities and commodities all higher? Have we been witnessing a classic example of The News and Fanciful Notions of Financial Nirvana following the direction of Bubble markets?

If abundant liquidity has been more prominent in setting securities prices than sound analysis, I will suggest a few areas where conventional thinking could prove immoderately optimistic. First, the much anticipated U.S. economic slowdown could be postponed due to interest rate-induced extraordinary housing inflation, record construction, record home equity extraction, and continued strong gains in personal income and perceived wealth. Second, the notion that inflation has peaked is inconsistent with the interest rate and liquidity backdrop, not to mention the upward pressure on compensation. It is the nature of 3.5% inflation to beget 4% inflation, and one should not dismiss the secondary effects from an extended period of high oil and commodities prices. Third, pondering the global environment, perhaps the Chinese, Russian, Korean, and other central bankers will now quietly attempt to convert a portion of ever-inflating quantity of dollar balances into oil and other things with intrinsic value. Now that would be a particularly ominous development for the notion of Bretton Woods II - just when it was gaining prominent bull market enthusiasts.

And perhaps the Fed is ready to declare quick victory, pack their briefcases and cheekily celebrate after nine effortless little baby-step innings. Yet little do they appreciate that it is a best-of-seven games series, and their wily opponent has been happy to spot them game one. The current interest rate, liquidity, speculation, economic and global backdrops are conducive to only greater Monetary Disorder and unwieldy imbalances - both at home and abroad. Would $70 crude, spiking commodities prices and a long, hot summer housing mania catch the Fed's attention?

Well, I'm sticking with the view that the Fed will be forced to step up and play ball. And it is when times get tough - when unstable markets turn uncooperative - that everyone will be reminded as to why it is so important for a central bank not to fall so far behind the curve. This Time it is Different: In an extraordinarily uncertain and problematic environment, the Fed somehow telegraphed to an extremely leveraged and speculative marketplace that there was nothing to worry about.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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