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September 23, 2006

Q2 2006 Flow of Funds
by Doug Noland

For the week, the Dow slipped 0.5% and the S&P500 fell 0.4%. Economically sensitive issues generally underperformed. The Transports and Morgan Stanley Cyclical indices dropped 1.7%. The Utilities declined 0.7% and the Morgan Stanley Consumer index 0.4%. The broader market gave back some of its recent gains. The small cap Russell 2000 dropped 1.5%, and the S&P400 Mid-Cap index fell 1.2%. The NASDAQ100 slipped 0.6%, and the Morgan Stanley High Tech index declined 0.5%. The Semiconductors lost 3.1%, and The Street.com Internet Index declined 1.2%. The NASDAQ Telecommunications index gained 0.9%, increasing y-t-d gains to 11.2%. The Biotechs dropped 2.2%. The Broker/Dealers and Banks were slightly up on the week, increasing 2006 gains to 14.7% and 8.3%, respectively. Although bullion gained $11.20, the HUI gold index declined 1.3%.

For the week, two-year Treasury yields sank 19 bps to 4.67%. Five-year yields fell 20 bps to 4.55%, and bellwether 10-year yields dropped 19 bps to 4.60%. Long-bond yields sank 17 bps to 4.74%. The 2yr/10yr spread ended the week inverted 7 bps. The implied yield on 3-month December '06 Eurodollars declined 9.5 bps to 5.305%. Benchmark Fannie Mae MBS yields sank 21 bps to 5.79% (low since late February!), this week marginally outperforming Treasuries. The spread on Fannie's 4 5/8% 2014 note narrowed 2 to 32, and the spread on Freddie's 5% 2014 note narrowed one to 30. The 10-year dollar swap spread declined one to 53.5. Treasuries left corporate bonds in their wake, with junk spreads widening 13 bps this week.

September 22 - Bloomberg (Eddie Baeb): "The U.S. Southeast dominated the municipal bond market this week as Georgia, Louisiana and Florida led states and local governments selling $7.27 billion of tax-exempt debt as borrowing rates fell."

Investment grade issuers included Westfield Group $1.5 billion, ONEOK Partners $1.4 billion, Western Union $1.0 billion, JPMorgan Chase $1.0 billion, Sun Life $900 million, Meridian funding $750 million, American General Financial $475 million, Con Edison $400 million, Peco Energy $300 million, Avalonbay Communities $500 million, Genworth Global $200 million, and BNSF Railway $110 million.

Junk bond funds saw outflows of $20 million during the week (from AMG). Junk issuers included Berry Plastics $425 million, Fleetpride $150 million, and McleodUSA $120 million.

September 18 - Bloomberg (Caroline Salas): "Standard & Poor's cut its prediction for how high defaults on high-yield, high-risk bonds will rise during the next 18 months as the global non-payment rate for U.S. and foreign companies fell to a record low."

Convertible issuers included Priceline.com $300 million, First Industrial LP $175 million, Biomed Realty $175 million, and Incyte Genomics $130 million.

International dollar debt issuers included RAS Laffan LNG $1.55 billion, Barclays Bank $1.35 billion, and Braskm $275 million.

Japanese 10-year "JGB" yields declined 3.5 bps this week to 1.62%. The Nikkei 225 index fell 1.9% (down 3.0% y-t-d). German 10-year bund yields sank 8 bps to 3.69%. Emerging markets were mixed. Political uncertainty again weighed on Brazilian markets. Brazil's benchmark dollar bond yields rose 11 bps to 6.51%, while the Bovespa equity index dropped 3.8% (up 4.0% y-t-d). The Mexican Bolsa dipped 0.7% this week, lowering y-t-d gains to 20.2%. Mexico's 10-year $ yields fell 7 bps to 5.74%. Russian 10-year dollar Eurobond yields dipped 3 bps to 6.80%. The Russian RTS equities index lost 3%, reducing 2006 gains to 44% and 52-week gains to 56%. India's Sensex equities index added 1.9% (up 30% y-t-d).

Freddie Mac posted 30-year fixed mortgage rates declined 3 bps to 6.40%, the low going back to last week of March - but up 60 basis points from one year ago. Fifteen-year fixed mortgage rates fell 5 bps to 6.06%, yet were 69 bps higher than a year earlier. One-year adjustable rates dropped 6 bps to a 25-week low 5.54%, an increase of 106 bps y-o-y. The Mortgage Bankers Association Purchase Applications Index slipped 3% this week. Purchase Applications were down 20% from one year ago, with dollar volume down 22%. Refi applications jumped 9.5% to a 32-week high. The average new Purchase mortgage increased to $222,100, while the average ARM declined to $354,800.

Bank Credit dropped $44.9 billion last week to $8.014 TN. Year-to-date, Bank Credit has expanded $508 billion, or 9.5% annualized. Bank Credit inflated $631 billion, or 8.5%, over 52 weeks. For the week, Securities Credit sank $19 billion. Loans & Leases dropped $25.9 billion during the week and were up $345 billion y-t-d (8.9% annualized). Commercial & Industrial (C&I) Loans have expanded at a 15.2% rate y-t-d and 13.9% over the past year. For the week, C&I loans declined $4.3 billion, and Real Estate loans dropped $11.3 billion. Real Estate loans have expanded at a 9.7% rate y-t-d and were up 10.2% during the past 52 weeks. For the week, Consumer loans fell $5.4 billion, while Securities loans gained $3.6 billion. Other loans were down $8.4 billion. On the liability side, (previous M3 component) Large Time Deposits increased $6.7 billion.

M2 (narrow) "money" supply dropped $32 billion to $6.868 TN (week of September 11th). Year-to-date, narrow "money" has expanded $214 billion, or 4.5% annualized. Over 52 weeks, M2 has inflated $288 billion, or 4.5%. For the week, Currency dipped $1.2 billion, and Demand & Checkable Deposits sank $38 billion. Savings Deposits were unchanged, while Small Denominated Deposits gained $3.3 billion. Retail Money Fund assets rose $3.7 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, declined $4.8 billion last week to $2.226 Trillion. Money Fund Assets have increased $173 billion y-t-d, or 11.5% annualized, with a one-year gain of $270 billion (13.7%).

Total Commercial Paper jumped $18.3 billion last week (7-wk gain of $92.5bn!) to a record $1.882 Trillion. Total CP is up $241 billion y-t-d, or 20.1% annualized, while having expanded $276 billion over the past 52 weeks (17.2%).

Asset-backed Securities (ABS) issuance this week rose to $21 billion. Year-to-date total ABS issuance of $532 billion (tallied by JPMorgan) is running about 4% below 2005's record pace, with y-t-d Home Equity Loan ABS sales of $364 billion 1% above last year.

Fed Foreign Holdings of Treasury, Agency Debt declined $8.7 billion to $1.673 Trillion for the week ended September 20th. "Custody" holdings were up $154 billion y-t-d, or 13.9% annualized, and $217 billion (14.9%) over the past 52 weeks. Federal Reserve Credit gained $2.4 billion to $828.9 billion. Fed Credit is up $2.5 billion (0.4%) y-t-d. Fed Credit is up 3.6% ($28.5bn) over the past year.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $544 billion y-t-d (18.4% annualized) and $642 billion (16.3%) in the past year to a record $4.591 Trillion.

Currency Watch:

The dollar index fell almost 1% to 84.87. On the upside, the Swiss franc gained 1.6%, the Paraguay guarani 1.3%, the British pound 1.1%, the South Korean won 1.0%, and the Euro 1.0%. On the downside, the South African rand declined 3.6%, the Turkish lira 3.4%, the Brazilian real 2.6%, and the Hungarian forint 1.3%.

Commodities Watch:

Gold rose 1.9% to $589.70 and Silver 4% to $11.31. Copper jumped 4%, increasing y-t-d gains to 78%. November crude sank $3.73 to end the week at $60.29. October Unleaded Gasoline dropped 6.5%, and October Natural Gas fell 7.1% (down 58% y-t-d). For the week, the CRB index declined 1.8% (down 9.3% y-t-d), and The Goldman Sachs Commodities Index (GSCI) sank 3.1% (down 3.2% y-t-d).

Japan Watch:

September 21 - Bloomberg (Lily Nonomiya): "Japan's trade surplus surged in August as automobile shipments to the U.S. rose at the fastest pace in almost a decade... The trade surplus widened 96 percent to...$1.7 billion from a year earlier... Exports rose 17.7 percent..."

September 22 - Bloomberg (Lily Nonomiya): "Japan's manufacturers became more optimistic and increased spending plans this quarter, signaling they'll fuel growth in the world's second-largest economy... Business investment rose at the fastest pace in almost five years in the second quarter..."

September 22 - Financial Times (Mariko Sanchanta and Jim Pickard): "Richard Li, the Hong-Kong based internet and telecoms tycoon, yesterday made history and a hefty profit by selling Pacific Century Group's landmark building in central Tokyo for $1.7bn - the highest price ever paid for a single property in Japan. The exorbitant prices of rent property transactions in Tokyo have signalled an end to the persisent asset deflation that dragged the nation's econmy into recession in the early nineties. But the valuations have also raised concern that the market is overheating."

September 19 - Bloomberg (Finbarr Flynn and Eijiro Ueno): "Land prices in Japan's three biggest cities of Tokyo, Osaka and Nagoya rose for the first time in 16 years as competition intensifies among real estate investment funds for acquisitions. Property prices in the three cities rose an average 0.9 percent, with residential land prices in three central wards of Tokyo surging 18 percent, while commercial areas gained 14 percent in the year ended July 1. 'In Tokyo, big property companies are getting bullish,' said Takehiro Sato, a Tokyo-based economist at Morgan Stanley."

China Watch:

September 22 - MarketNewsInternational (Zhou Xin): "China's small and medium-sized exporters are busily responding to a strengthening currency - but not in the way that the government, or China's critics, would like. Even as senior government officials carp on about the need for corporates and financial institutions to improve their hedging capabilities to manage foreign exchange risk, managers at small- and medium-sized enterprises told Market News that it's far easier to boost prices and increase output..."

September 21 - Bloomberg (Yanping Li): "Overseas lenders have invested a combined $17.9 billion in 18 Chinese banks as at the end of June... The People's Bank of China...had given its approval to 71 overseas lenders to open 214 branches in the country as of June 30..."

September 20 - Bloomberg (John Liu): "China Mobile Ltd., the world's largest cell-phone operator by users, added 4.42 million subscribers in August, taking its total number of customers to 282.7 million."

September 21 - Bloomberg (Vicki Kwong): "China's Guangdong province, which has the largest economy in the country, will spend 290 billion yuan ($37 billion) expanding its roads and ports, as it seeks to win to further investment from overseas companies."

September 18 - Bloomberg (Irene Shen): "China's local governments made a 210 billion yuan ($26.4 billion) profit selling land to developers last year, underlining the central leadership's challenge to rein in illegal seizures and cool a real estate boom."

September 19 - Bloomberg (Luo Jun and Yanping Li): "Chinese bankers' confidence in the economy fell to the lowest level in more than two years, reflecting doubts that government efforts to cool expansion in lending and investment are working, the central bank said."

September 21 - Bloomberg (Hui-yong Yu): "Hong Kong overtook London for the highest rents for prime office space in the first half, while Moscow and Dubai surpassed Beijing and Shanghai in new construction, a survey by commercial real estate brokerage Colliers International said. Asking rents for the best quality office space reached $224.53 per square foot in Hong Kong as of June, compared with $206.57 a foot in London..."

Asia Boom Watch:

September 22 - Bloomberg (Cherian Thomas): "India's exports growth slowed last month as floods in various parts of the country hurt overseas sales... Exports in August increased 21 percent to $10.38 billion, slower than the 35 percent gain in July..."

September 20 - Bloomberg (Kartik Goyal): "India's advance tax collections in the April 1-Sept. 15 period rose 29.8 percent to 371.3 billion rupees ($8 billion) from the year earlier."

September 21 - Bloomberg (Theresa Tang): "Taiwan's export orders rose more than expected in August... Export orders...climbed 18.3 percent to $26.2 billion after increasing 19.4 percent in July..."

September 22 - Bloomberg (Theresa Tang): "Taiwanese unemployment fell to a more than five-year low in August as exporters...expanded factories. The seasonally adjusted jobless rate dropped to 3.85 percent..."

September 21 - Bloomberg (Kim Kyoungwha): "South Korean consumers became the most pessimistic in almost two years, signaling spending may slow further and crimp growth in Asia's third-largest economy."

September 18 - Bloomberg (Jason Folkmanis): "Vietnamese exports to the U.S. rose 33 percent in the first seven months of the year, paced by increased shipments of clothing and crude oil."

Unbalanced Global Economy Watch:

September 19 - Bloomberg (David Clarke): "Millionaires are multiplying in the world's fastest-growing economies, leading to a potential boon for banks that manage money for the wealthy, according to a report by the Boston Consulting Group. Assets held by the rich in Brazil, Russia, India and China are set to rise by $2 trillion, or 71 percent, to $4.8 trillion by 2010... Millionaires' wealth in the four countries is growing 11 percent a year on average, compared with 5.6 percent elsewhere."

September 21 - CNW: "The Monster Employment Index Canada soared by 12 points in August to a new high of 130 amid a strong rebound in online recruitment activity across Canada. Five out of 10 job classifications tracked by the Index advanced during August, led by occupations in healthcare; education and government; culture and sport; sales; and, business, finance and administration."

September 21 - Bloomberg (Greg Quinn): "Canadian retail sales rose 1.5 percent to a record high in July, led by a rebound in automobiles, as consumers took advantage of a federal sales-tax cut and dealer incentives."

September 22 - Bloomberg (Tasneem Brogger): "Icelandic wage growth accelerated to 10.6 percent in August, the fastest pace since March 1998, after a wage accord that took affect July lifted salaries and as unemployment dropped to the lowest in five years."

September 20 - Bloomberg (Craig Stirling): "U.K. mortgage lending rose by a record in August, a sign the $6.8 trillion property market absorbed an interest-rate increase, figures from the British Bankers' Association showed."

September 22 - Bloomberg (Gabriele Parussini and Sandrine Rastello): "Consumer spending in France, Europe's third-biggest economy, jumped the most in seven years in August as unemployment fell."

September 20 - Bloomberg (Sheyam Ghieth): "Italy's unemployment rate fell to the lowest in more than 14 years, a government report showed today... The unemployment rate fell to 7.0 percent..."

September 17 - Bloomberg (Patricia Hidalgo): "Spanish economic growth will reach 3.2 percent next year, exceeding the 3 percent prediction by the International Monetary Fund, Finance Minister Pedro Solbes said."

September 19 - Bloomberg (Tasneem Brogger): "Most Danish businesses are having trouble finding workers with the right qualifications, a situation that's preventing them from producing enough to meet demand... More than 80 percent of companies needing skilled and unskilled laborers weren't able to find qualified workers at some point over the past year, the...Confederation of Danish Industries said..."

September 19 - Bloomberg (Tasneem Brogger): "Denmark's economy is at increasing risk of overheating as rising wages threaten to outstrip productivity gains, the country's central bank said. 'The risk of overheating has been growing,' Nationalbanken said... 'There is a large probability that continued demand pressures will leave a permanent mark on prices and wages.'"

September 20 - Bloomberg (Alistair Holloway): "Finland's economy expanded an annual 6.2 percent in July, the 13th consecutive month of growth, led by metals companies and the electronics industry."

September 20 - Bloomberg (Aaron Eglitis): "The economies of Latvia, Lithuania, and Estonia, the only former Soviet states in the European Union, will grow an average 9.5 percent this year as private consumption booms, Citigroup Inc. predicted. Citigroup increased the estimate today from 8.8 percent..."

September 21 - Bloomberg (Tracy Withers): "New Zealand's annual current account deficit widened to a record in the second quarter amid higher interest payments to foreign lenders, offsetting an increase in exports and tourist spending."

Latin American Boom Watch:

September 21 - Bloomberg (Eliana Raszewski): "Argentina's economy grew in July at the fastest pace in eight months... Gross domestic product grew 9.1 percent from a year earlier..."

September 21 - Bloomberg (Andrea Jaramillo): "Colombia's industrial output surged to a 15-month high in July, led by production of non-metal minerals and sugar mills. Industrial production, excluding coffee processing, rose 13.6 percent in July from a year earlier..."

Central Banker Watch:

September 18 - Bloomberg (Rainer Buergin and Nikola Kemper): "European Central Bank officials said inflation pressures may persist beyond 2007, indicating they'll keep raising interest rates into next year. 'We still see quite strong inflation dynamics throughout 2007, into 2008,' ECB council member Axel Weber said... Klaus Liebscher, another board member, said in a separate interview...'now's not the time to relax.'"

Bubble Economy Watch:

jpSeptember 22 - Bloomberg (Margot Habiby): "The 400 richest people in the U.S. are all billionaires for the first time ever this year, according to Forbes Magazine's annual list."

September 20 - Bloomberg (Elin McCoy): "The New York wine auction season started with four sales last week and is set to become a record breaker. 'This is the greatest season ever for offerings,' says Richard Brierley, 33, head of North American sales at Christie's..."

Real Estate Bubble Watch:

September 19 - Bloomberg (Brian Louis): "Home prices in Southern California, where some of the nation's most-expensive neighborhoods are located, rose 2.7 percent in August, the smallest gain since 1999. The median price for a home in Los Angeles, Orange, San Diego, Riverside, San Bernardino and Ventura counties was $489,000, compared with $476,000 a year earlier...DataQuick...said..."

September 18 - Bloomberg (Shobhana Chandra): "Confidence among U.S. homebuilders dropped to a 15-year low this month as sales slowed and profits dropped, according to a private survey..."

September 20 - Bloomberg (David M. Levitt): "Billings by U.S. architecture firms last month rose to the highest level in 13 months, suggesting a stronger outlook for the nation's commercial construction market. The Architecture Billings Index rose to 59.5 last month, from 51.8 in July and 49.2 in June, the...American Institute of Architects said..."

Financial Sphere Bubble Watch:

September 18 - The Wall Street Journal (James R. Hagerty): "The U.S. Treasury has backed away from its position that Fannie Mae and Freddie Mac should be required by law to slash their holdings of home mortgages, a Treasury official said. The softer Treasury stance suggests that the Bush administration is giving up its effort to change the fundamental nature of the two government-sponsored providers of funding for home loans and would settle for merely regulating them much more closely."

Energy Boom and Crude Liquidity Watch:

September 21 - Financial Times (Carola Hoyos): "The costs of finding additional reserves of oil and gas have soared, an industry study shows, adding to the malaise of international oil companies. 'Reserves replacement costs surged 73 per cent as increased capital spending did not translate into incremental reserve additions,' a study of 200 oil and gas companies found."

Climate Watch:

September 19 - Bloomberg (Gemma Daley and Madelene Pearson): "Australia, the world's second-largest wheat exporter, cut its harvest forecast by 28 percent because of dry weather, helping to boost prices that are averaging the highest in 10 years."

Speculator Watch:

September 19 - Bloomberg (Hamish Risk): "The global credit-derivatives market has more than doubled in the past year to $26 trillion, the International Swaps and Derivatives Association said... Trading in credit derivatives grew nearly three times faster than contracts on interest rates, the largest part of the derivatives market. Interest-rate swaps, agreements to switch between fixed and floating rate payments, rose almost 25 percent to $250.8 trillion in the year to June 2006, ISDA said. The rapid pace of innovation 'continues to fuel the growth,' said Robert Pickel, ISDA's chief executive... 'This is enabling more and more firms to benefit from these risk management tools.'"

September 21 - Financial Times (Paul J. Davies): "The global credit derivaties market is expected to grow to more than $33,000bn by the end of 2008, according to a survey from the British Banker's Association..."

September 21 - Bloomberg (Katherine Burton and Justin Baer): "Amaranth Advisors LLC, the hedge-fund company that imploded after wrong-way bets on natural gas, said losses swelled by $1.4 billion this week because the firm had to unload assets at a discount to avoid a shutdown. Amaranth funds plunged 65 percent, or more than $6 billion, this month as of Sept. 19..."

Fiscal Watch:

September 18 - Bloomberg (Alison Fitzgerald): "The U.S. Treasury received a one-day record of $85.8 billion in tax receipts on Sept. 15, including a one-day record $71.8 billion in corporate tax receipts, according to government statistics..."

Q2 2006 "Flow of Funds":

One might find occasion to be encouraged by this week's Flow of Funds data. Total Non-Financial Debt growth did slow from the first quarter's torrid 9.5% rate down to 6.4% seasonally-adjusted and annualized (SAA) - consistent with the slowdown in the real economy (nominal GDP slowing from Q1's 9.0% to Q2's 6.3%). It is worth noting however, that federal government borrowings declined 2.4% SAA during the quarter, a sharp reversal of Q1's 11.3% increase. At 9.1%, Total Household Borrowings remain robust, although down somewhat from the first quarter's 9.6%. Corporate debt growth slowed to 6.7% from the previous quarter's 8.8%, while State & Local borrowings accelerated from a 3.5% rate to 6.6%.

I'm anything but encouraged by the Credit data. For one, Financial Sector Credit Market Borrowings actually accelerated - rising from Q1's 8.6% pace to a notable 10.2% SAA. This confirms that financial conditions remain extraordinarily loose, as well as suggests that expectations for weaker economic activity only foster greater financial sector leveraging and speculating. In nominal SAA dollars, Financial Sector Credit Market Borrowings expanded at a $1.342 TN pace, up from Q1's $1.110 TN and Q2 2005's $1.171 TN. By major instrument category, "Open Market Paper" expanded at $309 billion SAA (18.0% annualized) to $1.475 TN; "GSE Issues" $300 billion SAA (11.5% annualized) to $2.686 TN; "Agency- and GSE-backed Mortgage Pools" $308 billion SAA (6.5% annualized) to $3.814 TN; and "Corporate Bonds" $406 billion (9.7% annualized) SAA to $4.559 TN.

Over the past year, Financial Sector Borrowings increased 9.1%. By Instrument, Open Market Paper expanded 21%, GSE Issues 3.9%, Agency MBS 6.9%, and Corporate Bonds 11.5%. It is worth noting that the pace of Financial Sector Borrowings over the past year has been more than double that of M2 growth (4.4%). With Commercial Paper leading the surge in "Open Market Paper" and the ABS boom driving "Corporate Bond" issuance, key components of the current Monetary Inflation are outside the ambit of the "narrow" M2 monetary aggregate. Money Market Fund Assets expanded at a 10.6% rate during the quarter to $2014 TN, with a one-year gain of 12.9%. Institutional Money Funds (and old M3 component) are the rapidly expanding category, so M2 (which includes only Retail Money Funds) has been capturing very little of the intermediation of the booming CP and ABS market noted above.

Recall that the majority of Bank Liabilities - including Deposits and "Federal Funds and Security RPs" - are classified by the Fed as outside the category "Credit Market Borrowings." Banking Assets expanded at a SAA $941.4 billion during the quarter to $9.771 TN. For comparison, Bank Assets expanded $350 billion during 2001, $477 billion in 2002, $507 billion in 2003, $748 billion in 2004, and $763 billion during 2005. Bank Credit expanded at a blistering 11.8% pace during the quarter to $7.894 TN, up from Q1's 11.3% and Q2 2005's 9.5% - providing additional testament to the U.S. financial sector's growing disconnect with the real economy.

On the Bank Asset side, Loans increased at a 10.3% pace during the quarter to $5.670 TN, down slightly from Q1's 10.5%, with Mortgages expanding at a 14.2% rate to $3.132 TN (up from Q1's 8.8%); U.S. Government Securities holdings increased at a 14.6% pace (vs. Q1's 13%) to $1.269 TN; and Corporate Bond expanded at a 21% rate (vs. Q1's 13.8%) to $747 billion. On the Liability side, Total Deposits expanded at an 8.9% rate during the quarter to $5.730 Trillion; Fed Funds & Securities RPs rose at 22.9% rate to $1.196 TN; Credit Market Instruments increased 25% annualized to $890 billion and Miscellaneous Liabilities 9.4% to $1.761 Trillion. Over the past four quarters, Total Deposits expanded 9.8%, Fed Funds & Securities RPs 11.2%, and Credit Market Borrowings 12.3%.

And if the historic Bank Credit expansion does not fully explain continued over-liquefied markets, look no further than the ongoing Wall Street Bubble. Broker/Dealer Assets expanded $552 billion SAA during the quarter, a rate of 17.6%, to 2.409 TN. For comparison, Broker/Dealer Assets increased $278 during 2003, $232 billion in 2004, and $299 billion during 2005. Broker/Dealer Assets expanded 17.5% over the past year and 46% over two years. During Q2, Miscellaneous Assets were up $469 billion annualized (37% pace) to $1.454 TN, with a one-year gain of $315 billion, or 27.6%. On the Liability Side, Security Credit expanded at an 18.1% rate to $895 billion; Security RPs 11.3% annualized to $840 billion; and Due to Affiliates 16% annualized to $1.015 Trillion. Over four quarters, Security Credit is up 11.7%, Due to Affiliates 7.1%, and Securities RPs 23.4%.

Examining the smaller sectors, Finance Company Assets declined at a 0.8% rate during the quarter to $1.854 TN, Funding Corps down 5% annualized to $1.981 TN, Savings Institutions up at a 7.3% rate to $873 billion, Credit Unions down 0.2% annualized to $703 billion, and REITs up 19.8% annualized to $573 billion. REIT assets were up 20.9% over the past year.

Mortgages remain the asset of choice for Financial Sector leveraging. Total Mortgage Debt increased $1.168 TN SAA during the quarter to $12.758 TN, down from Q1's $1.313 TN. Still, this compares to the '90's annual average Total Mortgage debt growth of $269 billion and average growth of $889 billion during the first 5 years of the current decade. During Q2, Home Mortgage debt growth slowed to a 9.6% rate (down from Q1's 9.7% and Q4 '05's 12.9%) to $9.839 TN, while Commercial Mortgage debt growth accelerated to a 13.5% pace (vs. Q1's 11.5%). Total Mortgage Debt has inflated 12.7% over the past year, 30% over two years, and an astonishing 112% over seven years.

Rest of World (ROW) accumulation of U.S. financial assets has supplanted housing inflation as today's prominent Inflationary Manifestation (emanating from ongoing Credit Inflation). ROW holdings of U.S. Assets expanded at SAA $1.319 TN pace to $11.606 TN, down somewhat from Q1's SAA $1.470 TN, but up from Q2 2005's $1.001 TN. ROW Holdings were up $962 billion, or 9.0%, over the past year and an astonishing $3.017 TN, or 35%, in just 10 quarters. By category, ROW increased holdings of U.S. Credit Market Instruments SAA $854 billion, including Open Market Paper SAA $207 billion, Agency- and GSE-backed Securities SAA $234 billion, and U.S. Corporate Bonds SAA $397 billion. U.S. Time Deposits increased SAA $227 billion, while Net Interbank Asset dropped SAA $150 billion. ROW holdings of Miscellaneous Assets rose a SAA $311 billion, with Foreign Direct Investment up a SAA $194 billion. The increase in ROW holdings of Open Market Paper represented 82% of total net issuance during the quarter, 92% of Corporate Bond issuance and almost 50% of Agency Debt and MBS issuance. Little wonder markets remain extraordinarily liquid.

(My apologies: I ran out of time this evening and will have to finish up the flow of funds analysis over the weekend)

Since the Fed began cutting rates aggressively in early 2001, Total Credit Market Debt has increased $15.8 TN, or 58%, to $42.67 TN (320% of GDP!). The bond market turned giddy this week with the happy notion that Fed policy will soon be poised to once again inflate the market value of the ever-more-massive stockpile of U.S. fixed-income securities. We're now witnessing a consequence of the Fed's flawed "tightening" stance, focusing on economic vulnerability while disregarding precariously loose financial conditions.

As is reflected in the Q2 2006 Flow of Funds, there remains an overwhelming bias within the financial sector to leveraged existing assets (chiefly government, agency, and mortgage-related securities). This bias has intensified greatly during the third quarter. Ironically, the housing and economic decelerations are to this point engendering only a moderate slowdown in Non-Financial debt growth, while Financial Sector expansion goes into overdrive. The system's liquidity mechanism has not only become detached from the actual financing needs of the real economy, there is today a Powerful Propensity for Financial Excess to Accelerate Rapidly as the Economy Decelerates Only Moderately (too many waiting patiently to profit from another round of Fed largesse). This is a very important development.

With the debt markets having inflated at a much more rapid pace than the real economy over the life of this Amazing Credit Bubble, Credit Dynamics in the Financial Sphere Now Significantly Overshadow Those of the Economic Sphere. Speculative leveraging these days in the fixed-income markets has an unparalleled capability of creating abundant liquidity for the markets and system generally. And as bond prices inflate in response to heightened speculative leveraging and resulting liquidity, those that had been positioned for higher rates (both speculations and hedges) are forced to unwind these trades - in the process creating only more price inflation and liquidity over-abundance. Meanwhile, the yield curve gyrates and causes bloody havoc for myriad curve and rate speculations.

And I will be quite surprised if the Financial Sphere Horse does not once again lead the Economic Sphere Cart. Benchmark Fannie Mae MBS yields have now dropped 65 basis points from June highs. To what extent lower mortgage rates reignite housing markets will likely vary significantly by market. But they will surely incite an increase in transactions and, most likely, acceleration in already strong refinancings and equity extractions. Total Mortgage Debt growth can be expected to quicken from the first half's 10.1% pace. The Morgan Stanley Retail Index jumped to a new record high this week, now sporting a y-t-d gain of 10.2% and y-o-y rise of 21.3%.

We should also anticipate $900 billion Current Account Deficits in the not-to-distant future. The atypical slowdown now unfolding is concentrated in housing and U.S. automobile manufacturing. The Fed is focused on this vulnerability, ensuring an exaggerated response from highly over-liquefied and speculative markets. And it is this market response that will ensure continued heady household and business demand for imports. Alas, the specter of unending Credit Bubble excess, unending Current Account Deficits and resulting unending foreign buying of U.S. Treasuries, agencies, ABS, and MBS is providing the impetus for one heck of a liquidity-driven dislocation in bond prices.

There is certainly nothing like a concurrent descent in energy prices and bond yields to get the inflation doves chirping rather maniacally. Yet, the reality of the situation is that sinking bond yields and attendant gross liquidity excess are poised to stoke fires for sectors already demonstrating robust inflationary biases. Sitting near the top of the list, you should assume Income Inflation is salivating at recent market trading dynamics.

And, yes, Income Inflation is supporting inflated home prices that sustain the Mortgage Finance Bubble - that maintain over-consumption - that assures endless massive Current Account Deficits - that guarantees massive foreign buying of U.S. securities while writing yet another chapter in History's Greatest Bond Market Bubble. Inevitably, however, there will come a point when The Unrelenting Inflation in the Quantity of Late-Cycle U.S. Debt Instruments Collides with the Grossly Inflated Market Price of Total Dollar Financial Claims. And, sure, U.S. financial sector and bond market dynamics certainly increase the likelihood that this collision manifests in the currency markets. Even assuming that dollar confidence holds in the near-term, there remains the more nebulous issue of a bloated and foolhardy leveraged speculating community faced with the Upshot of Heightened Monetary Disorder, including wild volatility across the spectrum of global financial markets, widening spreads, wildly vacillating marketplace liquidity dynamics, and acute general financial and economic uncertainty. The bond market rally has become destabilizing.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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