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October 07, 2006

Inflationary Biases and Chasms at the Fed
by Doug Noland

This week, the Dow gained 1.5% (up 10.6% y-t-d) and the S&P500 1.0% (up 8.1% y-t-d). Economically sensitive issues performed well. The Transports jumped 2.6% and the Morgan Stanley Cyclical index 2.2%. The Utilities added 0.6%, while the Morgan Stanley Consumer index was about unchanged. The broader market was strong. The small cap Russell 2000 gained 2.0% (up 9.9% y-t-d), and the S&P400 Mid-Cap index rose 1.3%. The NASDAQ100 gained 1.9% and the Morgan Stanley High Tech index 1.3%. On the back of Micron's earnings disappointment, the Semiconductors declined 0.7%. The Street.com Internet Index jumped 2.9% (up 8.3% y-t-d), and the NASDAQ Telecommunications index advanced 3.1% (up 16% y-t-d). The Biotechs surged 5.6%. The Broker/Dealers rose 3.1%, increasing y-t-d gains to 20.1%. The Banks added 0.8% (up 9.9% y-t-d). With bullion down $25.50, the HUI gold index declined 2.8%.

For the week, two-year Treasury yields rose 5.5 bps to 4.74%. Five-year yields gained 6 bps to 4.64%, and bellwether 10-year yields jumped 7 bps to 4.70%. Long-bond yields gained 7 bps to 4.84%. The 2yr/10yr spread ended the week inverted 4 bps. The implied yield on 3-month December '07 Eurodollars rose 7 bps to 4.86% in a volatile week for prospective short-term interest rates. Benchmark Fannie Mae MBS yields rose 5 bps to 5.91%, this week outperforming Treasuries. The spread on Fannie's 4 5/8% 2014 note narrowed about one to 31, with the spread on Freddie's 5% 2014 note little changed at 31. The 10-year dollar swap spread increased one to 54.75. Corporate bonds generally made up some ground on Treasuries this week, with junk spreads narrowing about 4 bps.

Investment grade issuers included Lowes $1.0 billion, ABX Holdings $1.0 billion, GE Capital $750 million, Southwestern Public Service $450 million, MidAmerican Energy $350 million and GATX $200 million.

Junk bond funds saw inflows of $137 million during the week (from AMG). Junk issuers included Peabody Energy $900 million, Semgroup $600 million, ITC $500 million and Indianapolis P&L $150 million.

Convert issuers included United Dominion Realty $250 million, Forest City Enterprises $250 million, Diodes $200 million, World Acceptance $100 million and Lecroy $60 million.

International dollar debt issuers included NXP BV $3.75 billion, DNB Nor Bank $2.0 billion, Banco Mercantil $600 million, and Bertin LTDA $250 million.

Japanese 10-year "JGB" yields rose 3.5 bps this week to 1.70%. The Nikkei 225 index gained 1.9% (y-t-d up 2.0%). German 10-year bund yields increased 3 bps to 3.75%. Emerging markets were mostly impressive. Brazil's benchmark dollar bond yields declined 3.5bps to 6.32%. The Bovespa equity index surged 4.1% this week (up 13.4% y-t-d). The Mexican Bolsa gained 1.9%, increasing 2006 gains to 25.5%. Mexico's 10-year $ yields added one basis point to 5.77%. The Russian RTS equities index added 0.3%, increasing y-t-d gains to 38%. India's Sensex equities index was little changed (2006 gains of 31.7%). China's Shanghai Composite index gained 1.6% this week, increasing y-t-d gains to 50.9%.

This week, Freddie Mac posted 30-year fixed mortgage rates dipped one basis point to 6.30% and now are up only 32 bps from one year ago. Fifteen-year fixed mortgage rates were unchanged at 5.98%, 44 bps higher than a year earlier. One-year adjustable rates declined one basis point to 5.46% (up 69bps y-o-y). The Mortgage Bankers Association Purchase Applications Index jumped 7.6% this week. Purchase Applications were down 14.4% from one year ago, with dollar volume 14.8% lower. Refi applications surged 17.5% to the highest level since last October. The average new Purchase mortgage jumped to $227,100 (18-week high), and the average ARM rose to a record $382,700.

Bank Credit jumped $30.9 billion last week to $8.034 TN. Year-to-date, Bank Credit has expanded $528 billion, or 9.4% annualized. Bank Credit inflated $628 billion, or 8.5%, over 52 weeks. For the week, Securities Credit recovered $14.5 billion. Loans & Leases gained $16.5 billion during the week and were up $385 billion y-t-d (9.4% annualized). Commercial & Industrial (C&I) Loans have expanded at a 14.7% rate y-t-d and 13.2% over the past year. For the week, C&I loans declined $5.0 billion, while Real Estate loans surged $15.7 billion (2-wk gain of $30.7bn). Real Estate loans have expanded at a 10.7% rate y-t-d and were up 11.3% during the past 52 weeks. For the week, Consumer loans dipped $0.8 billion, while Securities loans gained $2.6 billion. Other loans were up $4.0 billion. On the liability side, (previous M3 component) Large Time Deposits expanded $14.6 billion.

M2 (narrow) "money" supply gained $7.0 billion to $6.897 TN (week of 9/25). Year-to-date, narrow "money" has expanded $211 billion, or 4.2% annualized. Over 52 weeks, M2 has inflated $283 billion, or 4.3%. For the week, Currency added $0.8 billion, and Demand & Checkable Deposits increased $12.8 billion. Savings Deposits dropped $19.5 billion, while Small Denominated Deposits rose $7.2 billion. Retail Money Fund assets increased $5.6 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, surged $24.8 billion last week to a record $2.243 Trillion. Money Fund Assets have increased $186 billion y-t-d, or 11.7% annualized, with a one-year gain of $290 billion (14.8%) - $6 billion greater than the gain in M2!

Total Commercial Paper rose $5.7 billion last week (9-wk gain of $118bn!) to a record $1.908 Trillion. Total CP is up $267 billion y-t-d, or 21.2% annualized, while having expanded $312 billion over the past 52 weeks (19.6%).

Asset-backed Securities (ABS) issuance slowed this week to $10 billion. Year-to-date total ABS issuance of $527 billion (tallied by JPMorgan) is running about 5% below 2005's record pace, with 2006 Home Equity Loan ABS sales of $381 billion in line with last year's pace. Also reported by JPMorgan, y-t-d Global CDO (collateralized debt obligation) Issuance of $328 billion is running 69% ahead of 2005.

Fed Foreign Holdings of Treasury, Agency Debt jumped $13.3 billion to a record $1.675 Trillion (week of 10/4). "Custody" holdings were up $156 billion y-t-d, or 13.3% annualized, and $210 billion (14.4%) over the past 52 weeks. Federal Reserve Credit rose $4.4 billion to $829.6 billion. Fed Credit is up $3.2 billion (0.5%) y-t-d, while having expanded 3.7% ($29.5bn) over the past year.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $578 billion y-t-d (18.6% annualized) and $662 billion (16.7%) in the past year to a record $4.5 Trillion.

October 3 - Bloomberg (Kevin Cho): "South Korea's foreign-exchange reserves gained for a third month in September... The reserves, the world's fifth-largest, climbed...to $228.2 billion last month [up 10% y-o-y]..."

Currency Watch:

October 4 - Bloomberg (Ye Xie): "Global daily currency trading will exceed $3 trillion next year, with more than 44 percent of volume conducted electronically, TowerGroup said. ...an increase from $1.77 trillion in 2004."

The dollar index gained 0.6% to 86.20. On the upside, the Iceland krona increased 2.5%, the Israeli shekel 1.3%, the Turkish lira 1.2%, the New Zealand dollar 0.8%, and the Indian rupee 0.8%. On the downside, the Norwegian krone declined 2.2%, the Swiss frank 0.8%, the Mexican peso 0.8%, the Canadian dollar 0.8%, the Australian dollar 0.8% and the Japanese yen 0.7%.

Commodities Watch:

October 5 - Bloomberg (Tony C. Dreibus): "Wheat prices in Chicago rose, extending a 10-year high, on speculation that the crop in Australia, the world's third-biggest exporter of the grain, will be smaller than forecast because of drought."

Gold fell 4.3% to $574 and Silver 3.2% to $11.175. Copper dipped 2%, reducing y-t-d gains to 76%. November crude fell $3.22 to end the week at $59.69. November Unleaded Gasoline dropped 2.9%, while November Natural Gas surged 14.5%. For the week, the CRB index declined 1.8% (down 9.5% y-t-d), and The Goldman Sachs Commodities Index (GSCI) dropped 1.8% (down 2.7% y-t-d).

Japan Watch:

October 2 - Bloomberg (Lily Nonomiya): "Japan's business confidence unexpectedly rose to a two-year high in September, increasing prospects that the central bank will raise interest rates by the end of the year."

October 5 - Bloomberg (Kyoko Shimodoi and Toru Fujioka): "Hiroko Ota, Japan's minister of economic and fiscal policy, said the end of deflation is in sight in the world's second-largest economy. Japan's corporate sector continues to do well and household spending is benefiting from the strength of the corporate sector... The economic recovery is being fueled by domestic demand, she added."

China Watch:

October 6 - Bloomberg (Nipa Piboontanasawat and Janet Ong): "China's surplus on the current account, which measures exports and imports of goods and services, widened in the first half... The gap swelled to $91.6 billion from $67.3 billion the same period last year..."

October 5 - Bloomberg (Yidi Zhao): "Almost 1000 new cars hit the roads of Beijing every day, state-run Xinhua News Agency reported... Beijing registered 155,936 vehicles in the first half, more than any other Chinese city and 7 percent of the country's total..."

Asia Boom Watch:

October 2 - Bloomberg (Young-Sam Cho and Seyoon Kim): "South Korea's exports climbed to a record in September on rising sales of cars and chips... Overseas shipments rose 22.1 percent from a year earlier to $29.9 billion..."

October 5 - Bloomberg (Stephanie Phang): "Malaysia's exports growth slowed in August as declining crude prices saw the value of oil shipments fall for the first time in four months. Exports rose 14.8% from a year earlier...following a revised 15.9% in July..."

October 5 - Bloomberg (Aloysius Unditu and Arijit Ghosh): "Indonesia's central bank cut its benchmark interest rate by half a percentage point, the fifth reduction since May... Bank Indonesia...reduced the rate...to 10.75 percent."

Unbalanced Global Economy Watch:

October 4 - Bloomberg (Alexandre Deslongchamps): "Canada's existing-home sales will reach a record for the sixth straight year in 2006, as low unemployment and rising incomes boost demand, the Canadian Real Estate Association said."

October 3 - Bloomberg (Craig Stirling): "Britons' borrowings against the value of their homes rose 13 percent in the second quarter from a year earlier, evidence that the $6.8 trillion housing market is supporting consumer spending."

October 6 - Bloomberg (Gabi Thesing): "German factory orders unexpectedly surged in August led by sales of plants and machinery. Orders increased 3.7 percent in August compared with a revised 2.1 percent the previous month..."

October 5 - Bloomberg (Ben Sills and Kristian Rix): "Industrial production in Spain, Europe's fifth-largest economy, expanded for a 10th month in August as growth among the country's European trading partners fueled exports. Production at factories, farms and mines rose 4.9 percent from a year-earlier..."

October 6 - Bloomberg (Bunny Nooryani and Beate Evensen): "Norway, the world's third-largest oil exporter, raised its forecast for economic growth and said it will increase spending on roads, health care and education as high energy prices boost revenue. The mainland economy...is set to expand 3.4 percent this year..."

October 2 - Bloomberg (Jonas Bergman): "Norway's domestic credit growth accelerated in August to the fastest pace since March 1988, adding to pressure on the central bank increase its interest rate. Credit for households, companies and municipalities rose an annual 14.7 percent..."

Latin American Boom Watch:

October 4 - Dow Jones (Gerald Jeffris): "Brazil posted net foreign exchange inflows in September of $5.13 billion, up from $1.29 billion in net inflows the previous month... The September foreign exchange result brought net inflows to $32.04 billion for the January to September period, up from $9.5 billion in the same period last year."

October 5 - Bloomberg (Telma Marotto): "Brazil's industrial output growth slowed in August, the latest sign that a currency rally is cutting into the expansion in Latin America's biggest economy. Production rose 3.2 percent from the year-earlier period, less than the 3.5 percent increase in July..."

October 2 - Bloomberg (Matthew Walter): "Argentina's September tax revenue rose 29 percent from a year earlier, the country's tax collection agency reported."

October 6 - Bloomberg (Alex Kennedy): "Venezuelan vehicle sales rose to a record in September...Sales of cars, trucks and buses...rose 90 percent to 33,384 units..."

Central Banker Watch:

October 5 - MarketNewsInternational (Claudia Hirsch): "Federal Reserve Board Vice Chairman Donald Kohn said...that any signs of further inflation would be bad for the economy and could require additional monetary policy response. 'I would be very, very concerned if I saw inflation moving higher from here," Kohn said... 'We need to be confident that it is moving down.' Further indications of inflation 'would be very adverse for the economy and I think would require further policy actions.'"

October 5 - MarketNewsInternational: "European Central Bank President Jean-Claude Trichet said Thursday he supported stronger international coordination of hedge fund supervision in the wake of recent troubles in the industry. 'It is quite obvious that you can and that you have to improve the situation in this area... In this area we need a world-wide solution. So there are no part solutions such as one continent, because it is a problem and a question that arises at the world level, obviously.'"

Bubble Economy Watch:

October 6 - Bloomberg (Joe Richter): "The U.S. economy created 51,000 jobs in September, fewer than economists predicted, a figure that was offset by upward revisions to payroll growth in previous months. Last month's gain in employment followed a 188,000 rise in August that was almost 50 percent bigger than previously reported...The unemployment rate unexpectedly fell to 4.6 percent, matching a five-year low... The figures suggest job creation is generating enough income to sustain consumer spending as the housing market slumps. Wage growth over the last 12 months [4.0%] matched a five-year high... The report also showed job growth during the 12 months ended in March may have been about 45 percent higher than previously reported. In a preliminary estimate, the Labor Department said payrolls for the 12 months ended in March 2006 will be revised higher by 810,000, the biggest revision since the Labor Department started benchmarking numbers in 1991."

The ISM Manufacturing Index declined 1.6 points to 53.5, with the Prices Paid component down 12 points to 61. New Orders were unchanged at 54.2. The ISM Non-Manufacturing Index dropped 4.1 points to 52.9, the lowest level since . It is worth noting that the New Orders component actually jumped 5.1 points to 57.2, while the overall index was impacted significantly by the 15.7 point drop by the Prices Paid component. Initial Jobless Claims dropped 14,000 last week to 302,000, a 10-week low.

October 6 - Dow Jones (John McAuley): "Chain store sales registered another solid year-over-year gain in September... Year-over-year sales were said to have increased in a range of 3.8% to 4.1% from the September 2005 level after a similar increase in August and an average 3.7% rate of increase in the first half of the year."

October 2 - The Wall Street Journal (Christopher Conkey): "A year into the housing market's slowdown, Americans have yet to snap shut their wallets, defying predictions that the cooling market would have a chilling effect on consumer spending. This year, despite what appears to be the most significant housing-market slump in more than a decade, the nation's consumers have increased their purchases of goods and services at an inflation-adjusted annual rate of more than 3% -- just as they have for the past two years. 'They're not backing off,' says Janet Hoffman, managing partner of consulting firm Accenture Ltd.'s North American retail practice."

October 6 - EconoPlay.com (Gary Rosenberger): "Another massive import wave in August threatens to blow away the record trade gap set one month earlier...say cargo executives. But declining crude oil prices are likely to provide some balm for the trade gap in August and contribute to a sharp narrowing in September and beyond... Export activity also looked strong in August but took a back seat to imports... The big drop in oil prices also means a reprieve on transportation inflation, with fuel surcharges having come down hard in recent weeks and more declines scheduled for November. The big story for the second consecutive month was the import swell at the nation's two largest container ports, Los Angeles and Long Beach, where combined imports rose 16% year-over-year - well above the steady 10% to 12% increases seen from January through July. 'These are monster numbers no matter how you cut them - it was our highest inbound total ever and the highest total ever,' said Art Wong, spokesman for the Port of Long Beach."

October 4 - The Wall Street Journal (Ryan Chittum and Vauhini Vara): "Judging from its first week, one of the nation's largest urban malls, the Westfield San Francisco Centre, is poised to shake up the city's retail landscape. Shoppers waited in a line that stretched around the block at Market and Fifth streets to preview the 338,000-square-foot Bloomingdale's, second in size only to the flagship Bloomingdale's store on Manhattan's East 59th Street... 'It's kind of like Vegas,' a 36-year-old lawyer, Allison Wang, commented to her husband, Tim Wang, as they stood near the historic domed rotunda incorporated into the design of the nine-story mall."

Real Estate Bubble Watch:

October 6 - The Wall Street Journal (Damian Paletta): "A federal banking regulator sounded warnings about potential problems ahead with commercial real-estate loans and subprime adjustable-rate mortgages. The Federal Deposit Insurance Corp., in its quarterly state-profile analysis, said the concentration of commercial real-estate loans has reached 'historic highs.' Regulators, including the FDIC and Federal Reserve, have struggled to warn small lenders in particular against becoming overexposed in this sector, requesting higher capital protections and stricter internal controls for banks with large commercial real-estate portfolios. Also, the FDIC said analysts in its San Francisco and New York regions have reported 'deterioration in the performance' of subprime ARMs compared with fixed-rate mortgages. This trend 'may reflect 'payment shock' for some adjustable-rate borrowers,' the FDIC said."

October 4 - The Wall Street Journal (Jennifer S. Forsyth and Christine Haughney): "Rent for office tenants rose in the third quarter at the fastest pace in six years, while vacancy rates continued to decline... ...The amount office tenants actually pay once concessions are factored in - grew 2.3% nationwide from July to September of 2006."

October 4 - Bloomberg (Kathleen M. Howley): "Manhattan cooperative apartment prices fell 16 percent in the third quarter as more New Yorkers avoided lengthy co-op approval proceedings by opting for condominiums that typically have fewer regulations and higher prices. The average price of a co-op...fell to $1.09 million from a record $1.3 million in the second quarter, according to...Miller Samuel Inc. ..."

October 4 - Bloomberg (David M. Levitt): "Manhattan office vacancy rates fell to their lowest levels in five years in the third quarter, pushed by financial services and law firms expanding as the stock market booms, real estate brokerage Cushman & Wakefield said... Lower Manhattan led the growth, with office vacancies there falling to 9.1 percent from...11.5 percent a year ago... Midtown vacancies fell to 6.5 percent from 6.9 percent the quarter before."

October 3 - Bloomberg (David M. Levitt): "Construction spending in New York City will rise to a record $20.8 billion this year and exceed $21 billion in each of the next two years, fueled by a surge in public spending, said the New York Building Congress, an industry group. Mass transit, schools and highways will account for the biggest share, jumping 20 percent to $11.6 billion in 2006, $12.1 billion in 2007 and $13.2 billion in 2008, based on current city and state budgets. Demand for housing also is contributing, with more than $5 billion in spending and the addition of 30,000 new units annually through 2008."

Financial Sphere Bubble Watch:

October 4 - Financial Times (Michael Mackenzie): "Hedge funds focused on debt markets are set to achieve some of the strongest returns in the industry this year, while others such as those focused on macro strategies or equities stumble, according to JPMorgan. Credit funds...are achieving returns of 10-15 per cent in the year to date, analysts at the bank said. However, the main source of these gains has been increasingly concentrated bets on the booming European leveraged loan market... 'Amid all the reports of losses at a large multi-strategy fund and poor performance across the macro fund community, it is easy to overlook the performance of credit funds,' said Stephen Dulake, European credit analyst at JPMorgan... Demand for loans from hedge funds and other specialist investors remains very strong, which in turn allows banks to feel comfortable in continuing to lend more funds to low-rated companies helping to keep the default rate low."

October 3 - Dow Jones (Marietta Cauchi): "Private equity firms have raised a massive $300 billion so far this year and the total is set to hit $400 billion for the full-year... The money raised to date, by 436 new private equity funds, is an increase of 6% on the $283 billion raised for the whole of 2005 and smashes industry records, according to...Private Equity Intelligence. U.S.-based funds raised the lion's share of the total - some $199 billion in 225 new funds, followed by European-based funds which raised $70 billion and 101 funds based in Asia and elsewhere raising a total $31 billion."

October 4 - Financial Times (Peter Smith): "Buy-out groups levied near record amounts of debt on European companies they bought or refinanced in the third quarter, according to research from S&P's Leveraged Commentary and Data. The credit industry newsletter found that, on average, the ratio of total debt to ebitda rose to a multiple of 5.8 in the three months ended September, its highest level since 2000. The previous high of 5.7 for leveraged buy-out deals in the current cycle was recorded in the opening quarter of 2006, with a dip to 5.4 in the second quarter of this year."

Energy Boom and Crude Liquidity Watch:

October 5 - Financial Times (Richard Dean): "Gulf Arab investors are looking to pour billions of dollars into Indian real estate, as Indian regulators ease restrictions on foreign capital flowing into the sector. The Gulf's oil-fuelled current account surplus will hit $227bn this year, according to the Institute of International Finance, and that money is looking for a home. With domestic real estate markets saturated and the west seen as increasingly hostile by some, Gulf investors are turning to India's emerging property market. 'The opportunities in India are immense,' said Rakesh Patnaik, head of real estate investment at Global Investment House, a Kuwaiti investment bank. 'India is still a new market. It is only in the past 12-24 months that it has opened up.'"

October 5 - Bloomberg (Will McSheehy): "Saudi Basic Industries Corp., the world's biggest chemical maker by market value, plans to raise as much as $6 billion next year to fund construction of new plants to meet Asian and European demand."

Speculator Watch:

October 4 - Financial Times (Michael Mackenzie): "Chicago's big two derivatives exchanges saw strong trading volume growth in the third quarter led by bets on interest rates as investors positioned themselves for a pause by the US Federal Reserve and a slowing economy... At the CBOT, trading volume rose 21 per cent during the third quarter from the same period in 2005, with average daily volume up 23 per cent from the prior year. Meanwhile, the CME said average daily volume during the quarter rose 28 per cent from the same period a year ago with interest rate volumes climbing 27 per cent..."

October 6 - Bloomberg (Katherine Burton): "The Vega Select Opportunities hedge fund, known for making bets on bonds, received redemption requests for as much as $400 million after falling almost 11 percent last month, investors said. Vega Select started September with $1 billion of assets, down from $2.2 billion at the end of 2004..."

October 4 - Bloomberg (Jenny Strasburg): "The number of new hedge funds fell 55 percent in the first six months of 2006 as the $1.2 trillion industry failed to sustain the record pace of startups... Managers opened 549 hedge funds in the first half, compared with 1,211 a year earlier..."

Inflationary Biases and Chasms at the Fed:

At 4.6%, the U.S. Unemployment Rate has not been lower since June of '01. The 4.0% y-o-y increase in average hourly earnings is at a five-year high. At the same time, September's 51,000 jobs gain was unimpressive and below consensus, although the August jobs expansion was revised up almost 50% to a respectable 188,000. And, apparently, the Department of Labor is about to revise last year's payrolls data higher by 810,000. Perhaps today's action signals that the bond market will no longer so easily ignore tight labor markets.

So, Wednesday the plain-spoken chairman Bernanke commented that housing is in a "substantial correction" and likely to shave 1% off GDP. The Dow surged 123 points, bond yields dropped, and emerging markets powered higher. Clearly, the (global) marketplace has fondly vivid memories of the Greenspan Fed inciting an historic bout of housing inflation to help mitigate the financial and economic fallout from the technology bust. The markets can be forgiven for perceiving that (The Inflationist) Prof. Bernanke would be just delighted by further bond and equity market rallies.

Mr. Bernanke, the academic, relies heavily upon his economic forecasting models. He can confidently predict quantitative impacts to both GDP and core inflation from a housing slowdown. I would today, however, suggest unusual caution with such an analytical approach. The great unknown at this point - one that certainly cannot be effectively incorporated into econometric models - is how the financial markets would respond to the prospect of a Bernanke Fed easing cycle and, importantly, how such a response would dictate the pace and nature of economic activity. Considering his scholarly emphasis and expertise, Dr. Bernanke would dovishly view today's housing markets (faltering Bubbles) with trepidation, while paying merely lip service to inflationary risks deemed fleeting in nature. His idiosyncratic perspective has suited the bond market just fine.

Interestingly, Vice Chairman Donald Kohn and Philadelphia Fed President Charles Plosser came out Thursday and spoke directly to their views that inflation is these days likely a greater risk than economic weakness. Astutely, I would say, Mr. Plosser commented that it's difficult to know how housing will impact the general economy in the short-run, and it may turn out that monetary policy may not be sufficiently tight to restrain heightened inflationary pressures. Mr. Kohn, with 35 years of experience at the Fed, stated that "the risk to my outlook for economic activity may be skewed to the downside, while those to my forecast of gradually declining inflation are tilted to the upside. In the current circumstance, the upside risks to inflation are of greater concern." Mr. Kohn also stated that "to date there is little evidence that this correction in the housing market has had any significant adverse spillover effects on other parts of the economy." It is also worth noting that Mr. Kohn's long-time close colleague, Alan Greenspan, this afternoon was quoted as saying that the "the worst may well be over" for the housing slump (believe it or not...)

Thus far, the bond market has largely ignored the (deepening?) chasm at the Fed between the doves and hawks. With the Federal Reserve's tradition of acceding the Chairman overwhelming command over policy, the analytical prism through which Mr. Bernanke views the world has been widely adopted by market analysts. The new Fed chief assures the marketplace that he's ready to respond to any further acceleration in core prices - if he really must, and such pretense (in an environment of weak housing and robust inflationary impulses that largely eschew "core" consumer prices) has more than sufficed in the eyes of the market. I would suggest, however, that Dr. Bernanke's rather eccentric (dovish) views on monetary management leave his credibility with traditional (hawkishly-inclined) central bankers on tenuous footing. This could become a major issue for the markets in the event the economy reaccelerates and/or inflationary pressures do not wane.

I found Bill Gross's October investment outlook particularly pertinent. Mr. Gross quoted (two-time world poker champ) Puggy Pearson: "Ain't only three things to gamblin': knowing the 60/40 end of a proposition, money management, and knowing yourself." He then noted how this was "incredibly similar to my [Gross's] own philosophy" gleaned from a mathematics professor and the blackjack table. The key to success to be applied to investing was "identifying opportune moments when the odds favored the player as opposed to the dealer and by altering the size of the bets accordingly."

At least until today, the bond market has perceived that we're in the midst of one of those opportune moments when it makes sense to bump up the bets and take some of the house's money. The consensus view is that housing markets are in serious trouble and, hence, the economy is highly vulnerable - with perhaps even latent deflationary biases. The odds are - as reflected in fixed income prices - that the Bernanke Fed will likely resort to cutting rates in the not too distant future. Besides, the specter of the bond bears and derivative traders all scrambling amongst each other to cover Treasury and agency short positions - when much of the actual supply of these securities is today held by foreign central banks and institutions - was, in its own right, a proposition worthy of a decent-sized wager.

The marketplace has been more than willing to disregard heightened inflationary pressures, strong employment and income growth, and an economy that has proved notably "resilient" through various shocks and setbacks. The bond bears have of late been impaired, with the path of least resistance leading to higher bond prices. Recent bullish enthusiasm - subsequent to the cuddliest of bond (teddy) bear markets - implies a robust bond and Credit market Inflationary Bias.

It is not unreasonable to assume chairman Bernanke has a bias against further tightening, nor is it brash to presume that he fully intends to move early and aggressively to thwart the financial and economic risks associated with bursting Bubbles - housing or otherwise. Yet there are very serious risks associated with this entire notion of Greenspan/Bernanke New Era central banking. This is a regime where asset and economic Bubbles are ignored as they're inflated, only for the Fed to adopt aggressive ("risk management") inflationary tactics when they eventually risk being deflated. Basically, the gist of such an approach is that a bursting Bubble can and should be mitigated by inflating elsewhere - in particular inciting sufficient Credit creation and "animal spirits"/speculative impulses to maintain abundant system liquidity; to keep asset markets sufficiently levitated; and to ensure expanding economic output.

The dilemma that emerges from the remediation of one Bubble with another (bigger one) is multifaceted. For one, it fosters an overwhelming profit motive/speculative bias that evolves over time to permeate all asset markets. Second, it accommodates and eventually firmly ingrains a Financial Structure (i.e. the powerful GSEs, Wall Street firms, hedge funds, derivatives, securitization markets, "structured finance," bank real estate lending, etc.) that propagates asset inflation and Bubbles (U.S. bonds 1993, emerging markets 1993-1997, technology, stocks, bonds again, housing, etc. thereafter). Third, an aggressively expanding Financial Sector and attendant securities markets inflation guarantee a self-reinforcing escalation in financial leveraging, instigating Monetary Processes whereby speculative positions over time play an increasingly instrumental (if largely unrecognized) role in system liquidity conditions. Fourth, when a central bank actively induces leveraged speculation as an expedient policy mechanism for system stimulation/inflation - as it clearly did in 2002 - it will not easily divorce itself from obliging a relatively small but powerful cross-section of society. Fifth, as we're now witnessing with housing, policies that incite serial Bubbles ensure inherent fragility that inevitably traps policymakers in an overly accommodative posture.

The upshot of the Fed's experimental policy regime is a volatile confluence of enticing asset inflation and an enormous and immensely powerful Financial Sphere towering over a submissive little central bank hamstrung by myriad susceptible Bubbles largely of its own making. Basically, elemental fragility is held at bay only through loose monetary policies, counterproductive inordinate transparency, and resultant ongoing profligate financial conditions. And such a backdrop certainly won't go unnoticed by a gumptious financial apparatus immersed in a Credit inflation, asset Bubbles and speculative profits bonanza. Again, it is this extraordinary backdrop that forces my analysis to focus on systemic Inflationary Biases, while at this point downplaying obvious vulnerabilities in housing and the economy.

Bloomberg's Brian Sullivan moderated a panel discussion this week on the U.S. residential housing slowdown. While I agreed with the premise of many of their comments, I was struck by how confident Stephen Roach and Nouriel Roubini were in forecasting rapid U.S. economic retrenchment. Unless one is confident predicting the direction of highly unsettled financial markets and Credit conditions over the coming months - which I am admittedly not - I would urge caution when it comes to predicting economic performance.

In particular, Roach and Roubini were in strong agreement that the Fed - "serial Bubble blowers" that they are - has simply run out of Bubbles to mitigate the bursting housing Bubble. Such analysis is close enough to correct to be dangerous. Indeed, I believe their view overlooks the paramount dynamic today impacting both the Financial and Economic Spheres: the system remains extraordinarily governed by Credit Bubble "blow-off" dynamics. The Mortgage Finance Bubble hasn't as yet taken so much as a tender body blow, while corporate and government finance remains in rapid expansion mode. M&A and stock repurchases are on record pace. And, importantly, Income Growth has supplanted housing inflation as a key Inflationary Manifestation.

The system is on track for record Credit creation this year, with resulting massive Current Account Deficits and energized Credit systems around the globe fueling systemic asset inflation and ongoing liquidity overabundance around the world - sinking commodities prices notwithstanding. The expansive leveraged speculating community remains at the epicenter of systemic Inflationary Biases, as well as recent commodities selling. To be sure, the list of major hedge fund casualties is growing, but to this point the losses meted out to the energy and commodities bulls, along with the bond and equities bears, has proved awfully constructive for the bond and Credit bulls (note from Financial Sphere Watch above how debt market and "credit" hedge funds are among this years top performers).

More than housing - the system's weak link lies today, as it has for some time, in securities leveraging. And while the summer bond rally has provided relief for bond investors (as well as fun and games for some), it is been destabilizing for the system. The bond bears were run out of town, hedges against higher rates were unwound, while speculations and hedges for lower rates were established. And I would suspect the financial markets' overwhelming Inflationary Bias has not gone unnoticed by the Fed "hawks," including Messrs. Kohn, Lacker, Moscow and Plosser.

It's my own view that the summer rally has likely only postponed any eventual move by the Fed to cut rates and has even increased the possibility that more hikes will be necessary. If the interest-rate markets are now forced to abruptly reverse course and price in such a scenario, well, the markets will have relished in the opportunity to do the most damage to the largest number. It is, after all, the dreaded "V" move in market yields - especially MBS - that can prove especially destabilizing to the leveraged players and derivative traders - hence system liquidity. And I don't want to get all carried away by a couple days of rising market yields. But I do see the current backdrop of Myriad Inflationary Biases with the distinct possibility of Deepening Chasms at the Fed.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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