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February 02, 2007

Income Growth and Credit Bubble Dynamics
by Doug Noland

The Dow gained 1.3%, and the S&P500 rose 1.8%. Economically-sensitive issues continued to outperform. The Transports surged 6.2%, increasing 2007 gains to 9.8%. The Morgan Stanley Cyclical index rose 2.8%, increasing y-t-d gains to 5.6%. The S&P Homebuilding index surged 9.0% this week, and the Morgan Stanley Retail index gained 3.3% (up 7.1% y-t-d). The Utilities increased 2.3%, and the Morgan Stanley Consumer index added 1.0%. The broader market was quite strong. The small cap Russell 2000 gained 2.7% and the S&P400 Mid-Cap index 2.9%. The NASDAQ100 gained 1.4%, and the Morgan Stanley High Tech index rose 1.7%. The Semiconductors added 0.8%. The Street.com Internet Index jumped 3.1%, and the NASDAQ Telecommunications index rose 1.4%. The Biotechs increased 2.0%. The Broker/Dealers gained 1.9%, and the Banks increased 1.3%. With bullion up $2.15, the HUI Gold index ended the week about unchanged.

Two-year government yields declined 5 bps to 4.93%. Five and 10-year Treasury yields fells 5 bps to 4.82%. Long-bond yields declined 5 bps to 4.92%. The 2yr/10yr spread ended the week inverted 11 bps. The implied yield on 3-month December '07 Eurodollars dropped 6 bps to 5.145%. Benchmark Fannie Mae MBS yields declined 7 bps to 5.87%, this week outperforming Treasuries. The spread on Fannie's 5 1/4% 2016 note narrowed 2 to 31, and the spread on Freddie's 5 1/2% 2016 note was little changed at 31. The 10-year dollar swap spread declined 1.2 to 49.8. Corporate bond spreads were generally stable to wider, with junk spreads notably wider this week.

Investment grade issuers included US Bancorp $3.0 billion, AT&T $1.5 billion, SBC Communications $1.25 billion, PNC Funding $600 million, Hilcorp Energy $475 million, Textron $300 million, Centerpoint Energy $400 million, and Alabama Power $200 million.

Junk issuers included RBS Global $950 million, Yankee Acquisition Corp $525 million, Transdigm $300 million, BMS Holdings $150 million, and American Pacific $110 million.

Convert issuers included Kyphon $350 million, Sunpower $175 million, Borland $175 million, and Trico Marine $125 million.

International issuers included European Investment Bank $3.0 billion, Orascom Telecom $750 million, Geophysique $400 million, Axtel SAB $275 million, and Sul America $200 million.

January 30 - Bloomberg (Cherian Thomas): "India's debt rating was raised to investment grade by Standard & Poor's for the first time in 14 years as Asia's fourth largest economy grows at a record pace."

Japanese 10-year "JGB" yields rose 4 bps this week to 1.72%. The Nikkei 225 added 0.7% (up 1.9% y-t-d). German 10-year bund yields dipped 3 bps to 4.06%. With the exception of China, emerging debt and equities markets mostly performed well. Brazil's benchmark dollar bond yields dropped 12 bps this week to 6.01%. Brazil's Bovespa equities index gained 1.3% (up 1.2% y-t-d). The Mexican Bolsa surged 3.3% (up 5.6% y-t-d). Mexico's 10-year $ yields declined 7 bps to 5.71%. Russia's 10-year Eurodollar yields were unchanged at 6.77%. India's Sensex equities index gained 2.1% to a new record (up 4.5% y-t-d). China's Shanghai Composite index sank 7.3%, fully erasing early 2007 gains.

Freddie Mac posted 30-year fixed mortgage rates surged 9 bps last week to 6.34% (14-wk high and up 11 bps y-o-y). Fifteen-year fixed mortgage rates jumped 8 bps to 6.06% (up 25 bps y-o-y). And one-year adjustable rates rose 5 bps to 5.54% (21 up bps y-o-y). The Mortgage Bankers Association Purchase Applications Index gained 1.3% this week. Purchase Applications were down 7.1% from one year ago, with dollar volume 4.2% lower. Refi applications increased 4.9%. The average new Purchase mortgage increased to $237,900 (up 3.2% y-o-y), and the average ARM rose to $387,000 (up 10.7% y-o-y).

Bank Credit gained $1.5 billion (week of 1/24) to a record $8.309 TN. Bank Credit expanded $732 billion, or 9.7%, over 52 weeks. For the week, Securities Credit declined $6.4 billion. Loans & Leases gained $7.8 billion to a record $6.013 TN. Commercial & Industrial (C&I) Loans expanded 11.1% over the past year. For the week, C&I loans declined $4.9 billion, while Real Estate loans jumped $13.5 billion. Bank Real Estate loans rose 14.4% over the past year. For the week, Consumer loans increased $2.0 billion, while Securities loans fell $9.6 billion. Other loans increased $6.6 billion. On the liability side, (previous M3) Large Time Deposits expanded $4.9 billion.

M2 (narrow) "money" rose $8.1 billion to a record $7.084 TN (week of 1/22). Narrow "money" expanded $357 billion, or 5.3%, over the past year. M2 has expanded at a 7.9% pace during the past 20 weeks. For the week, Currency dipped $0.6 billion, and Demand & Checkable Deposits declined $12.4 billion. Savings Deposits jumped $16.8 billion, and Small Denominated Deposits gained $2.0 billion. Retail Money Fund assets added $2.4 billion.

Total Money Market Fund Assets (reported by the Investment Company Institute) dropped $35.4 billion last week to $2.356 Trillion. Money Fund Assets inflated $309 billion over 52 weeks, or 15.1%. Money Fund Assets have expanded at a 14.6% rate over the past 20 weeks.

Total Commercial Paper dipped $0.5 billion last week to $1.995 Trillion. Total CP has increased $295 billion, or 17.3%, over the past 52 weeks. Total CP has expanded at an 18% pace over the past 20 weeks.

Asset-backed Securities (ABS) issuance slowed this week to $7 billion. Year-to-date total ABS issuance of $43 billion (tallied by JPMorgan) is running behind the $51 billion from comparable 2006.

Fed Foreign Holdings of Treasury, Agency Debt jumped $10.8 billion last week (ended 1/31) to a record $1.790 Trillion, with a 5-week gain of $38.1 billion. "Custody" holdings were up $250 billion y-o-y, or 16.2%. Federal Reserve Credit last week expanded $7.1 billion to $844.2 billion. Fed Credit was up $29.9 billion y-o-y, or 3.7%.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $833 billion y-o-y (20.1%) to a record $4.974 Trillion. "BRICS" reserves were up 36.6% y-o-y to $1.628 Trillion.

Currency Watch:

The dollar index declined 0.4% this week to 84.79. On the upside, the Turkish lira gained 2.0%, Brazil's real 1.6%, the Norwegian krone 1.2%, and the Iceland krona 1.2%. On the downside, the Thai baht declined 4.1%, the New Zealand dollar 2.1%, the Chilean peso 1.1%, and the Canadian dollar 0.4%.

Commodities Watch:

February 2 - Bloomberg (Millie Munshi and Pham-Duy Nguyen): "Zinc plunged the most in nine years and copper dropped to a 10-month low, fueled by a report of losses by metals-trading hedge fund Red Kite Management Ltd. Red Kite's $1 billion fund lost 20 percent in the year to Jan. 24, the Wall Street Journal reported..."

January 30 - Bloomberg (Allen T. Cheng): "Chinese President Hu Jintao, visiting Africa for the second time in a year, will bring billions of dollars in investment and loans to eight countries this week in a bid to secure resources from oil to gold."

For the week, Gold added 0.3% to $648.15 and Silver 0.4% to $13.425. Copper sank 8.2% to a 10-month low. March crude jumped $3.75 to $59.17. February Gasoline and February Natural Gas both rose 3.9%. For the week, the CRB index gained 1.8% (down 1.9% y-t-d), and the Goldman Sachs Commodities Index (GSCI) surged 3.5% (down 1.1% y-t-d).

Japan Watch:

January 31 - Market News International: "Japanese household spending in December fell a real 1.9% year on year to an average Y340,959 ($2,799), down for the 12th straight month, while the average real income at salaried workers' households jumped 6.5% mainly on winter bonuses, up for three months in a row, official data showed..."

January 31 - Bloomberg (Jason Clenfield): "Japan's wages fell at the fastest pace in 16 months in December as companies paid lower winter bonuses, signaling consumer spending may remain too sluggish for the central bank to raise interest rates."

China Watch:

February 2 - Bloomberg (Yanping Li): "China's economy may grow 10.1% in the first quarter, driven by expanding exports and investments, according to Unirule Institute of Economics, a private think tank whose members include central bank adviser Fan Gang. Fixed-asset investment may increase 23% in the first quarter, consumer prices may advance by 2.5%, imports may rise 21% while exports may gain 25 percent..."

February 1 - Market News International: "The Chinese government is planning a sweeping overhaul of the way in which its $1 trln pile of foreign exchange reserves is managed, the Southern Weekend newspaper said. The move which will include both the establishment of a new vehicle under the Ministry of Finance and a broadened scope for Central Hujin Investment, the pre-existing investment company which currently sits under the central bank, the newspaper said."

February 1 - Financial Times (Jo Johnson): "China's introduction of locally assembled Japanese 'bullet trains' shows that the country has completed the transfer of foreign world-class high-speed rail technology, Beijing's Ministry of Railways has claimed. Lightly modified versions of Japan's E2-1000 Shinkansen went into service on lines around Shanghai last week but the rail ministry and official media have played down the trains' origins and instead stressed China's success in 'digesting' foreign technology."

January 31 - Bloomberg (Jianguo Jiang): "Chinese companies sold 101.5 billion yuan ($13 billion) worth of bonds domestically last year, 55 percent more than in 2005, a government official said."

February 1 - Bloomberg (Ting Ting Ng): "Hong Kong's retail sales grew by the most in 11 months in December as stock market gains and pay rises encouraged the city's 7 million people to spend. Sales climbed 11.5 percent from a year earlier..."

India Watch:

February 1 - Financial Times (Jo Johnson): "India's central bank, under pressure to tame rising inflation amid surging stock and property markets, again raised interest rates yesterday and warned of further 'signs of overheating' in the world's second fastest growing economy. The economy is set for its fastest annual growth since the start of reforms in 1991 amid growing concerns of overheating. The Reserve Bank of India raised its repo rate by 25 basis points to 7.5 per cent. It increased its gross domestic product growth forecast for the year to March 2007 to 8.5-9 per cent, up from 8 per cent..."

Asia Boom Watch:

February 1 - Bloomberg (Seyoon Kim): "South Korea's exports rose at the fastest pace in more than two years in January, signaling overseas sales of chips, cars and ships will help extend the nation's longest economic expansion in a decade. Exports climbed 21.4 percent from a year earlier after rising 13.8 percent in December..."

January 31 - Bloomberg (Shamim Adam): "Singapore's jobless rate fell in the fourth quarter as a strengthening economy boosted annual job creation to a record... The unemployment rate in Southeast Asia's fourth-largest economy dropped to 2.6 percent...the lowest since the first quarter of 2006..."

January 31 - Bloomberg (Clarissa Batino): "Philippine money-supply growth quickened for a fourth month in December, the central bank said. Domestic liquidity expanded 21.4 percent in December from a year earlier..."

Unbalanced Global Economy Watch:

January 31 - Bloomberg (James Lumley): "The world's economy is at greater risk from a 'shock' than it has been for at least three years, in part because of the increasing complexity of global markets, the U.K.'s market regulator said."

February 2 - Bloomberg (Craig Stirling): "U.K. personal insolvencies surged 59 percent last year to a record, exceeding 100,000, as rising interest rates forced consumers to default on swelling debts. Individual insolvencies in England and Wales totaled 107,288, up from 67,584 in 2005...The reading was the highest since records began in 1960."

January 31 - Bloomberg (Greg Quinn): "Canadian existing-home sales just missed setting a fifth-straight record last year, as prices rose the fastest since 1989... The 483,609 existing homes sold last year fell short of the 2005 mark by 180 units...the Canadian Real Estate Association said... The average resale price rose 11 percent to C$276,974 ($234,863)..."

January 30 - Financial Times (Ben White and Jeremy Grant): "The high street saw its strongest January sales growth for three years, according to a survey released yesterday... The CBI retail sales survey appears to have confounded concerns that better-than-expected sales during the Christmas period would be at the expense of a weaker start to the new year."

January 31 - Bloomberg (Claudia Rach): "Germany's unemployment rate fell in January to the lowest in almost five years... The jobless rate, adjusted for seasonal swings, fell to 9.5 percent from 9.8 percent in December..."

January 30 - Bloomberg (Flavia Krause-Jackson and Steve Scherer): "Italian tax revenue jumped more than 10 percent last year as tax evasion declined and growth accelerated, the Finance Ministry said."

February 1 - Bloomberg (Ben Sills): "Economic growth in Spain accelerated to the fastest pace since 2001 in the fourth quarter as higher exports offset the effect of rising interest rates, the Bank of Spain said."

January 30 - Bloomberg (Jonas Bergman): "Swedish retail sales surged in December, pushing growth over the year to a record amid declining unemployment and rising incomes in the largest Nordic economy. Sales rose 2.5% from November and 10.9% from a year earlier..."

January 31 - Bloomberg (Robin Wigglesworth): "Norway's domestic credit growth slowed to 14.6 percent in December... Credit growth for households, companies and municipalities slowed from 14.8 percent in November..."

January 29 - Bloomberg (Monika Rozlal): "Poland's economy expanded in 2006 at the fastest annual pace in nine years as buoyant exports encouraged companies to step up hiring and raise wages while record-low borrowing costs boosted investments. Gross domestic product grew 5.8 percent last..."

January 31 - Bloomberg (Hans van Leeuwen): "Australian banks' lending to consumers and businesses rose at the slowest pace in 17 months in December, as interest rate increases crimped borrowing. Total lending by banks and other financial institutions advanced 0.9 percent from November... Loans to consumers to buy houses increased 1 percent for an annual gain of 14.5 percent."

Latin American Boom Watch:

January 30 - Bloomberg (Patrick Harrington): "Mexico's economy probably grew 4.8 percent last year, the fastest pace in six years, helped by increased industrial output and construction, the Finance Ministry said..."'

February 1 - Bloomberg (Daniel Helft): "Argentina's jobless rate fell as a result of economic growth to 9.6 percent in the fourth quarter last year, the lowest in 13 years..."

January 30 - Bloomberg (Heather Walsh): "Chilean joblessness declined in the fourth quarter to its lowest level since 1998, as farmers and manufacturers increased hiring to meet rising sales. The unemployment rate fell to 6.0%..."

Central Banker Watch:

January 31 - Bloomberg (Gautam Chakravorthy): "Yaga Venugopal Reddy, governor of the Reserve Bank of India, comments on the country's monetary policy while speaking to reporters... 'We are not in a position to take the risk of allowing the asset bubble to build up till such time that it bursts. In our economy, in our society, we cannot afford to take extreme risk. We are trying to make it more difficult for them to get resources from banks. That's the best recourse we can take."

Bubble Economy Watch:

Fourth quarter Nominal GDP rose to 5.0%, up from Q3's 3.8% and compared to Q4 2004's 5.1%. Personal Consumption rose an annualized 4.40% (real), up from Q3's 2.8%, and Q2's 2.60%.

February 1 - Bloomberg (Michael Tsang and Daniel Hauck): "Profitability at U.S. companies is shrinking as wages rise at the fastest pace in six years. That may make stock gains harder to come by, if history is any guide. Profit margins...reached a record in 2006 after rising in 18 straight quarters... Now, almost half of the S&P 500 companies to report fourth-quarter earnings have said margins shrank or were unchanged..."

January 29 - Bloomberg (Daniel Taub): "Construction of office buildings, hospitals, hotels and other non-residential U.S. buildings is expected to rise almost 7% this year, driven by growth in the economy, the American Institute or Architects said. The expected increase in construction follows a rise of almost 6% last year..."

February 2 - PRNewswire: "The latest data from Phoenix Marketing International's Affluent Marketing Service reveals that the number of millionaire households in the U.S. now stands at 5.4 million, soaring 56% since 2003. The Phoenix study defines a 'millionaire' household as one having at least $1 million in liquid or 'investable' assets.

February 2 - PRNewswire: "Coming off its thirteenth year of consecutive sales increases, Mercedes-Benz USA...reported sales of 17,069 new vehicles for January 2007, up 36.9 percent from last January making this the best January sales in the company's history."

Financial Sphere Bubble Watch:

January 26 - Bloomberg (James Tyson): "The regulator for Fannie Mae and Freddie Mac is considering ways to determine whether the two mortgage finance companies have enough equity to contain risks following $11.3 billion in accounting errors. The Office of Federal Housing Enterprise Oversight is 'exploring various economic capital measures,' according to a 'supervision handbook' released today... Fannie Mae and Freddie Mac own or guarantee 40 percent of the $10.5 trillion residential U.S. mortgage market."

February 2 - PRNewswire: "CME, the world's largest and most diverse derivatives exchange, today announced January volume averaged 5.5 million contracts per day, up 16 percent from January 2006."

Mortgage Finance Bubble Watch:

February 2 - Bloomberg (Jody Shenn): "Defaults on mortgages to people with poor or limited credit histories in November surpassed levels reached during the last recession in 2001, according to Friedman Billings Ramsey Group Inc. The percentage of so-called subprime mortgages packaged into securities and delinquent by 90 days or more, in foreclosure or already turned into seized properties rose to 10.09 percent from 9.08 percent in October..."

January 31 - Bloomberg (Darrell Hassler): "Sales of securities backed by the riskiest debt used to finance office buildings, shopping centers and hotels may almost double this year as occupancy rates rise and late commercial mortgage payments remain near a six-year low. New issues of commercial real estate collateralized debt obligations, or CDOs, may jump to $60 billion in 2007 from a record $35 billion last year, according Wachovia Corp. analyst Tony Butler..."

Real Estate Bubbles Watch:

February 1 - Bloomberg (Hui-yong Yu and Bob Ivry): "Vornado Realty Trust raised its bid for Equity Office Properties Trust to about $41 billion in cash and stock, topping Blackstone Group LP's $38.3 billion offer in the competition for the biggest real estate takeover ever."

Energy Boom and Crude Liquidity Watch:

February 2 - PRNewswire: "Exxon set the record for the largest annual corporate profit of $39.5 billion last year even with a 4% decline in fourth-quarter profit... Shell, the world's second largest oil company, set a company record earning $25.4 billion in 2006..."

February 1 - Bloomberg (Jim Efstathiou Jr.): "President George W. Bush will seek an additional $9 billion from Congress in his 2008 budget to provide loan guarantees to companies developing alternative energy sources... The U.S. House has already approved $4 billion for the loan program..."

Climate Watch:

January 31 - Bloomberg (Brian Parkin and Claudia Rach): "Germany is having the warmest January in 31 years, with temperatures about 5 degrees Celsius above average, the German DWD weather service said."

Fiscal Watch:

February 2 - Associated Press: "The Bush administration will ask for another $100 billion for military and diplomatic operations in Iraq and Afghanistan this year and seek $145 billion for 2008, a senior administration official said... The requests... would bring the total appropriations for 2007 to about $170 billion..."

Speculator Watch:

February 1 - Financial Times (Chris Hughes): "An imbalance between supply and demand is nudging up prices of distressed and 'stressed' debt to inflated levels, bankers have warned. Distressed debt typically trades at a discount to its par value, reflecting the increased credit risk of the underlying company... Gareth Noonan, managing director of European high-yield capital markets at Merrill Lynch, said stressed bank and mezzanine debt were trading at levels which might not reflect credit quality since a relatively big number of investors was chasing a limited number of distressed opportunities. 'There are more than 20 dedicated distressed investors and fewer than 10 distressed opportunities,' he said. 'As a result, most stressed or distressed debt, especially senior debt, is trading at inflated levels.'"

Financial Sphere Bubble Watch:

January 30 - Financial Times (Ben White and Jeremy Grant): "US, UK and European regulators have expressed concern in recent meetings that investment banks may be allowing hedge funds to increase their borrowing capacity using collateral that could lose its value rapidly in a financial crisis. The regulators have asked banking executives in the meetings on Wall Street to detail exactly how they use portfolio netting, a practice that allows hedge funds to use relatively illiquid securities such as credit default and total return swaps as collateral to reduce overall margin requirements. The fear among some regulators and outside observers is that in a big market dislocation the funds might be unable to sell those securities, increasing the likelihood of widespread defaults."

Income Growth and Credit Bubble Dynamics:

Personal Income expanded a record $658 billion during 2006 to $10.897 Trillion. In percentage terms, this 6.4% growth was the strongest since 2000's 8.0% ($627bn nominal). Growth accelerated from 2005's 5.2%, 2004's 6.2%, 2003's 3.2%, 2002's 1.8%, and 2001's 3.5%. Dissecting the data somewhat, Total Compensation grew at a 6.6% pace last year, up from 2005's 5.5% to the fastest growth since 2000. It is also worth noting that Income from Assets (chiefly Interest & Dividends) increased a record $138 billion during 2006 to $1.657 Trillion, up sharply from 2005's $92 billion increase. In percentage terms, its 9.1% growth rate was the strongest since 2000's 9.7% ($123bn nominal). In combination, Compensation and Income from Assets - 84% of total Personal Income - expanded at a 7.0% rate during 2006, up meaningfully from 2005's 5.6% to the strongest growth since 2000's 8.4%.

Total Non-Farm Payrolls expanded 2.242 million during 2006. While down somewhat from 2005's 2.541 million jobs created, last year's job gains were still the second-largest increase since 1999's 3.172 million. Goods Producing employment was little changed (up 112,000) for the year, at 22.522 million. Meantime, Service Producing employment recorded surging growth, increasing 2.531 million to 114.625 million. This was a significant jump from 2005's growth of 1.715 million. Examining the previous five-year period, take note that Service Producing employment surged 7.000 million compared to the 574,000 decline posted by the Goods Producing sector. There are now five Service Producing jobs for every one Goods Producing job, up from a ratio of four-to-one ten years ago.

It is worth recalling that the economy lost 1.76 million jobs (1.48 million in the Goods Producing sector) during 2001, the year following the end of the tech/telecom boom. Income Growth slowed rapidly, falling from 2000's 8.0% to 2001's 2.8%, and 2002's 2.5%. Let's briefly contemplate why the post-housing Bubble backdrop is thus far following a much different course than that from the previous bursting Bubble.

For starters, the bursting of the tech/telecom Bubble precipitated a dramatic change in industry Credit and Liquidity conditions. A major reversal of speculative flows ensued, leading to a wave of insolvencies, (high paying) job losses, and an enormous evaporation of financial wealth (in equities, bonds and corp. loans). The booming tech/telecom industry abruptly lost access to new finance, a particularly problematic development for scores of companies with operating losses and negative cash-flows.

Corporate (non-financial) debt growth slowed during 2001 to 4.7%, a rapid drop-off from 2000's 8.2% and less than half 1999's 9.8% expansion. Speculative contagion effects were significant, as losses in telecom debt in particular led to heightened risk aversion in other sectors (and in CDOs generally). Corporate debt managed a miniscule and insufficient 0.3% expansion during 2002, with the post-Bubble debt crisis gathering momentum. Importantly, the bursting of the technology Bubble was a major Credit event with an almost immediate impact on Corporate Credit Availability and Marketplace Liquidity. Corporate Credit spreads blew-out suddenly during 2000 (junk spreads basically doubled to 700bps), only to spike to even wider extremes during 2001 and 2002.

While we must wait another month for year-end data, 2006 corporate debt growth will undoubtedly have continued its trend of steady acceleration. With heavy fourth quarter borrowings, Corporate Debt Growth likely surpassed 8% last year. This would be up strongly from 2005's 5.5%, 2004's 3.7%, and 2003's 1.9% - to the strongest expansion since boom-time 2000. In contrast to the bursting of the technology Bubble, corporate Financial Conditions eased markedly with the onset of the housing bear market.

Corporate Credit Availability and Marketplace Liquidity have never been as easy as they were last year - and remain today. With housing coming off the boil, the Fed was afforded the luxury of relaxing and allowing market perceptions of Goldilocks to take command. And with the majority of U.S. mortgage risk essentially nationalized through government and the GSE guarantees, there was little marketplace fear of contagion effects unfolding abruptly in the mortgage finance space. Indeed, Credit spreads narrowed almost across the board, and corporate risk premiums virtually collapsed.

Instead of 2000's abrupt and disruptive reversal in speculative flows away from corporate America, peculiar 2006 speculative dynamics saw a veritable onslaught of finance looking to corporate Credits for easy profits. Amazingly, manic conditions enveloped the Credit default swap, Credit "arbitrage," leveraged loan and corporate bond markets, a development certainly exacerbated by the recycling operations of massive U.S. Current Account Deficits and other outflows - by central banks and the "rest of world" into Treasuries and investment grade US securities. Bubbles inherently create their own self-sustaining liquidity.

Returning to the post-tech Bubble backdrop, double-digit mortgage Credit growth did bolster the general economy during 2000-2003. Booming mortgage and financial sector debt growth (with the anticipation of an aggressive Fed easing cycle) fostered over-liquefied conditions in the Treasury, investment-grade, and ABS/MBS marketplaces (providing endless cheap liquidity, Mortgage Finance Bubble excesses, and rampant housing inflation). Yet despite ample system Credit and liquidity growth, the bursting Bubble and speculative dynamics dictated that finance was keen to stay clear of much of the vulnerable corporate sector (certainly including telecoms, autos and consumer finance). The upshot was tight Credit conditions - in some cases wrenching - that significantly restrained job and Income growth. Yet, at the same time, housing inflation-induced borrowing and spending provided a key stabilizing force for the general economy (as well as Current Account Deficits sufficient to liquefy the world).

Jumping forward to the present, bursting housing Bubbles have created a Credit conditions backdrop radically different from the post-tech risk-aversion, revulsion, and carnage. While there is, as one would expect, mounting stress in the subprime and mortgage broker/lender arenas, there has to this point been little spillover. In reality - and in notable contrast to 2001/'02 - the corporate debt sector has, on the margin, benefited handsomely from housing travails. As I have noted previously, last year's economic Bubble moderation proved a powerful boon for leveraged speculation in corporate debt and Credit instruments.

With corporate debt growth accelerating in the face of still robust Total Mortgage Debt Growth (likely near 10%), the combination of booming corporate, mortgage and financial sector borrowings created unparalleled Loose Financial Conditions. Instead of the slowdown in housing-related spending pushing the Economic Sphere into recession, newfound restraint in this sector proved instrumental in creating an economic backdrop exceptionally conducive to Financial Sphere excess.

Last year certainly provided a clear example of how the economy and financial sector are evolving, adapting and mutating systems. As analysts, we must be willing ourselves to adjust and adapt. While the housing "ATM" was absolutely crucial for consuming our way through 2001-'03's tepid jobs and earnings backdrop, it became much less so during 2006 (with heightened Income and equities inflation). Importantly, when it comes to employment and Income growth, I would argue forcefully that corporate Credit and liquidity conditions hold sway. Some expected the bursting housing Bubble to have a tech-like immediate and spectacular economic impact. But it actually proved more a case of Ultra-Loose Financial Conditions boosting Income growth, in the process working to stabilize inflated home prices. Relatively stable home prices, then, proved sufficient to sustain the Mortgage Finance Bubble and Credit Bubble generally.

As we now look ahead to 2007, there are notable crosscurrents, uncertainties and ambiguities. Labor markets are tight generally, with increasing pockets of exceptional tightness. There remains an inflationary bias in compensation, exacerbated by ongoing easy Financial Conditions. Corporate cash flows remain strong, fueled by unrelenting system Credit growth. Additionally, funds to borrow stay too cheap and too readily available. And the booming stock market only heightens the sense of urgency for businesses to pay up for required skills and manpower. On the one hand, if one were to extrapolate the current labor and liquidity backdrop, a strong case could be made for an even stronger year of Income growth. Yet one must these days be unusually cautious when it comes to extrapolating recent Financial Conditions.

To be sure, there is a fundamental flaw in the goldilocks analysis: It ignores the enormous ongoing degree of Credit, liquidity, and speculative excess necessary to sustain this most expansive boom. A tremendous amount of system Credit growth was required last year to maintain elevated home prices; to inflate stock prices; and to drive robust Income growth - not to mention the $Trillion or so that gushed out and further distorted global economies, markets and financial systems. Especially after last year's Income, equities, and global inflations, even greater excess will be necessary to sustain the Credit and Economic Bubbles this year and next.

The markets are content to make and live with two bold assumptions: One, the environment is non-inflationary and will remain so. Two, there is little risk associated with the creation and distribution of this ongoing massive liquidity. Neither holds water. There is in fact considerable risk going forward that Income growth surprises on the upside, forcing the Fed to de-pause and perhaps even tighten Financial Conditions. I will suggest, however, that the greater risk lies with speculative dynamics and the inevitable reversal of speculative flows out of this nebulous Bubble I'll label "Credit arbitrage" (multifarious activities that are essentially writing flood insurance during a drought).

I'll conclude by theorizing that a good percentage of the seven million "services" jobs added over the past five years owe much of their existence to rampant Credit and asset inflation. They're (seductively and dangerously) Bubble Manifestations similar to the tech employment boom that proved so susceptible and disruptive. And, clearly, accelerating Income Growth is at this point very much a Credit Bubble phenomenon. For now, these dynamics ensure extraordinary uncertainty. Yet we should expect the eventual bursting of this Bubble to initiate job and Income losses that will make post-tech Bubble dislocations look inconsequential by comparison.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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