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March 03, 2007

The Confluence
by Doug Noland

What a week. The Dow dropped 4.2% and the S&P500 4.4%. The Transports sank 7.3%, reducing 2007 gains to 4.9%. The Morgan Stanley Cyclical index dropped 4.9%, cutting y-t-d gains to 3.4%. The Utilities declined 1.8%, and the Morgan Stanley Consumer index fell 3.5%. The highflying broader market fell to earth quickly. The small cap Russell 2000 sank 6.2% (down 1.6% y-t-d), and the S&P400 Mid-cap index dropped 5.1% (up 2.4% y-t-d). The NASDAQ100 dropped 6.2% and the Morgan Stanley High Tech index 6.1%. The Semiconductors declined 5.6%. The Street.com Internet Index dropped 6.3% and the NASDAQ Telecommunications index 7.3%. The Biotechs were hit for 6.6%. The Broker/Dealers dropped 7.6% and the Banks 4.4%. With bullion sinking $40, the HUI Gold index was clobbered for 9.5%.

"Flight to quality" and upheaval... Two-year government yields dropped 27 bps to 4.53%. Five-year yields sank 22 bps to 4.44%, and 10-year Treasury yields fell 17 bps to 4.50%. Long-bond yields dropped 14 bps to 4.50%. The 2yr/10yr spread tightened a notable 10 bps this week to an inverted 3 bps. The implied yield on 3-month December '07 Eurodollars sank 30 bps to 4.77%. Benchmark Fannie Mae MBS yields fell 10 bps to 5.65%, this week notably underperforming Treasuries. The spread on Fannie's 5 1/4% 2016 note was 5 wider to 38, and the spread on Freddie's 5 1/2% 2016 note was 5 wider to 37. The 10-year dollar swap spread rose 4.25 to 56.5. Corporate bonds couldn't come close to keeping up with spiking Treasuries, with junk spreads widening as much as 25-30 bps this week.

Investment grade issuers included Procter & Gamble $1.4 billion, McKesson $1.0 billion, Citigroup $650 million, and John Deere $300 million.

Junk issuers included Umbrella Acquisition $1.5 billion, Liberty Mutual $1.0 billion, Allied Waste $750 million, Reader's Digest $600 million, Valassis Communications $540 million, Leucadia National $500 million, US Oncology $425 million, Avnet $300 million and Alliance One $150 million.

Convert issues included Xilinx $900 million, Mylan Labs $600 million, Hospitality Properties $500 million, Skyworks Solutions $200 million, and Magma Design $50 million.

International issuers included Gazprom $1.3 billion.

Japanese 10-year "JGB" yields declined one bp this week to 1.66%. The Nikkei 225 dropped 5.3% (unchanged y-t-d). German 10-year bund yields declined 11 bps to 3.93%. Emerging equity markets were hammered, while debt markets were notably resilient. Brazil's benchmark dollar bond yields rose only 4 bps this week to 5.86%. Brazil's Bovespa equities index sank 7.7% (down 4.7% y-t-d). The Mexican Bolsa fell 7.7% (down 0.5% y-t-d). Mexico's 10-year $ yields dropped 8 bps to 5.54%. Russia's 10-year Eurodollar yields declined 2 bps to 6.69%. India's Sensex equities dropped 5.5% (down 6.5% y-t-d). China's Shanghai Composite index dropped 5.6%, reducing 2007 gains to 5.8%.

Freddie Mac posted 30-year fixed mortgage rates declined 4 bps last week to an 8-week low 6.18% (down 6 bps y-o-y). Fifteen-year fixed mortgage rates fell 5 bps to 5.92% (up 3 bps y-o-y). And one-year adjustable rates were unchanged at 5.49% (up 15 bps y-o-y). The Mortgage Bankers Association Purchase Applications Index jumped 5.2% this week. Purchase Applications were down 0.2% from one year ago, with dollar volume up 3.7%. Refi applications gained 1.2%. The average new Purchase mortgage slipped to $239,900 (up 3.9% y-o-y), and the average ARM increased to $389,600 (up 15.3% y-o-y).

Bank Credit added only $3.2 billion (week of 2/21) to a record $8.375 TN. Bank Credit has expanded at a notably slower 6.2% annualized rate y-t-d (8 wks), with a one-year gain of $738 billion, or 9.7%. For the week, Securities Credit declined $2.9 billion. Loans & Leases rose $6.2 billion to a record $6.152 TN. Commercial & Industrial (C&I) Loans expanded 11.2% over the past year. For the week, C&I loans increased $3.5 billion, and Real Estate loans gained $5.7 billion. Year-to-date, C&I loans have expanded at a 6.9% rate and Real Estate loans at a 9.2% pace. Bank Real Estate loans expanded 14.2% over the past year. For the week, Consumer loans declined $4.2 billion, and Securities loans dipped $2.8 billion. Other loans increased $4.0 billion. On the liability side, (previous M3) Large Time Deposits added $0.8 billion.

M2 (narrow) "money" increased $12.3 billion to a record $7.111 TN (week of 2/19). Narrow "money" expanded $368 billion, or 5.5%, over the past year. M2 has expanded at a 7.4% pace during the past 20 weeks. For the week, Currency added $0.5 billion, while Demand & Checkable Deposits dropped $10.9 billion. Savings Deposits jumped $18.4 billion, and Small Denominated Deposits added $2.1 billion. Retail Money Fund assets increased $2.3 billion.

Total Money Market Fund Assets (reported by the Invest. Co. Inst) dropped $23.3 billion last week to $2.397 TN. Money Fund Assets have risen $133 billion over the past 20 weeks (15.2% annualized) and $349 billion over 52 weeks, or 17.0%.

Total Commercial Paper declined $4.7 billion last week to $2.011 TN, with a y-t-d gain of $36.5 billion (10.7% annualized). CP has increased $97 billion (13% annualized) over 20 weeks, and $315 billion, or 18.6%, over the past 52 weeks.

Asset-backed Securities (ABS) issuance slowed to $11 billion. Year-to-date total ABS issuance of $114 billion (tallied by JPMorgan) is running significantly behind the $142 billion from comparable 2006. Year-to-date Home Equity ABS issuance of $58 billion is way behind last year's comparable $83 billion. But year-to-date US CDO issuance of $53 billion is ahead of comparable 2006's $38 billion.

Fed Foreign Holdings of Treasury, Agency Debt rose $6.8 billion last week (ended 2/28) to a record $1.833 Trillion, with a y-t-d gain of $81.3 billion (26.8% annualized). "Custody" holdings have expanded at a 23% rate over 20 weeks and 16.0% y-o-y ($254bn). Federal Reserve Credit expanded last week $1.8 billion to $853.5 billion. Fed Credit was up $32.7 billion y-o-y, or 4.0%.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $819 billion y-o-y (19.5%), surpassing $5.0 TN for the first time.

February 26 - Bloomberg (Fabio Alves): "Brazil's foreign reserves may surpass $100 billion this week as the central bank boosts its purchases of dollars to stem the real's gains. Brazil's international reserves on Feb. 22 reached $98.2 billion, a record high for Latin America's biggest economy and nearly equal to Mexico's and Argentina's reserves combined."

Currency Watch:

March 2 - Bloomberg (Min Zeng and Ye Xie): "The yen rose to the highest level in almost three months against the dollar, heading for its biggest weekly gain since December 2005, after a slump in emerging-market stocks and bonds discouraged investors from borrowing the Japanese currency to buy higher-yielding assets."

The dollar index slipped 0.4% to 83.64, although there was plenty of currency action away from the greenback. On the upside, the Japanese yen increased 3.7%, the Swiss franc 1.3%, the Taiwan dollar 0.7%, and the Swedish krona 0.3%. On the downside, the South African rand declined 4.7%, the Turkish lira 3.7%, the New Zealand dollar 2.7%, the Brazilian real 2.0%, the Iceland krona 1.5%, and the Canadian dollar 1.5%.

Commodities Watch

March 1 - Bloomberg (Xiao Yu): "China, the world's biggest consumer of copper, imported more of the metal in January than in any month since June 2005 and demand is showing no sign of slackening as the country enters its peak demand period."

February 26 - Bloomberg (Daniel J. Goldstein): "Cattle prices in Chicago surged to their highest level since 2003 after a government report signaled U.S. beef processors may have fewer animals available to slaughter this year. Hog futures also rose. U.S. feedlots, burdened by higher costs for corn, are taking in fewer animals to fatten for slaughter."

For the week, Gold fell 5.9% to $642.45 and Silver sank 11.8% to $12.98. Copper dropped 5.8%. April crude slipped 8 cents to $61.14. April Gasoline jumped 4%, while April Natural Gas dropped 8%. For the week, the CRB index declined 1.4% (up 0.9% y-t-d), and the Goldman Sachs Commodities Index (GSCI) fell 1.0% (up 2.7% y-t-d).

Japan Watch:

February 28 - Market News International: "The notional outstanding amount of over-the-counter (OTC) derivatives transactions by major Japanese institutions at end-December 2006 was $18.7 trillion, up 9.5% from end-June 2006, the Bank of Japan said... The outstanding balance of derivatives for exchange-traded contracts rose 15.5% to $8.5 trillion in the same six month period. Among OTC contracts, the balance of interest rate related contracts at end-December was $15.8 trillion, up 8.3% from end-June, while the balance of forex related contracts was $2.9 trillion, up 16.2%..."

China Watch:

March 2 - Bloomberg (Zhang Dingmin): "China tightened controls on short-term foreign borrowing by local banks to protect the country's financial security and help correct international imbalances, the currency regulator said. The State Administration of Foreign Exchange has lowered borrowers' outstanding foreign-debt quotas for 2007... 'Short-term foreign debt is rising too fast,' the regulator said. China's medium and short-term foreign debt rose 16% in 2006..."

February 28 - Bloomberg (Zhang Dingmin): "China's property prices rose faster in January...even as the government has been trying to slow increases with curbs on land supply and bank loans. Prices in 70 major Chinese cities last month increased 5.6% from a year earlier..."

February 26 - Bloomberg (Samuel Shen): "China's retail sales surged 15% from a year earlier to 220 billion yuan ($28.2 billion) during the nation's week-long Lunar New Year holiday, spurred by rising incomes."

February 28 - Bloomberg (Nipa Piboontanasawat): "Hong Kong's economy extended its longest winning streak since 1997 with a 7 percent expansion in the fourth quarter, the government said... Hong Kong's growth spurt has lasted three and a half years, the city's best performance since the Asian financial crisis..."

India Watch:

February 28 - Bloomberg (Cherian Thomas and Kartik Goyal): "India's economy grew at the slowest pace in more than a year as patchy monsoon rains crimped farm production, which accounts for a fifth of the nation's economy. Asia's fourth-largest economy expanded 8.6 percent in the three months ended Dec. 31..."

February 28 - Bloomberg (Bibhudatta Pradhan): "India's Prime Minister Manmohan Singh said today that reining in prices was 'not an easy task' and that inflation was a matter of concern. The government would seek to contain inflation, the prime minister told reporters in New Delhi today, on the eve of the annual budget presentation. The government's challenge was to curb inflation while stimulating growth, Singh said. 'We are trying to control inflation without hurting agricultural and industrial growth,' Singh said. 'It is not easy to control inflation while stimulating the growth impulses in our economy.'"

February 27 - Bloomberg (Cherian Thomas): "India needs to step up supply of farm products and manufactured goods to 'tame' inflation stoked by record economic growth, a finance ministry report said... Inflation in India...is at a two-year high as consumer demand aided by surging loan growth and higher salaries outstrips the production of wheat, cement, steel and other products."

February 27 - Bloomberg (Cherian Thomas): "India's government may spend as much as 60 percent more on ports, power plants and roads in its next budget, allowing companies to cut costs and help damp the fastest inflation in two years."

Asia Boom Watch:

March 2 - Bloomberg (Theresa Tang): "Taiwan's growth in export orders accelerated in January... Orders...climbed 17.3 percent from a year earlier..."

February 28 - Bloomberg (Theresa Tang): "Taiwan's jobless rate held at almost the lowest in six years in January as domestic demand boosted the economy. The seasonally-adjusted rate was unchanged from 3.9%..."

March 1 - Bloomberg (Seyoon Kim): "South Korea's exports increased at the slowest pace in four months in February... Exports climbed 11.3 percent from a year earlier..."

February 28 - Bloomberg (Stephanie Phang): "Malaysia's economy grew at the slowest pace in a year in the fourth quarter as exports eased amid weaker demand for electronics from markets such as the U.S. The $147 billion economy expanded 5.7% from a year earlier..."

February 28 - Bloomberg (Clarissa Batino): "Philippine money-supply growth quickened for a fifth month in January on higher remittances, investment and lending, the central bank said today. Domestic liquidity expanded 22.8%..."

Unbalanced Global Economy Watch:

March 2 - Bloomberg (Theophilos Argitis): "Canada's economic growth in the fourth quarter was the slowest in more than three years, as manufacturers sold their inventories to meet demand and consumer spending eased. Gross domestic product growth in the world's eighth-largest economy eased to an annualized 1.4% rate between October and December, from a revised 2% pace in the third quarter..."

February 27 - Bloomberg (Matthew Brockett): "Money-supply growth in the euro region unexpectedly held at a 17-year high in January, strengthening the case for the European Central Bank to keep raising interest rates. M3 money supply, which the ECB uses as a gauge of future inflation, rose 9.8 percent from a year earlier, the same as in December..."

February 28 - Bloomberg (Christian Wienberg): "Denmark's economic growth unexpectedly slowed to 2.9% in the fourth quarter as a mounting labor shortage crimped production at some companies and the trade balance deteriorated. Growth slowed from 3.2%..."

February 28 - Bloomberg (Jonas Bergman): "Growth in Swedish household debt slowed in January as the central bank raised its benchmark interest rates seven times in the past thirteen months to damp growth and borrowing in the largest Nordic economy. Household borrowing growth slowed to an annual 12% from 12.3% in December..."

March 1 - Bloomberg (Jonas Bergman): "Swedish economic growth accelerated to 4.7% percent in the fourth quarter as companies increased investment and rising employment spurred consumer spending in the largest Nordic economy."

February 28 - Bloomberg (Robin Wigglesworth): "Norway's domestic credit grew an annual 14.5 percent in January, the eighth consecutive month in excess of 14%, maintaining pressure on the central bank to quicken interest rate increases."

March 1 - Bloomberg (Robin Wigglesworth): "Norway's jobless rate fell to 2.2% in February, increasing concern that a labor shortage may push wages up further and put pressure on the central bank to quicken its pace of rate increases."

February 26 - Bloomberg (Maria Levitov): "Russia's mergers and acquisitions climbed 57 percent in volume last year, spurred by the positive macroeconomic climate, said KPMG Ltd. The volume of M&A deals grew to $63.6 billion from $40.5 billion in 2005..."

March 1 - Bloomberg (Mark Bentley): "Turkish exports climbed 25% in February from the same period last year, according to...the Turkish Exporters' Assembly."

March 2 - Bloomberg (Steve Bryant): "Turkish inflation accelerated in February for the second straight month... Annual inflation in February quickened to 10.2%..."

February 27 - Bloomberg (Nasreen Seria and Lukanyo Mnyanda): "South Africa's economy expanded an annualized 5.6 percent in the fourth quarter, the fastest pace in more than two years, as investment surged and a weaker rand helped spur manufacturing and mining."

Latin American Boom Watch:

March 1 - Bloomberg (Adriana Arai): "Mexican bank lending to private companies and individuals fell 0.5 percent in January, the first monthly drop in three years."

February 28 - Bloomberg (Fabio Alves): "Brazil's economy expanded at the slowest pace in South America last year as the government failed to spur investment in machinery, factories and infrastructure projects. Growth quickened to 2.9% from 2.3% in 2005..."

March 1 - Bloomberg (Eliana Raszewski): "Argentina's economy will keep growing at a 'high rate' this year, President Nestor Kirchner [said]... 'Argentina's economy is heading to its fifth straight year of economic growth at a strong annual pace of about 8 percent and 9 percent, without showing signs of a slowdown,' said Kirchner."

February 28 - Bloomberg (Eliana Raszewski): "Argentina's jobless rate fell to 8.7% in the fourth quarter, the National Statistics Institute reported. The unemployment rate dropped from 10.2%..."

February 26 - Bloomberg (Eliana Raszewski): "Argentina's supermarket sales by volume rose 16.5 percent in January from a year earlier, the National Statistics Institute said."

March 1 - Bloomberg (Alex Kennedy): "Venezuela's annual inflation rate rose to its highest since 2004 in February as shortages of food, construction materials and medicines pushed up prices. Consumer prices increased 20.4 percent in the 12 months through February..."

February 28 - Bloomberg (Alex Emery): "Peru's economy expanded for a 32nd straight quarter...on a surge in construction, manufacturing and silver output. Gross domestic product in the fourth quarter rose 8%, compared with 7.6% growth in the same period a year earlier..."

Central Banker Watch:

February 26 - Bloomberg (Aaron Pan and Stanley White): "Central banks are increasingly diversifying their reserves, including cutting holdings of dollars, according to a survey sponsored by Royal Bank of Scotland Group Plc, the U.K.'s second-largest bank. Italy, Russia, Sweden and Switzerland have made 'major adjustments' in foreign-exchange holdings favoring the euro and the pound, according to the poll conducted by Central Banking Publications Ltd... China also plans to manage its reserves more actively, the report said."

Bubble Economy Watch:

The ISM Manufacturing index jumped 3 points during February to 52.3, the strongest reading since September. Prices Paid surged 6 points to a 5-month high 59. Production and New Orders both jumped almost 5 points to 54.1 and 54.9, respectively.

January Personal Income was up a much stronger-than-expected 1.0%, the strongest rise in a year. Personal Spending was up a stronger-than-expected 0.5%, down slightly from December's robust 0.7% gain. Construction Spending was down 0.8% from December and down 1.2% from January 2006. And while Residential Construction Spending was 12.7% below the year earlier level, Nonresidential was up 13.5% y-o-y.

Financial Sphere Bubble Watch:

March 2 - Dow Jones (Leslie Wines): "The cost of insurance against a default by top investment banks Goldman Sachs Group Inc., Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Morgan Stanley ballooned this week, amid increased nervousness about their exposure to the shaky subprime lending market. The trend toward more expensive credit-default swap protection for these four banks began last week and accelerated this week, said Michael Fuhrman, an institutional equities salesman for GFI, an inter-dealer broker for credit derivatives."

February 27 - Bloomberg (Alan Purkiss): "Money that U.S. banks have set aside to cover bad loans is at its lowest level for 17 years at least, the Wall Street Journal reported, citing SNL Financial. According to data from 518 banks...banks had 1.09 percent of the total value of their loans set aside at the end of last year, down from 1.14 percent in 2005, 1.63 percent in 1992 and 1.48 percent in 1990."

February 26 - Bloomberg (Yalman Onaran): "Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, gave Chief Executive Officer Richard Fuld a 17 percent raise to $40.5 million in 2006, a year in which Lehman posted a record annual profit."

Mortgage Finance Bubble Watch:

February 28 - New York Times (Vikas Bajaj): "The easy money is making a quick exit out of risky mortgages. During the housing boom that ended in 2005, money was poured with abandon into exotic home loans that let people buy homes with little down or without verifying their incomes. Now, lenders, financiers and buyers of mortgages are pulling back. In a sign of that wariness, Freddie Mac, one of the largest buyers of mortgages, said yesterday that it would tighten lending standards and stop buying certain kinds of risky home loans made to borrowers with weak, or subprime, credit records. The move comes as default rates are rising, smaller lenders are starting to fail and investors are shunning bonds backed by mortgages. The pullback will be most severely felt by minority and poor home buyers and owners, who will face trouble in refinancing adjustable rate loans that they can no longer afford. Those looking to buy homes with a small down payment or none could also be forced to pay higher interest rates and may not be able simply to declare their income without providing documentation like tax returns and paycheck stubs. 'Lenders and originators are being significantly penalized for the loose standards that we saw last year,' said Brian J. Carlin, head of fixed-income trading at JPMorgan Private Bank. 'And they are going to take that out on current borrowers.'"

March 2 - The Wall Street Journal (James R. Hagerty): "Countrywide Financial Corp., the largest U.S. home mortgage lender, reported sharp increases in late payments, including loans by borrowers with relatively strong credit records. In a SEC filing, the... lender said payments were at least 30 days late at the end of 2006 on 2.9% of prime home-equity loans serviced by the company, up from 1.6% a year earlier and 0.8% at the end of 2004. Countrywide said payments were late on 19% of subprime mortgage loans, up from 15.2% at the end of 2005 and 11.3% at the end of 2004."

Real Estate Bubbles Watch:

March 1 - Bloomberg (Kathleen M. Howley and Brian Louis): "The U.S. real estate boom has gone West and Northwest. The state with the fastest growing home prices in the fourth quarter was Utah, at 18%, more than double the U.S. average... Wyoming was No. 2 at 14.3% and Idaho was third at 14%. Washington gained 13.7%, and Oregon was fifth at 13.5%. Nationally, the real estate market stagnated, with a gain of 5.87% from a year earlier, the slowest pace since 1999, the Office of Federal Housing Enterprise Oversight said..."

Climate Watch:

February 27 - Associated Press: "More than 1,300 tons of farm-raised fish have suffocated to death in southern Colombia, where a four-month drought caused by El Nino has drained a reservoir to dangerously low levels... Since then authorities have counted more than 1,200 metric tons of fish -- an estimated 3 million in all -- that have died from scorchingly high temperatures that have lowered oxygen-rich reservoir levels by 15 feet in recent months."

Speculator Watch:

March 2 - Bloomberg (David Glovin): "David Becker, a former Citigroup Inc. commodities trading head who pleaded guilty to fraud, told prosecutors last year about alleged 'widespread' wrongdoing at his and rival banks in a bid to win leniency, his lawyer said. Becker, 40, admitted in September that he conspired to inflate trading profits by $20 million at the Citibank unit of Citigroup...in hopes of winning a bigger bonus... 'Becker related information about widespread practices at the commodities trading desks at large investment banks,' including Morgan Stanley, Goldman Sachs Group Inc., Societe Generale, Deutsche Bank AG and UBS AG, defense lawyer Ira Sorkin wrote in court papers filed Feb. 23 seeking a reduced sentence. The banks allegedly sought 'to overstate the value of commodities transactions and portfolios,' the lawyer wrote."

The Confluence:

What a difference a week makes. Not many trading sessions ago global equity markets were generally near record highs and Credit spreads rested at record tightness. Global risk markets are now on much less sure footing.

Of course, faltering markets evoke pronouncements of "economic fundamentals remain sound" that, for me, always recall the history of the 1929 experience. Certainly, economic and asset market booms will engender faith in policies, policymakers and markets, not to mention a strain of fanaticism from the bullish camp. Persevering through a few bouts of financial tumult (and bearish prognostication) only forges a more emboldened bullish contingent.

Larry Kudlow's op-ed piece in yesterday's Wall Street Journal, "The Prosperity Boom", captures the essence of today's optimism.

"The high-tech, productivity-driven U.S. economy is more durable and flexible than its liberal-left critics will ever admit. It is a private-sector free-enterprise economy, not a government-planned one. Innovation is strong and entrepreneurial spirits are high. The four prosperity killers, a paradigm coined by Arthur Laffer many years ago, all look dormant: inflation, taxes and regulatory burdens are low, while free trade keeps expanding."

Yet there's a fundamental problem with the Kudlow, Art Laffer and bullish consensus view of the U.S. economic miracle: Finance is today hopelessly unsound. And the reality of this predicament is that if you lose your bearings and get your finance terribly wrong, well, other things (so-called "fundamentals") end up not really mattering all that much. In general, a lot of decent economic policymaking can be more than negated by financial system mismanagement. More likely, Credit system misdeeds and resulting pricing distortions will elicit policy decisions which only exacerbate financial excess and Bubble tendencies. Credit Bubbles (and attendant asset inflation) tend to turn conventional analysis on its head, with "good" policies deemed those that work to prolong the fateful boom. Self-reinforcing asset Bubbles and policymaker complicity are virtually guaranteed - and pose a great systemic dilemma.

When it comes to so-called "prosperity killers," a prolonged bout of rampant Credit and speculative excess has no equal. Moreover, a decent case can be made that, for example, cutting taxes and reducing regulator burdens during a burgeoning Credit Bubble will only exacerbate excess and resulting economic maladjustment. Promote "pro-growth" programs in the midst of terminal "blow-off" excesses and you're hankering for a real mess. And, as we appreciate, confusing moderate consumer price inflation for astute policymaking and stable finance is a hallmark of the disasters back in the late-twenties in the U.S. and late-eighties in Japan. These are not a political views, but analyses of Credit, inflation, and speculation dynamics.

Not surprisingly, Mr. Kudlow and others are content already to target foreign scapegoats for our heightened financial and economic instability: "...The trigger for Tuesday's drop undoubtedly came from China. The Chinese have sent a Shanghai flu across the globe." He blames "higher reserve requirements for banks, tighter interest rates, stricter implementation of a capital-gains land tax, and perhaps some form of capital controls are all in the rumor mill. This sounds like root-canal advice from the U.S. Treasury and the IMF, which somehow are dissatisfied with 10% growth and 2% inflation in China. France, Germany, Japan or Latin America should have it so bad."

Today's economic policy fanatics haven't met a Bubble they haven't fallen for. This group also seems determined to keep their heads planted firmly in the sand, with analysis incredibly off the mark. In their (over-confident) minds, analyst warnings of the perils of poor lending, leveraged speculation, derivatives, Current Account Deficits and Bubbles have already been proven inept. All the same, the Chinese stock market was certainly not the "trigger" for heightened global market tumult. Instead, look directly to the realm of (U.S. gone global) "contemporary finance" - risky lending; imprudent risk intermediation, packaging and disbursement; rampant leveraged speculation; and sophisticated derivative trading strategies. The consequences of massive liquidity excess, global performance-chasing financial flows, trend exacerbating hedging-related trading, and unavoidable (Ponzi Finance) instability will inevitably come home to roost. It started this week.

Those believing that they are examining sound economic "fundamentals" should ponder the possibility that they are actually observing distorted signals (i.e. robust earnings growth, abundant liquidity, low Treasury yields, narrow Credit spreads, booming tax receipts, easily financed twin deficits, etc.) from a system embarked on an unsustainable financial path. At some point, financial crisis will force through a wrenching adjustment period. One can expect this process to be instigated and shaped by a radical change in the global liquidity backdrop and the flow of finance.

This week saw a tenuous backdrop lurch (as we've witnessed previously) into a significant event for highly correlated global risk markets. I'll make a few observations: First, we've clearly reached the point where global Bubble excesses are so egregious and prevailing that overextended markets have basically lost their capacity for pullbacks that don't incite fears of attempted mass exits and dislocations. Second, the principal contagion mechanisms are the hedge funds, "brokerage" proprietary trading desks, rampant capricious speculative flows, and ballooning global derivatives markets. Third, and significantly, The Confluence of several key developments quickly pushed the risk markets to a state of heightened tumult.

The breakneck meltdown of the subprime originators; Freddie Mac and others scurrying to exit the business; and the great uncertainty associated with tightened mortgage Credit conditions comprised a major Credit market development. The hasty rally in the yen was a second major market occurrence with negative ramifications for global leveraged speculation. At the same time, Treasury prices spiked higher on safe haven buying, the reversal of spread trades, and interest-rate hedging-related buying (unwind of previous hedges as well as MBS-related hedging). Top this off with a synchronized drop in global equities prices and selling in metals and other commodities, and you have a series of market gyrations that epitomizes the nightmare scenario for the leveraged speculating community.

Weaker U.S. economic data - and the prospect for worse - exacerbated the rally in Treasury bonds. Importantly, with a large percentage of U.S. government debt "locked up" with foreign central banks, pension funds, and insurance companies - and a huge short position associated with (borrow cheap lend dear) spread trades and interest-rate hedges - the Treasury market some time back evolved into a highly unstable short-squeeze tinderbox. For the leveraged players, the spark came from an especially dangerous Confluence of subprime mortgage problems begetting self-reinforcing mortgage Credit tightening - of yen strength inciting the self-reinforcing unraveling of yen "carry trade" speculations - and of safe haven and self-reinforcing derivative-related buying and spread trade unwinding in the Treasury market - altogether immediately emerging as a potentially highly destabilizing Confluence of market developments.

So, in short order, global risk markets were hit with self-reinforcing mortgage Credit, yen "carry trade," and Treasury "melt-up". Almost across the board, Credit spreads and risk premiums widened significantly. Credit derivative indices mounted a snappy "V" reversal from record low prices. And not unexpectedly (considering the nature of global speculative financial flows), fears of a reversal in speculations, aggressive derivative-related trading, and de-leveraging quickly mounted. Global markets relishing in the perception of endless liquidity were abruptly walloped with the specter of a liquidity crisis. Chinese policymakers and equities had little to do with these dynamics.

I won't venture a guess as to how quickly things will unravel from here. And not having a clue as to the actual size of the yen carry trade, or the true scope of leveraged speculation, or the underlying nature and dynamic-hedging characteristics of a couple hundred Trillion of global derivatives, I'm not going to tonight profess any great insight as to how close we moved this week toward the proverbial breaking point. I've always thought the scenario of spiking interest rates, a plummeting dollar, and spreads widening to be more conducive to immediate systemic dislocation. But, then, there was LTCM...

While this week certainly brought the potential for a systemic Credit and liquidity crunch closer to reality, I'm not yet ready to dismiss the likelihood that a significant decline in market yields will prove stimulating to some sectors - perhaps the key corporate debt and prime mortgage arenas. New homes sales may be horrendous, but there are indications that existing sales are showing signs of life - but only for as long as mortgage Credit is readily available for the vast majority of buyers. Interestingly, "prime" MBS spreads to Treasuries widened right along with most risk premiums this week. The MBS/ABS markets and the corporate Credit default swap marketplace must be monitored closely for indications of general liquidity tightness.

For now, I'll continue to assume an especially unbalanced and, at times, chaotic flow of finance throughout our highly unbalanced Bubble economy. Interestingly, energy prices for the most part held their own this week and emerging debt markets showed little fear of waning liquidity. At this point, liquidity issues appear a greater concern within the Financial Sphere than they do for the Economic Sphere. Of course this is a very fluid situation and circumstances could deteriorate rapidly. To what extent unfolding tightened conditions in subprime and, perhaps, certain other segments of the Credit system interplay with looser Financial Conditions associated with declining market yields for much of the investment grade marketplace is a fundamental analytical issue.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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