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June 01, 2007

The Other Side to the Story
by Doug Noland

For the week, the Dow gained 1.2% (up 9.7% y-t-d) and the S&P500 1.3% (up 8.3%). The Transports surged 3.4%, increasing y-t-d gains to 16.8%. The Morgan Stanley Cyclical index jumped 2.8%, increasing 2007 gains to 22.1%. The Utilities rose 1.4% (up 12.1%), and the Morgan Stanley Consumer index gained 1.2% (up 8.2%). The broader market was exceptionally strong. The small cap Russell 2000 and S&P400 Mid-Cap indices gained 2.8%, increasing y-t-d gains to 8.4% and 14.6%. The NASDAQ100 posted a 2.0% advance (up 9.8%) and the Morgan Stanley High Tech index a 1.4% gain (up 8.6%). The Semiconductors rose 1.9% (up 4.7%). The Street.com Internet Index jumped 2.2% (up 10.3%) and the NASDAQ Telecommunications index 3.0% (up 7.6%). The Biotechs gained 1.8% (up 9.6%). The Broker/Dealers surged 5.2%, increasing 2007 gains to 10.8%. The Banks added 0.5% (up 0.1%). With bullion gaining $15.65, the HUI Gold index rallied 6.0%.

Bear market action had two-year U.S. government yields surging 11.5 bps to 4.97%. Five-year yields jumped 12 bps to 4.92%. Ten-year Treasury yields rose 9.5 bps to 4.95% (9-mnth high). Long-bond yields gained 5.5 bps to 5.06%. The 2yr/10yr spread ended the week inverted 2 bps. The implied yield on 3-month December '07 Eurodollars surged 11 bps to 5.335%. Benchmark Fannie Mae MBS yields jumped 9 bps to 6.08%, this week performing about in line with Treasuries. The spread on Fannie's 5% 2017 note widened one to 39, and the spread on Freddie's 5% 2017 note widened one to 38. The 10-year dollar swap spread increased 2.2 to 57.8. Corporate bond spreads narrowed slightly, with the spread on a junk index two bps narrower.

May 30 - Bloomberg (Elizabeth Stanton): "For the moment, at least, financing the U.S. budget deficit may be getting less arduous as foreign investors now own a record 80 percent of the Treasury notes due in three to 10 years. Not since the 19th century have foreigners held so much American debt, said Alan Taylor, a professor of economic history at the University of California, Davis. International investors own $672 billion of the $835.4 billion Treasuries due in three to 10 years, according to...Lawrence Dyer, strategist at HSBC Securities USA Inc."

May 30 - Financial Times (David Oakley and Michael MacKenzie): "Non-government bond issuance surged in May on the back of rising mergers and acquisition activity and moves by an increasing number of banks and companies to refinance debt. Overall bond issuance in dollars, euros, sterling and yen rose to close to $300bn - the highest ever during the month of May and the second highest monthly figure, according to Dealogic, the data provider."

Investment grade issuers included ERP Operating LP $1.0bn, Duke Energy $500 million, Allstate $500 million, Enbridge $400 million, Regency Centers $400 million, Tenaska Gateway $350 million, and Kansas City P&L $250 million.

May 30 - Standard & Poor's: "High-yield issuance in 2007 continues at a record pace, as $408 billion in combined supply from high yield and leveraged loans have come to market by early May...in 2007, 43% of high-yield bond issuance has been rated 'B-' or below versus 32% in 2006... LBOs are becoming riskier, as leverage has increased. Indeed, debt-to-EBITDA multiples for LBOs have inched up to around 5.9x on average in the first quarter of 2007, up from 4.85x in 2004... Highly leveraged transactions (10x debt to EBITDA) and private equity's willingness to pay themselves large special dividends shortly after a deal has closed have not yet hindered creditors' eagerness to finance LBOs."

May 30 - Bloomberg (Caroline Salas): "Risk premiums on high-yield, high-risk corporate bonds fell to a record low... The extra yield investors demand to own U.S. junk bonds instead of Treasuries narrowed to 2.42 percentage points on average yesterday... The spread is less than half the average of more than 5 percentage points over the past five years, and is down from more than 10 percentage points in 2002."

Junk issuers included Forest Oil $750 million, Spansion $625 million, Lyondell Chemical $510 million, Cricket Communications $350 million, Puget Sound Energy $210 million, and Health Net $170 million.

This week's convert issuers included NII Holdings $1.0bn, Kulicke & Soffa $100 million, and Luminent Mortgage $90 million.

International dollar bond issuers included Lukoil $1.0bn, and Banco Macro $100 million.

June 1 - Bloomberg (Kim-Mai Cutler): "Risk premiums for developing countries' bonds fell to a record low today... The average spread...narrowed 5 basis points...to 1.47 percentage points..."

German 10-year bund yields jumped 7 bps to 4.45%. Japanese 10-year "JGB" yields rose 5 bps to 1.76% (7-mnth high). The Nikkei 225 jumped 2.7%, increasing y-t-d gains to 4.3%. Emerging equities markets were mostly on fire, while debt markets held their own as global bond yields marched higher. Brazil's benchmark dollar bond yields jumped 9 bps this week to 5.81%. Brazil's Bovespa equities index jumped 3.5%, increasing y-t-d gains to 20.1%. The Mexican Bolsa surged 4.1%, increasing 2007 gains to 20.8%. Mexico's 10-year $ yields rose 4 bps to 5.63%. Russia's RTS equities index gained 1.9% (down 4.8% y-t-d). India's Sensex equities index increased 1.6% (up 5.7% y-t-d). China's Shanghai Composite index dropped 4.3%, reducing y-t-d gains to 50% and 52-week gains to 138%.

Freddie Mac posted 30-year fixed mortgage rates gained another 5 bps to 6.42% (down 25bps y-o-y), the highest rate since mid-September. Fifteen-year fixed rates rose 6 bps to 6.12% (down 14 bps y-o-y). Reversing part of last week's spike, one-year adjustable rates declined 7 bps to 5.57% (down 11bps y-o-y). The Mortgage Bankers Association Purchase Applications Index fell 2.5% for the week. Purchase Applications were up 8.4% from one year ago, with dollar volume 13.3% higher. Refi applications dropped 13% for the week, yet dollar volume was still up 56% from a year earlier. The average new Purchase mortgage declined to $239,800 (up 4.5% y-o-y), while the average ARM increased to $409,300 (up 17.2% y-o-y).

Bank Credit rose $8.4bn (week of 5/23) to $8.510 TN. For the week, Securities Credit surged $19.5bn. Loans & Leases dropped $11.1bn to $6.223 TN. C&I loans declined $13.4bn, while Real Estate loans jumped $10.3bn. Consumer loans added $0.6bn, while Securities loans declined $4.2bn. Other loans declined $4.5bn. On the liability side, (previous M3) Large Time Deposits fell $3.8bn.

M2 (narrow) "money" jumped $18bn to $7.244 TN (week of 5/21). Narrow "money" has expanded $200bn y-t-d, or 7.0% annualized, and $447bn, or 6.6%, over the past year. For the week, Currency slipped $0.2bn, while Demand & Checkable Deposits added $0.6bn. Savings Deposits jumped $17.5bn, while Small Denominated Deposits dipped $0.4bn. Retail Money Fund assets increased $0.3bn.

Total Money Market Fund Assets (from Invest. Co Inst) declined $8.8bn last week to $2.489 TN. Money Fund Assets have increased $107bn y-t-d, a 10.6% rate, and $425bn over 52 weeks, or 20.6%.

Total Commercial Paper jumped $25.4bn last week to a record $2.113 TN, with a y-t-d gain of $139bn (16.6% annualized). CP has increased $325bn, or 18.2%, over the past 52 weeks.

Asset-backed Securities (ABS) issuance slowed to $10bn. Year-to-date total US ABS issuance of $301bn (tallied by JPMorgan) is running about 2% ahead of comparable 2006. At $481bn, y-t-d Home Equity ABS sales are 29% below last year's pace. Meanwhile, y-t-d US CDO issuance of $151 billion is running 23% ahead of record 2006 sales.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 5/30) jumped $14.6bn to a record $1.959 TN, with a y-t-d gain of $207bn (28% annualized). "Custody" holdings expanded $345bn during the past year, or 21.4%. Federal Reserve Credit last week rose $3.7bn to $853.8bn. Fed Credit has gained $3.7bn y-t-d, with one-year growth of $26.8bn y-o-y (3.2%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $565bn y-t-d (28% annualized) and $941bn y-o-y (21%) to a record $5.376 TN.

June 1 - Financial Times (Richard Beales): "Six Persian Gulf states now have almost $1,600bn in foreign assets, dwarfing even China's mammoth $1,100bn of foreign reserves, according to a new report from the Institute of International Finance."

Currency Watch:

The dollar index was little changed at 82.29. On the upside, the Brazilian real gained 2.7%, the New Zealand dollar 2.7%, the Colombian peso 2.4%, the Canadian dollar 1.8%, and the Australian dollar 1.8%. On the downside, the Swedish krona declined 1.3%, the Bolivian boliviano 1.2%, the Thai baht 0.8%, and the Indonesian rupiah 0.6%.

Commodities Watch

For the week, Gold gained 2.4% to $671.65, and Silver jumped 5.7% to $13.74. Copper rallied 2.5%. July crude dipped 12 cents to $65.08. July gasoline declined 2.9%, while July Natural Gas gained 1.1%. For the week, the CRB index added 0.3% (up 2.2% y-t-d), while the Goldman Sachs Commodities Index (GSCI) was little changed (up 9.6% y-t-d).

Japan Watch:

May 30 - Financial Times (David Pilling and Mariko Sanchanta): "Japan's jobless rate fell to a nine-year low of 3.8%... However, figures on consumer spending and retail sales were mixed, underlining the slow pace at which a tightening labour market is boosting wages and prices."

May 31 - Bloomberg (Kathleen Chu and Kazue Somiya): "Nomura Real Estate Holdings Inc., which completed Japan's largest initial public offering last year, plans to increase office rents by as much as 20% in 2007 as the longest economic boom since World War II spurs demand."

May 30 - Bloomberg (Kathleen Chu): "Tokyo office rents advanced last year as Japan's economic rebound pushed up demand for space, slashing vacancy rates to the lowest since 1991... The office vacancy rate in the Japanese capital's 23 wards fell to 2.6% in 2006, from 4% in 2005..."

China Watch:

May 29 - Bloomberg (Luo Jun): "China's trade surplus may swell to as much as $300 billion this year... The trade surplus will be between $250 billion and $300 billion, compared with $177.5 billion in 2006, the National Development & Reform Commission said..."

May 30 - Bloomberg (Nipa Piboontanasawat): "The World Bank raised its forecast for China's economic growth and Moody's... China's economy, the world's fourth largest, will expand 10.4% in 2007, the World Bank said...up from a November forecast of 9.6%..."

June 1 - Bloomberg (Nipa Piboontanasawat): "China's manufacturing activity rose in May to the highest level in more than two years after a surge in bank lending, according to a survey by Hong Kong-based CLSA Asia Pacific Markets."

May 30 - Bloomberg (Nipa Piboontanasawat): "China's debt rating may be increased, Moody's..., citing the country's swelling foreign-exchange reserves and success in strengthening its banking system. China's A2 long-term foreign-currency rating is under review for possible upgrade..."

May 29 - Bloomberg (Zhang Shidong): "China's brokerage accounts topped 100 million for the first time as new investors rush to invest in the country's stock market... Investors yesterday opened a record 455,111 accounts to trade mainland shares and mutual funds..."

May 29 - Financial Times (Francesco Guerrera): "A disease killing millions of pigs in China has sharply lifted the price of pork, the country's staple meat, fuelling fears about inflation... Pork prices have risen as much as 30% in Chinese cities over the last week... wholesale prices for pigs have gone up even more, rising 71.3% since April. China's 500m-odd pigs are the country's most important source of affordable meat..."

May 28 - Bloomberg (Nipa Piboontanasawat and Patricia Kuo): "Hong Kong's exports grew at a faster pace in April as the city shipped more goods to and from China... Overseas sales rose 12.6% from a year earlier..."

India Watch:

June 1 - Associated Press: "India's merchandise exports rose 23.1% in April from a year ago, despite a sharp appreciation in the Indian currency, the commerce ministry..."

May 31 - Financial Times (Jo Johnson): "India enjoyed its second-fastest year of growth since independence last financial year, according to government statistics released this afternoon showing the economy expanded by 9.4% in the 12 months to March 2007... Growth in the first quarter of last year was revised up by nearly an entire percentage point to 9.6%...and then accelerated further in the second quarter, covering July-September, to 10.2%..."

May 29 - Financial Times (Francesco Guerrera): "India yesterday joined the list of countries with trillion-dollar stock markets, passing another milestone in its 16-year transition from socialist backwater to the first rank of the world's major free market economies."

Asia Boom Watch:

May 30 - Bloomberg (Seyoon Kim): "South Korea's industrial output rose more than three times as much as expected in April, helped by increased exports of chips and cars. Manufacturing production jumped 3.1% from March..."

June 1 - Bloomberg (Seyoon Kim): "South Korea's exports rose more than expected last month... Exports climbed 11.9% in May from a year ago..."

May 28 - Bloomberg (Shanthy Nambiar): "Indonesia's economy may expand 6.3% this year as the government continues to promote overseas investment and growth of its energy sector, President Susilo Bambang Yudhoyono said."

May 31- Bloomberg (Francisco Alcuaz Jr.): "The Philippine economy grew in the first quarter at the fastest pace in more than six years... The $117 billion Southeast Asian economy expanded 6.9% from a year ago..."

Unbalanced Global Economy Watch:

May 30 - Bloomberg (Greg Quinn): "Canada's current-account surplus widened to its biggest in a year between January and March, led by energy exports. Receipts from outside Canada exceeded payments sent abroad by $6.04 billion..."

May 30, 2007 - Globe & Mail (David George-Cosh): "Canada's housing market has continued to escape the downturn unfolding in the U.S., with the average resale price of a home climbing above the $300,000 mark for the first time in April. Average prices, sales values and listings all set fresh records last month, and regional disparity continued to be the story with most of the frenzy taking place in provinces west of Ontario, according to the Canadian Real Estate Association."

May 29 - UPI: "A survey found that most British brides-to-be want big glamorous and expensive weddings that will impress their guests... The average cost of a wedding and reception has doubled in the past decade to almost $40,000. That comes to about $120 per minute."

May 30 - Bloomberg (Gabi Thesing): "Money-supply in the euro region grew at close to the fastest pace in 24 years in April, supporting the case for higher European Central Bank interest rates. M3 money supply...rose 10.4% from a year earlier, after increasing 10.9 in March... The rate of expansion in March was the fastest since February 1983."

May 29 - Bloomberg (Edgar Ortega and Elizabeth Hester): "The lights may be going out on Wall Street, where for the first time since World War II bankers are on the verge of earning less from initial public offerings than in Europe. As American underwriters continue to charge double the going fee rate on European IPOs, the total amount of money raised in Europe so far this year is 78% greater than the value of U.S. offerings..."

May 30 - Bloomberg (Sandrine Rastello): "French unemployment fell in April, cutting the jobless rate to the lowest in 24 years after companies added jobs at the fastest pace in six years. Unemployment fell by 20,000 from March to 2.26 million..."

May 29 - Bloomberg (Christian Wienberg): "The Danish government lifted its inflation forecast for next year as a labor shortage pushed up wages, saying it needs to lead a 'responsible fiscal policy' to prevent local industry becoming uncompetitive. Inflation will quicken to 2.4% in 2008, compared with a December forecast of 2.1%..."

May 31- Bloomberg (Robin Wigglesworth): "Norway's domestic credit growth slowed to 14.3% in April as 10 interest rate increases since June 2005 reduced demand for loans."

May 31- Bloomberg (Robin Wigglesworth): "Norway's jobless rate fell to 1.7% in May, the lowest since December 1987, fueling wage growth and adding to pressure on the central bank to quicken the pace of interest rate increases. The rate dropped from 2% in April..."

May 31 - Bloomberg (Robin Wigglesworth): "Norwegian retail sales growth accelerated to 10.3% in April, beating a 27-year high set in March, as higher salaries and increased employment fuel a spending boom."

May 29 - Bloomberg (Nasreen Seria): "South Africa's economy expanded an annualized 4.7% in the first quarter, exceeding 4% for a ninth consecutive quarter, fueled by a construction boom."

May 28 - Bloomberg (Nasreen Seria): "South African retail sales rose an annual 15.8% in April, little changed from the previous month..."

May 31 - Bloomberg (Hans van Leeuwen): "Australian business investment rose in the first quarter as miners expanded... Capital spending on equipment, buildings and plant climbed 9.1% in the three months ended March 31 from the previous quarter..."

Latin American Boom Watch:

May 29 - Bloomberg (Bill Faries): "Argentina's supermarket sales by volume rose 14.6% in April from a year earlier, the National Statistics Institute said."

May 31- Bloomberg (Alex Emery): "Peru's economy expanded at a 7.2% pace in the first quarter, because of higher retail sales and increased construction."

Central Banker Watch:

May 30 - Bloomberg (Robin Wigglesworth): "Norway's central bank raised its benchmark interest rate for the 10th time in two years to head of higher inflation as a mounting labor shortage threatened to boost wage growth. Norges Bank increased the deposit rate by a quarter-point to 4.25%..."

May 28 - Bloomberg (Gabi Thesing): "European Central Bank council member Axel Weber said he sees 'upward risks' to inflation in the 13 nation euro area due to economic expansion and 'excessive wage accords'... 'We also see risks coming from the monetary pillar... We can't rule out that the ample liquidity will not end up pushing up consumer prices through various channels, even though it's not doing that now and just driving asset prices.'"

May 29 - Bloomberg (Greg Quinn): "The Bank of Canada said for the first time in a year that it's ready to increase interest rates because inflation is accelerating faster than it expected."

June 1 - Bloomberg (Scott Lanman): "The Federal Reserve's seven-member Board of Governors would have six confirmed millionaires should lawmakers approve the nominations of Capital One Financial Corp. executive Larry Klane and Virginia banker Elizabeth Duke. Klane, 46, and his family reported holding assets valued at about $12.7 million to $45.5 million..."

Bubble Economy Watch:

May 31 - Financial Times (Edward Luce): "American politics is experiencing hyperinflation. Whether it is the bitterly controversial legacy of President George W. Bush, the war in Iraq, the 'global war on terror', the threat of climate change, a deteriorating US healthcare system or the fear of a further loss of jobs to outsourcing, rarely has so much been invested in the outcome of one presidential election. Candidates from both parties together raised more than $150m in the first quarter of 2007, six times as much as the equivalent period in 2003 and eight times as high as 1999. By the end of this year - more than 10 months before polling day - the leading candidates will have raised at least $100m apiece. 'The final two nominees will probably spend $1bn between them - we are going to have America's first billion-dollar president,' says Michael Toner, who stepped down as head of the Federal Election Commission in March. 'There is nothing to compare to this level of spending. We are off the charts.'"

May 29 - Financial Times (Francesco Guerrera): "This recruiting season at top US business schools is the most competitive since the bursting of the technology bubble, as private equity firms, hedge funds, and real estate companies join investment banks and other traditional seekers of young talent... Recruiting at business schools reached its peak in 1999, but after the technology boom subsided, recruiting and hiring was lacklustre for several years. It has recently started to pick up, and this spring, it is 'the healthiest in year', according to Jonathan Masland, of Tuck School's Career Development office at Dartmouth College."

Financial Sphere Bubble Watch:

May 31- Dow Jones (Damian Paletta): "The banking industry continued to feel stress from the housing slump in the first quarter of 2007, with net income down from one year earlier and the number of troubled loans increasing for the fourth consecutive quarter, the Federal Deposit Insurance Corp. reported... In anticipation of a worsening credit environment, banks set aside an additional $3.2 billion for loan losses in the first quarter of 2007, an increase of 54.6% from the first quarter of 2006... The banking industry recorded $36.0 billion in net income in the first quarter, down from $36.9 billion in the first quarter of 2006. Still, it marked the fourth-highest quarter ever reported."

MBS/ABS/CDO/Derivatives Watch:

June 1 - Bloomberg (David Evans): "Bear Stearns Cos., the fifth-largest U.S. securities firm, is hawking the riskiest portions of collateralized debt obligations to public pension funds. At a sales presentation of the bank's CDOs to 50 public pension fund managers in a Las Vegas hotel ballroom, Jean Fleischhacker, Bear Stearns senior managing director, tells fund managers they can get a 20% annual return from the bottom level of a CDO."

M&A and Private-Equity Bubble Watch:

May 28 - Financial Times (Francesco Guerrera): "Buy-out groups in the US are having their busiest month on record after launching nearly $82bn-worth of bids since the beginning of May... The spike in activity in May comes on the back of $78bn-worth of deals in April, the third busiest month on record."

May 31 - Financial Times (Sundeep Tucker): "Record numbers of Chinese companies are looking for overseas acquisitions, according to results of a survey published on Wednesday which foreshadows a global buying spree with potential political repercussions.... Indian companies have recently embarked on a global acquisitions binge, highlighted by Tata Steel's $11bn takeover this year of Corus, the Anglo-Dutch steelmaker..."

May 30 - Bloomberg (Harris Rubinroit): "Kohlberg Kravis Roberts & Co. will seek a record $16 billion of so-called covenant-lite loans to help fund its buyout of First Data Corp.... Banks led by Credit Suisse Group agreed to provide a $14 billion seven-year term loan and a $2 billion six-year revolving credit facility... The covenant-lite term loan would be the largest of its type."

May 29 - Bloomberg (Harris Rubinroit): "SLM Corp., the largest U.S. provider of student loans, will receive a $12.5 billion loan and sell $4 billion of notes to fund its buyout... Bank of America Corp. and JPMorgan Chase & Co. agreed to provide the $12.5 billion seven-year secured, term loan, SLM said..."

May 30 - Bloomberg (Kabir Chibber and John Glover): "The biggest winners from the global buyout boom are hiring distressed-debt bankers in Europe at the fastest pace in five years... 'When the turn does come, it will be unlike anything we have ever seen before,' said Iain Burnett, 43, managing director of Morgan Stanley's special situations unit... 'The scale of it could be considerable because of the size of some of these leveraged deals...' Firms are paying as much as $3 million a year for bankers who advise bankrupt companies and for traders who specialize in defaulted debt..."

Energy Boom and Crude Liquidity Watch:

May 28 - Bloomberg (Glen Carey): "Saudi Arabia, holder of the world's largest proven oil reserves, said imports rose an annual 31% in February as purchases of electrical and transportation equipment increased... Imports grew to...$5.9 billion in February..."

Fiscal Watch:

May 31 - USA Today (Dennis Cauchon): "The federal government recorded a $1.3 trillion loss last year -- far more than the official $248 billion deficit -- when corporate-style accounting standards are used, a USA TODAY analysis shows. The loss reflects a continued deterioration in the finances of Social Security and government retirement programs for civil servants and military personnel. The loss -- equal to $11,434 per household -- is more than Americans paid in income taxes in 2006. 'We're on an unsustainable path and doing a great disservice to future generations,' says Chris Chocola, a former Republican member of Congress...and corporate chief executive who is pushing for more accurate federal accounting. Modern accounting requires that corporations, state governments and local governments count expenses immediately when a transaction occurs, even if the payment will be made later. The federal government does not follow the rule..."

May 30 - Bloomberg (Martin Z. Braun): "New York City will collect almost $9 billion more in the current and next fiscal year than city officials forecast one year ago even after accounting for unforeseen spending, according to...comptroller Thomas DiNapoli. The city will collect $5 billion in unexpected revenue for the fiscal year ending June 30 as Wall Street profits surged to $20.9 billion..."

Speculator Watch:

May 30 - Financial Times (Brooke Masters): "The massive infusion of cash into the so-called hedge fund communities in New York, Connecticut and California has proved to be fatal to many marriages - and a windfall for lawyers, psychiatrists and forensic accountants who specialise in the super rich. 'There is no question that a huge infusion of wealth to relatively young people has a disastrous effect on the marriage's stability,' says Bern Clare, a Manhattan divorce lawyer... 'When you are dealing with the über-wealthy, you are dealing with the über-lawyers," says Kevin Tierney, the presiding judge of the family division in Connecticut's Stamford-Norwalk district... 'They have accountants and para-legals and duelling experts.' Further complicating matters is that the assets involved, unlike real estate or jewellery, are highly variable, depending on the gyrations of the stock market. 'You can have an asset change by $1m while a witness is on the stand,' Judge Tierney says."

The Other Side to the Story:

Yesterday's headline read "U.S. Economic Growth Weakest in Over 4 Years." At 0.6%, revised first quarter annualized Real GDP was certainly nothing to write home about. Gross Private Investment contracted at a 9.3% annualized rate, led by a 15.4% annualized drop in Residential Investment. And the ongoing weakness in housing was confirmed by this morning's Pending Homes Sales data (weakest in four years). Certainly, there is some support for the bearish view that ongoing housing weakness is in the process of dragging down the U.S. consumer and our consumption-based economy. But why then is the Morgan Stanley Cyclical index sporting a 22% y-t-d gain, the Dow Transports a 17% rise, and U.S. and global stock markets all posting robust advances on top of last year's gains? Why are 10-year Treasury yields almost back to 5%?

There is an Other Side to the Story. First quarter Nominal GDP actually expanded at a 4.7% rate, an increase from Q4's 4.1% and Q3's 3.9%. At 4.0%, the strongest GDP Price Index gain in years weighed heavily on Real GDP. Interestingly, Personal Consumption was actually revised up to a respectable 4.4% rate (from 3.8%), accelerating from Q4's 4.2%, Q3's 2.8%, and Q2's 2.6%. In annualized nominal dollars, Personal Consumption jumped 5.8% ($522bn) from Q1 2006 to Q1 2007's $9.601 TN.

How is it possible that consumer spending holds up so well in the face of faltering housing markets and reduced mortgage borrowings? Well, there's no mystery. First quarter Personal Income expanded at a blistering 9.4% pace, up sharply from Q4's 5.9%, Q3's 5.0% and Q2's 3.2%. In nominal annualized dollars, first quarter Personal Income increased 5.8% ($626bn) from Q1 2006 to Q1 2007's $11.348 TN. Disposable Income grew an annualized 8.2%, up from Q4's 5.4% and Q3's 5.7%.

The huge Income gains were not a one quarter anomaly. We already knew that, through the first seven months of fiscal year 2007, federal Personal Income Tax receipts were running 17.3% ahead of the year ago level. Clearly, enormous capital gains and investment income growth coupled with strong compensation trends are having a significant impact.

I read interesting research the other day taking exception to the bullish view that the economy will soon emerge from a "mid-cycle slowdown." I appreciated the analytical focus on the relationship between GDP and debt growth. The basic premise was that only accelerated debt growth would empower an economic bounce-back. And it was their view that with household mortgage debt growth slowing sharply and government deficits shrinking, even a meaningful jump in corporate borrowings would likely prove insufficient to support the necessary expansion in total system Credit. I'm mentioning this Credit analysis because it touches upon key pertinent analytical and economic issues.

To begin with, this analysis follows the conventional method of examining Household, Corporate and Government debt growth - analyzing only "Non-Financial" Credit. It is traditional thinking that Financial Sector debt must be disregarded, as including it with "Non-financial" debt would be counting the same loan twice (for example, a home mortgage loan held on a bank's balance sheet). And while there is definitely a "double counting" issue at play, financial sector borrowing dynamics should be anything but ignored - especially these days. They are the key to liquidity abundance and hold the key to sound analysis.

As I've noted in previous analyses, the aggressive financial sector expansion in the face of slowing Non-Financial Debt was the notable 2006 development. From the Fed's Z.1 report, nominal Non-Financial Debt growth slowed to $2.100 TN from 2005's $2.279 TN. Yet at the same time Financial Sector Credit Market Borrowings (that exclude some categories of financial sector borrowings, i.e. deposit growth) increased a record $1.200 TN, up significantly from 2005's $1.040 TN. Remarkably, Broker/Dealer assets surged 29% last year to $2.742 TN.

The slowdown in Non-financial debt growth has been consistent with moderating nominal GDP (as one should expect). What has caught many analysts by surprise, however, is the acceleration of Income Growth and overly abundant marketplace liquidity (and booming global stock markets). In both cases, the rapid expansion of Financial Sector debt has played the prevailing role.

Examining the "Big 5" Wall Street broker/dealers (Goldman, Morgan Stanley, Merrill, Lehman, and Bear Stearns), one can see that combined 2006 Net Revenues were up 33% y-o-y to $133bn. These firms paid out 44% of Net Revenues - or $58.3bn - in Compensation last year. Compensation actually increased 31% from 2005. Furthermore, the spectacular growth trend has only accelerated so far in 2007, with combined "Big 5" Assets expanding at a 41% rate during the first quarter. Combined first quarter compensation increased to $19.7bn, in the most direct flow of financial sector leveraging to augmented income growth.

Obviously, "Big 5" paychecks are only part of today's Financial Sphere Compensation Bonanza. Employee pay was up 18% y-o-y during 2006 to $30.3bn at Citigroup, 17% y-o-y to $21.2bn at JPMorgan, and 21% y-o-y to $18.2bn at Bank of America, to mention a few of the largest "banks." And we cannot forget the hedge fund industry. To get some perspective on potential income gains, let's assume a $2.0 TN (or so) industry enjoys returns of 10%. With the industry standard 20% incentive payouts, hedge fund managers would enjoy a $40bn windfall ($2.0TN*.10%*.20%). Whether it is a Wall Street firm, "money center bank," hedge fund, or local bank branch, the expansion of financial Credit provides growing revenues and rising income that Bubble outside the traditional confines of Non-financial debt statistics.

But direct compensation is only one aspect of today's Credit Bubble-induced surge in financial sector debt growth. On might have assumed that slowing mortgage debt growth would have impacted liquidity. Instead, the rapidly expanding financial sector - aggressively using leverage to balloon securities holdings - set in motion unprecedented marketplace liquidity creation. This liquidity has fueled myriad self-reinforcing asset price and Credit booms.

June 1 - Bloomberg (Bryan Keogh): "U.S. corporations...sold a record $141.6 billion of bonds in May... Sales shattered the previous high of $131.8 billion in November, according to...Bloomberg... U.S. corporate bond issuance this year totals $531.6 billion, up from $464.3 billion the same period a year ago... 'What's driving corporate bond issuance has been the funding of acquisitions, stock buybacks and special dividends,' said John Lonski, chief economist at Moody's..."

Importantly, overly abundant liquidity has spurred a historic global M&A and debt issuance boom. At $530.9bn, year-to-date corporate issuance is running 16% ahead of last year's record pace. And it is worth noting that, according to Bloomberg, "banks, brokerages, insurers and other financial companies" accounted for $92.4bn, or 65%, of May's record bond sales. It has become rather obvious that financial sector Credit expansion is financing much of the acquisitions boom.

Deals are driving debt issuance, and each acquisition completed with debt adds additional "liquidity" into the system. Some of this new liquidity flows to the sellers, where it will be used to purchase other assets or financial instruments. Some of this newly created liquidity is enjoyed by the acquirer through the currently popular private-equity "special dividend." Some of the new financial Credit becomes Revenues and Income for the various financial intermediaries.

Meanwhile, the M&A boom is definitely a major factor stoking stock prices generally, in the process providing additional collateral for leveraging (i.e. margin debt, derivatives, borrowing against capital gains). The backdrop certainly provides ample incentive to start a new business or aggressively grow an existing one in hope of a deal. And, importantly, strong earnings growth coupled with abundant liquidity spur the ongoing stock repurchase boom, reinforcing asset inflation and a recursive cycle of Credit and liquidity excess - not to mention huge liquidity windfalls for corporate insiders and others sellers. It was double-digit financial sector debt growth that permitted last year's record $432bn S&P500 companies' stock repurchases, buybacks that enriched many and supported general stock market inflation. Today's powerful interplay between financial sector and corporate Credit growth should not be downplayed.

Importantly, the massive expansion of financial sector Credit has become the key marginal source of liquidity for the real economy. Undoubtedly, it is the prevailing underlying source - The Other Side of the Story - for booming government tax receipts and shrinking deficits. I would also argue that the ballooning financial sector goes far in explaining how the (negative savings rate) household sector retains sufficient liquidity to send $100s of billions to speculate on foreign financial markets. And keep in mind that the "recycling" back of some of this liquidity (in conjunction with Current Account Deficits) is spurring double-digit U.S. export growth and huge foreign purchases of U.S. assets. This process today provides another important source of revenue and income growth outside of domestic Non-Financial Debt growth.

While it is impossible to quantify, I am convinced that the rampant financial sector expansion is distorting the true scope of the current Credit expansion. Clearly, the massive expansion of Financial Credit is boosting Income, gains on assets sales, foreign flows recycled back into the U.S. economy and confidence generally. As such, it today requires less - and perhaps significantly less - household, corporate and government debt growth to sustain the U.S. Bubble than would traditionally be the case.

It is my belief that the U.S. bond market is coming to recognize this dynamic. For some time, players have been monitoring housing market dynamics with the expectation that an abrupt slowdown in mortgage Credit growth would have dire implications for the vulnerable U.S. economy and Credit system generally. Not only has unparalleled financial sector expansion created more than ample liquidity to sustain the boom, resulting income and securities markets gains have supported home prices and held a full-scale housing bust at bay.

Some analysts see rising global bond yields as evidence of waning liquidity. I believe that bond markets are instead finally wising up to the implications of chronic global liquidity excess and the likelihood that central banks still have an abundance of work ahead of them - perhaps even at the Federal Reserve. Considering the amount of leveraging in the system - especially in the U.S. where markets have been too well-positioned for the next easing cycle - it is now conceivable that a spike in rates could lead to some problematic de-leveraging and liquidity issues.

I don't buy into the bulls' fanciful imminent recovery from a "mid-cycle slowdown" thesis for a moment. I'm also not much of a fan of the prevailing bearish view that housing is well into the process of dragging the economy into recession. I, instead, see the economy in the process of bouncing back at the hands of precarious Credit Bubble excess - especially throughout the financial sector. Housing has been a meaningful setback, but the enterprising U.S. Credit system has found a way to sustain more than ample Credit and liquidity creation - not to mention speculation.

I've argued for too long that the U.S. Credit Bubble is acutely vulnerable to a spike in interest rates. With the booming U.S. financial sector and global financial and economic Bubbles as a backdrop, we might now be only a growth spurt and a negative inflation surprise from testing this thesis. Deleveraging and the unwinding of speculative positions - and the associated reversal of today's key sources and flows of liquidity - would be especially debilitating for our unstable financial sector and economy. And that's, as they say, The Other Side of the Story.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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