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July 06, 2007

Monopoly
by Doug Noland

For the week, the Dow gained 1.5% (up 9.2% y-t-d) and the S&P500 1.8% (up 7.9%). The Transports jumped 2.5% (up 14.7%), as the Morgan Stanley Cyclical index closed the week up 2.2% to a new record high (up 23.2%). The Utilities rallied 0.7% (up 7.3% y-t-d), and the Morgan Stanley Consumer index increased 0.9% (up 5.8%). The broader market rallied sharply. The small cap Russell 2000 jumped 2.2% (up 8.2%), and the S&P400 Mid-Caps rose 2.3% (up 13.9%). Strong technology performance continued. The NASDAQ 100 jumped 2.7%, increasing y-t-d gains to 13.2%. The Morgan Stanley High Tech index gained 2.3%, increasing 2007 gains to 12.1%. The Semiconductors surged 2.6% (up 10%). The Street.com Internet Index rose 1.8% (up 12%) and the NASDAQ Telecommunications index 3.3% (up 14.7%). The Biotechs added 0.7% (up 3.8%). The Broker/Dealers rallied 3.5% (up 7.9%), and the Banks gained 1.2% (down 2.7%). With bullion gaining $6.15, the HUI index rallied 6.6%.

Trade interest rate and yield curve markets at your peril. Two-year U.S. government yields this week rose 12 bps to 4.98%. Five-year yields surged 16 bps to 5.09%. Ten-year Treasury yields jumped 16 bps to 5.18%. Long-bond yields ended the week 15 bps higher at 5.27%. The 2yr/10yr spread ended the week at 20 bps. The implied yield on 3-month December '07 Eurodollars increased 7.5 bps to 5.36%. Benchmark Fannie Mae MBS yields rose 11 bps to 6.37%, this week outperforming Treasuries. The spread on Fannie's 5% 2017 note was little changed at 44, and the spread on Freddie's 5% 2017 note little changed at about 45. The 10-year dollar swap spread increased 0.4 to a multi-year high 64.2. Corporate bond spreads were volatile, with the spread on a junk index narrowing slightly this week.

There was little debt issuance this holiday week.

July 5 - Bloomberg (Cecile Gutscher and Caroline Salas): "The world's biggest bondholders have had their fill of leveraged buyouts, convinced that increasing mortgage delinquencies will drag down the U.S. economy and drive debt-laden companies into default. TIAA-CREF, which oversees $414 billion in retirement funds for teachers and college professors, is boycotting some debt offerings used to finance LBOs. Fidelity International...and Lehman Brothers Asset Management LLC...say they're avoiding debt from buyouts. Investors are getting skittish just as private-equity firms led by Kohlberg Kravis Roberts & Co. and Blackstone Group Inc. prepare to sell $300 billion of bonds and loans to finance LBOs, according to Bear Stearns Cos. In the past two weeks alone, more than a dozen companies were forced to postpone or restructure debt sales."

International dollar bond issuers included Merna Reinsurance $1.1bn, million.

German 10-year bund yields jumped 10.5 bps to 5-year high 4.675%, while the DAX equities index added 0.5% (up 22% y-t-d). Japanese 10-year "JGB" yields rose 6 bps to 1.93%. The Nikkei 225 was little changed (up 5.3% y-t-d). Emerging equity markets were on fire, while debt markets were under only moderate pressure. Brazil's benchmark dollar bond yields rose 2.5 bps this week to 6.12%. Brazil's Bovespa equities index surged 3.8% to a record high (up 26.9% y-t-d). The Mexican Bolsa jumped 4.0% to an all-time closing high (up 22.5% y-t-d). Mexico's 10-year $ yields rose 6 bps to 5.97%. Russia's RTS equities index rallied 4.1% (up 2.7% y-t-d). India's Sensex equities index gained 2.1% (up 8.5% y-t-d). China's Shanghai Composite index swung back and forth, ending the week 1.0% lower (up 41.3% y-t-d and 117% the past year).

Freddie Mac posted 30-year fixed mortgage rates declined 4 bps to 6.63% (down 16bps y-o-y). Fifteen-year fixed rates fell 4 bps to 6.30% (down 14bps y-o-y). One-year adjustable rates rose 6 bps to 5.71% (down 12bps y-o-y). The Mortgage Bankers Association Purchase Applications Index increased 2% this week. Purchase Applications were up 5% from one year ago, with dollar volume 11.4% higher. Refi applications fell 2.6% for the week, although dollar volume was up 21.3% from a year earlier. The average new Purchase mortgage declined to $236,400 (up 6.1% y-o-y), and the average ARM slipped to $396,600 (up 16.9% y-o-y).

Bank Credit declined $19.9bn (week of 6/27) to $8.567 TN. For the week, Securities Credit fell $12.5bn ($24.3bn 2-wk decline). Loans & Leases declined $7.5bn to $6.273 TN. C&I loans dropped $8.3bn, and Real Estate loans dipped $0.8bn. Consumer loans declined $4.2bn. Securities loans rose $8.7bn, while Other loans fell $2.8bn. On the liability side, (previous M3) Large Time Deposits expanded $5.5bn.

M2 (narrow) "money" rose $10.5bn to a record $7.262 TN (week of 6/25). Narrow "money" has expanded $218bn y-t-d, or 6.2% annualized, and $430bn, or 6.3%, over the past year. For the week, Currency added $0.2bn, while Demand & Checkable Deposits declined $6.7bn. Savings Deposits gained $8.7bn, and Small Denominated Deposits increased $2.6bn. Retail Money Fund assets increased $5.5bn.

Total Money Market Fund Assets (from Invest. Co. Inst.) surged $23bn last week to a record $2.560 TN. Money Fund Assets have increased $178bn y-t-d, a 14.4% rate, and $422bn over 52 weeks, or 19.7%.

Total Commercial Paper surged $25.4bn last week to a record $2.168 TN, with a y-t-d gain of $193bn (18.9% annualized). CP has increased $384bn, or 21.5%, over the past 52 weeks.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 7/4) increased $7.0bn to a record $1.982 TN. "Custody holdings" were up $230bn y-t-d (25.3% annualized) and $346bn during the past year, or 21.1%. Federal Reserve Credit last week jumped $9.7bn to $857.3bn. Fed Credit has expanded $5.1bn y-t-d, with one-year growth of $21.1bn (2.5%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $636bn y-t-d (25.4% annualized) and $993bn y-o-y (22.3%) to a record $5.4 TN.

July 6 - Bloomberg (Anoop Agrawal): "India's foreign-exchange reserves increased $937 million to $213.49 billion in the week ended June 29..."

Currency Watch:

July 3 - Bloomberg (Kosuke Goto): "Japanese housewives are helping to moderate currency swings by betting against professional investors, Bank of Japan board member Kiyohiko Nishimura said. 'The arrival of Japanese households as major investors seems to have affected foreign-exchange markets,' Nishimura, 54, said... 'The gnomes of Zurich were accused in their day of destabilizing markets. The housewives of Tokyo are apparently acting to stabilize them.' Nishimura is the first policy maker to comment on increasing foreign-exchange margin trading, which last month helped push implied volatility on one-month yen options to the lowest since the Bank of Japan began compiling data in August 1992."

The dollar index declined 0.5% to 81.26. On the upside, the Iceland krona gained 1.9%, the Czech koruna 1.6%, the Thai baht 1.3%, the Chilean peso 1.1%, and the Swedish krona 1.0%. On the downside, the Japanese yen declined 0.8%, the Swiss franc 0.6%, the South African rand 0.5%, and the Philippines peso 0.5%.

Commodities Watch

July 4 - Financial Times (Javier Blas): "Food prices will rise by between 20 and 50% over the next decade from average levels over the last ten years, supported by the growth of the biofuel industry and increased food demand in emerging countries, a study warned yesterday. The report by the United Nation's Food and Agriculture Organization (FAO) and the OECD, added that long-term prices would be up to 30% higher than previously estimated."

July 6 - Financial Times (Geoff Dyer): "Food prices are set for a period of 'significant and long-lasting' inflation because of demand from China and India and the use of crops for biofuels, according to the head of Nestlé. Peter Brabeck, chairman of the world's largest food company, said rises in food prices reflected not only temporary factors but also long-term and structural changes in supply and demand. 'They will have a long-lasting impact on food prices,' he told the Financial Times... Several food companies have warned about the short-term outlook for prices, but Mr. Brabeck's comments are among the starkest warnings that a long period of rising food prices could stoke broader inflationary pressures... Corn prices have risen about 60% and wheat about 50% over the last 12 months. Sugar, milk and cocoa prices have also surged, prompting the biggest increase in retail food prices in three decades in some countries."

July 5 - Bloomberg (Yoshifumi Takemoto): "Japanese steel company costs may rise more than expected this year as raw material prices gain, said Shoji Muneoka, executive vice president of Nippon Steel Corp., the world's second-largest steelmaker. Costs may increase as much as 1 trillion yen ($8 billion), 43% more than an industry forecast, as prices rose for iron ore, coking coal, molybdenum, nickel, tin, scrap metal and shipping, Muneoka said..."

For the week, Gold gained 0.9% to $655.80, and Silver jumped 2.3% to $12.76. Copper surged 4.4%. August crude rose $2.13 to a 10-month high $72.81. August gasoline gained 3.2%, while August Natural Gas sank an additional 4.9%. For the week, the CRB index increased 1.6% (up 4.4% y-t-d), and the Goldman Sachs Commodities Index (GSCI) jumped 2.4% (up 15.4% y-t-d).

Japan Watch:

July 3 - Financial Times (Michiyo Nakamoto): "Big foreign investment banks achieved record revenues in Japan last year largely because of the strength of their brokerage operations, despite a lacklustre stock market. Morgan Stanley posted a 21% rise in revenues to a record Y238.6bn for the year to March, followed by Goldman Sachs, which saw record revenues of Y231.3bn, up 4%. Merrill Lynch, Deutsche Securities and UBS also posted record revenues in Japan... This has prompted UBS to increase its Tokyo headcount by 20% this year, while Morgan Stanley and Deutsche increased their staffs by 14% and Goldman Sachs by 10%."

China Watch:

July 4 - Financial Times (Robin Kwong, Sundeep Tucker and Anuj Gangahar): "Capital raised by new listings in China is set to exceed $52bn this year, twice the figure forecast in January, putting the mainland on track to become the world's leading centre for share offerings this year... The flood of offerings is being driven by mainland companies' rush to benefit from valuations on the soaring stock market. The main Shanghai index has trebled in the past 18 months. 'This latest forecast is scary,' said a senior Hong Kong banker..."

July 5 - Bloomberg (Li Yanping): "China's trade surplus may have widened by more than 60% to $110 billion in the first half of 2007, state-run Xinhua News Agency reported..."

July 5 - Bloomberg (Kelvin Wong): "Hong Kong's retail rents will surge 19% in the 12 months through May 2008 on increased local consumer spending and an influx of overseas retailers, according to...Colliers International..."

July 5 - Bloomberg (Nipa Piboontanasawat): "Hong Kong's property sales rose 32% to HK$213.7 billion ($27 billion) in the first six months of 2007 from the same period a year earlier... The number of transactions climbed 33%..."

India Watch:

July 2 - Financial Times (Joe Leahy): "In India, barely a week goes by without a company announcing another major fund-raising exercise. In the latest such move, government-controlled State Bank of India, the country's largest bank, said last week it needs Rs500bn ($12.3bn) of capital over the next three years and will raise part of it through share offerings. 'We need capital, all banks in India need capital, because the Indian economy is growing at a fantastic pace and bank lending is growing 25% plus,' SBI chairman Om Prakash Bhatt said. All of this is music to the ears of international investment banks. They have been scrambling to boost their presence in India to ride the boom..."

July 3 - Bloomberg (Anil Varma): "India's central bank faces 'severe policy challenges' in managing capital inflows attracted by the nation's record economic growth, Governor Yaga Venugopal Reddy said. 'We have several significant economic strengths but we also have twin deficits - current and fiscal; have a higher component of more volatile portfolio flows on capital account and severe policy challenges in managing capital flows.'"

July 2 - Bloomberg (Kartik Goyal): "India's trade deficit widened in May as companies imported more machinery and other goods, taking advantage of a record rise in the nation's currency. The trade deficit was $6.22 billion in May compared with $4.26 billion a year earlier..."

Asia Boom Watch:

July 2 - Bloomberg (Seyoon Kim): "South Korea's export growth accelerated and the nation's finance minister said improving overseas sales will help drive a faster expansion of Asia's third-largest economy in the next six months. Exports climbed 15.9% in June from a year earlier..."

Unbalanced Global Economy Watch:

July 5 - The Wall Street Journal (Deborah Solomon): "Governments from Canada to China are considering or implementing restrictions on foreign purchases of companies, factories, real estate and natural resources in their countries, moves that U.S. officials fear could harm global economic growth if they proliferate. 'Perhaps the greatest challenge is rising investment protectionism, and we've got to work very hard to keep investment barriers low,' says U.S. Deputy Treasury Secretary Robert Kimmitt, who recently visited Moscow and Beijing to urge officials to minimize restrictions on foreign investment."

July 5 - Bloomberg (Greg Quinn): "Canadian building permits rose 21% in May to a record, a pace almost four times faster than economists forecast, led by commercial office space in the western cities of Calgary and Vancouver."

July 6 - Bloomberg (Alexandre Deslongchamps): "Canada's economy added 34,800 jobs in June, twice as many as expected, and the unemployment rate stayed at a 33-year low for a fifth month, giving the Bank of Canada more reason to raise interest rates next week."

July 3 - Bloomberg (Fergal O'Brien): "European unemployment fell to a record in May as companies added jobs to meet strengthening demand, a sign wage claims may rise and inflationary pressures increase. The jobless rate in the 13-nation euro area declined for a seventh month, dropping to 7% from 7.1% in April..."

July 3 - Bloomberg (Fergal O'Brien): "Ireland's economic growth quickened in the first quarter, as companies invested more and exports rose. Gross domestic product increased an annual 7.5%, the fastest pace since the third quarter of 2006..."

July 6 - Bloomberg (Simone Meier): "Swiss unemployment declined in June, pushing the jobless rate to the lowest in almost five years as companies step up spending and hiring to meet orders... The jobless rate fell to 2.7%..."

July 5 - Bloomberg (Andreas Cremer): "German Economy Minister Michael Glos comments on prospects for growth in Europe's largest economy... 'The shortage of skilled labor in Germany is giving us reason for concern. Business is desperately looking for qualified staff even though 20,000 engineers are registered as unemployed. That doesn't make sense and slows the economic upswing. We need more investment in education... Our economy is running at full steam, Germany has again become the engine of growth in Europe.'"

July 2 - Bloomberg (Robin Wigglesworth): "Norway's domestic credit growth accelerated to 14.8% in May, adding to expectations the central bank will keep raising interest rates to curb spending and inflation."

July 4 - Bloomberg (Maria Levitov): "Russia's money supply expanded 19% in the first quarter and will probably expand as much as 39% by the end of the year, central bank Chairman Sergei Ignatiev said. 'The money supply has so far been growing too quickly,' Ignatiev told lawmakers at the parliament..."

July 4 - Bloomberg (Maria Levitov): "Russia's annual inflation rate accelerated to 8.5% in June on higher prices of fruits and vegetables, central bank chairman Sergey Ignatiev said. Inflation increased from 7.8% in May..."

July 2 - Bloomberg (Mark Bentley and Steve Bryant): "Turkey's economic growth accelerated in the first three months... Gross domestic product in the EU candidate expanded an annual 6.8%, compared with 5.2% in the previous three months..."

Latin American Boom Watch:

July 2 - Bloomberg (Bill Faries): "Argentina's June tax revenue rose as exports and consumer spending in South America's second-largest economy heads into its fifth straight year of growth. Tax revenue in June rose 30.4% from a year earlier to 18 billion pesos ($5.8 billion)..."

Central Banker Watch:

July 5 - Bloomberg (Svenja O'Donnell): "The Bank of England raised its benchmark interest rate for the fifth time in a year as accelerating economic growth and surging house prices kept inflation above target. The nine-member Monetary Policy Committee...increased the bank rate by a quarter-point to 5.75%, the highest since April 2001... Inflation has held above the bank's 2% target for more than a year as a boom in London's financial services industry and rising home values powered the fastest economic growth in three years."

Bubble Economy Watch:

July 5 - Financial Times (Daniel Pimlott): "Amid crowds of cranes, rumbling concrete trucks and grand schemes for its future, New York is experiencing one of the greatest eras of development in its history. A series of dramatic skyscrapers, including the new World Trade Center, is set to transform the city as financial giants such as Goldman Sachs and Bank of America cash in on the strength of the US economy... The New York Building Congress expects 'unprecedented construction levels' this year and next, with total construction spending for the city likely to breach $25bn this year..."

Financial Sphere Bubble Watch:

July 2 - Financial Times (Richard Beales and Francesco Guerrera): "Some US companies are starting to take on more debt in order to pay it out to shareholders - a response to rampant leveraged buy-outs and activist investors. The moves, while still unusual, could herald a gradual shift among publicly listed companies towards more aggressive capital structures. Recent announcements include...Home Depot's intention to borrow $12bn to help finance a $22.5bn share buy-back and plans at Expedia...to spend $3.5bn buying back 42% of its shares - funding part of the buy-back with debt."

Mortgage Finance Bubble Watch:

July 5 - The Wall Street Journal (Rex Nutting): "More Americans fell behind on debt payments in the first quarter than at any time since the 2001 recession, despite fewer delinquencies on credit-card debts, the American Bankers Association reported... Delinquencies of all types of consumer loans rose to 2.42% in the first quarter from 2.23% in the fourth quarter, led by higher rates of late payments for real-estate loans."

Foreclosure Watch:

MBS/ABS/CDO/Derivatives Watch:

July 6 - Financial Times (James Mackintosh and Paul J Davies): "Investment banks are demanding more capital to back loans to hedge funds investing in US subprime mortgage-linked debt, as they try to head off a repeat of the near-collapse of two Bear Stearns hedge funds. The 'haircut', or margin requirement, on financing provided to buy collateralised debt obligations (CDOs) backed by subprime mortgage bonds has been increasing sharply, in many cases doubling, according to hedge funds, bank executives and prime brokers."

July 6 - Financial Times (Paul J Davies): "The fallout from the crisis at two Bear Stearns hedge funds in the broader market for the complex securities they hold is likely to worsen, as investment banks cut their credit exposure to funds involved in the field. It is far from certain how significant the direct impact of these cuts will be and even more uncertain are the knock-on effects to other areas of structured credit and debt markets beyond. But some in the market say that whatever the outcomes, the current troubles in collateralised debt obligations of asset-backed securities are a sneak preview of what the next broad-based downturn in markets might look like."

Real Estate Bubbles Watch:

July 5 - The Wall Street Journal (Jennifer S. Forsyth): "Office rents are skyrocketing across the nation, driving up costs for businesses large and small, thanks to a dearth of space in some major markets and a new breed of deep-pocketed landlords who can afford to hold out for premium tenants. Nationwide, effective rents on office properties... jumped an average of 3.1% during this year's second quarter, up from gains of 2.8% in the first quarter and 2.1% in the year-earlier period, according to a report...by Reis Inc. That was the sharpest quarterly increase since the third quarter of 2000..."

July 5 - Financial Times (Jim Pickard, David Turner and Dan Pimlott): "All the best parties tend to conclude with painful hangovers. In real estate, the celebrations have been going on for nearly five years against the heady backdrop of strong investor demand, rising prices, cheap debt and a benign occupier market. Some canny investors have made a killing from highly geared bets on rising property markets from Mumbai to Madrid. And global real estate stocks are up 341% since March 2003. Now, however, someone appears to have turned off the music. Share prices of some real estate companies have taken a battering in recent months. In the UK, some of the biggest groups are down 20 to 30% from their new year highs."

July 3 - Bloomberg (Sharon L. Crenson): "Manhattan co-operative apartment prices fell in the second quarter, the first decline in four years, as buyers favored condominiums that are free of resale and sublet restrictions. The median price of a co-op declined 3.7% to $695,000 in the period ending June 30, according to...Miller Samuel Inc. and broker Prudential Douglas Elliman Real Estate. The median price for a condo climbed 5.1% to $1.04 million."

M&A and Private-Equity Bubble Watch:

July 3 - Financial Times (Paul J Davies ): "At the height of the first junk-rated debt crisis in 1989, RJR Nabisco sold what remained until very recently the biggest ever slug of high-yield bonds. But what is less well remembered is that the company and its buy-out backers, Kohlberg Kravis Roberts, raised only about $4bn from its $6.1bn bond issue as market turmoil forced it to offer much of the debt at a hefty discount. For many people, the parallels between then and now are striking. With plenty of leveraged buyout-related loans and bonds due to hit the markets in coming months, the massed ranks of private equity groups and investment banks will be hoping they do not suffer the same fate. But with US and European companies...all bringing or expected to bring huge junk-rated bond or loan deals in coming weeks and months, investor sentiment and appetite is likely to be well tested. Nowhere is this more true than in the US, where a record $215bn of loans is expected to be sold into the markets over the second half of the year, according to data from S&P... Crucial to the success of these loan sales and others in Europe is the health of a highly complex and still young market for collateralised loan obligations (CLOs)... The big problem facing sponsors of leveraged buy-outs in particular is that in modern credit markets, sentiment in CLOs and thus in underlying loan markets has become far more closely inter-linked with that in a far broader range of other markets..."

July 5 - Financial Times (Ben White and James Politi): "Kohlberg Kravis Roberts, which filed for a $1.25bn initial public offering late on Tuesday, expects to trade at a valuation multiple equal to, or higher, than rival Blackstone. Insiders said KKR's belief is based on the fact that it is a pure-play buy-out firm, without Blackstone's exposure to other asset management businesses. If the expectation is justified then KKR would be valued at more than $15.5bn... KKR's move continued a wave of alternative asset managers - including Blackstone, Fortress and Och-Ziff Capital Management - that are seeking to raise permanent capital to expand operations, attract talent and offer founders a way to cash in on the boom in the private equity and hedge fund industries."

Energy Boom and Crude Liquidity Watch:

July 5 - Bloomberg (Will McSheehy): "The Kuwait Investment Authority, which oversees as much as $400 billion for the Persian Gulf state, made a fiscal year profit of $28.5 billion from investments in companies... Kuwait's Future Generation Fund and General Reserve Fund, both managed by the authority...made a combined profit of 8.2 billion dinars ($28.5bn) in the year to March 31, a 23% increase on the previous year..."

July 6 - New York Times (Leslie Wayne): "The chairman of Emirates airline -- Sheik Ahmed bin Saeed al-Maktoum of the ruling family of Dubai -- has grand ambitions and a bankroll to match. He has a huge pot of money to spend: $82 billion from his government, the airline and other financiers. He loves large planes, and he has ordered 55 superjumbo A380s, to create the biggest fleet of these double-decker planes in the world. And he wants to make Dubai, a sheikdom by the sea, the busiest airline hub in the world, overtaking London, New York and Singapore... Emirates is the world's fastest-growing airline -- it will take delivery of one new Boeing or Airbus plane a month for the next five years... 'We've never seen anything like it before,' said Robert Cullemore, a consultant at Aviation Economics, an advisory firm in London. 'We've never seen growth at this rate.'"

July 3 - Bloomberg (James Brooke): "The Ritz-Carlton Moscow threw open its neo-imperial doors near the Kremlin this week. The cheapest room for the summer tourist season is $1,036 with tax. That rate reflects how Moscow hotel openings are lagging behind room demand fueled by soaring tourism, exports and investor interest in the world's largest energy producer."

July 3 - Bloomberg (Shanthy Nambiar and Matthew Brown): "Nasser David Khalili, catapulted into the top five of the U.K. rich list by the soaring value of his Islamic art, said the jump in prices for old works by Muslim artists has barely begun. 'Anyone who says Islamic art is expensive is dreaming,' said Khalili... 'The Muslim world is not short of money, but the world is short of objects. This is only the beginning.' Governments and millionaires in nations from Saudi Arabia to Malaysia, enriched by a doubling of crude oil prices in four years, are bidding for a dwindling supply of surviving artifacts from 1,400 years of Islamic culture. Khalili said his seven-century-old 'Jami' al-Tawarikh, one of the world's earliest histories, is now worth 15 to 20 times the $12 million he paid for it in 1990."

Monopoly:

Is an attempt to make some sense out of recent crosscurrents even plausible? One would have expected rising global yields, mounting U.S. consumer debt issues, and serious festering problems within Wall Street "structured finance" to have by now at least somewhat impinged marketplace liquidity. And, actually, the vast majority of Credit spreads have widened meaningfully over the past few weeks. Deteriorating market conditions have forced an increasing number of debt deals to be re-priced, postponed, or cancelled altogether. M&A Bubble vulnerability has become palpable.

Yet over-liquefied global equities markets are at or near record highs; crude is rapidly approaching $73; gold is back above $650; major commodities indices are rallying back toward all-time highs; and international debt issuance is running at a record pace. Buyout announcements are unrelenting. And despite the housing downturn and subprime implosion, the U.S. Bubble economy chugs right along. Non-farm payrolls have increased 871,000 year-to-date, only moderately below the pace of job generation over the past two years. The Morgan Stanley Cyclical index enjoys a 23% 2007 gain. The NASDAQ Composite sits today on a one-year gain of 23.7% (up 10.4% y-t-d).

Let's first delve briefly into the (Bubble) economy and then return to the markets. June's 132,000 and May's revised 190,000 (from 157,000) jobs created confirm ongoing economic expansion. This should not be surprising considering continuing Credit excess and the strong inflationary biases that persist in many sectors (certainly including the stock market/M&A/general finance, exports, energy, commodities, agriculture, healthcare, the military and government). Healthcare employment increased 42,000 during June, with Government jobs up 40,000 and "Leisure" 39,000. Year-to-date, Service Producing jobs have gained 943,000, with Education & Health Services up 291,000, Leisure 194,000, Trade & Transport 107,000, and Business Services 80,000. Goods Producing employment has declined 72,000 y-t-d, with Manufacturing losing 84,000 jobs and Construction (only) 3,000.

June Hourly Earnings were up 3.9% y-o-y, now hovering near 4% annual increases for 14 straight months. Keep in mind that y-o-y Hourly Earnings growth peaked at 4.3% during 2000 and then fell below 4% during the five year period July 2001 through June 2006. Upward wage pressures certainly appear more pervasive today than they were during the technology/telecom Bubble period. Skilled workers remain in short supply in most industries - a dynamic one would not expect to play well with bond managers.

The schizophrenic Treasury market was hit head-on this week by a strong ISM Manufacturing report (up one to 56), a booming ISM Non-Manufacturing number (up one to 60.7), and today's robust jobs data. Rather abruptly, last week's fear of impending Credit tumult was - at least for top-tier fixed income - temporarily displaced by angst associated with an overheated global economy, heightened inflationary pressures, and rising global rates. Visions of impending Fed easing were overcome by the menacing view of a Fed forced down the road into additional rate hikes.

On the one hand, there is significant stress in the U.S. CDO marketplace with the very real potential to expand into a serious liquidity event. On the other, energized Credit systems across the globe are today firing on virtually all cylinders. The debt markets are caught confounded and indecisive with respect to the nuances of this newfound global Credit and liquidity juggernaut, as well as to the scope of the liquidity-creating function undertaken by the CDO marketplace over the past couple years. There is today an unusually fine line between an unwieldy global liquidity Bubble and the mounting risk of a liquidity dislocation in the market for financing risky securities. Such uncertainty has become a distinguishing feature of the today's Credit and speculation-induced Monetary Disorder.

The risks of a flight away from the CDO market are very real and won't likely dissipate anytime soon. "Ponzi Finance" dynamics have created acute fragility. A run on these illiquid instruments would be immediately problematic, requiring re-pricing throughout. Since a large amount of these securities are financed through the Wall Street "repo" machine, lower prices would instigate margin calls and forced liquidation. The risk of a problematic deleveraging and marketplace dislocation is today quite high.

By their nature, prolonged Credit Bubbles concentrate incredible financial power in fewer and fewer bigger hands. Those most successful at financial innovation exploit their capacity to intermediate Credit and issue the debt instruments sought by the marketplace. The natural inclination is to capitalize fully on one's financial advantage - to consolidate power by outgrowing, acquiring, merging or linking with a dwindling cadre of "competitors." This dynamics melds well with the progressively arduous task of creating and distributing the ever-larger quantities of Credit instruments necessary to sustain the Bubble. Wall Street's incredible "success" with electronic "money" owes much to its ability to have made a Monopoly out of the business of "structured finance."

When this Credit Bubble inevitably bursts, the large financial operators (the Wall Street firms, "money center" banks, hedge funds, financial guarantors, and rating agencies) will be anathema to the general public (and legislators!) as they were in the post-1929 crash environment. In the meantime, however, we should expect the "money" changers to go to great lengths to sustain the boom. Not only do Wall Street investment bankers today control the creation of debt instruments (contemporary "money" and Credit), the firms also dominate the entire risk intermediation (i.e. derivatives) and financial asset management business. I mention this only to remind readers that - as one would expect at this stage of a historic financial Bubble - we are not these days dealing with "free" or "efficient" markets. It doesn't work that way.

At the same time, I don't believe the Fed, Wall Street, or any group has much control over developments other that to work diligently to ensure sufficient Credit creation. Command over how this created purchasing power flows through the global economy and markets is becoming a different story altogether. And that, loyal readers, is the age old dilemma of inflationary booms. I may believe we are on the precipice for one heck of a problem associated with the reversal of speculative flows to risky and illiquid debt instruments. But what that means in the near-term to U.S. and global equities markets is anything but clear.

I've written in the past how markets can go haywire near inflection points. In reality, these days they have a strong propensity for doing it. The NASDAQ Bubble is the poster child. Increasingly evident fundamental problems - a faltering telecom debt Bubble, rapidly weakening industry profit trends, and acute "Ponzi Finance" dynamics - surely played an instrumental role in the final melt-up and resulting subsequent collapse. Certainly, huge short positions and derivatives bets created the backdrop for destabilized market conditions and dislocation.

Witnessing recent market dynamics, I am increasingly of the view that we are experiencing oddities reminiscent of the 1999/early-2000 market dislocation. To be sure, there are eerie fundamental parallels along with abundant "technical" fodder. The number of outstanding NASDAQ shares sold short in June was up 37% from a year earlier and 28% higher for the NYSE. Over the past six months, short interest has expanded at a 65% rate at NASDAQ and 58% at the NYSE. We also know that derivative positions and trading activity have surged.

I'll assume that so-called "market neutral" strategies are responsible for much of the increased shorting, especially the more recent proliferation of "130/30" (130% long and 30% short) strategies. Having lived through all the squeezes and nonsense orchestrated against bearish positions during the nineties, I'll cynically suggest that we shouldn't be all too surprised if this current bout of speculative excess runs its course only after wreaking some bloody havoc on this popular strategy. Actually, this dynamic already may help explain the strong gains posted by stocks with oversized dollar value shorts positions (i.e. Amazon, Research in Motion, Apple, Google, Intel, GM, etc.)

Short squeezes create market liquidity, albeit temporarily. I would also argue that rising stock markets (and asset markets generally) generate their own liquidity, especially when derivatives strategies proliferate. Writing out-of-the-money call options to finance the purchase of out-of-the money put options was a popular hedging strategy in the late nineties. Such trades have little market influence as long as the market trades in narrow range. But, and as we saw with NASDAQ, these strategies can be destabilizing in rapidly rising markets, adding marketplace leverage and the forced unwind of hedges on the upside. I see no reason not to expect today's unfathomable derivative positions to run amuck.

How far we are today into an upside market dislocation is impossible to discern. Yet I certainly suspect that speculative dynamics have reemerged as an integral aspect of market behavior, at home and likely abroad. The specter of a synchronized global market "melt-up" and the acute susceptibility to breakdown such a scenario would entail is one aspect of the unfolding "worst-case scenario." As I expounded above, today's global Credit apparatus has extraordinary command over the liquidity-creation process. It's just losing more and more control over inflationary effects in an asset manic world. But that definitely doesn't mean the Game is over.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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