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July 13, 2007

Inflation Analysis
by Doug Noland

For the volatile week, the Dow gained 2.2% (up 11.6% y-t-d) and the S&P500 1.4% (up 9.5%). The Morgan Stanley Cyclical index rose another 2.0%, increasing y-t-d gains to 25.9%. The Transports jumped 2.6% (up 17.8%). The Utilities gained 2.0% (up 9.5%) and the Morgan Stanley Consumer index 1.2% (up 7.1%). The small cap Russell 2000 added 0.4% (up 8.6%), and the S&P400 Mid-Caps increased 1.1% (up 15.2%). The highflying NASDAQ100 rose 2.2%, increasing 2007 gains to 15.7%. The Morgan Stanley High Tech index gained 1.9% (up 14.3%). The Semiconductors jumped 3.0% (up 13.2%). The Street.com Internet Index rose 1.8% (14.0%). The NASDAQ Telecommunications index jumped 3.6%, increasing y-t-d gains to 18.9%. The Biotechs advanced 1.5% (up 5.4% y-t-d). The (wild) Broker/Dealers ended the week up 0.4% (up 8.3%) and the Banks gained 0.6% (down 2.1%). With Bullion rising $10.80, the HUI Gold index rallied 1.2%.

Two-year U.S. government yields this week declined 6 bps to 4.92%. Five-year yields fell 8.5 bps to 5.00%. Ten-year Treasury yields dropped 9 bps to 5.10%. Long-bond yields ended the week 8 bps lower at 5.19%. The 2yr/10yr spread ended the week at a positive 12 bps. The implied yield on 3-month December '07 Eurodollars declined 2.5 bps to 5.335%. Benchmark Fannie Mae MBS yields declined 5 bps to 6.32%, this week underperforming Treasuries. The spread on Fannie's 5% 2017 note widened one to 45, and the spread on Freddie's 5% 2017 note widened one to 46. The 10-year dollar swap spread increased 0.6 to 64.8. Corporate bond spreads widened further, with the spread on a junk index this week increasing a notable 17 bps.

July 9 - Financial Times (Paul J Davies): "The price of junk-rated loans in the US and European markets has tumbled in the past couple of weeks as investors begin to turn away from the asset class, according to new data from S&P LCD, the market information service. US leveraged loan prices have fallen to their lowest level in more than four years, while in the derivatives markets a sell-off has pushed the prices of both US and European loan risk to less than the face value of the loans themselves. The fall in prices is significant for banks and private equity firms preparing to launch new debt deals after recent buy-outs because it implies a rise in loan yields, which means higher borrowing costs... Growing concerns about the level of borrowings employed by private equity and the aggressiveness of debt structures, coupled with the problems in the US subprime mortgage market, have sparked a crisis of confidence in debt markets."

Investment grade debt issuers included Lehman Brothers $5.0bn, XTO Energy $1.25bn, Disney $1.1bn, Limited Brands $1.0bn, Tennessee Valley Authority $1.0bn, John Deere $500 million, PepsiAmericas $300 million, Commercial Metal $400 million and Rochester G&E $100 million.

Junk issuers included Bruce Mansfield $1.135bn, and American Capital Strategies $500 million.

Convert issuers included Newmont Mining $1.0bn, Live Nation $200 million, Sonosite $200 million, and Kendle Intl $175 million.

International dollar bond issuers included Merna Nationwide Building Society $2.0bn, Bancaja $1.3bn, Turanalem Finance $1.0bn, and Neo-China Group $400 million.

July 11 - Bloomberg (Hamish Risk): "Corporate bond risk soared in Europe by the most in at least three years as debt rating downgrades on U.S. subprime securities triggered a worldwide sell-off, according to traders of credit-default swaps."

German 10-year bund yields declined 6 bps to 4.62%, while the DAX equities index added 0.6% (up 22.7% y-t-d). Japanese 10-year "JGB" yields were unchanged at 1.93%. The Nikkei 225 gained 0.5% (up 5.9% y-t-d). Emerging equity markets were strong, and debt markets generally rallied. Brazil's benchmark dollar bond yields declined 2 bps this week to 6.10%. Brazil's Bovespa equities index surged 3.1% to a new record high (up 29.6% y-t-d). The Mexican Bolsa was little changed (up 22.5% y-t-d). Mexico's 10-year $ yields dropped 6 bps to 5.92%. Russia's RTS equities index jumped 4.4% (up 7.3% y-t-d). India's Sensex equities index gained 2.1% (up 10.8% y-t-d). China's Shanghai Composite index ended the week 3.5% higher (up 46.3% y-t-d and 136% over the past year).

Freddie Mac posted 30-year fixed mortgage rates jumped 10 bps to a four-week high 6.73% (down one basis point y-o-y). Fifteen-year fixed rates gained 9 bps to 6.39% (up 2bps y-o-y). One-year adjustable rates were unchanged at 5.71% (down 4 bps y-o-y). The Mortgage Bankers Association Purchase Applications Index increased 3.8% this week. Purchase Applications were up 21.1% from one year ago, with dollar volume 27.5% higher (likely distorted by the holiday week). Refi applications fell 3% for the week, although dollar volume was up 40.4% from a year earlier. The average new Purchase mortgage declined to $233,100 (up 5.3% y-o-y), and the average ARM fell to $392,400 (up 20.3% y-o-y).

Bank Credit jumped $24.9bn (week of 7/4) to a record $8.603 TN. For the week, Securities Credit rose $13.6bn. Loans & Leases expanded $11.3bn to $6.296 TN. C&I loans increased $6.8bn, while Real Estate loans fell $10.6bn. Consumer loans jumped $10.9bn. Securities loans added $1.3bn, and Other loans gained $3.0bn. On the liability side, (previous M3) Large Time Deposits increased $5.3bn.

M2 (narrow) "money" increased $4.5bn to a record $7.264 TN (week of 7/2). Narrow "money" has expanded $220bn y-t-d, or 6.0% annualized, and $438bn, or 6.4%, over the past year. For the week, Currency increased $0.9bn, and Demand & Checkable Deposits increased $15.4bn. Savings Deposits fell $14.6bn, and Small Denominated Deposits increased $0.8bn. Retail Money Fund assets added $2.1bn.

Total Money Market Fund Assets (from Invest. Co Inst) jumped another $19.5bn last week to a record $2.579 TN. Money Fund Assets have increased $197bn y-t-d, a 15.4% rate, and $440bn over 52 weeks, or 20.6%.

Total Commercial Paper jumped $11.2bn last week to a record $2.179 TN, with a y-t-d gain of $204.6bn (19.2% annualized). CP has increased $393bn, or 22%, over the past 52 weeks.

Asset-backed Securities (ABS) issuance was a slow $6.5bn. Year-to-date total US ABS issuance of $411bn (tallied by JPMorgan) is now running about 10% behind comparable 2006. At $199bn, y-t-d Home Equity ABS sales are about a third below last year's pace. Meanwhile, y-t-d US CDO issuance of $191 billion is running 13% ahead of record 2006 sales.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 7/11) increased $6.8bn to a record $1.989 TN. "Custody holdings" were up $237bn y-t-d (25% annualized) and $356bn during the past year, or 21.8%. Federal Reserve Credit last week declined $3.0bn to $854.3bn. Fed Credit has expanded $2.1bn y-t-d, with one-year growth of $24.4bn (2.9%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $776bn y-t-d (30% annualized) and $1.39 TN y-o-y (22.9%) to a record $5.587 TN.

Currency Watch:

July 13 - Bloomberg (Megumi Yamanaka): "Iran asked Japanese refiners to switch to the yen to pay for all crude oil purchases, to counter the risk that U.S. dollar transfers may be frozen by increased sanctions. Iran wants yen-based transactions 'for any/all of your forthcoming Iranian crude oil liftings,' according to a letter sent to Japanese refiners... The request is for all shipments 'effective immediately,'..."

July 12 - Financial Times (Michael Mackenzie): "The dollar's slide this week to multi-year lows against a number of currencies has come amid a fresh wave of concerns about US economic growth and the sustainability of foreign investor appetite for US assets... The catalyst for this latest dollar weakness is concern that the US consumer, for years the mainstay of the economy, could be flagging. Such worries followed evidence that the US housing market still does not appear to be finding a bottom along with news that retailers are suffering."

July 11 - Market News International: "China's large and growing trade surplus helped drive Chinese foreign exchange reserves up another $130.6 bln in the second quarter of this year, though unwinding financial transactions between the central bank and domestic lenders also played decisive parts... China's foreign exchange reserves at the end of June were $1.3326 trln, reflecting growth of $130.6 bln in reserves in the second quarter of 2007... Adding in the first quarter's $135.7 bln increase, and China has accumulated a total $266.3 bln in foreign exchange reserves so far this year, exceeding total foreign exchange reserve accumulation over the whole of 2006."

July 11 - Bloomberg (Shigeki Nozawa): "Japan, the largest overseas holder of U.S. Treasuries, should invest $700 billion of its currency reserves in higher-yielding assets such as stocks and corporate bonds, said Takatoshi Ito, an adviser to the prime minister. The reserves should be managed by a special fund that will gradually diversify into euros, Australian dollars and emerging market currencies... Central banks in South Korea, China and Taiwan have announced plans to buy assets with higher returns than U.S. debt..."

The dollar index sank 1.1% to a multi-year low 80.39. On the upside, the Thai baht gained 3.0%, the Czech koruna 2.7%, The Brazilian real 2.2% (to a 7-yr high), the Australian dollar 1.5%, the Swiss franc 1.3%, the Swedish krona 1.3%, the British pound 1.2%, the Norwegian krone 1.2%, the Japanese yen 1.2%, and the Euro 1.1%. On the downside, the dollar made headway against the Ugandan shilling (down 2.5%), the Gambian dalasi (down 1.9%), the Somali shilling (down 1.8%) and the Zambian kwacha (down 1.4%).

Commodities Watch

July 11 - Financial Times (Daina Lawrence): "A rule of thumb for the price of oil in the past five years has been to take the last digit of the year and add a zero: 2002 saw prices in the $20s; 2003 in the $30s; now oil is hovering around $70 a barrel. These high prices are desirable for steering the economy away from oil, but in the meantime they could also spell trouble. Oil companies need to adjust to this new reality and rethink their business model. The latest report by the International Energy Agency warns of an oil supply crunch in five years. Demand is expected to rise at more than 2% annually. Supply, the IEA calculates, will not be able to keep pace."

July 10 - Bloomberg (Wang Ying): "China's crude oil imports jumped 20% in June from a year earlier as production from domestic fields failed to keep pace with energy demand in the world's fastest-growing major economy. Imports climbed to 14.12 million metric tons (3.45 million barrels a day)..."

July 10 - Financial Times (Jenny Wiggins): "Toast at breakfast may soon be more of a treat than a staple after Premier Foods, the owner of Hovis bread, yesterday said it was preparing to raise bread prices for the second time in six months. The pending increase - which the company attributed to rising wheat costs - is merely the latest in a series of price increases food and drink companies have been trying to pass on to consumers this year. The series has seen costs of making bread, beer, yoghurt and chocolate as well as dozens of others packaged food products become increasingly expensive. In the first half of the year, Lehman Brothers' ingredients cost index - which covers cocoa, coffee, oats, tea, soyabeans and milk, among other commodities and which is based on spot rates - rose 14.9%. That follows a 16.5% increase in the second half of 2006. The biggest increase has occurred in powdered milk prices. These have nearly doubled compared with the same period a year ago. Barley prices have also shot up 53%, while corn prices are up 68%."

July 11 - Bloomberg (Chanyaporn Chanjaroen): "Lead rose to a record $3,000 a metric ton in London as stockpiles shrank and demand increased from China, the largest consumer of the metal.... Demand for the metal used in car batteries will exceed production by 74,000 tons this year, according to Macquarie Bank... Stockpiles tracked by the London Metal Exchange fell 125 tons to 42,925 tons... They have declined 61% in the past 12 months."

July 10 - The Wall Street Journal (John J. Fialka): "Government efforts to reduce U.S. reliance on imported oil are forcing up prices for another indispensable commodity: soap. Soap and detergent makers say they are being hurt by a double whammy of federal subsidies and mandates that has reduced the supply and pushed up the costs of a key ingredient, beef tallow. The steeply rising price of corn, driven by a federal requirement to use more ethanol, has pushed up corn prices, making animal feed more expensive and prompting farmers to blend the less-expensive tallow and other fats into their feed. The upshot: In the past year, beef-tallow prices have doubled."

For the week, Gold rose 1.6% to $666.70 and Silver 2.8% to $13.11. Copper was little changed. August crude gained $1.12 to an 11-month high $73.93. August gasoline fell 3.7%, while August Natural Gas rallied 3.4%. For the week, the CRB index rose 1.3% (up 5.8% y-t-d), and the Goldman Sachs Commodities Index (GSCI) gained 1.8% to a near record high (up 17.4% y-t-d).

Japan Watch:

July 11 - Bloomberg (Toru Fujioka): "Japan's current account surplus widened in May as a weaker yen increased the value of overseas investment income and exports. The surplus expanded 31% to 2.13 trillion yen ($17.5 billion) from a year earlier..."

July 11 - Bloomberg (Mayumi Otsuma): "Japan's wholesale inflation accelerated in June as oil and other commodity prices rose, prompting food and packaging companies to pass on costs to clients. An index of prices companies pay for energy and raw materials climbed 2.3% from a year earlier..."

China Watch:

July 11 - Bloomberg (Nipa Piboontanasawat): "China's economy expanded more than the government initially estimated in 2006, taking the pace of growth to the fastest in 12 years. Gross domestic product rose 11.1% from a year earlier to 21.09 trillion yuan ($2.79 trillion)..."

July 10 - Financial Times (Richard McGregor and George Parker): "China's swelling monthly trade surplus hit a new high in June of $26.9bn, an 85.5% increase on the same month last year... The surplus for the first half of the year has now reached $113bn, more than for the whole of 2005... 'This level of trade surplus is unprecedented for China or any other major economy in the world,' said Hong Liang, of Goldman Sachs. Exports of some products jumped dramatically in the first half, such as steel, which was up by 97%, and containers, up by 55%."

July 11 - Bloomberg (Nipa Piboontanasawat and Lee Spears): "China's money supply growth topped the central bank's target for a fifth straight month... M2...rose 17.1% in June from a year earlier to 37.8 trillion yuan ($5 trillion)..."

July 11 - Bloomberg (Li Yanping): "China's 2007 retail sales may rise 15.8% to 8.8 trillion yuan ($1.16 trillion), the fastest annual growth pace in a decade, according to...the country's top planning agency."

July 11 - Bloomberg (Nipa Piboontanasawat): "China's tax revenue rose 29% in the first six months of 2007 from a year earlier, the official Xinhua News Agency reported."

July 10 - Bloomberg (Tian Ying): "China's first-half vehicles sales rose 23% as economic growth spurred demand for passenger cars and commercial vehicles."

July 10 - Bloomberg (Maria Levitov): "China's government must pursue tougher monetary policies to ensure the world's fast-growing major economy doesn't overheat, Finance Minister Jin Renqing said."

India Watch:

July 9 - Financial Times (Joe Leahy): "A sign of how quickly the private equity industry has grown in India is the location of many of the firms' offices. Such has been the industry's haste to tap Asia's newest private equity market that many firms have not had time to find proper premises and still work out of five-star hotel rooms. 'When I started looking at India in 2004, there were fewer than 15 private equity fund managers we could have looked at. Now there are [perhaps] 150 trying to put money to work there,' says Anne-Maree Byworth, India portfolio director with CDC Group... India is the latest Asian country to attract the attention of the world's leading buy-out funds. They are estimated to have a total of $25bn intended for the region, which with leverage provides a war chest for deals in excess of $100bn."

Asia Boom Watch:

July 9 - Financial Times (Joe Leahy): "The volume of initial public offerings in Asia is set to increase sharply in the second half of this year driven by deals from China and India. Companies in Asia excluding Japan are planning to launch IPOs with a total value of $47bn in the six months ending December, up 37.8% compared with the first half..."

July 9 - Bloomberg (Perris Lee): "Taiwan's export growth accelerated more than expected in June on increased shipments to China, where manufacturing was the strongest in more than two years. Exports rose 11% from a year earlier..."

July 11 - Bloomberg (Kim Kyoungwha): "South Korea's government increased its 2007 economic growth forecast because of a rebound in consumer spending and surging exports... The economy will advance 4.6% this year..."

July 10 - Bloomberg (Hui-yong Yu): "Morgan Stanley set a record for real estate purchases in South Korea with its agreement to buy Daewoo Engineering & Construction Co.'s Seoul head office for 960 billion won ($1 billion), brokers said."

July 10 - Bloomberg (Shamim Adam): "Singapore's economy grew at the fastest pace in two years as soaring demand for apartments and offices spurred construction... Gross domestic product expanded an annualized 12.8% in the three months ended June, up from a revised 8.5% in the first quarter..."

Unbalanced Global Economy Watch:

July 13 - Bloomberg (Simon Packard): "Luxury home prices in London rose at the fastest monthly rate since real estate broker Knight Frank LLC began tracking them 31 years ago... The average price of the costliest houses and apartments in the British capital gained 3.1% in June..."

July 10 - Financial Times (Leslie Crawford and Mark Mulligan): "Spanish companies face much tougher credit conditions as a result of a dramatic change in perceptions of country risk, brought on by fear that Spain's house price bubble is about to burst. According to rating agency Standard & Poor's, Spanish corporate debt is at an historic high point, totalling 106% of gross domestic product last year compared with a Eurozone average of 70%. The surge follows a credit-driven acquisition spree at home and abroad. But banks that extended credit freely into the boom are now encountering problems in syndicating some of the riskier loans. Spanish real estate groups have been locked in negotiations with their creditors, who are having difficulties syndicating loans."

July 10 - Bloomberg (Jonas Bergman): "Swedish unemployment fell to the lowest in at least 15 years in June as companies increased hiring amid the fastest economic growth since the turn of the decade. The...rate fell to 3.7%..."

July 11 - Bloomberg (Maria Levitov): "Russia's trade surplus expanded 13% in May from the previous month, as imports continued to grow faster than exports, the central bank said. The surplus rose to $12.7 billion, compared with $11.2 billion in April, the Moscow-based central bank said... Imports totaled $17.6 billion in May, while exports reached $30.3 billion... Sales of imported cars jumped 60% to 510,000 units in the first half..."

July 11 - Bloomberg (Maria Levitov): "The Russian government's budget surplus probably reached 1.07 trillion rubles ($40 billion) in the first half of the year, the Finance Ministry said."

July 11 - Bloomberg (Maria Kolesnikova): "Wheat prices in Russia rose by 10% on the week, prompting Russian bakers to demand that the government limit prices and exports, Vremya Novostei reported. Bread prices in Russia could rise by 40% by the end of 2007..."

Latin American Boom Watch:

July 12 - Financial Times (Richard Lapper and Adam Thomson): "President Martín Torrijos of Panama yesterday unveiled what could become one of the biggest investment projects in the country's history, with a value of up to $10bn. The creation of an urban centre the size of central London on the outskirts of Panama City is the latest sign of an economic boom that has invited comparisons between Panama and bigger international business centres, such as Dubai."

Central Banker Watch:

July 10 - Financial Times (Daina Lawrence): "Canada's central bank raised its key interest rate on Tuesday amid growing concern about inflationary pressures and a soaring Canadian dollar... The Bank of Canada raised the overnight rate to 4.5%, up one quarter of a percentage point, the highest in six years... 'Some modest further increase in the overnight rate may be required to bring inflation back to the target over the medium term," reported the bank.'"

Bubble Economy Watch:

May's Trade Deficit increased from April's $58.7bn to $60.0bn. Goods Exports were up 11.2% from May '06 to a record $93.3bn. Goods Imports were up 4.1% y-o-y to $162.3bn.

July 13 - Bloomberg (Linda Sandler): "Christie's International, the world's largest art seller, said auctions and private sales rose almost 30% on premium prices for Warhols and an influx of new buyers."

Financial Sphere Bubble Watch:

July 10 - Financial Times (Michiyo Nakamoto and David Wighton): "Chuck Prince yesterday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, declaring that Citigroup was 'still dancing'. The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity at the moment it would not be disrupted by the turmoil in the US subprime mortgage market. He also denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back, in spite of problems with some financings. 'When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing,' he said... 'The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be. At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don't think we're at that point.'"

July 12 - Bloomberg (Le-Min Lim): "Judy Carline helps expatriates settle in after they've transferred to Hong Kong. These days, she spends most of her time helping anxious parents who are trying to get their kids into international schools. 'This year is particularly bad,' says Carline, a real estate agent at Savills Plc. There are more of 'these bankers, between 35 and 42, with young children. These days, people think their 3-year-olds are going to Harvard. The Manhattan ladies, they are the worst. They work themselves into a state.' Hong Kong's booming economy and increased demand for English-language instruction from local Chinese parents have filled the city's international schools to the bursting point."

Mortgage Finance Bubble Watch:

July 11 - Bloomberg (Bernard Lo and Debra Mao): "Alphonso Jackson, U.S. Secretary of Housing and Urban Development, said the mortgage default crisis in the U.S. may involve 20% of subprime loans... 'Remember that the subprime loans made in '04, '05, '06, were probably, most of them were stable and good - 80% of them. But we're going to have a problem: 20% of the loans are pretty bad. We believe the Federal Housing Administration, under HUD, can save a number of those buyers who went to the subprime market and did not go to the prime market.'"

July 13 - Bloomberg (Josephine Lau): "The U.S. is urging China's central bank to buy more mortgage-backed securities after a surge in defaults by risky borrowers in the world's largest economy eroded demand for such instruments. 'It's not a matter whether they're going to do more business in mortgage-backed securities, it's who they're going to business with,' U.S. Department of Housing and Urban Development Secretary Alphonso Jackson told reporters in Beijing. He met with central bank Governor Zhou Xiaochuan and Minister of Construction Wang Guangtao in the nation's capital this week. The U.S. housing regulator is seeking to tap China's $1.33 trillion of foreign-currency reserves after surging defaults on subprime mortgages caused the near-collapse last month of two hedge funds run by Bear Stearns Cos."

July 13 - Bloomberg (Rachel Layne): "General Electric Co. plans to sell WMC Mortgage, the company's three-year-old U.S. subprime mortgage unit, following a surge in defaults by borrowers. 'The mortgage industry has greatly changed since the purchase of WMC,' Laurent Bossard, chief executive officer of the division, said... 'The current subprime market environment has made a significant negative impact on the business.'"

Foreclosure Watch:

July 12 - Bloomberg (Dan Levy and Brian Louis): "Mortgage foreclosures in the U.S. jumped to a record in the first half... Almost 926,000 foreclosure notices were filed, 56% more than a year earlier and the most since...RealtyTrac started tracking the data in 2005. Foreclosures were the highest last month in California and Florida, where some home prices have fallen as much as 25%, and Ohio and Michigan, where the automotive industry fired more than 50,000 people in the past 10 years."

MBS/ABS/CDO/Derivatives Watch:

July 11 - Bloomberg (Caroline Salas and Mark Pittman): "On Wall Street, where the $800 billion market for mortgage securities backed by subprime loans is coming unhinged, traders are belatedly acknowledging what they see isn't what they get. As delinquencies on home loans to people with poor or meager credit surged to a 10-year high this year, no one buying, selling or rating the bonds collateralized by these bad debts bothered to quantify the losses. Now the bubble is bursting and there is no agreement on how much money has vanished: $52 billion, according to an estimate from...Credit Suisse... earlier this week that followed a $90 billion assessment from...Deutsche Bank AG."

July 11 - Dow Jones (Anusha Shrivastava): "Standard & Poor's said... it is reviewing the credit ratings of some collateralized debt obligations - complex securities that have been under the spotlight... The ratings firm said that this review is based on the outcome of reviews for possible downgrade it is currently conducting of 612 classes of residential mortgage-backed securities backed by subprime collateral. The affected classes total approximately $12 billion in rated securities, roughly 2.13% of the $565.3 billion in U.S. residential mortgage bonds rated by S&P between the fourth quarter of 2005 and fourth quarter of 2006."

July 12 - Bloomberg (Mark Pittman and Jody Shenn): "Standard & Poor's cut credit ratings on $6.39 billion of bonds backed by subprime mortgages and Fitch Ratings said it may cut $7.1 billion on expectations home-loan defaults will increase. S&P lowered ratings on 562 securities, including 64 that were under scrutiny before this week. Fitch put 170 subprime transactions 'under analysis,' indicating that they may be cut. Ratings of 19 collateralized debt obligations were placed on review for a downgrade..."

Real Estate Bubbles Watch:

July 11 - UPI: "While the subprime U.S. real estate market is in the dirt, high-end U.S. homes are in clover, an analysis of nationwide home sales published Wednesday showed. The national trend has gone largely unnoticed because Washington and the National Association of Realtors...don't report statistics for different price segments, The New York Times said. The newspaper and DataQuick...found sales of homes in the top 5% of the market have been rising in many cities -- often selling at above-asking prices - while sales have fallen in the market's middle and bottom sectors."

July 12 - Bloomberg (Sharon L. Crenson): "Manhattan apartment rents jumped by as much as 36% in the past five years, driven higher by a scarcity of space and rising prices for condominiums and co-operatives... 'Rents increased dramatically,' Citi Habitats Chief Operating Officer Gary Malin said... 'New York is a renter-based city, with approximately 75% of its overall housing comprised of rental properties.'"

July 10 - Bloomberg (Sharon L. Crenson): "Rents for Manhattan's prime offices surged 38% in the second quarter to a record as financial services companies sought more space, according to... Cushman & Wakefield. Average asking rents rose to $69.58 a square foot for Class A properties... Average rents on all classes of office space climbed 36% to $59.17 a square foot..."

July 9 - Bloomberg (Hui-yong Yu): "The vacancy rate in neighborhood and community shopping centers in the U.S. climbed to 7.3% in the second quarter to the highest in almost four years as weakness in Ohio offset strength in California, according to Reis Inc."

M&A and Private-Equity Bubble Watch:

July 12 - Financial Times (Gillian Tett and Joanna Chung): "A year ago, some analysts at Deutsche Bank made a striking call: at a big financial industry conference in Barcelona, they predicted that the subprime sector was heading for problems - even though most large banks were relatively upbeat about the sector at the time. A year later, senior Deutsche Bank officials are keen to avoid seeming too smug about the call... As befits a man [Anshu Jain, co-head of its investment bank] who is renowned as one of the City's canniest operators...Mr Jain is keen to avoid sounding alarmist about market woes. However, he accepts that there is now a rising danger of so-called 'event risk', not simply in the subprime sector, but also in leveraged finance... 'The question is whether what has happened in subprime could now be repeated in leveraged lending, given that leverage ratios continue to ratchet up... [It is] likely not - at least for as long as the world economy keeps growing in line with our analysts' projections. [But] if growth slows down, there could be consequences.'"

Energy Boom and Crude Liquidity Watch:

July 12 - Bloomberg (Jim Kennett): "Exxon Mobil Corp., the oil company John D. Rockefeller formed in 1882, became the only publicly traded company valued above half a trillion dollars."

July 11 - Bloomberg (Tarek Al-Issawi): "Saudi Arabia led the Middle East in spending on telecommunications services with $10.6 billion spent last year, Asharq al-Awsat reported..."

July 10 - Bloomberg (A. Craig Copetas): "The luxury-submarine business is sometimes hard to fathom. 'If you can find my submarine, it's yours,' says Russian oil billionaire Roman Abramovich. And that's all the reclusive owner of the Chelsea Football Club has to say. The ocean floor is the final spending frontier for the world's richest people... Journeying to see what's on the bottom aboard a personal submersible is a wretched excess guaranteed to trump the average mogul's stable of vintage Bugattis or a $38 million round-trip ticket to the International Space Station... Luxury-submarine makers and salesmen from the Pacific Ocean to the Persian Gulf say fantasy and secrecy are the foundations of this nautical niche industry built on madcap multibillionaires."

Fiscal Watch:

After nine months of the fiscal year, total federal receipts are running 7.5% ahead of lasts years pace. Year-to-date spending is running 2.5% above a year ago.

July 10 - Bloomberg (James Kraus): "The cost of the wars in Iraq and Afghanistan has increased to $12 billion a month, from $8 billion two years ago, after an increase in troop levels, the Wall Street Journal reported. So far, Congress has allocated $610 billion in war-related money since the Sept. 11, 2001..."

Speculator Watch:

July 10 - Financial Times (Anuj Gangahar): "Hedge fund launches in the United States are up sharply for the year to date, with 72 new funds with a combined $14bn in assets beginning to trade, according to a survey. Over the same period last year, 51 new funds were launched, raising $11.7bn, according to latest figures from Absolute Return Magazine..."

Inflation Analysis:

For lack of a better adjective, I'll say it was a rather "idiosyncratic" week for the markets and otherwise. Monday, Citigroup's CEO Chuck Prince made curious comments regarding the boom in M&A finance (quoted by the FT - see above): "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing... The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be. At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don't think we're at that point."

Not all that comforting. I could only chuckle when a journalist from the Wall Street Journal, appearing on CNBC, compared Mr. Prince to a ticket scalper outside a concert venue imploring potential buyers with assurances of that the show was going to be so good they certainly wouldn't want to miss out.

On Wednesday, Alphonso Jackson, the Secretary of Housing and Urban Development (HUD), was on Bloomberg television warning that the U.S. mortgage default crisis may impact one-fifth of all subprime loans. This is no small sum considering that there are $800bn of outstanding subprime MBS (from Bloomberg). And what do you know, on Friday a Bloomberg article had Secretary Jackson meeting with Bank of China officials in Beijing urging the Chinese to "buy more mortgage-backed securities after a surge in defaults by risky borrowers in the world's largest economy eroded demand for such instruments." Another ticket scalper in an age of scalpers, though one apparently forced to admit something like this: "Ok, I know you know this show isn't going to be pretty but, please my friend, I really need you to help me out on this one."

And when it comes to "selling a bill of goods," I refuse to let Dr. Bernanke's Tuesday speech, Inflation Expectations and Inflation Forecasting, before the Monetary Economics Workshop of the National Bureau of Economic Research, go unanswered. For starters, I don't recommend reading it. It is academic, written specifically for so-called monetary economists, and basically propounds doctrine that is worse than irrelevant with respect to current inflation dynamics. I find it disturbingly detached from reality.

I'll plead once again that the issues of "money", Credit, and inflation are much too vital to the long-term health of free-market democracies to be left to a select group of policymakers and "ivory tower" dogma. I would instead argue that it is imperative that citizens become sufficiently educated on the perils of Credit inflation, financial excess, and unsound "money." This would provide our only hope against the inflationary tendencies of politicians, the Fed, and the Financial Sphere - tendencies that turn highly toxic when mixed with high octane contemporary "money." Whether by design or, perhaps more likely, his theoretical indoctrination, Dr. Bernanke's inflation discussion continues to evade and obfuscate when it comes to the central monetary issues of our day.

Dr. Bernanke: "As you know, the control of inflation is central to good monetary policy. Price stability, which is one leg of the Federal Reserve's dual mandate from the Congress, is a good thing in itself, for reasons that economists understand much better today than they did a few decades ago."

That's all well and good, but to commence fruitful discussion and debate first requires up-to-date, understandable, and reality-based definitions of "inflation" and "price stability." It should be clear by now that sticking with Milton Friedman's "too much money chasing too few goods" over-simplification does more analytical harm than good. "Money" was already too much of an unclear, amorphous and indefinite concept during Dr. Friedman's heyday. The ongoing "evolution" of contemporary "money" only lunged ahead madly over the past decade or so. Moreover, adherence to a Friedmanite monetary perspective leads one to an ill-advised focus on "narrow money" and confined "core" consumer price inflation, along with a false notion of the government's capacity to manage both. Today, "good monetary policy" and "price stability" are erroneously associated with perpetual - if perhaps only moderate - inflation in a narrow index of aggregate goods and services prices that represents such a small (and shrinking) part of total economy- and market-wide expenditures.

It's more productive to start with "inflation" as a multitude of potential effects emanating from the creation of Excess Purchasing Power. These may include various price effects, although excess purchasing power also typically engenders elevated real investment, imports, and/or market speculation. Inflation's price influences may develop in "core" consumer prices, or perhaps become more prevalent in energy and food prices - depending on many factors including supply/demand dynamics and the nature of the flow of funds/purchasing power. Especially if a Credit system is heavily focused on real (i.e. real estate, sport franchises, art, collectables, etc.) and financial (bonds, stock, "structured" instruments, commodities-related, etc.) assets, asset prices will be a prevailing Inflationary Manifestation. Contemporary "price stability" must be examined in the context of system-wide price levels, Credit growth by sector and in aggregate, and the scope and nature of speculation - and it should begin with the asset markets.

We have today a unique finance-driven economy that becomes more finance-dominated each passing year (month). Analytically, it is important to conceptualize the evolving nature of finance generally and appreciate that a finance economy will be an atypically mutating economic animal. The pool of available finance grows ever larger; the flows of finance become all the more powerful; the speculative impulses more intense and diffuse; and the inflationary impacts more dramatic, yet almost by design not in the general ("core" CPI) price level. In particular, incredible amounts of financial "wealth" are being created, distributed and expended quite unequally (a key Credit Bubble-induced inflationary dynamic). It is not hyperbole to suggest that financial, economic and inflationary dynamics have been radically transformed over recent years to the point of leaving policymakers and conventional economic doctrine in the dark.

Today, the U.S. and global economies are buffeted by powerful inflationary forces unlike anything experienced in decades - if ever. Years of unrelenting Credit and speculative excess have created a vast global pool of enterprising global "purchasing power" (including hedge funds and other leveraged speculators, sovereign wealth funds, pension funds, mutual funds, insurance companies, etc.) searching high and low for robust returns. At the same time, the perception that the U.S. dollar is now a perpetually devaluing currency has created a powerful inflationary bias in myriad "non-dollar" asset classes across the globe. Dr. Bernanke and the Fed would be better off disposing of the old academic articles and notions of inflation and starting from scratch.

In a week when Dr. Bernanke applauded "good monetary policy" and "price stability," U.S. financial markets were notable for demonstrating acute instability. Dr. Bernanke states that, "undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability." He then reiterates the commonly accepted view that - because of the Fed's ongoing commitment and success in fighting inflation - inflation expectations "have become much better anchored over the past thirty years." This may have been somewhat the case for a period of time, but it is foolhardy to believe it holds true these days. After all, seemingly the entire world prescribes to the view of ongoing asset and commodities inflation. And these expectations - in conjunction with liquidity and Credit abundance - provide one of the more highly charged inflationary backdrops imaginable.

I don't recall Dr. Bernanke's mentioning asset inflation in his speech, although he does sanguinely address the inflationary (non-) ramifications of the surge in oil prices. "...A one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent 'wage-price spiral.' With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices." And, "the long-run effect on inflation of 'supply shocks,' such as changes in the price of oil, also appears to be lower than in the past," along with "inflation is less responsive than it used to be to changes in oil prices and other supply shocks."

The major issue I have with such conjecture is that it blindly disregards the key issues and prevailing dynamics of contemporary finance. Oil has always been the most important commodity in the world, yet it has never been as economically and financially critical to the world as it is today. The huge inflation in oil and energy prices has had much to do with the massive expanding global pool of dollar balances (mostly emanating from our Current Account Deficits), the depreciating value of the dollar, and the associated massive liquidity over-abundance throughout Asia. Energy and related inflation has had and will, going forward, have only greater geopolitical consequences. It is nonsensical today to concentrate on oil inflation's (to date) impact on "core" U.S. consumer prices.

Liquidity-induced oil price inflation has been exacerbated by the interplay of boom-time global demand increases (especially in Asia). Knock-on effects then included the liquidity/purchasing power accumulated by OPEC and other exporters, as well as speculative buying internationally. Importantly, inflating energy prices have fostered Credit creation through myriad channels. For one, U.S. companies, governments, individuals and the economy overall have borrowed more for energy purchases, in the process working to sustain destabilizing Current Account Deficits in the face of a weakening dollar. There has been no "supply shock" specifically because easily accessed cheap Credit has provided sufficient added purchasing power to ensure uninterrupted energy demand ("monetization").

Across the globe, more borrowed finance has been needed to acquire energy resources and companies; more has been borrowed to explore, develop and extract oil and pursue alternative energy sources. The rising values of energy assets (including oil company stock prices and energy derivatives) have created additional collateral to borrow against. And, more recently, the surge in energy prices has led to more broad-based secondary effects, including the large transportation and food sectors - which will work to encourage additional borrowing and broadening price effects. It would be a huge analytical blunder to expect that "energy prices should not lead to a permanent increase in inflation but only to a change in relative prices."

Importantly, rising oil prices were initially an inflationary effect which, accommodated by easy "money," spurred greater Credit creation and increasingly potent inflationary forces. Inflation begets inflation, and the Fed can continue to downplay asset and commodities inflation at our currency's peril. Both may be exerting only modest pressure on "core" consumer price indices these days, but such a narrow-minded focus completely misses the point.

The Fed is forever fond of gauging "long-run inflation expectations" by measuring the difference in yields between nominal and inflation-indexed bonds. In the current financial backdrop, this is comforting but flawed analysis. It may illuminate the markets' best guesswork with respect to prospective CPI levels, but when it comes to actual "inflation expectations" I would suggest the Fed monitor a "basket" of indicators including the price of gold, oil, energy, and general commodities indices, the "commodity" currencies, global equities and real estate prices and, importantly, the global demand for Credit. Furthermore, a reasonable view of "inflation expectations" could be gleaned through the study of speculative leveraging throughout global financial and asset markets. The key inflationary focus today should be on factors and dynamics driving Credit growth and speculative excess.

While on the subject, it's worth noting that speculative excess in the U.S. stock market has reached the greatest intensity since early- 2000. The nature of current synchronized global market speculation is extraordinary to say the least. Virtually all markets everywhere. Here at home, all the fun and games and squeezes should have the Fed alarmed. Destabilizing market "melt-ups" are the last thing our vulnerable system needs right now.

And when I commented above that Dr. Bernanke's (and the Fed's) inflation doctrine was "worse than irrelevant," I had today's global financial backdrop in mind. To be sure, a policy of pegging short-term rates with promises of fixating two eyes on "core" CPI and no eyes on asset prices/Credit/or speculative excess has been fundamental in nurturing the history's greatest Credit Bubble. Or, from another angle, relatively stable CPI has ensured runaway Credit inflation and speculative asset Bubbles. And the marketplace's inability to orderly adjust to rising global bond yields, surging energy prices and mounting inflationary pressures, and unfolding Credit market tumult portend problematic market dislocations at a future date.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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