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October 12, 2007

Not So Benign Neglect
by Doug Noland

For the week, the Dow added 0.2% (up 13.1% y-t-d) and the S&P500 0.3% (up 10.1%). The Transports were hit for 1.1% (up 8.3%), while the Morgan Stanley Cyclical index increased 0.3% (up 21.9%). The Utilities gained 0.9% (up 11.9%), while the Morgan Stanley Consumer index was little changed (up 8.5%). The small cap Russell 2000 slipped 0.4% (up 6.8% y-t-d) and the S&P400 Mid-Cap index 0.2% (up 13.4%). The NASDAQ100 gained 1.3%, increasing 2007 gains to 24%. The Morgan Stanley High Tech index rose 1.4% (up 21.2%). The Semiconductors dropped 2.3% (up 4.2%). The Street.com Internet Index jumped 1.8% (up 23.7%), and the NASDAQ Telecommunications index rose 1.0% (up 26.1%). The Broker/Dealers dipped 0.5% (up 0.3%), while the Banks gave back 2.3% (down 8.1%). With Bullion gaining $6.40 and trading intraday above $750, the HUI Gold index jumped 4.9% (up 22.2%).

Interest rates are back on the rise. Three-month Treasury bill rates jumped 21 bps this week to 4.18%, the high since Sept. 6th. Two-year government yields rose 14 bps to 4.21%. Five-year yields ended the week 7.5 bps higher at 4.41%. Ten-year Treasury yields increased 4 bps to 4.68%, and long-bond yields added 4 bps to 4.90%. The 2yr/10yr spread narrowed this week to 47 bps. The implied yield on 3-month December '08 Eurodollars rose 11 bps to 4.585%. Benchmark Fannie Mae MBS yields were unchanged at 5.98%, this week again outperforming Treasuries. The spread on Fannie's 5% 2017 note widened 2 to 42, and the spread on Freddie's 5% 2017 note widened 2 to 42. The 10-year dollar swap spread declined 1 to 62, the low going back to mid-June. Corporate bond spreads continued to narrow. The spread on an index of junk bonds ended the week sharply narrower.

Investment grade debt issuers included Citigroup $3.0bn, HSBC $2.5bn, ERAC Finance $2.75bn, Goldman Sachs $2.0bn, Darden Restaurant $1.15bn, VF Corp $600 million, HCP Inc $600 million, and Alabama Power $200 million.

Junk issuers included AES Corp $2.0bn and Allison Transmission $550 million.

Convert issuers included Istar Financial $800 million, Rayonier $250 million and Morgans Hotel $150 million.

Foreign dollar bond issuance included Deutsche Bank $3.0bn, Oester Kontrolbank $1.75bn, Export-Import Bank of Korea $1.5bn, Midori LTD $260 million, Industrias Metal $225 million, and Grupo Juo Sab $200 million.

German 10-year bund yields rose 7 bps to a two-month high 4.42%, while the DAX equities index ended the week unchanged (up 21.3% y-t-d). Japanese 10-year "JGB" yields added 0.5 bps to 1.70%. The Nikkei 225 advanced 1.4%, increasing 2007 gains to 3.25%. Most emerging equities markets built on recent gains, while debt markets were mostly quiet. Brazil's benchmark dollar bond yields increased 4 bps to 5.83%. Brazil's Bovespa equities index surged 3.4% to a record high (up 40.4% y-t-d). The Mexican Bolsa jumped 3% (up 22.8% y-t-d). Mexico's 10-year $ yields increased 2 bps to 5.60%. Russia's RTS equities index gained 2.3% (up 12.5% y-t-d). India's Sensex equities index increased 3.6% to another record (up 33.6% y-t-d and 46.9 y-o-y). China's Shanghai Exchange jumped 6.3% to a record high (up 121% y-t-d and 232% y-o-y).

Freddie Mac posted 30-year fixed mortgage rates gained 3 bps this week to 6.40% (up 3bps y-o-y). Fifteen-year fixed rates rose 3 bps to 6.06% (unchanged y-o-y). Curiously, one-year adjustable rates surged 15 bps to 5.73% (up 17 bps y-o-y).

Bank Credit surged $54.5bn for the week (10/3) to a record $8.982 TN. Bank Credit has now posted an 11-week gain of $339bn (18.5% annualized) and y-t-d rise of $686bn, or 10.7% pace. For the week, Securities Credit surged $42bn. Loans & Leases increased $12.5bn to a record $6.595 TN (11-wk gain of $271bn). C&I loans jumped $16.8bn, increasing the y-t-d growth rate to 21.3%. Real Estate loans declined $4.9bn. Consumer loans dipped $3.4bn. Securities loans added $1.9bn, and Other loans increased $2.3bn. On the liability side, (previous M3) Large Time Deposits rose $7.9bn (4-wk gain of $78.1bn).

M2 (narrow) "money" added $2.1bn to a record $7.384 TN (week of 10/1). Narrow "money" has expanded $340bn y-t-d, or 6.3% annualized, and $470bn, or 6.8%, over the past year. For the week, Currency gained $1.8bn, and Demand & Checkable Deposits increased $4.9bn. Savings Deposits fell $10.5bn, and Small Denominated Deposits increased $1.7bn. Retail Money Fund assets rose $4.3bn.

Total Money Market Fund Assets (from Invest. Co Inst) increased $16.8bn last week to a record $2.909 TN. Money Fund Assets have now posted an 11-week gain of $335bn (60% annualized) and a y-t-d increase of $527bn (28% annualized). Money fund asset have surged $644bn over 52 weeks, or 28.5%.

Total Commercial Paper rose $5.0bn to $1.865 TN. CP is down $359 bn over the past nine weeks. Asset-backed CP declined an additional $6.3bn (9-wk drop of $256bn) to $918bn. Year-to-date, total CP has declined $109bn, with ABCP down $166bn. Over the past year, Total CP has contracted $49bn, or 2.6%.

Asset-backed Securities (ABS) issuance increased to $11bn this week. Year-to-date total US ABS issuance of $481bn (tallied by JPMorgan) is running 30% behind comparable 2006. At $213bn, y-t-d Home Equity ABS sales are 51% off last year's pace. Year-to-date US CDO issuance of $274 billion is running 2% below 2006 sales.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 10/10) increased $5.5bn, surpassing $2.0 TN for the first time. "Custody holdings" were up $252bn y-t-d (18.2% annualized) and $317bn during the past year, or 18.8%. Federal Reserve Credit last week declined $3.3bn to $858.3bn. Fed Credit has increased $6.1bn y-t-d and $27.2bn over the past year (3.3%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.050 TN y-t-d (28% annualized) and $1.189 TN year-over-year (25.4%) to a record $5.861 TN.

Credit Market Dislocation Watch:

October 10 - Financial Times (Saskia Scholtes): "Banks and investors are still struggling to value mortgage securities backed by subprime home loans more than four months after valuation disputes came to light... The problems forced several hedge funds to the brink...and others to suspend investor withdrawals because they were unable to properly value their portfolios. The latest of these is Ellington Management Group, a $5.2bn debt-focused hedge fund, which said in a letter to clients...that it was temporarily suspending withdrawals from two of its funds because of valuation problems in the market for complex mortgage securities. The move underscores how the riskiest tier of the mortgage market remains illiquid, even as more normal conditions return to most other asset classes. Mike Vranos, chief executive at Ellington, wrote: 'There has recently been little or no trading in certain lower-rated or unrated subprime mortgage securities. As a result, enormously wide spreads have developed between bids and offers on many of these securities.' In a letter to clients last week, John Devaney, chief executive of United Capital Markets, a troubled broker-dealer and hedge fund manager in the asset-backed securities market, said: 'Liquidity is horrible and prices are in the range of five to 50 points apart sometimes just hours or days apart.' Mr Devaney added that the existence of the nascent derivatives market for such securities, in the form of the ABX index, had exacerbated the sell-off and uncertainty over true valuations. 'The CDS market and its size has contributed greatly to the volatility. As prices dropped, there were - and still are - those forced to sell, taking off leverage.' Mr Vranos at Ellington said the situation meant there was 'no way to determine net asset values that would be fair both to investors redeeming from these funds and to investors remaining in these funds'.

October 8 - Financial Times (James Mackintosh and Saskia Scholtes): "Investment banks are creating discounted securities to help them clear out billions of dollars of assets they had been holding for complex structured credit deals cancelled during the summer credit squeeze. Last week, Deutsche Bank sold at a discount and for half its usual fee a $2bn collateralised loan obligation (CLO) - a bundle of differently-rated securities backed by a portfolio of loans... The deals help remove an overhang of loans in bank warehouses that has contributed to depressed loan prices as banks have been forced to liquidate CLO deals lacking buyers... The CLO market suffered a virtual buyers' strike over the summer as investors recoiled from all complex structured credit products."

October 8 - Financial Times (Deborah Brewster): "Vanguard, one of the world's biggest fund managers, says it was caught off-guard by the impact of the turmoil in the credit markets on its $25bn in quantitative investments, and believes such strategies will be more volatile than it first thought... Quantitative strategies have produced outstanding returns in recent years, but many 'quants' were hit badly this summer as the turmoil that began in the US mortgage market spread to other parts of the financial system... An estimated $500bn is in quantitative funds. The notional value of money quantitatively managed is probably $1,000bn, if leverage is taken into account."

October 12 - Financial Times (Michael Mackenzie and Saskia Scholtes): "Interbank lending rates in short-term money markets, benchmarked by the London Interbank Offered Rate (Libor), have eased since the height of the summer credit squeeze but remain at elevated levels. Problems are most apparent at three-month maturities, with banks reluctant to lend to each other amid uncertainty about their funding needs and whether they will be forced to make good ailing commercial paper programmes and other commitments. 'Libor is like a car's oil warning light,' said David Darst, chief investment strategist at Morgan Stanley. 'It is on, but it doesn't tell us whether we need half a quart of oil or the engine is about to seize up.'"

October 12 - Financial Times (Gillian Tett): "Seven months ago, the Bank of England issued a strikingly prescient warning about 'value at risk' (VAR) models. While these models have become endemic in the financial world in recent years, they have a nasty habit of being self-reinforcing, or so the Bank observes. When volatility is low in the markets - as it has been during most of this decade, when VAR models have flourished - these tools typically offer a very flattering picture of risk-taking. That prompts banks to take more risk, which reduces market volatility further as more cash chases assets... One big investment bank has recently analysed the impact of its own recent asset sales. These suggest that, while these sales should have cut VAR by half in recent weeks on constant volatility levels, in practice this gain was more than wiped out by ensuing market price swings. By scurrying to reduce risk, in other words, the banks may end up simply running to stand still. This problem will undoubtedly leave many observers to conclude that there are flaws in the VAR concept. Behind the scenes, that is precisely what many risk experts now privately say."

October 12 - The Wall Street Journal (Susan Pulliam, Randall Smith and Michael Siconolfi): "Since the invention of the ticker tape 140 years ago, America has been able to boast of having the world's most transparent financial markets. The tape and its electronic descendants ensured that crystal-clear prices for stocks and many other securities were readily available to everyone, encouraging millions to entrust their money to the markets. These days, after a decade of frantic growth in mortgage-backed securities and other complex investments traded off exchanges, that clarity is gone. Large parts of American financial markets have become a hall of mirrors."

October 9 - Financial Times (Ben Hall and Tony Barber): "The French government last night stepped up its drive for tighter financial regulation in the wake of summer's market turmoil, proposing a set of controls on securitisation and bank liquidity that go substantially further than EU calls for greater transparency. ...Christine Lagarde, French finance minister, calls for securitisation to be subject to a 'degree of standardisation', so that there is effectively a limit on the complexity of credit instruments. She also wants tighter regulation of off-balance sheet special investment vehicles and of the 'originate and distribute' model of credit... 'Unregulated entities' involved in such operations should be subject to the same regulatory supervision as banks, she writes."

Currency Watch:

October 13 - Shanghai Daily: "China's foreign exchange reserves reached US$1.43 trillion at the end of September, up 45% from the same period last year, the People's Bank of China said... Over the first nine months, US$367.3 billion was added to the country's cache of foreign exchange reserves... The massive forex reserves are causing excess liquidity in China. At the end of September, China's M2...grew 18.45% from a year ago to 39.31 trillion yuan (US$5.23 TN)."

The dollar index was down slightly this week to 78.12. For the week on the upside, the New Zealand dollar increased 1.9%, the Swedish krona 1.7%, the South African rand 1.1%, the Canadian dollar 1.5%, the Australian dollar 1.2%, the Norwegian krone 0.8%, the Euro 0.9%, and the Danish krone 0.9%. On the downside, the South Korean won declined 0.2%, the Japanese yen 0.2%, and the British pound was unchanged.

Commodities Watch:

October 8 - AFP: "China's net imports of crude oil rose 18.1% in the first eight months of the year as the booming country's voracious energy demands continued to grow, state media reported... Net imports reached 108.2 million tonnes from January to August, Xinhua news agency said, quoting figures from the General Administration of Customs... It has been a net importer of oil since 1993 and imported 138.8 million tonnes of crude in 2006, up 16.9% from the previous year. Imports last year accounted for 47% of the country's overall consumption..."

October 10 - Bloomberg (Winnie Zhu): "Saudi Aramco plans to increase oil exports to China by at least 9% this year to meet rising demand from refiners in the world's fastest-growing major economy, said two company officials."

October 10 - Financial Times (Javier Blas and Chris Flood): "Codelco, the world's largest copper producer, yesterday said the metal's bull market would continue next year as rising Chinese demand more than offset weak US consumption and a 'double-digit' surge in production costs... 'Demand is growing fast in emerging markets; in particular in China. This process will continue in 2008...'"

October 10 - Financial Times (Javier Blas): "The Baltic Dry Index, a gauge of freight costs for dry bulk commodities such as iron ore, coal and grains, yesterday surged above 10,000 points for the first time. The index was bolstered by demand from China and a jump in US cereal exports to the Asia-Pacific region. The index jumped 3.6% on the day to 10,218 points, taking its increase since January to almost 140%. Freight costs have risen fivefold since 2003."

October 10 - Bloomberg (Debarati Roy): "Sinosteel Corp., China's second-biggest iron-ore trading company, expects the contract price for the steelmaking ingredient to gain 25 percent next year, driven by increased demand, a company executive said. 'China's demand is unstoppable,' Hongsen Wang, managing director at the company's Indian unit, said today in an interview from New Delhi. Wang had forecast a 5% price gain in May. 'Supply continues to lag demand,' Wang said."

October 10 - Bloomberg (Joi Preciphs): "Expanding the corn crop to make more ethanol for fuel risks damaging the U.S. water supply with soil and chemical runoff while creating local shortages, a U.S. panel of scientific advisers found. 'If projected future increases in use of corn for ethanol production do occur, the increase in harm to water quality could be considerable,' the panel, the National Research Council's Water Science and Technology Board, said."

For the week, Gold rose 0.9% to $749.10, and Silver jumped 3% to $13.90. December Copper slipped 2%. November crude surged $2.47 to a record $83.69. November gasoline added 1.7%, while November Natural Gas declined 1.4%. December Wheat fell 3.8%, reducing y-t-d gains to about 60%. For the week, the CRB index gained 1.3% (up 8.6% y-t-d). The Goldman Sachs Commodities Index (GSCI) advanced 1.5% (up 26.7% y-t-d).

Japan Watch:

October 11 - Financial Times: "Whether out of skill or sheer luck, Japan has so far appeared blissfully isolated from the credit turmoil that has embroiled western markets. But amid ample liquidity, one pool has all but dried up. Japanese consumer finance companies are finding it difficult to raise funds in the capital markets. In particular, issuance of asset-backed securities by consumer lenders has ground to a halt, depriving some lenders of an important source of funds."

China Watch:

October 10 - Bloomberg (Zhang Dingmin): "China's economy may expand by 11.6% this year after growing by 11.1% in 2006, showing 'more obvious' signs that the world's fastest-growing major economy is overheating, a government think-tank said. The government should take 'decisive' measures to slow economic growth in 2008...the Chinese Academy of Social Sciences said..."

October 11 - Bloomberg (Nipa Piboontanasawat): "China's trade surplus jumped 56% in September to $23.9 billion, adding pressure on the central bank to increase borrowing costs and let the yuan strengthen faster to prevent the economy overheating."

October 10 - Bloomberg (Allen T. Cheng and Dune Lawrence): "China has 106 billionaires, up from 15 last year, as surging stocks boost the wealth of the nation's richest people, according to the Shanghai-based Hurun Report... China's billionaire tally is second only to that of the U.S., which has 400... 'China may have 200 billionaires, we just haven't identified them yet -- there are a lot of people out there who don't report their assets,' said Rupert Hoogewerf, who has produced the list since 1999. 'The new wealth we haven't discovered yet is lying in the stock markets.'"

October 12 - Bloomberg (Li Yanping): "China's tax revenue rose 31% in the first three quarters of this year, the biggest increase since 1994, as stamp duty income surged with the stock market's rally..."

October 8 - Bloomberg (Dune Lawrence): "China's consumer goods sales during the seven-day National Day holiday period climbed 16% from a year earlier to almost 350 billion yuan ($46.7 billion), the Ministry of Commerce said... Sales increased 35% in Chongqing municipality in central China, 25% in Shanghai and 23% in the eastern province of Jiangsu..."

October 11 - Bloomberg (Philip Lagerkranser): "Agricultural Bank of China, saddled with $100 billion of bad loans, may move some of its 14,500 rural branches to independent companies to speed up a government bailout and sell shares for the first time... China has spent about $500 billion bailing out its biggest lenders over the past decade."

October 8 - Bloomberg (Kelvin Wong): "Prime office rents in Hong Kong's central business district rose 28% to a record this year as a stock market boom spurred banks to hire workers, fueling demand for space."

India Watch:

October 11 - Bloomberg (Cherian Thomas): "India's industrial production growth exceeded expectations in August, accelerating for the first time in five months, as record investment in factories, roads and power plants boosted demand for cement and steel. Production at factories, utilities and mines jumped 10.7% from a year earlier..."

Asia Bubble Watch:

October 8 - Bloomberg (James Peng): "Taiwan's export growth unexpectedly accelerated in September as demand from China and Southeast Asia offset weaker U.S. orders. Overseas sales rose 10.6% from a year earlier..."

October 10 - Bloomberg (Shamim Adam): "Singapore's economy grew more than forecast in the third quarter... Gross domestic product jumped an annualized 6.4% after adjusting for inflation... Singapore's expansion has pushed inflation and private home costs to the highest in more than a decade and encouraged companies to hire at an unprecedented pace."

October 8 - Financial Times (Sundeep Tucker): "Asia's listed companies and their investors have taken advantage of buoyant equity markets in the region this year to raise record funding via follow-on share offerings... The volume of follow-on issuance across Asia, excluding Japan, reached $71.5bn in the first nine months, a 72% rise on the same period last year, Thomson Financial found."

October 10 - Financial Times (Norma Cohen): "Securities exchanges in the Asia-Pacific region have experienced the most explosive growth during the past year, with the National Stock Exchange of India emerging as the world's third most active exchange measured by volume, according to a study from Celent, the exchanges consultancy firm... The study, titled 'Global Securities Exchanges Landscape', found that in terms of growth in trading activity, the biggest increases occurred in Asia, particularly in China where the Shanghai and Shenzhen exchanges increased the value of equities traded by 591% and 485%, respectively... Overall, the number of equities trades worldwide increased 44 per cent between the first half of 2006 and that of 2007..."

Unbalanced Global Economy Watch:

October 8 - Bloomberg (Sebastian Boyd): "London finance companies may cut jobs next year and trim bonuses by 16% as U.S. subprime-mortgage losses spill over into the U.K. economy, according to the Centre for Economic and Business Research Ltd. Next year's estimated losses of 6,500 banking and fund-management jobs could be the most severe since 2000..."

October 11 - Bloomberg (Svenja O'Donnell): "U.K. house prices fell at the fastest pace in two years in September...the Royal Institution of Chartered Surveyors said. The number of real-estate agents and surveyors saying prices declined outnumbered those reporting gains by 15%, the biggest negative balance since September 2005..."

October 9 - Financial Times (John Murray Brown): "Ireland has already seen its religious orders selling off land. Now it is the members of some of the country's exclusive golf clubs who are voting to cash in their greens and fairways to make way for new housing. Some clubs have pulled off attractive deals with developers, but others may be too late to the party amid signs the Irish property boom has come to an end. Gerard McDonnell of Pembroke McDonnell estate agents believes the reality is rather worse. 'Prices are down 10% and that's if you get it,' he says."

October 8 - Bloomberg (Jonas Bergman): "Sweden's unemployment rate fell...to 3.3% from 3.4% in August..."

October 10 - Financial Times (Krishna Guha): "The economies of eastern Europe are vulnerable to a reversal of the surge of private capital that has poured into emerging markets in recent years, the International Monetary Fund says in its latest World Economic Outlook analysis... The IMF says 'large capital inflows are of particular concern to countries with substantial current account deficits, such as many in emerging Europe', as well as countries with inflexible exchange rate regimes."

October 10 - Bloomberg (Bradley Cook): "Russian consumer prices will rise more than 9% this year, Economy Minister Elvira Nabiullina said..."

Latin America Watch:

October 11 - Market News International (Charles Newbery): "A surge in tomato prices this month in Argentina sparked a five-day boycott that forced restaurants to stop offering the vegetable... Independent consumer rights organizations organized the action against tomatoes...to force down prices... Pricey tomatoes and other fresh foods -- and boycotts may now extend to bread, chicken, potatoes and squash -- have rekindled debate about consumer price pressures and what the next government will do about it."

Bubble Economy Watch:

October 10 - Financial Times (Francesco Guerrera): "Corporate America is braced for the worst period of economic uncertainty since the start of the decade as the credit squeeze and the housing meltdown heighten the risk of a sharp slowdown in the US. US chief executives say the economic outlook has not been as difficult as this to read since the last recession in 2000-2001 and warn that, despite signs of a pick-up, the threat of a significant contraction in growth is still alive. Conflicting economic indicators and volatile business conditions make it difficult to take crucial strategic decisions such as whether to hire or fire staff and increase or slash capital expenditure..."

October 11 - Dow Jones (Brian Blackstone): "U.S. import prices increased sharply last month on higher oil and food prices...a fifth-straight rise in prices of goods from China suggests the U.S. can no longer count on cheap imports from that country to offset domestic inflationary pressures... In the 12 months through September, import prices increased 5.2%, up sharply from August's 1.9% year-on-year rate and the highest since August 2006."

October 12 - The Wall Street Journal (Greg Ip): "The richest Americans' share of national income has hit a postwar record, surpassing the highs reached in the 1990s bull market, and underlining the divergence of economic fortunes blamed for fueling anxiety among American workers. The wealthiest 1% of Americans earned 21.2% of all income in 2005, according to...the IRS. That is up sharply from 19% in 2004, and surpasses the previous high of 20.8% set in 2000, at the peak of the previous bull market in stocks. The bottom 50% earned 12.8% of all income, down from 13.4% in 2004..."

Fiscal Watch:

October 9 - Bloomberg (Adam L. Cataldo): "New Jersey faces a budget deficit that may exceed $3 billion in fiscal year 2009... The shortfall for the year that begins next July is larger than the $2.5 billion projection made by Governor Jon Corzine...in March... Tom Vincz, a treasury department spokesman, said the new deficit figure is 'on the high side' of projections at this point, and is due to rising costs for such things as employee benefits and salaries."

October 10 - Financial Times (Daniel Dombey): "The White House on Tuesday sought to counter accusations that its plans to build the biggest embassy in the world were over budget, badly behind schedule and entrusted to an unreliable contractor. Democratic congressmen this week attacked the administration's record on the construction of its $592m Baghdad embassy... Henry Waxman...wrote to Condoleezza Rice, the secretary of state, citing claims that the cost of building the embassy had risen by a further $144m and that its fire safety equipment did not work."

Central Banker Watch:

October 11 - Bloomberg (Gabi Thesing): "European Central Bank governing council member Axel Weber said the bank may need to raise interest rates to a level that restricts economic growth to keep inflation under control. 'If risks to price stability are threatening to materialize, monetary policy can't lose sight of its primary mandate -- even if that means no longer supporting the robust economy or becoming restrictive,' Weber, who also heads Germany's Bundesbank, said... There may be an 'additional need' to raise interest rates, given the 'expected acceleration in euro-region inflation over the coming months.'"

October 10 - Bloomberg (Jennifer Ryan and Brian Swint): "Bank of England Governor Mervyn King suggested he's reluctant to cut interest rates to shield lenders from increased credit costs and predicted more 'turmoil' in financial markets. 'The current turmoil in financial markets is not over,' King said... The benchmark interest rate 'will not be set now to insulate the banking system from the re-pricing of risk. But you can be sure that we will do whatever is necessary to keep inflation close to the 2% target.'"

California Watch:

October 10 - Bloomberg (Daniel Taub): "California home prices probably will drop 4% next year, the biggest decline in 15 years, as stricter lending standards keep some buyers out of the market, the California Association of Realtors said. The median price for houses and condominiums in California likely will decline to $553,000... Lenders are requiring buyers to make larger down payments and have higher credit ratings to qualify for mortgages... About 334,500 houses and condominiums likely will be sold next year in California...down 9%... That drop follows a projected 23% sales decline this year. 'Sales could decline more steeply in 2008 if the current liquidity crunch in the mortgage markets has a longer-than-expected duration...' Colleen Badagliacco, president of the California Association of Realtors, said..."

October 11 - Los Angeles Times (Annette Haddad): "The slow housing market didn't stop Martha Franco and thousands of other real estate agents from attending the California Assn. of Realtors annual convention...but it did factor into how she and others spent their day there. It was standing room only at sessions focusing on foreclosures and other consequences of the slump... The trade group projects that 40% of the 500,000 licensed real estate agents in California will probably let their licenses lapse when they come up for renewal, noted Kevin Burke, a real estate attorney...who is on the Realtors' executive committee."

Mortgage Finance Bust Watch:

October 11 - Bloomberg (David Mildenberg): "Countrywide Financial Corp., the largest U.S. mortgage company, said late payments at its servicing unit rose, foreclosures doubled and new loans fell 44% as housing sales slowed. Overdue loans as a percentage of unpaid principal increased to 5.85% in September from 4.04% a year earlier... Foreclosures climbed to 1.27% from 0.51%."

October 11 - The Wall Street Journal (Kelly Evans): "The mortgage mess is claiming a new group of victims: renters. Across the country, a rising number of landlords are falling behind on mortgage payments, sending their properties into foreclosure, according to legal-services attorneys, local officials and financial experts -- and in many cases, their tenants are being forced out of their homes. Often, the tenants' first inkling of trouble occurs when they get a letter from the bank directing them to leave the premises."

Foreclosure Watch:

October 11 - Bloomberg (Dan Levy): "U.S. foreclosures doubled in September from a year earlier as subprime borrowers struggled to make payments on their adjustable-rate mortgages, RealtyTrac Inc. said. There were 223,538 foreclosure filings last month, including default and auction notices and bank repossessions, RealtyTrac said... California had the most with 51,259 and Florida was second with 33,354. The national foreclosure rate was one for every 557 households."

October 10 - UPI: "Foreclosure auctions, with up to 700 houses available for bid, are popping up across the United States in another sign of the housing slump and credit crunch."

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

October 11 - The Wall Street Journal (Rick Brooks and Costance Mitchell Ford): "As America's mortgage markets began unraveling this year, economists seeking explanations pointed to 'subprime' mortgages issued to low-income, minority and urban borrowers. But an analysis of more than 130 million home loans made over the past decade reveals that risky mortgages were made in nearly every corner of the nation, from small towns in the middle of nowhere to inner cities to affluent suburbs. The analysis of loan data by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined $1.5 trillion in high-interest-rate loans. Most subprime loans, which are extended to borrowers with sketchy credit or stretched finances, fall into this basket."

Real Estate Bubbles Watch:

October 10 - Dow Jones: "Demand for previously owned homes will decline in 2007 at a larger rate than previously forecast... The National Association of Realtors said Wednesday that existing-home sales are expected to total 5.78 million in 2007. That would be down 10.8% from 6.48 million in 2006. A month ago, the NAR predicted an 8.6% drop... The NAR sees the sales pace at 6.12 million next year. A month ago, NAR was predicting 6.27 million for 2008."

October 9 - New York Times (Christine Haughney): "Javier Miglin may walk away from an $80,000 down payment on a condominium with water views in Miami. Randal Mills may give up a $130,000 deposit on a 15th floor condo on the Strip in Las Vegas.... 'We're at the riskiest point of the condo lending cycle as these projects are being completed,' Jefferson L. Harralson, a bank analyst at Keefe, Bruyette & Woods, said. 'In the coming weeks and months, we're going to find out what the demand for these condos really is...' Nationwide, the number of condos completed this year will be up 45 percent -- 232,933 vs. 160,239 -- from 2006, according to data tracked by Marcus & Millichap Real Estate Investment Services... But sales have fallen 12% through August... And recent trends in Las Vegas and Miami...are worse. In the three-month period from June through August, sales fell 46% in Las Vegas and 29% in Miami from the year-earlier period, Marcus & Millichap said."

Speculator Watch:

October 10 - Bloomberg (Christine Harper): "Morgan Stanley...said its quantitative strategy traders lost $390 million during a single day in August as their computer models failed to account for 'widespread' investor selling. The company's traders lost money on 13 days during the quarter... 'The largest loss days resulted from losses associated with quantitative strategies in early August 2007, when these strategies were adversely affected by widespread portfolio reductions,' the company said."

October 10 - Bloomberg (Pierre Paulden, Jacqueline Simmons and Hamish Risk): "The Calyon trader fired last month for alleged unauthorized trading that led to 250 million euros ($353 million) of losses said his bosses knew what he was doing and considered him a 'golden child' of the New York office. 'There was nothing deceptive or rogue,' Richard 'Chip' Bierbaum, 26, said... 'My positions were reported on a daily basis. It did not blow up. I expect there were some losses but nowhere near the amounts they are discussing. I was the golden child of credit trading in New York.'"

Crude Liquidity Watch:

October 8 - Bloomberg (Daniel Kruger): "The biggest quarterly rally for U.S. government securities in five years is getting an extraordinary boost from the burgeoning reinvestment of petrodollars by the Organization of Petroleum Exporting Countries. OPEC members increased their holdings of Treasuries 12% this year through July to $123.8 billion... The prospect that OPEC's share of U.S. debt is growing is based on the 31% rise in oil since December, which will raise OPEC revenue... to $630 billion this year and...$688 billion in 2008..."

Not so Benign Neglect:

Federal Reserve President William Poole spoke Tuesday before the Industrial Asset Management Council in St. Louis.

In the Q&A session, a member of the audience posed the follow question:

"Dr. Poole, on M3 - I believe it is a number the government doesn't now publish - what effect do you think the amount of money we're printing and putting into the economy - what effect does it have as far as devaluing the dollar in the world markets."

Dr. Poole's response:

"The Federal Reserve stopped publication of M3 a year or so ago... It was after extensive exploration of whether anybody actually used the measure. We didn't use it internally and we decided that very few people actually used it... Now that is not in anyway directly related to the other question you asked about the depreciation of the dollar.

The depreciation of the dollar is something that is not explicable. And the way I like to phrase this - I like to put my academic hat back on. If you look at academic studies of forecasts of the exchange rates across the major currencies, you find that the forecasts are simply not worth a damn. Your best forecast of where the dollar is going to be a year from now is where it is now. There is no model that will beat that simple model. And people have dug into this over and over again. Obviously, you can make a ton of money if you were able to have accurate forecasts. No one has been able to come up with a forecasting methodology that will make you a lot of money. And you can't make money under the forecast that the dollar is the same as it is right now a year from now. I can go a step beyond that though - and this is what I think is really interesting. The academic literature is also full of papers trying to explain exchange rate fluctuations after the fact - after you have all the data that you can put your hands on - data that you can't accurately forecast, but data that after you get your hands on it might logically explain the fluctuations of currency values. And those models aren't worth a damn either. We cannot explain the fluctuations of currencies after they have occurred even with all the data that we can dig out. And therefore, to me, it's completely unsupported idle speculation not only to make the forecast but to talk about why the dollar has behaved as it has. I know the financial pages and the traders love to talk about that, but I would challenge any of them to construct a model that would stand up to a peer review journal in economics or finance. The models just aren't that good."

A post-event question from a Bloomberg reporter: "I was hoping you could elaborate a little bit on the implications of the weakness in the dollar right now... whether implications on inflation or just the economy in general."

Dr. Poole: "I don't see any implications for inflation, at least with the magnitude of the depreciation that we've seen so far. The evidence is that - there's a literature that looks at what's called "pass through" - pass through of changes in domestic prices. And the evidence is that the pass through coefficient has gotten small and smaller."

Dr. Poole and the Federal Reserve more generally are at this point succumbing to Not So Benign Neglect of our nation's currency. For a top U.S. central banker to claim today that the dollar's ongoing five-year devaluation is "inexplicable" is simply hard to swallow. And to seemingly dismiss analyses of the predictably deleterious currency effects stemming from unprecedented Credit excess and resulting Current Account Deficits (as "completely unsupported idle speculation") is barren central banking. I would also suggest to Dr. Poole that there surely won't be a single hedge fund manager or Wall Street proprietary trader interested in submitting an academic paper on the issue of forecasting the dollar: they have been and remain far too busy making enormous and easy speculative profits from dollar debasement.

The nature of Dr. Poole's dismissal of currency-induced inflationary ramifications is further indicative of what are increasingly evident deficiencies in our "academic" Fed. September's 4.4% y-o-y increase in the Producer Price Index follows yesterday's report of a 5.2% y-o-y jump in the Import Price Index (monthly imports running almost $200bn!). And with crude trading today above $84 for the first time - and commodities indices recently breaking out to new record highs - this is not the time for inflation complacency. Surging energy costs have already spread to the food complex and beyond. The nature of Inflation Dynamics will now ensure more pronounced "knock-on" effects throughout. It is also worth noting that the Baltic Dry Freight cost index this week increased y-t-d gains to 140% (up "fivefold since 2003"). Especially with China, India and greater Asia's heightened inflationary backdrop, to not expect a meaningfully higher "pass through" from foreign manufactures is wishful thinking, suspect analysis, and regrettably poor central banking.

While on the subject of less-than-exemplary central banking, this week's improved Trade Deficit is deserving of a brief comment. It has been the Greenspan/Bernanke doctrine to view the weakening dollar as an integral facet of an expected long-term gradual adjustment in global imbalances - including our Current Account position. As such, August's better-than-expected $57.6bn trade shortfall (vs. year ago $67.6bn) - with Goods Exports up 13.2% y-o-y compared to a 2.4% gain in Goods Imports - might be viewed as confirming the merits of the gradualist approach.

Not surprisingly, the dollar barely budged from multi-decade lows despite the positive trade news. At this point, any marginal beneficial improvement in trade-related financial flows is inconsequential when compared to the massive scope of speculative finance these days seeking to profit from further dollar depreciation. The fact of the matter is that the "gradualist" approach completely failed to anticipate that multi-year dollar debasement would stoke powerful Inflationary Biases throughout "Un-dollar" asset classes (certainly including currencies, commodities, international real estate, global equity and debt securities, and art/collectables). And once Bubbles take hold...

The fateful flaw in U.S. central banking has been to focus on a depreciating dollar as the key mechanism for rectifying excesses and imbalances, while completely disregarding Credit and financial excesses. It was an easy - seemingly painless - expedient that had no chance of success. The pressing need to commence the process of financial and economic adjustment ("pressing" in respect to the nature of escalating distortions and structural impairment) required policies that would directly alter financial developments and restrain excess.

Instead, a declining dollar within the backdrop of Federal Reserve accommodation worked only to further bolster distortions and imbalances both at home and abroad. It can be viewed as the worst of all policy courses - virtually condoning a system of escalating Credit and speculative abuses, while ensuring a major additional element (our weak currency) supportive of global excesses. To be sure, Destabilizing Monetary Processes and Monetary Disorder sprang from the confluence of booming Wall Street finance, the burgeoning leveraged speculator community, and rapidly escalating Inflationary Biases and Bubble Dynamics throughout global Credit and economic systems. Weak dollar policies could not have been more Bubble friendly.

Confronted abruptly this summer with Acute Financial Fragility, the Fed in both words and deeds again aggressively accommodated Bubble perpetuation. It is important to compare and contrast the current "reliquefication"/"reflation" with the previous episode. First, and foremost, when the Fed began aggressive post-tech Bubble "mopping-up" accommodation in early 2001, the dollar index traded near 120 (today 78.22). Approaching $6.0 TN, international reserves assets have inflated about three-fold since 2001. Chinese reserves have ballooned from about $170bn to $1.434 TN. The price of oil is up almost three-fold; gold almost the same. The price of copper has inflated from about $80 to $350, lagging some of the other industrial metals. The price of wheat is up more than three-fold. The Goldman Sachs Commodities index rallied from 250 to 550. Brazil's Bovespa equities index has inflated from about 15,000 to 62,500; the Mexican Bolsa 5,000 to 32,500; Russia's RTS 130 to 2,100; the Shanghai Composite from about 2,000 to 6,000; and India's Sensex 4,000 to 18,000.

The median price of a home in California began 2001 at about $244,000, before topping out this April at $597,640. Contrarily, after spiking to 4,816 in March of 2000, the NASDAQ100 did not trade back above 2000 for more than seven years. Post-tech Bubble liquidity (characteristically) avoided the technology sector like the plague. After all, a much more enticing Inflationary Bias was gaining momentum with fledgling Mortgage Finance and Housing Bubbles ("Liquidity Loves Inflation"). The Fed may have believed it was conducting appropriate "mopping up" policies, but commanding Financial Structures ensured that it was more a case of Bubble accommodation.

The serious issues associated with the current "reflation" are many. For one, the dollar is structurally quite fragile while the most robust Inflationary Biases are in non-Dollar Asset Classes. Previously, Fed reflationary policies provided a competitive advantage for U.S. risk assets that worked to incite sufficient financial flows to support or even boost the greenback. This proved a huge ongoing advantage for our expansionary Credit system. Today, the negative ramifications associated with dollar weakness more than offset the Fed's capacity to inflate U.S. securities prices. The Fed's rate cut proved a bonanza for most foreign markets (currencies, commodities, equities, bonds, etc.), especially relative to dollar-denominated mortgage securities (the previous Bubble asset class of choice).

The Flow of Finance will now pose extraordinary challenges and risks. The unfolding mortgage crisis (especially in "private-label" and jumbo) will prove stubbornly immune to "reliquefication" benefits. This dynamic places home prices, the consumer balance sheet, and the general economy in harm's way. At the same time, there's the stock market Bubble and an acutely vulnerable dollar. I will presuppose that the Fed is hopeful to ignore equities and currencies, while operating monetary policy with a focus on the Credit market and real economy. Such a policy course, however, implies at this point much greater currency, market stability, and inflationary risks than our central bankers seem to appreciate.

I would furthermore contend that the nature of current Risk Intermediation is seductively problematic. On a short-term basis, enormous bank and money-fund led financial sector expansion has been sufficient to over-inflate non-mortgage Credit. It's been too easy - and Credit to sustain the boom too risky. Meantime, post-Bubble risk aversion festers in mortgage-related finance that will creep ever-closer to spilling over into an economic downturn and a reemergence of financial turbulence.

Despite current market euphoria, these processes are significantly elevating the systemic risks associated with today's ballooning financial sector balance sheet. A stock market Bubble beset by destabilizing speculative dynamics only compounds systemic vulnerabilities. Such a backdrop seems to beckon for a currency crisis, a risk that leaves the Federal Reserve with much less flexibility than it or the markets today appreciate. There are major costs associated with Not So Benign Neglect. The Fed had better at least start sounding like they've thought through some of the issues.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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