| This week the Dow gained 1.1% (up 6.4% y-t-d), and the S&P500 rose 0.8% (up 6.2% y-t-d). The Transports increased 1.0%, increasing 2006 gains to 13.4%. The Morgan Stanley Cyclical index jumped 2.7%, pushing y-t-d gains to 16.5%. The Utilities added 0.5% (up 14.1%) and the Morgan Stanley Consumer index 0.6% (up 6.7%). The small cap Russell 2000 added 0.4% (up 5.7%), and the S&P400 Mid-Cap index gained 0.7% (up 10.9%). The NASDAQ100 added 0.3% (up 7.9%), and the Morgan Stanley High Tech index gained 1.3% (up 7.0% y-t-d). The Semiconductors rose 1.4%, increasing 2006 gains to 8.1%. The Street.com Internet Index jumped 1.5% (up 6.8%), and the NASDAQ Telecommunications index rose 1.0% (up 7.2%). The Biotechs slipped 0.8% (up 9.8% y-t-d). The Broker/Dealers surged 2.7% (up 7.2%), and the Bank added 0.4% (up 0.1%). With bullion up $6.60, the HUI Gold index increased 0.3%. More curve gyrations. Two-year government yields rose 2 bps to 4.675%. Meanwhile, five-year yields declined 4 bps to 4.55%, and 10-year Treasury yields fell 5 bps to 4.64%. Long-bond yields dropped 8 bps to 4.81%. The 2yr/10yr spread ended the week inverted 3.5 bps. The implied yield on 3-month December ’07 Eurodollars added one basis point to 5.08%. Benchmark Fannie Mae MBS yields declined 3 bps to 5.78%, this week underperforming Treasuries. The spread on Fannie’s 5 1/4% 2016 note narrowed 2 to 33, and the spread on Freddie’s 5 1/2% 2016 note narrowed 2 to 33. The 10-year dollar swap spread decreased slightly (0.2) to 53.8. Corporate bonds spreads were generally a little tighter, with the spread on a junk index 4 narrower. At $34.5bn, this was the second-strongest week of debt issuance so far this year (from Bloomberg). Investment grade issuers included Morgan Stanley $3.75bn, Capmark Financial $2.55bn, and Camden Property Trust $300 million. Junk issuers included Edison Mission $2.7bn, Qwest $500 million, Saint Acquisition $835 million, United Refining $125 million, Dune Energy $300 million, Local TV Finance $190 million, Atlantic Express $185 million, and Rare Restaurant $100 million. This week’s convert issuers included Sinclair Broadcasting $300 million and Savvis $300 million. International issuers included Danske Bank $2.0bn, Caisse Eparg $1.25bn, Trans-Canada Pipeline $1.0bn, Nexen $1.5bn, Petro Trin/Tobago $750 million, Canadian Pacific $450 million, Swedish Export Credit $400 million, and Petrobras $300 million. May 3 – Financial Times (David Oakley and Saskia Scholtes): “The European junk bond market grew dramatically in the first quarter of this year in a powerful sign that the world economy is in robust health. Only two months after stock markets fell sharply round the globe, the big jump in high-yield bonds suggests the economy rode the storm…new issuance in the first quarter of this year jumped 78.9%, compared with the same period last year, on the back of mergers and acquisitions, private equity-led leveraged buy-outs and strong economic fundamentals.” German 10-year bund yields declined 2 bps to 4.19%. Japanese 10-year “JGB” yields were up slightly to 1.625%. The Nikkei 225 dipped 0.3% (up 1.0% y-t-d). Emerging markets were mixed to higher. Turkey’s ISE equities index dropped 4.4%, reducing y-t-d gains to 14.6%. Brazil’s benchmark dollar bond yields rose 2 bps this week to 5.55%. Brazil’s Bovespa equities index jumped 3.1% to a new record high (up 13.8% y-t-d). The Mexican Bolsa rose 2.3% to a record high (up 13.5% y-t-d). Mexico’s 10-year $ yields fell 5 bps to 5.40%. Russia’s RTS equities index fell 1.5% (up 0.4% y-t-d). India’s Sensex equities index declined 2.0% (up 1.1% y-t-d). China’s Shanghai Composite index gained 2.1%, ending a shortened trading week with a y-t-d gain of 44% and 52-week rise of 167%. Freddie Mac posted 30-year fixed mortgage rates were unchanged at 6.16% (down 43bps y-o-y). Fifteen-year fixed rates were unchanged at 5.87% (down 35bps y-o-y). One-year adjustable rates declined one basis point to 5.42% (down 25bps y-o-y). The Mortgage Bankers Association Purchase Applications Index rose 4.0% this week. Purchase Applications were down 1.2% from one year ago, with dollar volume 1.2% higher. Refi applications fell 3.2% for the week, while dollar volume was up 37.3% from a year earlier. The average new Purchase mortgage dipped to $237,100 (up 2.4% y-o-y), while the average ARM increased to $393,200 (up 14.8% y-o-y). Bank Credit rose $14.3bn (week of 4/25) to a record $8.465 TN. For the week, Securities Credit was unchanged. Loans & Leases expanded $14.4bn to $6.192 TN. C&I loans added $1.5bn, and Real Estate loans jumped $7.0bn. Consumer loans increased $1.1bn, and Securities loans rose $2.8bn. Other loans gained $2.0bn. On the liability side, (previous M3) Large Time Deposits fell $9.0bn. M2 (narrow) “money” jumped $25bn to a record $7.237 TN (week of 4/23). Narrow “money” has expanded $194bn y-t-d, or 8.4% annualized, and $449bn, or 6.6%, over the past year. For the week, Currency gained $1.9bn, and Demand & Checkable Deposits added $1.2bn. Savings Deposits surged $24.3bn ($44.9bn 2-wk gain), while Small Denominated Deposits added $0.4bn. Retail Money Fund assets decreased $2.8bn. Total Money Market Fund Assets (from Invest. Co Inst) rose $12bn last week to $2.447 TN. Money Fund Assets have increased $65bn y-t-d, a 7.9% rate, and $408bn over 52 weeks, or 20%. Total Commercial Paper gained $2.4bn last week to $2.048 TN, with a y-t-d gain of $73.9bn (10.8% annualized). CP has increased $287bn, or 16.3%, over the past 52 weeks. Asset-backed Securities (ABS) issuance slowed to $9.0bn. Year-to-date total US ABS issuance of $233bn (tallied by JPMorgan) is now running 2% behind comparable 2006. At $126bn, y-t-d Home Equity ABS sales are about 25% below last year’s pace. Year-to-date US CDO issuance of $122 billion is running 22% ahead record 2006 sales. Fed Foreign Holdings of Treasury, Agency Debt rose $8.6bn last week (ended 5/2) to a record $1.927 TN, with a y-t-d gain of $175bn (28.8% annualized). “Custody” holdings expanded $315bn during the past year, or 19.5%. Federal Reserve Credit last week jumped $16.9bn to $866bn (up $14.7bn y-t-d). Fed Credit was up $43.9bn y-o-y, or 5.3%. International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up a stunning $505bn y-t-d (30.3% annualized) and $945bn y-o-y (21.6%) to a record $5.316 TN. May 3 – Bloomberg (Maria Levitov): “Russia’s foreign currency and gold reserves, the world’s third largest, surged $7.8 billion in a week as the government collects record revenue from commodity exports. The reserves climbed to $369 billion…” Currency Watch: The dollar index rallied 0.3% to 81.62. On the upside, the South African rand gained 0.5%, the Swiss franc 0.4%, the Singapore dollar 0.4%, and the Norwegian krone, Danish krone and Euro were all up 0.3%. On the downside, the Brazilian real declined 0.3% and the Australian dollar 0.3%. Commodities Watch May 2 – Financial Times (Neil Dennis): “Commodity prices may be soaring on record demand for raw materials but so too are the prices for shipping these goods around the world. This week, the Baltic Exchange's dry freight index, a composite of prices for shipping dry commodities, hit a record high of 6,248. The index has risen 41% this year. The voracious appetite for raw materials in China and India, whose rapidly expanding economies have fuelled the current commodity boom, has stoked demand for the transportation of these goods. Meanwhile, port congestion has led to delays and extra costs that shipping companies are passing on to customers.” For the week, Gold gained 1% to $688.55, while Silver slipped 0.3% to $13.53. Copper surged 6% to an 11-month high. Nickel traded today to a record high. June crude fell $4.53 to $61.93. June gasoline declined 1.9%, while June Natural Gas gained 1.4%. For the week, the CRB index declined 0.9% (up 1.3% y-t-d), and the Goldman Sachs Commodities Index (GSCI) fell 2.5% (up 7.3% y-t-d). China Watch: May 3 – Associated Press: “As many as 130 Chinese companies are due to take part in a mass purchase of U.S. goods next week, organizers said Thursday, in an apparent effort to ease tensions ahead of trade talks in Washington. …earlier Chinese news reports said companies planned to buy up to $16 billion worth of machinery, electronics and farm goods.” May 1 – Bloomberg (Nipa Piboontanasawat and Dune Lawrence): “Manufacturing activity in China expanded at the fastest pace in more than two years in April, according to a survey of purchasing managers released today.” May 2 – Bloomberg (Nipa Piboontanasawat and Bei Hu): “China Citic Bank Corp., which has held the biggest initial public offering this year, increased the sale by 15% to $5.95 billion after individual investors in Hong Kong ordered 230 times the number of shares available to them.” May 2 – Financial Times (Richard McGregor): “China’s rapidly worsening pollution is being driven by a surge in investment in energy-intensive heavy industry caused by cut-throat competition among cities and provinces, according to a study released today. The study, by the Peterson Institute for International Economics… says the huge investment in steel, aluminium, cement and other plant has begun to reverse almost three decades of gains in energy efficiency. ‘It is not air-conditioners and automobiles that are driving China’s energy demand but rather heavy industry,’say Daniel Rosen and Trevor Houser of China Strategic Advisory…” India Watch: May 3 – Bloomberg (Subramaniam Sharma): “India will become the world’s fifth-biggest consumer market by 2025, surpassing Germany, as incomes almost triple and assuming the South Asian nation’s economic growth rate ‘holds steady,’ McKinsey & Co. said.” May 1 – Bloomberg (Kartik Goyal and Cherian Thomas): “India’s exports in March grew at less than half the pace of the past year as a rising rupee hurt earnings from overseas sales of textiles, steel and other goods. Exports rose 8.8% to $12.6 billion in the month…” Asia Boom Watch: May 1 – Market News International: “South Korea’s export growth accelerated in April on strong demand for semiconductors, ships, cars, petrochemicals and steel, with total exports rising 17.8% year-on-year to $30.2 bln, the Commerce Ministry said.” May 3 – Bloomberg (Wahyudi Soeriaatmadja): “Indonesia, Southeast Asia’s biggest economy, will spend ‘significantly’ this year and next on building roads, ports and power plants, President Susilo Bambang Yudhoyono said. ‘Indonesia will achieve growth equality by spending on infrastructure projects,’ Yudhoyono said… Infrastructure spending will ‘boost peoples’ income and propel the economy across the nation.’ The government will be satisfied with economic growth rate of 6% and more this year…” Unbalanced Global Economy Watch: April 30 – Bloomberg (Jennifer Ryan): “U.K. house prices advanced the most in almost four years in April as London properties changed hands at a faster pace, according to a survey by Hometrack Ltd. The average cost of a home in England and Wales rose an annual 6.8%…” May 2 – Bloomberg (Brian Swint): “U.K. construction, which accounts for 6% of the economy, expanded at the fastest pace in more than three years last month, an industry survey showed.” May 2 – Bloomberg (Fergal O’Brien): “European unemployment fell to a record low in March, heightening concerns among monetary-policy officials that a tighter labor market may fuel increased wage demands and push up inflation. The jobless rate in the euro area fell to 7.2% from 7.3% in February…” May 1 – May 1 – Market News International: “Eurozone M3 money supply grew at the fastest annual pace in 24 years in March on the fastest monthly rise in more than 8 years… Moreover, growth of loans extended to the eurozone private sector reaccelerated in the reporting month… The annual growth rate of the broad M3 aggregate surged to a seasonally adjusted 10.9% in March from an unrevised 10.0% in February. The latest number represents the highest rate since February 1983, when 11.0% was recorded.” May 2 – Bloomberg (Brian Parkin): “The number of unemployed in Germany fell in April, keeping the jobless rate at the lowest level in almost six years, as companies hired workers to fill orders.” May 1 – Bloomberg Christian Wienberg): “Danish monthly retail sales growth unexpectedly quickened to 3.7% in March, the fastest rate in almost two years, as low unemployment continued to boost consumer spending.” May 3 – Bloomberg (Simone Meier): “Swiss consumer prices rose the most in more than 15 years in April as a drop in the franc made imported goods such as oil more expensive, strengthening the central bank’s case for further interest-rate increases. Consumer prices rose 1.1% from March…” April 30 – Bloomberg (Robin Wigglesworth): “Norway’s domestic credit growth slowed to 14.5% in March as higher interest rates and the prospect of further increases crimped demand for loans. Credit growth in households, companies and municipalities eased from a revised 14.6% in February…” May 2 – Bloomberg (Robin Wigglesworth): “Norwegian retail sales growth unexpectedly accelerated to an annual 9.6% in March as consumer spending was undeterred by higher interest rates. Sales growth expanded from 8.2% in February…” May 1 – Bloomberg (Steve Bryant): “Turkish exports rose to $8.2 billion in April, according to preliminary data… Exports rose 28.1% in the month from the same period a year earlier…” Latin American Boom Watch: May 2 – Bloomberg (Bill Faries): “Argentina’s April tax revenue rose 32.6% from a year earlier as the economy heads into a fifth straight year of growth.” Bubble Economy Watch: May 2 – Financial Times (Richard Waters and Kevin Allison): “An investment boom is underway in consumer video websites, drawing warnings of a new bubble in the venture capital business. The $1.65bn sale of YouTube to Google last year, along with an expected wave of advertising tied to online video, have prompted a stampede that some Silicon Valley financiers are already comparing to the dotcom bubble, though at this stage at least it remains on a far smaller scale. Video has become the hottest corner of a broader financing boom tied to so-called “Web 2.0” internet companies. The amount of US venture capital flowing into video-related start-ups of all types jumped by 95 per cent last year to $682m…” May 3 – Dow Jones: “Allied Pilots Association, which represents the 12,000 pilots of AMR Corp., is seeking average of an 17% annual pay increase over a three-year period.” May 2 – Bloomberg (Bill Rochelle): “U.S. bankruptcy filings in April were 47% higher than the same month last year, according to statistics compiled from government records by Automated Access to Court Electronic Records.” Mortgage Finance Bubble Watch: May 1 – Bloomberg (Alex Tanzi): “In the first quarter of 2007, the dollar volume of Freddie Mac owned loans that was cashed-out by homeowner refinancing fell to $70.5 billion from $77.0 billion in the fourth quarter of 2006… In the first quarter of 2007, 82% of Freddie Mac owned loans that were refinanced resulted in new mortgages of at least five percent more than the original mortgages. That was unchanged from 82% the previous quarter.” May 1 – Bloomberg (Brian Louis): “Billionaire real estate investor Sam Zell said the subprime mortgage crisis was fueled by an industry with lax standards. ‘Subprime was toxic,’ said Zell…’What did anyone expect?’” May 4 – Financial Times (David Oakley and Saskia Scholtes): “The crisis in the troubled US subprime mortgage market has reared its head again this week as the first-quarter earnings season revealed mortgage-related losses at UBS, the Swiss bank, and GMAC, the finance group owned by private equity firms and General Motors… Born of weaker lending standards…the distressed mortgages have come back to haunt many lenders. Dozens have had to shut their doors. Others, such as GMAC’s mortgage unit, have suffered losses. The mortgage unit Residential Capital – once a star profit generator for GM – posted a quarterly loss of $910m, more than offsetting gains from GMAC’s insurance and motor finance arms. It resulted in a first-quarter net loss for GMAC of $305m, against a $495m profit on the same period last year.” MBS/ABS/CDO Watch: April 30 – Bloomberg (Jody Shenn): “Too much demand for bonds, and investors’ complacency toward risk, can be blamed for the record early delinquencies and defaults on subprime home loans, speakers at an industry conference…said. The poor performance of subprime home loans made last year stems from an average drop of at least 0.50 percentage point in the yield premiums for credit risk on all types of fixed-income assets since 2000, Mortgage Bankers Association Chief Economist Doug Duncan said…” Real Estate Bubbles Watch: April 30 – The Wall Street Journal (Amy Hoak): “A sharp drop in investment-home sales offset a record number of vacation-home purchases to bring down the overall number of second-home purchases in 2006, the National Association of Realtors reported. Vacation-home sales rose 4.7% to a record 1.07 million homes in 2006… Investment-home sales fell 28.9% to 1.65 million homes… The share of second-home sales was 36% of all existing and new residential real-estate transactions in 2006, down from 40% of all sales in 2005… The median price of a vacation home was $200,000 in 2006, down 2%...” M&A and Private-Equity Bubble Watch: May 3 – Bloomberg (Junko Fujita): “Citigroup Inc. borrowed 1.45 trillion yen ($12bn) in Japan's largest syndicated loan to fund its purchase of Nikko Cordial Corp., said two bankers who were involved in the transaction.” May 2 – Bloomberg (Hamish Risk and Cecile Gutscher): “Kohlberg Kravis Roberts & Co. may bypass the bond market and use cheaper loans to cut the cost of financing its $22.2 billion purchase of U.K. drugstore Alliance Boots Plc, according to traders of credit-default swaps.” May 2 – Financial Times (James Politi): “The Dolan family on Wednesday hailed the benefits of private ownership as it agreed to buy Cablevision in a leveraged buy-out worth $22bn including debt that ended two years of uncertainty over the cable operator’s future.” Energy Boom and Crude Liquidity Watch: May 4 – Financial Times (David Oakley and Saskia Scholtes): “When an adviser presented Sheikh Mohammed bin Rashid al-Maktoum three years ago with a scheme to build one of the world’s biggest towers, Dubai’s ruler demanded to know what else was being planned around the world. The adviser returned with a list of the tallest buildings, with Taiwan's Taipei 101 reaching higher than the proposed Dubai tower. ‘The sheikh asked me: ‘Why is it taller - are people there smarter than you?’’says Mohammed Alabbar, the official and head of property giant Emaar. ‘That’s why I made sure our project was the tallest by far.’ Burj Dubai is still under construction; a floor is added every three days and its exact final size is a well-kept secret.” Climate Watch: May 3 – Bloomberg (Lars Paulsson and Paul Dobson): “Electricity prices may reach record highs in Europe, as forecasters predict a second straight summer of soaring temperatures. ‘The chances are we will see significant increases in prices,’ Kim Keats, head of power and fuels at ICF International…said… ‘Forward prices will take this into account.’” Speculator Watch: April 30 – Bloomberg (Daniel Kruger): “Federal Reserve Chairman Ben S. Bernanke’s assertion that interest rates may need to increase to curb inflation is wrong. That’s what Goldman Sachs Group Inc., Merrill Lynch & Co. and UBS AG are saying.” Then and Now: Reuters went with the provocative headline “Hedge fund risks worst since ‘98 crisis, Fed says.” Over at Marketwatch, it was “Hedge fund study suggests parallels with LTCM Crisis.” But it was the Financial Times’ Richard Beales that best captured the essence of NY Fed economist Tobias Adrian’s paper “Measuring Risk in the Hedge Fund Sector”: “The risk hedge funds pose to the global financial system has reached levels by some measures comparable to those just before the Long Term Capital Management fund imploded in 1998, the Federal Reserve Bank of New York said… But the New York Fed said the similarities - involving close correlation among hedge fund returns seen before the LTCM crisis and again recently - had different causes, making the current environment less alarming.” From Mr. Adrian’s research: “Hedge funds – private partnerships that are not directly regulated – have grown in importance in recent years. Total assets under the management of hedge funds are currently estimated at $1.5 trillion, and the funds contribute more than half of average trading volume in equity and corporate bond markets. While the funds are major liquidity providers in normal times, their use of leveraged trading strategies has raised concerns about their liquidity effects in times of market stress.” “Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998. A comparison of the current risk in correlations with the elevation before the 1998 event, however, reveals a key difference. The current increase stems mainly from a decline in the volatility of returns, while the earlier rise was driven by high covariances – an alternative measure of comovement in dollar terms. Because volatility and covariances are lower today, the current hedge fund environment differs from the 1998 environment.” The current environment differs profoundly from 1998. It may have been an oversight on my part, but I saw no reference in Mr. Adrian’s work to the fact that hedge fund assets in 1998 were “only” in the neighborhood of $240bn. Since then, the industry has ballooned more than six-fold, while total fund assets may very well increase in excess of $240bn just this year. Yet this in no way does justice to the dramatic transformation of the global Credit infrastructure – how leverage is employed, the players and instruments, the proliferation of derivatives, and the multitude of leveraged strategies. I applaud central bank efforts to better understand systemic risk, yet such an endeavor today demands a much more comprehensive and intensive approach. Notably, “Broker/Dealer” assets now approach $3.0 TN, after ending 1998 at $921bn. Commercial Banking Assets have grown from $5.63 TN to $10.20 TN, with Corporate and Foreign Bond holdings ballooning from $176bn to $781bn. Life Insurance Company Assets have increased from $2.77 TN to $4.71 TN. GSE Assets have doubled to $2.84 TN, and outstanding agency MBS has increased from $2.02 TN to $3.97 TN. Importantly, the ABS market has more than tripled in size from $1.16 TN to $3.60 TN. Money Market Fund Assets have increased from $1.33 TN to $2.31 TN. Over this period, the CDO market has exploded from inconsequential to untold Trillions. Total U.S. Credit Market Borrowings inflated from $23.3 TN to $44.6 TN. I’ll give the leveraged speculating community the benefit of the doubt and assume that leverage these days is not commonly employed to ridiculous LTCM-style extremes. I would suggest, however, the scope of “leveraging” employed throughout the various risk markets is today unlike 1998 or anything previously experienced. From Bank of International Settlement data, we know that the total notional value of global derivative positions ended 1998 at $80.3 TN – comprised of $18.0 TN Foreign Exchange; $50.0 TN Interest Rate; $1.5 TN Equity-Linked; $415bn Commodities; and $10.4 TN “Other”. Credit derivatives didn’t even have their own category. By the end of 2006, Total derivative positions had ballooned to $370 TN, with $38 TN Foreign Exchange; $262 TN Interest Rate; $6.8 TN Equity-Linked; $6.4 TN Commodities; $36 TN “Unallocated”; and $20.4 TN Credit Default Swaps (up more than 3-fold in 2 yrs). And while we have not had a major derivatives blow-up for some time, there have been the recurring hiccups that remind us of latent liquidity issues associated with bursting Bubbles and enormous derivative hedging/speculating operations. May 2 – The Wall Street Journal (Aparajita Saha-Bubna): “Placing the right bet is only half the battle. The other half is making sure one can cash out at the opportune time. Nowhere has this become more apparent than in the opaque market for derivatives based on bonds backed by subprime mortgages. Those who rushed into this market earlier this year are learning that being right isn’t good enough as they struggle to cash in on trades that are profitable only on paper. Investors, such as macro hedge funds, hit the bull’s-eye with their bet that the cost of protecting mortgage bonds against default would rise as borrowers with patchy credit struggled to meet their monthly payments. They bought such protection enthusiastically by entering into a privately negotiated derivative contract. But they underestimated the sticky nature of these derivatives, known as single-name asset-backed default swaps, that can trade infrequently due to the complexities of valuing them. ‘It looks like a great trade but it isn’t a profit if you can’t get out,’ said Scott Simon, who oversees $250 billion in mortgage- and asset-backed securities at Pimco… ‘Investors had a naive belief in liquidity thinking just because you buy it, you can sell it,’ Mr. Simon said.” And when it comes to differentiating 2007 from 1998, let’s not neglect that the U.S. Current Account Deficit is up four-fold from $214bn to last year’s $884bn. After ending 1998 at $5.29 TN, Rest of World (ROW) holdings of U.S. financial assets ballooned to $12.55 TN by the end of last year. Holdings of Credit Market Instruments jumped from $2.38 TN to $6.47 TN, while “Security RPs” holdings increased 10-fold to $780bn. It’s no coincidence that derivative positions have ballooned commensurate to the U.S. Current Account Deficit. To set the backdrop for this analysis, reflect back on the highly unstable global financial flows that were wreaking bloody havoc upon the emerging markets and economies back in 1997-1999. While U.S. trade deficits were quite formidable during this period, they were easily offset by the ongoing exodus of finance out of “developing” Asia, Russia and Latin America. The “run” on these currencies severely hamstrung domestic Credit systems, while depleted reserve holdings exacerbated outflows and emboldened speculative bearish bets against the “Periphery.” Global financial flows were disjointed and marketplace liquidity highly erratic and susceptible. In this vein, today’s contrast to 1998 could not be more striking. Foreign central banks – “developing” and otherwise – are absolutely awash in reserves and liquidity. Importantly, this dynamic has unleashed domestic Credit systems around the globe for extraordinary synchronized double-digit annual growth. Meanwhile, massive U.S. Current Account Deficits coupled with a quiet “exodus” by U.S. investors/speculators - shedding dollar liquidity to participate in the global inflationary boom - has simply inundated the world in liquidity. Major asset inflations are invariably caused by some – generally unrecognized – type of monetary disorder. In this case, its origination is within the U.S. Credit system. Strangely, this international backdrop of synchronized Credit booms, massive outward dollar financial flows, and unprecedented speculation has created financial flows that are these days as robust and predictable as they were vulnerable and erratic back in 1998. This has all been possible only because foreign central banks have been willing dollar liquidity “buyers of last resort.” Foreign central bank reserves expanded an unprecedented $945bn over the past year. Amazingly, so far this year the growth in reserves (now surpassing $5 TN) has accelerated to about a 30% annualized pace. Global derivatives have been able to expand right along with U.S. Current Account Deficits basically because of the aura of predictability associated with foreign central bank operations to recycle U.S. deficits. Over time, the certainty of central bank behavior has emboldened risk-taking. On a global scale, the herculean flows to world securities, asset, and commodities markets have created an extraordinary impetus for speculative endeavors (where derivatives have certainly played a major role). At the same time, the dependable recycling of (literally) Trillions of “Bubble dollars” directly back into U.S. debt securities has promoted aggressive speculating in our markets. To be sure, the steadfast foreign central bank “backstop bid” profoundly altered the perceived risk vs. potential reward for leveraged speculation in U.S. Credit instruments and the dollar more generally. The resulting boom in leveraged debt market speculation – certainly including dollar-supporting yen and Swissy “carry trades” – then fostered unchecked Credit expansion throughout the markets and economy at predictable spreads to the pegged “fed funds” rate. These dynamics created Wall Street a once-in-a-lifetime opportunity to amass incredible wealth and power. The 1998 environment – post Mexican “Tequila Crisis”, “Asian Contagion,” and Russian meltdown – was one of powerful global disinflationary forces and a paucity of liquidity. The hedge funds were, on the margin, either unwinding leveraged positions or placing bearish trades. And, as mentioned above, “King dollar” was like a magnet pulling precious liquidity to U.S. markets. In such an exceptionally strained liquidity environment, the degree of speculator leverage and the potential for de-leveraging to abruptly instigate marketplace dislocation (and contagion) were principal market issues. As we witnessed recently with the subprime crisis, the exceptionally vigorous flow of (non-precious) liquidity today sooths the markets like waves smooth the beach sand. Any de-leveraging that took place was easily outweighed by the unfailing expansion of speculation, Credit and liquidity generally (hedge funds, Wall Street, banks, securitizations, derivatives, foreign central banks and global Credit growth generally). At least for now, hedge fund de-leveraging and its potential market impact are not pressing issues for the Fed or the markets. I tend to view gross distortions emanating from (now out of control) global systemic liquidity excess as today’s critical issue. From this perspective, the unparalleled $500bn (or so) y-t-d increase in foreign central bank reserves is indicative of the inverse of 1998’s liquidity-constricting biases and dis-inflationary forces. Today, powerful expansionary biases foment only greater financial excess and historic asset and commodities inflation. At this point, the risk of irreparable system damage comes not from an unwind of leveraged speculations, but rather an all-encompassing frenzied expansion of global finance. About the only “de-leveraging” likely in this environment is buying associated with the covering of bearish hedges and speculations. One can think liquidity excess-induced marketplace dislocation or, perhaps, Mises’ “crackup boom” on a synchronized international scale. Undoubtedly, such incredible excess sets the stage for an eventual devastating reversal of financial flows. While the inflated “Periphery” is no doubt vulnerable, the wildly distorted “Core” is at great and escalating danger. Here, also, it is helpful to compare and contrast the late-nineties to today. Back then, chairman Greenspan and his “committee to save the world” had some distinct advantages that Mr. Bernanke will not enjoy. First, maturing “King dollar” gave the Fed great leeway to “reliquefy” and reflate. Second, the global disinflationary backdrop allowed global central bankers to loosen policies in an unprecedented fashion without worry of negative inflationary consequences. Third, as the world’s sole financial and economic “locomotive” at the time, U.S. monetary policy had significant sway over global energy, commodities and goods prices. Fourth, Asian, Russian, and “developing” economy central banks were desperate to build dollar reserves to protect against future currency runs. Fifth, the (“unaccountable”) GSEs were in aggressive balance sheet expansion mode. Six, the U.S. Mortgage Finance Bubble had not yet financed an historic housing inflation, encouraged U.S. households to take on incredible amounts of debt, and thoroughly distorted risk markets. And, seven, derivative markets were not approaching $400 TN, with incomprehensible risks and ramifications. In short, the Fed (overseer of the world’s reserve currency) has lost both its control over the inflationary process and its consequences, as well as its flexibility to respond to events. Admittedly, these extremely important developments are lost in today’s liquidity onslaught. When the eventual reversal of flows and dislocation arrives, it should be expected to have profound effects on the maladjusted U.S. economy and fragile U.S. and global Credit systems. I’ll venture a prediction that hedge fund de-leveraging will pale in comparison to the widespread tumult that will likely engulf currency, securitization, and derivatives markets – in risk intermediation generally. The derivatives markets are poised to falter into absolute liquidity nightmares, and this will not be a hedge fund-like de-leveraging issue easily resolved with aggressive rate cuts. And the longer current destabilizing flows are allowed to run roughshod – distorting prices, risk perceptions, and economic structures in the process - the more arduous the unavoidable adjustment period. That’s just the way it works. |
Wednesday, September 10, 2014
05/03/2007 Then and Now *
