| For the week, the Dow slipped 0.4% (up 8.4% y-t-d) and the S&P500 0.5% (up 6.9%). The Transports dropped 1.3% (up 12.9%), and the Utilities were clobbered for 4.4% (up 10.5%). The Morgan Stanley Cyclical index dipped 0.5% (up 18.7%) and the Morgan Stanley Consumer index 0.3% (up 7.0%). The S&P Homebuilding index actually jumped 3.8% this week. The small cap Russell 2000 gained 0.8% (up 5.4%), while the S&P400 Mid-Cap index slipped 0.2% (up 11.4%). The NASDAQ100 declined 0.4% (up 7.5%) and the Morgan Stanley High Tech index 0.2% (up 7.1%). The Semiconductors fell 2.3% (up 2.7%). The Street.com Internet Index posted a slight gain (up 7.9% y-t-d), while the NASDAQ Telecommunications index declined 0.9% (up 4.4%). The Broker/Dealers declined 0.3% (up 5.0%) and the Banks 0.8% (down 0.4%). With bullion down $5.45, the HUI Gold index declined 1.9% (down 4.7%). Two-year U.S. government yields rose 4 bps to 4.86%. Five-year yields jumped 6 bps to 4.79%. Ten-year Treasury yields gained 5.5 bps to 4.86%. Long-bond yields increased 4 bps to 5.0%. The 2yr/10yr spread ended the week at zero. The implied yield on 3-month December ’07 Eurodollars increased 2 bps to 5.225%. Benchmark Fannie Mae MBS yields jumped 7 bps to 5.99%, this week underperforming Treasuries. The spread on Fannie’s 5% 2017 note was little changed at about 38, and the spread on Freddie’s 5% 2017 note was little changed at 37. The 10-year dollar swap spread declined 0.25 to 53.5. Corporate bond spreads narrowed, with the spread on a junk index sinking 17 bps. Investment grade issuers included CVS Caremark $5.5bn, Amgen $4.0bn, Residential Capital $2.25bn, Travelers $1.5bn, M&T Bank $300 million, and Broadridge Financial Solutions $250 million. May 23 – Bloomberg (Jeff Green): “General Motors Corp….plans to bolster its cash by raising $5.2 billion selling convertible bonds and obtaining a line of credit.” Junk issuers included Enterprise Products $700 million, Fontainebleau Las Vegas $675 million, Tesoro $500 million, Rural Cellular $425, Psychiatric Solutions $250 million, Tampa Electric $250 million, Universal Hospital Services $230 million, Neff Corp $230 million, Mystic RE $150 million, CHR Intermediate $150 million, and Bonten Media Acquisition $125 million. This week’s convert issuers included General Motors $1.5bn and Lifepoint Hospitality $500 million. International dollar bond issuers included Credit Agricole $4.75bn, Pakistan $750 million, Lebanon $650 million, Standard Chartered $750 million and Bancolombia $400 million. May 21 – Financial Times (Lina Saigol and Joanna Chung): “A dramatic increase in initial public offerings by emerging market companies this year has raised $53.7bn on global markets. The level of funds raised is the highest on record for the first five months of the year, according to Dealogic, and represents half the volume for all of 2006. The spree of new issues in the developing world has been fuelled by ample liquidity in the financial system, a strong appetite for risk among investors and growing demand for new equity from fast-growing companies.” German 10-year bund yields rose 7 bps to 4.38%. Japanese 10-year “JGB” yields jumped 8 bps to 1.72%. The Nikkei 225 added 0.5% (up 1.5% y-t-d). Emerging equities markets were mostly higher, while debt markets sagged (as global yields marched higher). Brazil’s benchmark dollar bond yields jumped 12 bps this week to 5.74%. Brazil’s Bovespa equities index declined 0.9% (up 16.1% y-t-d). The Mexican Bolsa was little changed (also up 16.1% y-t-d). Mexico’s 10-year $ yields jumped 10 bps to 5.59%. Russia’s RTS equities index dropped 3.4% (down 6.5% y-t-d). India’s Sensex equities index increased 0.2% (up 4.0% y-t-d). China’s Shanghai Composite index surged 3.7%, increasing y-t-d gains to 56% and 52-week gains to 163%. Freddie Mac posted 30-year fixed mortgage rates surged 16 bps to 6.37% (down 25bps y-o-y), the highest rate since October. Fifteen-year fixed rates rose 14 bps to 6.06% (down 17bps y-o-y). One-year adjustable rates jumped 16 bps to 5.64% (up 3bps y-o-y), the high going back to August. The Mortgage Bankers Association Purchase Applications Index added 1.3% for the week. Purchase Applications were up 10.4% from one year ago, while dollar volume was 17.2% higher. Refi applications rose 1.9% for the week, with dollar volume up 53% from a year earlier. The average new Purchase mortgage increased to $242,300 (up 6.1% y-o-y), while the average ARM jumped to $408,700 (up 19.9% y-o-y). Bank Credit dipped $0.9bn (week of 5/16) to $8.501 TN. For the week, Securities Credit increased $1.2bn. Loans & Leases declined $2.1bn to $6.234 TN. C&I loans rose $6.3bn, while Real Estate loans declined $8.7bn. Consumer loans gained $1.7bn, while Securities loans slipped $0.2bn. Other loans fell $1.1bn. On the liability side, (previous M3) Large Time Deposits jumped $9.1bn. M2 (narrow) “money” dipped $1.9bn to $7.226 TN (week of 5/14). Narrow “money” has expanded $183bn y-t-d, or 6.7% annualized, and $445bn, or 6.6%, over the past year. For the week, Currency added $0.2bn, while Demand & Checkable Deposits declined $5.8bn. Savings Deposits fell $3.3bn, while Small Denominated Deposits added $0.6bn. Retail Money Fund assets increased $6.3bn. Total Money Market Fund Assets (from Invest. Co. Inst.) jumped $13bn last week to a record $2.498 TN. Money Fund Assets have increased $116bn y-t-d, a 12.0% rate, and $423bn over 52 weeks, or 20.6%. Total Commercial Paper added $0.8bn last week to a record $2.088 TN, with a y-t-d gain of $113bn (14.2% annualized). CP has increased $318bn, or 18.0%, over the past 52 weeks. Asset-backed Securities (ABS) issuance jumped to $32bn. Year-to-date total US ABS issuance of $285bn (tallied by JPMorgan) is running little changed from comparable 2006. At $144bn, y-t-d Home Equity ABS sales are 29% below last year’s pace. Meanwhile, y-t-d US CDO issuance of $142 billion is running 24% ahead of record 2006 sales. Fed Foreign Holdings of Treasury, Agency Debt last week (ended 5/23) increased $4.8bn to a record $1.945 TN, with a y-t-d gain of $193bn (27.2% annualized). “Custody” holdings expanded $328bn during the past year, or 20.3%. Federal Reserve Credit last week increased $2.3bn to $850bn. Fed Credit was down $2.1bn y-t-d, while increasing $27.3bn y-o-y (3.3%). International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $558bn y-t-d (29% annualized) and $965bn y-o-y (22%) to a record $5.368 TN. Currency Watch: The dollar index gained 0.2% to 82.27. On the upside, the Colombian dollar increased 2.7%, the Iceland krona 1.4%, the Thai baht 1.1%, and the British pound 0.6%. On the downside, Israeli shekel declined 2.6%, the Slovakian koruna 1.3%, the South African rand 1.1%, and the Polish zloty 1.1%. The Canadian dollar this week gained 0.4% to trade to a 30-year high. Commodities Watch May 24 – Financial Times (James Mackintosh): “Retail food prices are heading for their biggest annual increase in as much as 30 years, raising fears that the world faces an unprecedented period of food price inflation. Prices have soared as the expanding biofuels industry, climate change and the growing prosperity of nations such as India and China push up the costs of farm commodities including wheat, corn, milk and oils. Food companies have started passing on these increases to consumers but the prospect of sustained commodity price rises means the industry's profits could be hit as it is forced to absorb the higher costs itself.” May 23 – Financial Times (Jenny Wiggins): “The old adage that “as goes silver, so go soybeans” is more than just a whimsical piece of American farming folk wisdom. That commodity prices tend to rise and fall in unison is a deadly serious economic phenomenon for consumers around the world as food costs increase sharply, in some countries at the fastest pace for decades. Agricultural commodity prices are often volatile, in part due to weather fluctuations that affect crops. But what is unusual about recent price increases is that so many prices – everything from grains to ground nut oil – are rising simultaneously. Market observers say raw material prices are being driven up by shortages in supply…combined with increases in demand from countries such as China and India. They warn the world could be facing a period of ‘unprecedented food inflation’ over the next 18 months… ‘It could become a perfect storm scenario,’ says Michael Steib, food analyst at Morgan Stanley.” For the week, Gold declined 0.8% to $656, while Silver was unchanged at $13. Copper was little changed. July crude declined 78 cents to $65.20. June gasoline was about unchanged, while June Natural Gas fell 3.8%. Soybeans traded to an almost 3-year high. For the week, the CRB index was unchanged (up 1.9% y-t-d), while the Goldman Sachs Commodities Index (GSCI) dipped 0.6% (up 9.6% y-t-d). Japan Watch: May 21 – Financial Times (David Turner): “Direct investment by foreigners in Japan’s commercial property market more than tripled last year as low interest rates created money-making opportunities. Foreign investment ballooned to $13bn from an already substantial $4bn in 2005, according to international property company Jones Lang LaSalle.” May 24 – Bloomberg (Lily Nonomiya): “Japan’s exports to the U.S. fell for the first time in two years… Shipments to Asia and Europe grew. Exports rose 8.3% in April from a year earlier, cooling from 10.3% in March, the Ministry of Finance said… Shipments to the U.S. dropped 4.8%...” China Watch: May 22 – Financial Times: “In any ordinary economy, a triple-barrelled announcement of the kind issued by China’s central bank on Friday evening might have made more of an impression. …The People’s Bank of China tightened lending and eased controls on its currency, policy prescriptions that touch all their host’s concerns about Beijing’s seemingly unstoppable export-driven economy. The announcement…that Beijing’s new state investment agency had put $3bn of foreign exchange reserves into Blackstone… added further ballast… But such is the velocity and momentum of Chinese growth, and the sheer weight of money in the system, that financial markets soon shrugged off the monetary measures… For more than three years, Beijing has shouted from the rooftops that its economy is out of balance: too reliant on exports and investment for growth, with a dangerously high share of output from energy-intensive, polluting heavy industries. But the plethora of policies rolled out to rebalance the economy has had little, if any, impact…” May 21 – Financial Times: “With its $3bn investment in Blackstone, China’s new state investment corporation has delivered an emphatic message at home and abroad that it will be a very different kind of Chinese company from other state enterprises heading offshore… Beijing announced the establishment of the investment corporation earlier this year, giving it a mandate to manage more aggressively a portion of China’s $1,202bn in foreign exchange reserves.” May 23 – Bloomberg (Kelvin Wong and Bernard Lo): “Macau drew 2.23 million visitors in April, 19% more than a year earlier, as the opening of new casinos spurs growth…” India Watch: May 24 – Bloomberg (Kartik Goyal): “India must learn to manage money flows from overseas as economic growth lures companies and global funds, Finance Minister Palaniappan Chidambaram said… ‘Copious inflows of investment creates problem. We must learn to manage inflows… We must not do anything to restrict flows, both foreign and domestic…’” May 24 – Bloomberg (Abhay Singh and Anand Krishnamoorthy): “A cacophony of horns, revving engines and squealing brakes fills Jagdish Khattar’s 11th-floor office in…New Delhi’s central business district. The company Khattar runs, Maruti Udyog Ltd., makes half of the cars jostling on India’s roads… This year, India’s 1.1 billion people will snap up vans, small trucks and cars… more quickly than anyone except the Chinese, according to research firm Global Insight Inc. From 2006 through 2011, India will be the fastest-growing auto manufacturer among the world’s top 20 car-making countries…” Asia Boom Watch: May 22 – Bloomberg (Kelvin Wong): “Hong Kong is the world’s most expensive city to rent an apartment, followed by Tokyo, according to a survey by ECA International… An unfurnished three-bedroom apartment costs an average of $8,592 monthly in the former British colony, ECA said… Five Asian cities were among the world’s 10 costliest…” May 21 – Financial Times (Louise Lucas): “Asian companies are rushing to cash in on the confluence of cheap credit and booming markets by issuing record levels of convertible bonds. Asian companies have issued $15.9bn worth of convertible bonds so far this year, according to Dealogic, more than the amount issued in any of the last five full years.” May 24 – Bloomberg (Theresa Tang and Tim Culpan): “Taiwan’s economic growth accelerated in the first quarter, buoyed by increased Chinese demand for the island’s electronic exports. Gross domestic product expanded 4.15% from a year ago, the fastest rate in six months…” May 23 – Bloomberg (Theresa Tang): “Taiwan’s export orders increased more than 10% for a second straight month in April, as electronics demand from China…made up for slowing sales to the U.S. Export orders…advanced 11.3% from a year earlier…” May 21 – Bloomberg (Shamim Adam): “Singapore’s economy expanded 7.6% in the first quarter amid a boom in construction, exceeding all forecasts and increasing the likelihood that growth this year can withstand a U.S. slowdown.” Unbalanced Global Economy Watch: May 21 – Financial Times (Martin Arnold): “Lax monetary policy in countries such as China and Japan is fuelling the boom in private equity buy-outs that is worrying regulators and unions across the world, according to a report published today… ‘The [Organisation for Economic Co-operation and Development] report says ‘distortions’ in the global financial system - similar to those created by the Louvre Accord to shore up the US dollar in the late 1980s - are being exploited by the use of new derivatives products. The resulting excess liquidity is pushing up asset prices, increasing the risk of over-leveraged deals. ‘It is a basic proposition that if one fixes the price of money in parts of the world economy, one will not be able to control its supply,’ says Adrian Blundell-Wignall, deputy director of financial and enterprise affairs at the OECD, who wrote the report. ‘The recycling of this money is an integral part of the arbitrage opportunity that is driving the private equity boom,’ says Mr Blundell-Wignall, a former Citigroup analyst…” May 24 – Bloomberg (Simon Kennedy): “The Organization for Economic Cooperation and Development raised its forecast for global growth this year, predicting the economies of Europe and Japan will together outpace the U.S. for the first time in 16 years. The economy of the group’s 30 members will expand 2.7% this year, stronger than the 2.5% expected in November…” May 24 – Bloomberg (Brian Swint): “U.K. manufacturers had the most confidence about raising prices since 1995 this month as orders rose, adding to the case for higher interest rates, a survey by the Confederation of British Industry showed.” May 21 – Bloomberg (Brian Swint): “U.K. money supply growth unexpectedly accelerated to the fastest pace since October last month, giving the Bank of England room to raise interest rates again. M4…rose 13.3% from a year earlier…” May 23 – Bloomberg (Robin Wigglesworth): “Norway’s economy expanded 1.4% in the three months through March, more than expected… First quarter annual growth was 4.9%...” May 25 – Bloomberg (Maria Levitov): “The International Monetary Fund expects Russia's economy to expand at least 7% this year.” Latin American Boom Watch: May 24 – Bloomberg (James Attwood): “Argentina is facing its biggest power crisis since 1989 as natural-gas demand, both domestic and from neighboring Chile, outstrips supply, La Tercera reported.” May 23 – Bloomberg (Matthew Walter): “Chile’s economy expanded at its fastest pace in almost two years in the first quarter, powered by higher exports, investments and industrial output. Gross domestic product grew 5.8% in the first quarter from the year-ago period…” Central Banker Watch: May 23 – Bloomberg (Simone Meier): “The European Central Bank’s so-called monetary pillar remains an ‘indispensable element’ to measure inflationary pressures stemming from money-supply growth, Germany’s Bundesbank said in a research paper. ‘Monetary indicators contain important information for future inflation and should therefore play a role in the monetary-policy decision-making process,’ the bank’s economics department wrote in the paper published yesterday. ‘It can be safely concluded that the monetary pillar is an indispensable element of the eurosystem’s monetary policy strategy.’” May 23 – Market News International (David Barwick): “The European Central Bank, which is in a stance of ‘very strong vigilance,’ has not yet taken monetary policy where it needs to be and will act in a firm and timely manner to ensure price stability, ECB Governing Council member Axel Weber said…” May 21 – Bloomberg (Christian Vits and Matthias Wabl): “European Central Bank council member Klaus Liebscher [who also heads Austria’s central bank] comments on monetary policy and inflation in the 13-nation euro area: ‘Monetary policy has to act pre-emptively, there is no doubt. Secondly, you always have to have in mind the medium-term goal, and we have of course certain upward pressures’ on inflation.” May 23 – Bloomberg (Joao Lima): “Former Federal Reserve Chairman Alan Greenspan comments on income inequality in the U.S. and the setting of monetary policy. He spoke to a conference in Madrid via satellite. ‘In the United States the greatest threat that we have to our market capitalist system is the increasing degree of income inequality. On decision making at the Fed: ‘We were wrong on numerous occasions but on the actual procedure of coming to a conclusion, I think we right… Dealing with the world economy, which is in flux and which is to a very substantial extent very difficult to know and to detail, you have to formalize views of how you look at problems to reduce the risk of error.’” Bubble Economy Watch: May 23 – Bloomberg (Kathleen M. Howley): “Ron Baron, founder of the investment company bearing his name, didn’t hesitate to pay $103 million for a 40-acre parcel in East Hampton, New York. It is the record for a residential property in the U.S….” May 23 – The Wall Street Journal (Ryan Chittum): “Despite some concerns about the health of the American consumer, the shopping-mall industry’s annual deal fest shows few signs of a slowdown. Strong consumer spending has bolstered the retail real-estate industry in the last seven years… But the industry received a warning sign in April: Retail spending was down for the first time in several months… ‘The middle market has slowed down’ says David J. LaRue, president and chief operating officer of…Forest City Enterprises. ‘The consumer is not feeling as wealthy. But they still have jobs.’ He notes that luxury retailers are still ‘banging on all cylinders’” Financial Sphere Bubble Watch: May 21 – Bloomberg (Hamish Risk): “The global derivatives market grew at the fastest pace in at least nine years during 2006 as the amount of contracts based on bonds more than doubled to $29 trillion, the Bank for International Settlements said… Derivatives covering bonds and loans rose by $15 trillion last year…The total amount of over-the-counter contracts whose value is derived from price changes of bonds, currencies, commodities and stocks, or events like interest rates or the weather rose 39.5% to $415 trillion, the biggest jump since the BIS began compiling the data.” May 23 – Financial Times (Gillian Tett andTony Tassell): “The number of Asians sitting for the west’s benchmark qualification for financial market literacy has outstripped candidates from the US - marking another milestone in the region's rapidly growing influence on global markets. This year's crop of candidates for the Chartered Financial Analyst exam will mark a dramatic reversal from earlier decades, when candidates from Wall Street dominated the test for what is considered a core qualification for work in the securities industry. Asia will this year field 52,900 students for the exam, against 45,400 from the US, with the fastest growth coming from India and China…” Mortgage Finance Bubble Watch: May 24 – Reuters: “Angelo Mozilo, the butcher’s son who built Countrywide Financial Corp. into the largest mortgage lender in the United States, was in no mood for soul-searching over the subprime home crisis. Perched on an arm chair on a ballroom stage, Mozilo, who made $387 million in pay and stock options over the past five years, disavowed blame for the collapse, pleasing his audience of fellow mortgage-banking industry leaders and foot soldiers. ‘You’ve got to be careful here about blaming ourselves too much,’ the deeply tanned and sharply dressed chairman of Countrywide told the Mortgage Bankers Association this week. The real culprits, he argued, are the Federal Reserve with its series of interest rate hikes, crooked real estate speculators, falling housing prices and regulators’ attacks on interest-only and other risky subprime loans. His take contrasts starkly with the view of those who blame loose lending policies and oversight, and a get-rich-quick culture in the mortgage industry. The consequences of the housing collapse, however, are not open to debate. Tens of thousands of loans have failed, pushing subprime borrowers out of their dream homes, and many economists blame subprime lending woes for a slump in the housing market that could get worse. The downturn is likely to sap overall economic growth for the rest of this year.” MBS/ABS/CDO/Derivatives Watch: May 21 – Financial Times (Gillian Tett): “The total outstanding value of all derivatives contracts arranged in private deals around the world has now surged above $400,000bn for the first time, new estimates from the Bank for International Settlements will show today. The rise…means that the sector swelled by more than a third during 2006, from a total of $297,670bn in December 2005 to $415,183bn in December last year. The dramatic increase highlights the frenetic pace of financial innovation currently under way in the banking and hedge fund world, as these institutions use increasingly sophisticated ways to manage their risks and create investment strategies. And this is posing new challenges for regulators and investors. This is not least because most of this activity is now occurring in private deals away from regulated exchanges.” Real Estate Bubbles Watch: May 25 – The California Association of Realtors (CAR): “Home sales decreased 27.8% in April in California compared with the same period a year ago, while the median price of an existing home increased 6.2 percent [to $562,820]… ‘April sales fell in part because of tighter credit standards and growing concerns about the impact of subprime loans on the market…Throughout the state inventory levels have increased to their highest levels in recent years… C.A.R.’s Unsold Inventory Index for existing, single-family detached homes in April 2007 was 10 months, compared with 5.7 months for the same period a year ago.” Energy Boom and Crude Liquidity Watch: May 22 – Financial Times (Simeon Kerr): “The emergence of Gulf funds with significant stakes in HSBC and J Sainsbury this year has thrust the region’s investors onto the British high street for the first time… Gulf money has flooded into the UK before. In the 1970s, the Kuwait Investment Authority led the way, buying slices of large western groups such as BP. But the current wave, driven by an oil boom that has seen oil prices peak at $78, has been on a different scale.” May 24 – Bloomberg (Nariman Gizitdinov): “Kazakhstan plans for its economy to grow by 9.4% to 14.874 trillion tenge ($123.6 billion) next year as an oil-fueled boom drives expansion in the former Soviet Union’s second-biggest energy producer.” Climate Watch: May 21 – Financial Times (Ed Crooks): “World energy consumption and consequent carbon dioxide emissions will rise by about 60% between 2004 and 2030 under current policies… In its annual International Energy Outlook, the US Energy Information Administration predicts oil consumption will grow by 42%, natural gas consumption by 65%, and coal consumption by 74%. As a result, unless policies are changed, energy-related carbon dioxide emissions will rise by 59% to 42.9bn tonnes a year by 2030, the EIA believes.” May 21 – Bloomberg (Alan Bjerga): “Worsening drought, global climate change and overgrown forests are increasing firefighting costs for the U.S. Department of Agriculture, a Brookings Institution study found. Some 9.9 million acres of U.S. forest land burned in 2006, the most since at least 1960 when the government began keeping consistent records…” Speculator Watch: May 23 – Financial Times (James Mackintosh): “The biggest hedge funds tightened their grip on the industry last year, with the top 100 passing the $1,000bn mark for the first time and holding more than two-thirds of all hedge fund assets… The 100 largest hedge funds increased assets 39% last year, Alpha magazine found… Two investment banks, JPMorgan and Goldman Sachs, topped the rankings published yesterday for the second year in a row, with $33.1bn and $32.5bn respectively, followed by Bridgewater Associates…with $30.2bn. New York’s DE Shaw…was fourth with $27.3bn.” May 24 - Dow Jones (David Enrich and Kaja Whitehouse): “In the wake of Fortress Investment Group LLC’s successful initial public offering, more hedge funds are likely to go public this year, according to investment bankers… The desire for a currency to attract and retain talent in a competitive industry environment is a key force behind the increased interest in IPOs. Bankers say that many of their hedge-fund clients are looking at the possibility of going public. Souren Ouzounian, managing director in Merrill Lynch…, said he has about six hedge-fund clients that are mulling IPOs. Michael Rees, a Lehman…investment banker, said four of his clients are positioned to file in ‘the fairly near term.’ ‘They’re big firms,’ Rees said…” May 24 – Financial Times (Gillian Tett): “Imagine for a moment that you were suddenly told that 700 hedge funds had collapsed. Would you react with merely a nonchalant shrug of the shoulders? Or experience a sense of panic? It is not a hypothetical question. Last weekend the Financial Stability Forum – a committee of international policy makers – released its most comprehensive analysis of the hedge fund sector since 2000… This provides a fascinating snapshot of the explosive growth seen in this sector this decade. But it also highlights a fascinating fact: namely that while 1,518 new funds were apparently created last year, another 717 were liquidated too. That represents a death rate equivalent to about one 12th of all funds.” ‘A Scary Proposition’: May 25 – Financial Times (Tony Tassell and Joanna Chung): “Highly solvent SWF seeks mutually rewarding relationship. That might sound like an advert in a singles column but it is in fact shorthand for what is rapidly becoming a huge force in global markets and economies. A vast arsenal of money to invest in markets is fast being built up by the swelling ranks of so-called sovereign wealth funds (SWFs), schemes set to invest the growing foreign exchange reserves and savings of countries from Norway to China. Driven by trade surpluses unequalled as a percentage of the global economy since the beginning of the 20th century, official reserves held by some governments are now astronomically high and there is pressure to earn a better return by putting the money with specialised investment agencies. Morgan Stanley estimated in March that the total funds at the disposal of SWFs may be as high as $2,500bn, already around half the gross official reserves of all countries. By comparison, the global hedge fund industry is thought to manage about $1,500bn to $2,000bn of assets… The SWFs are growing fast as countries reap the benefits of high oil prices or large trade surpluses. ‘If we are right that these funds will grow by roughly $500bn a year, at the expense of official reserve growth, the total size of the SWFs should be as big as the official reserves in only five to six years’ time,’ Morgan Stanley estimated. How and where this massive - and often secretively managed - pool of funds is deployed will be one of the big investment themes of coming years. The evolution of these funds will have huge implications for financial markets.” May 25 – Market News International (David Barwick): “The potential rise in Chinese foreign exchange reserves to $2 trln sometime next year is a ‘scary’ proposition, People’s Bank of China advisor Fan Gang said… But Fan ruled out any sharp appreciation of the yuan to counter the accumulation of forex reserves, insisting that doing so against a continually depreciating dollar would have only a limited and short-term impact. ‘We don’t want to go (with) those big jumps in revaluation, because if we do this next year, or the next year, two years later it will come again, because the U.S. dollar will continue to fall. That’s the kind of turbulence we don’t want… The currency (exchange rate) is two sides of the (same) coin -- one side is the U.S. dollar, the other is the Chinese renminbi. If the U.S. dollar always has the intention to devaluate, it always becomes your problem to revaluate. And the U.S. dollar always has this tendency to devaluate.’ The practice of devaluing the U.S. dollar, Fan asserted, began in the 1960s with the German mark and continued in the 1970s with the Japanese yen. ‘Now it’s the turn of the Chinese currency. This is an international problem,’ he affirmed. ‘Because the U.S. prints money to buy things.’ He said that China’s growing current account surplus is a ‘really a serious issue’ and that the associated pile of foreign reserves, now at some $1.3 trln, ‘could be two trillion next year; that’s scary.’” It is Scary. Global Credit and speculative excess are these days as rampant as they are conspicuous. And as the number sympathetic to the Bubble hypothesis grows, I guess we shouldn’t be all that surprised by the genesis of an illusory notion that Bubbles “are great for the economy.” It’s all rather astounding and adds only more support for the view that, once they catch a head of steam, inflationary excesses will surely take on powerful lives of their own. This is especially true when the prevailing inflation is in asset prices. As ECB council member Klaus Liebscher stated this week, ‘Monetary policy has to act pre-emptively, there is no doubt.” It is most regrettable that the Federal Reserve (and Wall Street “mavens”) has been fixated on aggregate measures of (“core”) consumer prices instead of the actual underlying monetary (Credit) inflation. It’s flawed doctrine being discredited before our eyes. Importantly, a stable monetary environment would have safeguarded our Current Account from ballooning to today’s unmanageable Deficits. I don’t mean to suggest that our trading partners are not without some responsibility. But the Chinese and others can make a very strong case today for pinning blame for global imbalances on our financial excesses and inflationary policy biases. There is inevitably a high price to pay for inapt policies that explicitly disregarded money and Credit, stubbornly refused to address asset inflation and Bubbles and, worse yet, promised aggressive reflations as needed. Today, we negotiate and prescribe policy from a sadly weakened stature. After all, how can we earnestly stipulate fair trading practices when, as Fan Gang noted, “the U.S. prints money to buy things” – and floods the world in dollar liquidity in the process? It’s rather foolhardy to expect the Chinese to implement radical policy adjustments (including major currency revaluation) that they view, on the one hand, as highly risky and, on the other, as unlikely to rectify (U.S.-induced) imbalances. And how can you blame them? Our policymakers are resolutely averse to decisive policy action (with the exception, of course, of aggressive easing). Moreover, the Chinese look to Japan’s experience and believe the dire Japanese predicament has been very much the outcome of allowing domestic policies to be dictated out of Washington. For a variety of reasons, Chinese policymakers are a different breed than their Japanese counterparts. They will act in what they believe is in the best interest of the Chinese, and they will not respond favorably to outside pressure. They are steadfast and today hold a strong hand. Fifty years from now, when economic historians look back at this period, my hope is that they recognize that U.S. financial excess was the fountainhead for the massive – and increasingly unwieldy - global pool of finance/“liquidity.” It is not that I am obsessed with pointing fingers as much as I seek recognition – or more clearly stated - the return of understanding with respect to the dangers of ongoing Credit and speculative excess. This week from Alan Greenspan: “In the United States the greatest threat that we have to our market capitalist system is the increasing degree of income inequality.” He has often in the past made similar warnings regarding the risk of rising protectionist sentiments. I can only hope that at some point an understanding emerges that income equality, protectionism, and other serious “threats” to Capitalism are the inescapable handiwork of protracted Credit inflation and attendant Bubble excesses. Back in 2003, Mr. Greenspan professed that “spreading globalization has fostered a degree of international flexibility that has raised the possibility of a benign resolution to the U.S. current account imbalance.” Since then our Current Account Deficit has ballooned uncontrollably and global imbalances have worsened dramatically. Greenspan committed a historical policy blunder. As such, it would today be more seemly for him to direct his attention to U.S. policy issues and address imbalances that are clearly not going in the direction of “benign resolution” (or at least he should not ignore them). It is certainly time to rethink bullish notions related to “globalization” and “international flexibility” and recognize that we must take responsibility for returning our financial and economic houses to some semblance of order. Let’s return to the “Scary” thought of Chinese reserves hitting the $2 TN mark next year. Massive Current Account Deficits and escalating dollar outflows to play (“undollar”) global markets now combine for a parabolic surge in dollar liquidity outflows to the world. And from foreign official comments and the emergence of these so-called “sovereign wealth funds” it is equally clear that there is now a major shift afoot to “diversify.” It’s no longer a safe bet that dollar flows will be recycled predictably back almost exclusively into the comfortable confines of the Treasury and agency marketplace. On the margin, global “official” flows have an increasing appetite for “risk assets,” a major reversal that will go anything but unnoticed by the enterprising global leveraged speculating community. And it’s all quite illustrative of the powerful dynamic of inflationary excess begetting only greater excess. For some time, escalating dollar outflows and requisite foreign central bank recycling made Treasury/agency yields unattractive (the “conundrum”), squeezing the leveraged speculators further into riskier assets. The resulting Credit boom then engendered only more enormous dollar flows to be recycled, along with greater outperformance of global risk assets vs. U.S. Treasuries. Not surprisingly, the central banks (and “SWFs”) desire a piece of the action, exacerbating the flood of finance into global equities, M&A, CDOs and structured instruments, junk bonds and leveraged loans and other higher yielding instruments. I am not going to claim any great insight into possible ramifications for ballooning pools of finance prospecting the world for better returns. I’ll suggest it’s historic and warn it’s precarious. I’ll proffer that this unfolding dynamic (ongoing heightened Credit Availability, Marketplace Liquidity, and Inflationary Biases) will in general necessitate higher global official short-term interest rates. The U.S. bond market, in particular, has been positioned for a faltering economy and Fed rate cuts – a scenario less likely near-term because of the unfolding extraordinary global liquidity and risk-seeking backdrop. And I can appreciate that savvy bond fund managers would hesitate remaining on the wrong side of this Official Treasury for Risk Asset Trade. I also ponder the possibility (and ramifications) that the “SWFs” are now consciously seeking opportunities to hedge against rising inflation. So much for the Myth of Stable Inflationary Expectations. Such a backdrop would also be expected to support the runaway booms in the heavily populated economies of China, India, Russia and elsewhere, ensuring little respite from pricing pressures throughout the global energy and commodities complex. The Myth of Price Stability is taking yet another blow with recent strong inflationary pressures engulfing food and staples (see Commodities Watch). Today, it is almost a case of mounting global inflationary pressures everywhere outside of manufactured goods prices (held in check by Credit-induced “Investment Inflation”). I’ll suggest as well that we’ve entered a dangerous period of Bubble-on-Bubble Excess. Despite several years of significant stock market inflation – three-year gains of 46% for the Russell 2000, 51% for the S&P400 Mid-Cap index, and 40% for the Wilshire 5000 - liquidity abundance has nonetheless nurtured a fanciful view that U.S. equities remain “undervalued.” The S&P500 this week traded back to year-2000 record highs, with the bulls keen to note that earnings have risen markedly since then (corporate profits have doubled since 2000 in total from the National Income and Product Accounts, and similarly for S&P500 companies). So the bulls today trumpet the case that U.S. stocks are cheap in real terms (S&P500 at “only” 18 P/E) and relative to global equities prices. The reality of the situation, however, is that years of U.S. Bubble excess have significantly inflated “fundamentals” such as corporate earnings and cashflows and personal incomes, along with global asset prices generally. Bubble-on-Bubble excess today inflates the perceived reasonable bounds for valuation to extremes - on top of an earnings base that is acutely vulnerable to a post-Bubble collapse. Yet perceptions hold that market risk is today much lower than during the 2000 Bubble. As we now witness, financial excess inflicts its most seductive distortions to underlying “fundamentals” during the late phase of Credit Bubble excess. There is an argument that lingers to this day that stocks were not overvalued in the late twenties. And while P/E ratios were modest right up to the ’29 crash, underlying boom-time earnings had become grossly inflated - and vulnerable. Similar dynamics are at play today. I fully expect corporate profits, personal income, and government tax receipts to all prove highly susceptible to the inevitable Credit cycle downside. Some choose to define Bubbles as a divergence between asset prices and underlying “fundamentals”. I would instead stress how profoundly and surreptitiously late-stage Bubble dynamics distort fundamentals – as both Credit and asset prices lose their moorings to anything of stable value. It’s when the pendulum inevitably swings back and the market places cautious multiples on post-boom earnings (that can be abruptly sliced "in half") that create devastating losses for unsuspecting “investors.” I’m with Fan Gang on this: I find the current direction of things Scary. |
Wednesday, September 10, 2014
05/24/2007 A Scary Proposition *
