06/16/2005 To Liquidate or Inflate *

It was another captivating week in global financial markets.

It was another captivating week in global financial markets. Here at home, the Dow rose 1%, while the S&P500 added 1.6% to return to positive for the year. The economically-sensitive stocks were strong. The Transports rose 2%, and the Morgan Stanley Cyclical index jumped 3%. The Utilities added 1%, and the Morgan Stanley Consumer index gained 0.5%. The broader market remained quite strong. The small cap Russell 2000 gained 3%, and the S&P400 Mid-cap index rose 2% to a new all-time high. The NASDAQ 100, Morgan Stanley High Tech, NASDAQ Telecommunications and The Street.com Internet indices all gained about 1%. The Semiconductors were unchanged. The Biotechs surged 5%. The Broker/Dealers rose 2%, and the Banks added 1.4%. With bullion surging $10.60, the HUI Gold index jumped 5%.

For the week, two-year Treasury yields added one basis point to 3.70%. Five-year government yields rose two basis points, ending the week at 3.86%. The 10-year Treasury yield increased two basis points for the week to 4.07%. Long-bond yields rose four basis points to 4.36%. The spread between 2 and 30-year government yields rose three to 66. Benchmark Fannie Mae MBS yields added one basis point. The spreads (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note was unchanged at 31, while the spread on Freddie’s 5% 2014 note narrowed one basis point to 30. The 10-year dollar swap spread declined 0.25 to 41.0. Corporate bonds generally performed well. Auto bond and CDS markets were relatively quiet. Junk bond spreads narrowed again this week. The implied yield on 3-month December Eurodollars declined one basis point to 3.955%.

Corporate issuance slowed somewhat to $9.4 billion. Investment grade issuers included Citigroup $1.0 billion, Tennessee Valley Authority $1.0 billion, Oneok $800 million, World Savings $750 million, Marshall & Ilsley $650 million, Monument Global Funding $600 million, Gannett $500 million, Synovus Financial $450 million, Pricoa Global Funding $400 million, Dominion Resources $600 million, American Electric Power $345 million, Pacific Life $250 million, Ryder $200 million, Medical Services $150 million, and Corning $100 million.

Junk bond funds reported outflows of $384 million (from AMG). Junk issuers included Tenaska $360 million, Emmis Communications $350 million, Celestica $250 million, Rafaella Apparel $170 million, and Holly Energy $185 million.

Convert issues included Invitrogen $350 million and Oil States International $125 million.

Foreign dollar debt issuers included BNP Paribas $2.1 billion and PT Indosat $250 million.

June 13 – Bloomberg (Agnes Lovasz): “Emerging-market borrowing surged in the first quarter, led by eastern Europe, as governments and companies seeking to raise money benefited from demand for high-yielding assets, the Bank for International Settlements said. Gross international bond sales, including money raised to finance maturing debt in emerging economies, rose 32.7 percent from the fourth quarter to the highest since 1997, Basel-based BIS said… Net bond sales increased 36.3 percent, led by eastern European borrowers.”

Interestingly, Japanese 10-year JGB yields jumped 8.5 basis points this week to 1.30%. Emerging debt markets again performed well. Brazilian benchmark dollar bond yields sank 24 basis points to 7.64%. Mexican govt. yields ended the week about unchanged at 5.43%. Russian 10-year dollar Eurobond yields dipped one basis point to 6.04%.

Freddie Mac posted 30-year fixed mortgage rates rose 7 basis points to 5.63%, down 69 basis points from one year ago. Fifteen-year fixed mortgage rates increased 8 basis points to 5.22%. One-year adjustable rates increased 4 basis points to 4.25%. The Mortgage Bankers Association Purchase Applications Index jumped 10.4% to a new record high. Purchase applications were up 18% compared to one year ago, with dollar volume up almost 30%. Refi applications surged 25.6% to a 14-month high. The average new Purchase mortgage rose to $243,500. The average ARM surged to a record $356,500 (up 24% from the year ago average $287,600!). The percentage of ARMs dipped to 30.9% of total applications.

Broad money supply (M3) jumped $18.1 billion to $9.62 Trillion (week of June 6), with a notable three-week gain of $64 billion. Year-to-date, M3 has expanded at a 4.9% rate, with M3-less Money Funds growing at 7.0% pace. For the week, Currency added $0.9 billion. Demand & Checkable Deposits dropped $33.5 billion. Savings Deposits surged $51.5 billion. Small Denominated Deposits rose $3.3 billion. Retail Money Fund deposits dipped $1.6 billion, and Institutional Money Fund deposits fell $7.0 billion. Large Denominated Deposits gained $3.2 billion. For the week, Repurchase Agreements declined $1.6 billion, while Eurodollar deposits added $2.8 billion.

Bank Credit expanded $5.4 billion last week, increasing the year-to-date expansion to $452 billion, or 15.1% annualized. Securities Credit is up $157 billion, or 18.5% annualized, year-to-date. Loans & Leases have expanded at a 13.8% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 18.5%. For the week, Securities dipped $2.6 billion. C&I loans declined $6.1 billion. Real Estate loans surged $14.1 billion. Real Estate loans have expanded at a 15.1% rate during the first 23 weeks of 2005 to $2.711 Trillion. Real Estate loans are up $325 billion, or 13.6%, over the past 52 weeks. For the week, Consumer loans added $2.9 billion, while Securities loans declined $4.0 billion. Other loans added $1.2 billion.

Total Commercial Paper surged $21.3 billion last week to $1.539 Trillion. Total CP has expanded $124.7 billion y-t-d, a rate of 19.1% (up 14.4% over the past 52 weeks). Financial CP jumped $19.0 billion last week to $1.386 Trillion, with a y-t-d gain of $101.3 billion (17.1% ann.). Non-financial CP increased $2.3 billion to $152.9 billion (up 39.2% ann. y-t-d and 22.3% over 52 wks).

ABS issuance slipped to $17 billion (from JPMorgan). Year-to-date issuance of $337 billion is 27% ahead of comparable 2004. At $210 billion, y-t-d home equity ABS issuance is 33% above the year ago level.

Fed Foreign Holdings of Treasury, Agency Debt increased $4.7 billion to $1.436 Trillion for the week ended June 15. “Custody” holdings are up $101 billion, or 16.3% annualized, year-to-date (up $209bn, or 17%, over 52 weeks). Federal Reserve Credit declined $2.0 billion to $788.0 billion. Fed Credit has declined 0.7% annualized y-t-d (up $41.6bn, or 5.6%, over 52 weeks).

International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi - were up $564 billion, or 17.5%, over the past 12 months to $3.781 Trillion. Taiwan’s foreign reserves were up 10.6% over the past year to $253 billion.

Currency Watch:

Today’s steep drop pushed the dollar index to a more than 1% decline this week. The “commodity" currencies performed well. The Brazil real gained almost 4%, the South African rand 1.9%, the Chilean peso 1.8%, the Canadian dollar 1.8%, and the New Zealand dollar 1.6%.

Commodities Watch:

July crude oil surged $4.93 to a record $58.47. For the week, the CRB rose 2.8%, increasing y-t-d gains to 9.5%. The Goldman Sachs Commodities index surged 6.5%, pushing the 2005 rise to 27.5%. Corn posted its strongest weekly gain in 14 years and soybean the strongest week in 6 years (from Bloomberg). Copper traded to a new 16-year high.

June 15 – Financial Times (Thomas Catan): “World energy consumption surged 4.3 per cent last year, the biggest percentage rise since 1984 and the largest volume increase ever, according to new figures from BP, the oil company… Global consumption of oil also rose by 3.4 per cent, or 2.5m barrels a day, the biggest increase since 1978.”

June 15 – Bloomberg (Wing-Gar Cheng): “China’s use of natural gas may rise 12 percent a year over the next 15 years as the country builds more gas terminals and pipelines, boosting demand for the fuel, The China Petroleum & Chemical Industry Association said. Natural gas consumption may increase to 252 billion cubic meters by 2020, from 64.5 billion cubic meters this year, the Beijing-based association said…”

June 13 – Bloomberg (Wing-Gar Cheng): “China, the world’s biggest oil consumer after the U.S., boosted crude-oil imports 5.1 percent in the first five months of this year, the Customs General Administration of China said.”

June 16 – Bloomberg (Jennifer Itzenson): “Copper rose to a 16-year high in New York and reached a record in London as slumping inventories signaled growing demand in the U.S. and China for metal used in homes, cars and appliances. Stockpiles monitored by the London Metal Exchange fell 1,000 metric tons to 38,300 tons today, the lowest in 30 years and down 67 percent in the past year.”

China Watch:

June 16 – Bloomberg (Nerys Avery): “China’s fixed-asset investment gathered pace for a third month in May as more power plants and railways were built to reduce blackouts and ease transport bottlenecks in the world’s fastest-growing major economy. Investment in urban areas rose 26.4 percent from a year earlier to 1.97 trillion yuan ($238 billion) in the first five months… The increase is the biggest this year and follows a 25.7 percent gain for the first four months.”

June 15 – Bloomberg (Nerys Avery): “China’s industrial production rose faster than expected in May as overseas orders for products such as steel, shoes and laptop computers helped drive expansion in the world’s fastest-growing major economy. Production climbed 16.6 percent from a year earlier to a record 570 billion yuan ($69 billion) after a 16 percent gain in April…”

June 13 – Bloomberg (Nerys Avery): “China’s retail sales rose at a faster pace in May as higher incomes spurred spending on products including Tsingtao Brewery Co. beer, Hitachi Ltd. televisions and General Motors Corp. cars. Sales increased 12.8 percent from a year earlier to 489.9 billion yuan ($59 billion), after climbing 12.2 percent in April… Restaurant sales surged 20 percent, vehicle receipts rose 15 percent and garment sales climbed 19 percent.”

June 15 – Bloomberg (Wing-Gar Cheng): “Shanghai’s government, moving to avert summer blackouts that forced thousands of companies to slash production last year, asked factory owners to plan shutdowns and may allow power companies to raise prices. China’s biggest commercial city may have 2 million kilowatts less power than it needs this summer as the use of air conditioners pushes demand beyond generating capacity… The moves come two weeks after Beijing’s municipal government announced similar plans for the capital.”

June 15 – Bloomberg (Xiao Yu): “A recent investigation by China’s State Council, the nation’s cabinet, showed property prices in some Chinese cities including Beijing fell in May after the government unveiled measures last month to curb real estate speculation… Home prices in cities and provinces including Chongqing, Shandong, Hebei and Hubei dropped as much as 5.3 percent from the first quarter, the agency said today…”

June 16 – Bloomberg (Philip Lagerkranser): “Hong Kong’s unemployment rate unexpectedly fell to its lowest level in more than three years in May as construction companies and banks added jobs. The seasonally adjusted jobless rate slid to 5.7 percent last month from 5.9 percent in April…”

Asia Boom Watch:

June 16 – Bloomberg (Seyoon Kim): “South Korea’s jobless rate dropped in May for the first time in three months, boosting expectations domestic demand may pick up and companies may employ more staff, as construction sites and farms hired workers. The seasonally adjusted rate fell to 3.5 percent from April’s 3.6 percent…”

June 15 – Bloomberg (Seyoon Kim): “Combined sales at South Korea’s Lotte Department Store Co. and its two nearest competitors rose for a fourth straight month in May, adding to evidence consumer spending is rebounding from a two-year slump.”

June 13 – Bloomberg (Anuchit Nguyen): “New car sales in Thailand, Southeast Asia’s biggest auto market, rose 22 percent in May from a year earlier, helped by sales of pickup trucks, according to Toyota Motor Corp.’s local unit.”

June 13 – Bloomberg (Wahyudi Soeriaatmadja): “Automobile sales in Indonesia rose 28 percent in May from a year earlier, PT Astra International said today…”

June 15 – Bloomberg (Sara Webb and Amit Prakash): “Singapore’s retail sales rose a better-than-expected 13 percent in April from a year earlier as consumers bought more cars, furniture and household goods.”

June 15 – Bloomberg (Stephanie Phang): “Malaysia’s inflation rate accelerated in May to its highest since February 1999, reinforcing expectations the central bank will raise interest rates for the first time in seven years. The consumer price index rose 3.1 percent from a year earlier…”

June 14 – Bloomberg (Cherian Thomas and Kartik Goyal): “India’s exports rose 22 percent in May, boosted by shipments of leather and food products to East European countries and Asian markets such as Thailand. Exports rose to $7.2 billion in May, the Commerce and Industry Ministry said in a statement in New Delhi. Imports rose 35 percent to $10.8 billion in May, widening the trade deficit to $3.6 billion from $2.1 billion a year earlier.”

June 15 – Bloomberg (Pooja Thakur): “Shares of India’s smallest listed companies… have risen to records as economic growth boosts demand for parts and services, attracting buyers including Morgan Stanley and Goldman Sachs Group Inc… Companies such as Stone India, with a market value of as little as $16 million, are attracting international investors as economic growth of more than 6.9 percent boosts demand for cars, houses and services… The Mumbai stock exchange's Small-Cap Index has risen 33 percent this year…”

Unbalanced Global Economy Watch:

June 16 – Bloomberg (Tracy Withers): “New Zealand manufacturing sales rose for the first time in three quarters in the three months ended March 31, amid increased sales of meat, butter and milk powder. Sales rose 2.9 percent following a revised 0.9 percent decline in the fourth quarter…”

June 13 – Bloomberg (Tracy Withers): “New Zealand retail sales rose for the third month in four in April, helping support Reserve Bank Governor Alan Bollard’s view that household spending may fan inflation and prevent him cutting interest rates.”

Latin America Watch:

June 13 – Bloomberg (Patrick Harrington): “Mexico’s industrial output rose in April, led by the manufacturing of cars, auto parts and machines. Industrial production rose 5.2 percent from a year ago after falling 4.7 percent in March, the government said.”

June 15 – Bloomberg (Alex Emery): “Peru’s economy accelerated in April as natural gas, chemicals, paper and cotton output rose, the government said. Gross domestic product expanded 6.4 percent in the month from a year earlier, up from 4 percent growth in March…”

Bubble Economy Watch:

The June University of Michigan Consumer Confidence reading jumped strongly to the highest level since January. At 71, the National Association of Home Builders Market Index has not been higher since 1999. May Single-Family housing starts (1.704 million annualized) were the fourth highest on record. Bloomberg quoting Pulte Homes CEO Richard Dugas: “Demand across the entire country is really strong. I would characterize it as robust activity in almost every market.”

June 16 – Bloomberg (Vincent Del Giudice): “The U.S. Treasury, reaping the benefits of a growing economy, received a one-day record of $61 billion in tax receipts yesterday, including a one-day record $49 billion in corporate tax receipts... The previous one-day record for tax receipts was $56 billion on Dec. 15, 2000, and the previous one-day record for corporate tax receipts was $46 billion on Dec. 15, 2004…”

June 14 – Wall Street Journal (Rafael Gerena-morales): “Strong gains in corporate profits, household income and home sales are swelling tax revenues for states nationwide, helping to close budget gaps and boost spending. State-tax revenue for the July-March period of the fiscal year ending June 30 reached $387 billion, up 9.5% from the year-earlier period, according to a report soon to be released by the Nelson A. Rockefeller Institute of Government… Tax collections in the January-March quarter were up 11.7%, the strongest year-on-year growth for that period since at least 1991. The institute also says that if the current pace continues, states are on track to take in a record $550 billion for the full fiscal year… ‘We are now seeing year-over-year revenue growth’ at levels last seen before the recession, says Nicholas Jenny…with the Rockefeller Institute… Economists say there are three main factors behind the improvement in government finances. Tax collections from personal income are running about 10% ahead of last year. Corporate-tax revenues -- related in part to strong profits -- are running 20% to 60% ahead of a year ago in many states. And real-estate taxes in some states have doubled because of the heated housing market. Among these, the most puzzling element to analysts has been the growth in personal income. According to figures released last month by the Bureau of Economic Analysis, employee compensation rose at a seasonally adjusted annual rate of 10% during the fourth quarter of 2004 and 7.1% during the first quarter of this year.”

June 15 – Bloomberg (Danielle Sessa): “The New York Yankees unveiled plans to build a $800 million ballpark next to their current home in the Bronx that would give baseball's most successful franchise the most expensive stadium. The proposed ballpark would have fewer seats than the 82-year-old Yankee Stadium and triple the number of luxury suites. The Yankees would pay for it with tax-exempt financing, and New York City would contribute about $135 million toward park land in the area and improvements to the building site.”

June 15 – Dow Jones: “The U.S. commercial real estate market should experience ‘solid’ gains through 2006, the National Association of Realtors said Tuesday. ‘Even with a lot of new construction around the country, we are seeing healthy levels of commercial real estate space being purchased, rented and occupied,’ David Lereah, NAR’s chief economist, said… ‘As a result, vacancies are declining across the board - this is improving the fundamentals for commercial real estate sectors into the foreseeable future,’ he said.”

June 14 – Dow Jones: “Vacancy in Manhattan’s Class B office market fell in May while the Class A market remained fairly stable and asking rents continued to rise in most markets… The vacancy rate in the Class A market has been fairly flat at about 9.4% since February while the asking price for Class A space in Manhattan has risen, to $51.03 a square foot, on average, from $47.55 in May 2004.”

California Bubble Watch:

June 16 – East Bay Business Times: “Home prices in the (San Francisco) Bay Area continued climbing in May with the median price paid for a home in the Bay Area up 17.6 percent in a year's time to $595,000. According to DataQuick…Solano County prices rose 22.9 percent from last year to $429,000 in May, up from $349,000. Contra Costa County prices rose 19.5 percent from last year to $539,000 in May, up from $451,000. Alameda County prices rose 17.7 percent from a year ago to $573,000 in May, up from $487,000.”

Speculative Finance Watch:

June 16 – Wall Street Journal (Henny Sender): “Marin Capital Partners LP, a convertible-bond hedge-fund management firm with about $1.7 billion under management, has thrown in the towel. In a letter to investors Tuesday, it said it was closing down its funds and returning money to investors. The letter cited ‘a lack of suitable investment opportunities’ and little prospects to come up with winning bets… Like other funds that trade bonds that convert into stock, Marin has struggled with poor returns for some time… For the first five months of the year, Marin’s flagship Tiburon Fund was down 3.86%, while global convertible funds were down an average 6.95% as of May 27… The predicament of convertible-bond funds has been the predicament of all hedge funds, writ large. As more money has come into the strategy, returns have collapsed.”

Mortgage Finance Bubble Watch:

ARM behemoth Golden West Financial posted a strong May. Loans expanded at a 21% rate to $111.1 billion (assets increasing at a 14% rate). Mortgage Originations were up 15% from one year ago to $4.43 billion. On the Liability side, Total Deposits expanded at a 21% rate to $57.7 billion. Over the past year, Total Assets have increased 28%. Looking at Liabilities, FHLB borrowings were up 27% y-o-y to $35.8 billion and Total Deposits were up 21%.

June 16 – New York Times (David Leonhardt, Motoko Rich): “American homeowners have made a trillion-dollar bet that mortgage rates will remain near record lows for at least a few more years… The problem is that new types of mortgages that hold down monthly payments for families - helping many buy homes that they would not otherwise be able to afford - also require potentially far higher payments in future years. The bill will soon start to come due in a serious way, as the initial period of fixed payments, typically set at artificially low rates, expires for millions of homeowners with adjustable- rate mortgages. This year, only about $80 billion, or 1 percent, of mortgage debt will switch to an adjustable rate based largely on prevailing interest rates, according to an analysis by Deutsche Bank in New York. Next year, some $300 billion of mortgage debt will be similarly adjusted. But in 2007, the portion will soar, with $1 trillion of the nation's mortgage debt - or about 12 percent of it - switching to adjustable payments, according to the analysis.”

June 15 – Bloomberg (BusinessWire): “As condo conversion activity continues to intensify throughout the U.S., so does Fitch Ratings’ concern that many of these markets are becoming overheated, which may ultimately lead to higher default rates… The total volume of apartments purchased for conversion increased an astounding 350% last year to $13.3 billion. Fitch finds condo conversion loans to be riskier than traditional CMBS loans given the elements of construction/renovation risk, conversion stage risk and market risk inherent in all condo conversion loans…”

Earnings Watch:

Goldman Sachs posted a disappointing quarter (and the market loved it!). Net Earnings of $865 million were down 43% from the previous quarter and 27% from the year ago period. Total Revenues were up 17% from the year earlier quarter, with Interest Income up 80% to $4.867 billion ($19.5bn annualized!). “Net revenues in Trading and Principal Investments were $2.81 billion, 22% lower than the second quarter of 2004 and 36% lower than the first quarter of 2005.” “Net Revenues in Investment Banking were $815 million, 14% lower than the second quarter of 2004 and 9% lower than the first quarter of 2005.” “Assets under management increased 18% from a year ago to a record $490 billion, with net asset inflows of $10 billion during the quarter.” Goldman Sachs repurchased 15.5 million shares of stock during the quarter.

Lehman Brothers’ Net Income of $683 million was up 12% from the prior year period and down 22% from the previous quarter. Principal Transaction revenues were up 11% from the year ago quarter to $1.644 billion (to 50% of Net Revenues). Strong mortgages, structured finance and international (international revenues up 45% y-o-y) led the way. Total Interest & Dividend revenues for the quarter were up 71% from the prior year to $4.45 billion ($17.8bn annualized!). By segment, Capital Markets Revenues were up 14% y-o-y, with Fixed Income up 22%. “Record Investment Management revenues, which increased 10% to $72 million in the second quarter…” “For the second quarter… non-U.S. net revenues were $1.3 billion or 40% of the Firm’s total net revenues and up 45% from the prior year’s quarter.” Total Assets expanded at a 9.1% rate to $372 billion. Total Assets were up 7.4% from one year ago and 145% since the beginning of 1998. The company repurchased 8.3 million shares during the quarter.

Bear Stearns reported better-than-expected Net Income of $365 million. This was up 5.0% from the year ago quarter and down 3.6% sequentially. Net Revenues were up 8.7% from one year ago to $1.873 billion. Interest and Dividends was up 16.7% during the quarter to $1.192 billion, with a one-year gain of 139%. “Capital Markets net revenues for the second quarter…were $1.4 billion, up 7% (y-o-y)… Institutional Equities net revenues were $390 billion, up 59% (y-o-y)… Fixed Income net revenues were $808 million, down 6% from record net revenues of $860 million in the second quarter of 2004… Investment Banking net revenues of $232 million…were effectively unchanged (y-o-y)…” “Average customer margin debt balances for the quarter…were $58.7 billion, up 26% (y-o-y)…”

To Liquidate or to Inflate?

From the Department of Treasury’s website: “Andrew W. Mellon was nominated by President Harding to be the 49th Secretary of the Treasury. He was retained by President Coolidge and President Hoover, serving the three Administrations from March 4, 1921 until February, 1932. Secretary Mellon demonstrated financial ability early in life by starting a successful lumber business at the age of 17. He joined his father’s banking firm, T. Mellon & Sons, two years later and had the ownership of the bank transferred to him in 1882 at the age of 27. In 1889, he helped organize Union Trust Company and Union Savings Bank of Pittsburgh. He also branched out from banking into industrial activities, and built a great personal fortune from oil, steel, shipbuilding, and construction… Through the prosperous 1920’s, Mellon was a popular individual, but the onslaught of the depression affected his standing.”

Mr. Mellon was recognized by his contemporaries as a brilliant and compassionate American policymaker, businessman, philanthropist and statesman. Yet economic historians – not unjustifiably so – deride him for his most famous “tough love” approach to the “roaring twenties” hangover:

“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. … It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.”

It helps to appreciate the backdrop for Mr. Mellon’s comment. By the late-‘20s, he and others had grown quite concerned over what they considered a momentous inflationary boom that had transpired since the end of the First World War. Having witnessed recurring inflationary booms and subsequent painful busts during the second half of the nineteenth century, he believed that restraint and hardship were the only viable antidote for an extended period of excess. A difficult adjustment period was necessary to restore the financial and economic systems to stability, in the process returning both businessmen and workers to more industrious pursuits. Deflation must follow the inflationary boom because attempts to sustain the inflated price level, with its attendant profligacy and speculation, would prove futile, only spurring more dangerous excesses and imbalances. Sustaining or reigniting booms – while failing to “purge” unsound elements - would necessitate only more arduous and protracted adjustment periods.

It is worth pondering the merits of Mr. Mellon’s philosophy, if for no other reason than it is the antithesis of contemporary monetary and economic thinking. The notion that anything should be "Liquidated" or "purged" is dismissed out of hand. Apparently, there is virtually no financial or economic problem that cannot be rectified by Federal Reserve “reflationary” policies. No costs to over-consumption, uneconomic investment, over-borrowing or gross speculation that the Fed cannot easily mitigate. Furthermore, our “moral life” and “values” are supposedly enhanced by rising home, stock and bond prices; speculating in the markets and on mortgage rates has become the applauded social norm.

Meanwhile, the most “competent” individuals are today celebrated for profiting from rising asset prices, MBS spread trades and myriad opportunities for “financial arbitrage.” The massive wealth transfer to these “competents” is rationalized in terms of Adam Smith's "invisible hand" and Schumpeter’s “creative destruction.” The very foundation of contemporary “conservative” notions of economic wealth creation rests upon inflating house and securities prices, as well as with the creation and accumulation of financial claims. We are to focus on “intellectual output” and let others ship us their wares and energy resources.

Importantly, Andrew Mellon believed that inflationary booms had to be deflated to ensure the sustainability of the existing monetary regime (in his case, the gold standard). This, strangely, does not appear to be an issue today. Indeed, the viability of the “Bretton Woods II” non-regime essentially demands – and is dependent upon - unrelenting monetary inflation and attendant imbalances. And unprecedented U.S. imbalances are expected to be painlessly rectified over time through the “adjustment of global prices”. Mellon, on the other hand, would surely today argue that a properly functioning global currency regime is an absolute prerequisite to monetary and economic stability -- and that the sustainability of such a regime is foremost dependent upon the sound management of individual country financial systems and economies – not some nebulous/miraculous adjustment in international price levels.

It has always been my view that the Greenspan Fed believes (or, more likely, rationalizes) that it can comfortably tolerate excesses and avoid a major market bust, confident in its capacity to stabilize post-Bubble asset prices with aggressive reflationary policies. More specifically, the post-tech/telecom/equity market Bubble has been supported for several years by ultra-easy money policies, biding time until the economy's underlying price level catches up to previously inflated equity valuations. Globally, the post-eighties Japanese Bubble environment was stabilized by the Japanese easy-money policies, while biding time until inflating U.S. and global price levels caught up to those in Japan. Today, it is expected that the inflated U.S. cost structure and imbalances can be sustained until an inflating global (Chinese and “emerging” Asia) price level ensures a painless American adjustment period. Again, any suggestion that the U.S. must “Liquidate,” “purge,” or restrain anything in order to stabilize the system or stem escalating imbalances is today considered ludicrous.

Not only are we not “Liquidating,” the system is rapidly inflating the number of mortgage brokers, investment bankers, real estate agents, hedge fund managers, luxury retailers and homebuilders – in textbook “blow-off” fashion. And the most conspicuous consequences include almost $60 crude, record home and commodities prices, and an unprecedented $195 billion three-month Current Account Deficit. Rather than showing any indication of improvement, U.S. imbalances turn worse by the month. Non-financial Debt expanded at a seasonally-adjusted annualized rate of 10% during the first quarter, the S&P500 Homebuilding index is up 32% y-t-d (76% y-o-y), and mortgage debt growth has surely accelerated to unprecedented levels following the recent sharp decline in mortgage rates.

The current consensus view remains “‘90s complacent.” The previous decade’s “disinflationary” dynamics were complex and multi-dimensional. Yet I do believe that the early-decade collapse of Soviet economies, the bursting Japanese Bubble, a weakened U.S. banking system, and severely impaired “emerging” economies and financial systems all played a prominent role. Japanese and American monetary policymakers enjoyed great leeway in their reflationary policies. Not only were there downward pressures on global energy and commodities prices (and to a lesser extent on real estate), there was a strong bias for marginal liquidity to flow conveniently into U.S. financial assets. Today's strong inflationary bias in mortgage finance had yet to germinate. Moreover, a series of financial crises – and the rise of King Dollar - wrecked havoc and imposed discipline upon “emerging” economy Credit systems. The fledgling leveraged speculating community was chiefly a U.S. markets phenomenon, at least until later in the decade.

Today, powerful inflationary biases permeate global commodities and real estate markets. Liquidity is overly abundant for all, while discipline is imposed on no one. Not only has the global pool of speculative finance inflated multi-fold from the ‘90s, speculators no longer have reason or inclination to fixate on U.S. securities or even financial assets, generally. It was, after all, only a matter of time. In this regard, it is helpful to appreciate that the character of inflationary effects will always evolve throughout the life of a boom. Especially as it applies to an inflating pool of speculative finance, new asset classes will garner attention and their inflation will engender keen interest to identify the next hot asset class, group, sector or country. Mr. Mellon would argue that there is today no alternative than to Liquidate speculative excess. To accommodate inflation and speculation is to invite these forces to broaden and intensify. To be sure, the days of Inflationary Manifestations sitting tight in U.S. asset markets have ended.

It is now conventional wisdom that China must adjust its currency, savings propensities and consumption patterns to rectify “global imbalances.” In theory, having China inflate does seem a lot less onerous for everyone than having the U.S. commence Liquidating and Purging. But I caution not to peer through the ‘90s (dis)inflationary prism. Sustaining the U.S. Credit Bubble, along with resulting Current Account Deficits, these days ensures a strengthening inflationary bias throughout China, India, Russia, Brazil and other economies with large populations. Europe may be stagnating – with negative ramifications for global GDP – but the prominent inflationary issue today is not measured “output” in the “industrialized” world but heightened global demand for limited energy and commodities resources. The current U.S.-led global inflation should be thought of in terms of inflating the purchasing power of over three billion consumers. Again, this is an inflationary backdrop quite unlike the U.S. financial boom we so enjoyed during the nineties.

Sustaining current Inflationary Dynamics and Monetary Processes will also expand the already unwieldy dimensions of the global pool of speculative finance. And, sure, the bond bears have been squeezed and the stock bears are being squeezed, so all appears just hunky-dory in the markets. But looks are so often deceiving. Beneath the surface festers only greater uncertainty and instability. The Achilles heel is that the markets and economy will remain robust (awash in blow-off liquidity) for not one day longer than unprecedented Credit creation is sustained.

Characteristically, “Liquidity” and “Systemic Dislocation” trades increasingly captivate the monumental global speculating community. Is the global “Reflation Trade” unwinding or winding? Are interest rates finally poised to rise or are market dynamics (bears, derivatives and MBS) conducive to yet another tantalizing run for the roses? Is the dollar at the brink of crisis, or are the bears and derivative players positioned to be squeezed? Are interest-rate differentials and risk spreads widening or narrowing? What direction is the yield curve going to shift? Are buyers or sellers of Credit default swaps more vulnerable? Who has more momentum, greed or fear? Is the U.S. liquidity Bubble about to burst, or do blow-off excesses ensure that the “best” is saved – NASDAQ-style - for last?

Keep in mind that a coupling of Credit Bubble Blow-off and Speculative Market Dynamics assures that the most spectacular market gains manifest when those betting on system instability are forced to unwind their positions. As we witnessed with NASDAQ and the dollar, it is the nature of Financial Sphere Bubbles that speculative excess turns its most “frothy” when Economic Sphere fundamentals are well past their peak and poised to deteriorate (often rapidly). With Bubble dynamics in play throughout the U.S. and global Credit systems, today’s environment takes on extraordinary significance. Squeezes in the U.S. bond market, in particular, perpetuate the Mortgage Finance Bubble and its attendant Systemic Liquidity Bubble. This exacerbates excesses throughout the Financial and Economic Spheres, in the process creating the marketplace liquidity (and “psychology”) to wreak bloody havoc on trades placed to profit from or hedge against faltering liquidity.

There has and will, for the duration, be a thin line between a faltering Credit Bubble and Spectacular Blow-off Excesses. Inflationary dynamics currently demonstrate a strong propensity for only greater Bubbles and heightened Monetary Disorder, certainly including the potential for greater payoffs for speculators who eventually place winning bets on faltering U.S. liquidity. I fully expect only heightened volatility in global bond, equity, currency, and commodity markets. And I do see market unpredictability and wild volatility akin to a wrecking ball pounding away at the very foundations of speculator and system stability.

And while pundits can and do today make a pretty convincing - albeit superficial and mistaken - case for financial nirvana, the current environment is demonstrating characteristics of the forging of a historic top in “financial assets.” We are in the midst of unparalleled global monetary inflation, with oil and things outperforming many financial instruments. Meanwhile, the crowd is all crowded together with huge leveraged positions in myriad financial instruments. They may be convinced that bond prices are fundamentally based or they may simply be playing the game for all its worth. The lurking danger lies, however, with the reality that prices have been inflated by the very excess liquidity created through unprecedented mortgage Credit growth and their own securities leveraging.

To this point, bull market psychology has clung to the perception that rising oil and home prices, and other inflationary manifestations, will work to restrain growth and, thus, support elevated bond prices. In reality, inflating bond prices (declining rates) foster Credit excess that basically monetizes rising prices while providing the inflationary fuel for further price gains. “Real” interest rates have collapsed, and both the energized economy and inflationary pressures are responding as one would expect. It has always been a case of the necessity for U.S. Credit restraint. Yes, the faltering dollar played a major role in inciting global Credit and speculative excess. But now, with powerful forces unleashed, global inflationary pressures are ambivalent to the dollar’s recent rally. The onus must now shift away from the dollar to the true culprits – global interest rates, the speculative U.S. bond market and rampant mortgage and securities Credit excess. Are Japanese and European bond yields poised to rise?

To Liquidate or Inflate? Well, I see nothing on the horizon that makes me back away from my expectation that the Fed and the bond market will soon have reason to question the notion of a 3.5% “neutral rate.” With this in mind, the higher that bond, real estate and equities prices inflate, the more onerous the future liquidation of these Bubbles (along with underlying dollar instruments).