07/24/2003 Struggling Team Greenspan-Bernanke *

It appears wild volatility has likely returned to the stock market. On the back of generally favorable earnings reports, the Dow gained 1% and the S&P 500 less than 1%. 3M, Alcoa, and AT&T were this week’s leading Dow gainers. The Transports enjoyed a solid week, adding 1.5%, while the Utilities were unchanged. The Morgan Stanley Cyclicals gained 2.9%, while the Morgan Stanley Consumer index was slightly positive. The broader market was generally firm, with the small-cap Russell 2000 gaining almost 1%. The S&P 400 Midcap index was down slightly. The tech-heavy Nasdaq100 added better than 1%, increasing y-t-d gains to 30%. High tech strength continued, as the Morgan Stanley High Tech index rose by 2.3% (up 35% y-t-d). The Semiconductors added 1.8% on the week, increasing 2003 gains to 35%. The Street.com Internet index gained 2.4% (up 46% y-t-d), and the Nasdaq Telecom Index returned 0.7% (up 40% y-t-d). The Biotechs gave back 1% this week. Financial stocks enjoyed gains, with the Broker/Dealers and Banks up 1%. With bullion up $15.50, the HUI gold index surged 16%. The bond market remains extraordinarily volatile. For the week, two-year Treasury yields added 1 basis point 1.50%, while 5-year Treasury yields added 12 basis points to 2.98%. Ten-year yields closed the week at 4.18%, up a noteworthy 18 basis points. The long bond also saw its yield jump 18 basis points to 5.12%, the highest yield since early January. The yield on benchmark Fannie Mae mortgage-backs jumped 16 basis points, while the implied yield on agency futures surged 22 basis points (up 87 basis points from June lows!). The spread on Freddie’s 4 ½% 2013 note widened 5 to 43, and the spread on Fannie’s 4 3/8% 2013 note widened 4 to 43. The benchmark 10-year dollar swap spread increased 2.75 to 41.5, the widest since mid-April. Interestingly, corporate debt outperformed, with investment grade spreads narrowing modestly and speculative grade spreads impressively. The dollar rally came to an abrupt halt, with the dollar index declining almost 2% this week. In a fascinating development not indicative of marketplace adulation for Fed policies, the yield curve is becoming unusually steep. The spread between 2 and 10-year Treasuries closed today at 267 basis points, 16 wider for the week, 30 wider for two weeks, and almost 50 wider over four weeks. According to Bloomberg, this is “the widest gap in more than a decade.” All the same, it was another week of solid debt issuance. In the investment grade market, Wachovia issued $1.25 billion, American Express $1 billion, Lehman Brothers $1 billion, First Data $1 billion, Fifth Third Bancorp $500 million, Marsh & McLennan $300 million, IBM $250 million, Vectren Utility $200 million, Old Dominion Electric $250 million, Union Electric $200 million, Con Edison $200 million, National City Bank $250 million, and Dominion Resources $510 million. It was another big week in the junk area. Nextel priced $1 billion, ACC Escrow Corp. $900 million, Rural Cellular $325 million, Delphi Automotive $500 million, HCA $500 million, Westlake Chemical $380 million, Mandalay Resort $250 million, Kinetic Concepts $205 million, Payless Shoesource $200 million, and Westinghouse Air $150 million. And there were a handful of converts priced. Health Management Association sold $500 million, Chiron $450 million, Quantum Corp. $160 million and America West $75 million. Broad money supply (M3) declined $3.1 billion last week, this following the $125 billion surge over the previous two weeks. Demand and Checkable Deposits dipped $1 billion, while Savings Deposits added $2.7 billion. Small Denominated Deposits declined $2.1 billion, and Retail Money Fund deposits dropped $7.9 billion. Institutional Money Fund deposits declined $1.0 billion. Large Denominated Deposits added $600 million after last week’s $62.5 billion surge. Repurchase Agreements declined $2.2 billion, while Eurodollars increased $7.8 billion. Elsewhere, Total Bank Assets declined $19.5 billion during the week of July 16th. Securities positions sank $62.7 billion. Loans and Leases rose $28.7 billion, with Security loans up $24.6 billion. Commercial and Industrial loans added $1.2 billion and Consumer loans gained $3.1 billion, while Real Estate loans dipped $6.2 billion. Foreign “custody” holdings of U.S. debt instruments declined $4.5 billion. There were 31,408 bankruptcy filings last week. Year-to-date filings are up 9.9% (according to J.P. Morgan Equity Research). RockyMountain News (John Rebchook): “In the first six months of the year, there were 4,340 foreclosures in the seven-county (Denver) area…a 38.5 percent increase. (Quoting a local real estate professional) ‘Most of them are dealing with a loss of jobs and not being able to get a job paying the same salary. Another problem is these 125 percent loans. People refinanced and were listening to lenders who were able to get appraisals for unrealistic amounts.’” Freddie Mac posted 30-year fixed mortgage rates surged 27 basis points this week to 5.94%. One year adjustable-rate mortgage yields rose 9 basis points to 3.67%. Thirty-year rates are now up 73 basis points in five weeks. June New Homes Sales were reported at a stronger-than-expected and record pace of 1.16 million units. New Home Sales have surged 24% since February’s low and are now on pace to shatter last year’s record by more than 10%. To put this number into perspective, the trough during the early nineties recession was put in during January 1991 at 401,500 annualized units. The high during the three years 1990 through 1992 was 676,000 units. June sales were up 21% y-o-y, with average (mean) prices up 8.1% to $243,500. Annualized Calculated Transaction Value (CTV) surged 30.8% y-o-y to $282.5 billion. CTV is up 50% over two years (volume up 30% and prices up 15%) and 80% over three years (volume 46% and prices 23%). The inventory of New Homes increased another 4,000 during the month to 345,000, the highest level since July 1996. It is also worth noting that 26,000 New Homes were sold for $300,000 and over. This compares to 15,000 sold in this category during June 2002. Existing Home Sales were reported at a very strong rate of 5.83 million units (double the trough level of 2.90 million units from December 1990), with sales remaining above last year's record pace. The Average Price came in up $12,000 to a record $224,900. The Average Price was up $13,000 in the West to a record $292,200, $8,400 in the Northeast to $238,200, $8,600 in the Midwest to $182,000, and a noteworthy $15,500 in the South to $209,400. Inarguably, broad-based housing inflation runs unabated. And with y-o-y Average Prices up 6.6% and Volume up 8.6%, CTV is up 15.8% to $1.31 Trillion. Existing Home Sales CTV is up 29% over two years (prices 10% and volume 18%), 42% over three years (prices 13% and volume 26%) and 102% over six years (prices 38% and volume 46%). The number of homes available for sale increased 400,000 to 2.50 million, the highest level since September 1991. And there is little indication that higher mortgage rates have tempered overheated housing markets. Despite the mortgage refi application index dropping back to almost 6,000 from May’s record spike to 10,000, purchase applications remain quite strong. Purchase application volume last week was up 26.6% from a year earlier, with dollar volume up a notable 36.9%. From the Los Angeles Times (Elizabeth Kelly): “Overall, last month was the strongest June in the region (Southern California) since 1989… Experts attribute the record prices to a basic rule of economics: Demand is high but the supply of homes is small. ‘The low interest rates spur the buying frenzy,’ said Frank Almeida, a real estate agent based in Riverside. ‘But there is not enough inventory.’ …Prices (y-o-y) rose 16.4% to $313,000 in Los Angeles County, 15.3% to $414,000 in Orange County, 23.8% to $255,000 in Riverside County, 22.6% to $195,000 in San Bernardino County, 20.7% to $390,000 in San Diego County and 18.2% to $396,000 in Ventura County.” According to DataQuick, June Los Angeles County condominium prices were up 20.5% y-o-y, the largest ever price gain. It’s quite a Bubble our Federal Reserve has nurtured out in the Golden State and elsewhere. Today from the California Realtors Association (C.A.R.): “The median price of an existing, single-family detached home in California during June 2003 was $376,260, a 15.9 percent increase over the revised $324,640 median for June 2002…C.A.R’s Unsold Inventory Index for existing, single-family detached homes in June 2003 was 2.3 months…” Amazingly, the average home price in California is up $51,620 over the past twelve months. And while Southern California is white hot, the North is not doing too shabby. Year-over-year prices are up 15.5% in Northern California, 22% in Sacramento, 15.2% in Santa Barbara County and 13.8% in San Luis Obispo. With earnings reporting season, we again enjoy the opportunity to examine the doings of our major financial institutions. Are they increasingly financing investment, or are they sticking with their fixation on asset and consumption-based lending? “An economy is as its financial system lends.” Credit insurer Ambac enjoyed y-o-y EPS growth of 36%. Adjusted Gross Premiums Written surged 65% y-o-y, with Public Finance up 65%, Structured Finance 41%, and International up 123%. The company increased Net Financial Claims in Force (NFCF) by $19.4 billion during the quarter (13.5% annualized growth rate) to $594.8 billion. NFCF (insurance written) was up 18% y-o-y and up 33% in two years. The company ended the second quarter with Statutory Capital of $4.1 billion. Credit card behemoth MBNA Financial expanded Total Managed Loans at a 17% annualized rate during the quarter to $110.5 billion. Total Assets expanded at a 19% rate to $57.2 billion and were up 21% y-o-y. This was up from the first quarter’s 13% growth rate, and the strongest asset expansion since last year’s third quarter. The Managed Loan Delinquency rate dropped 28 basis points during the quarter to 4.46% and was down 34 basis point y-o-y. The Managed Loan Credit Loss rate of 5.35% was down 12 basis points during the quarter, but remains 26 basis points above the year ago level. From Citigroup: “Once again, our consumer business delivered exceptional income growth of 18%, led by 63% growth in Retail Banking…” Total Retail Revenues were up 24% y-o-y. Global Corporate and Investment Bank income was up 2% y-o-y on 7% revenue growth. In North America, Consumer Net income jumped 17% y-o-y, while Corporate Net Income declined 8%. Total Assets expanded at an 18% rate during the second quarter, acceleration from the first quarter’s 15% rate. Examining first-half asset growth, we see that Total Loans were down 2% to $438.6 billion. Meanwhile, Federal Funds Sold and Securities Borrowed or Purchased Under Agreements to Resell surged 20% to $167.3 billion. Trading Account Assets were up 12% to $174.3 billion, and Brokerage Receivables were up 73% to $44.0 billion. Investments were up 11% to $189.0 billion. JPMorganChase: Trading Revenues were up 20% from the first quarter and 102% from last year’s comparable quarter. The Total Credit Portfolio expanded at an 11.8% annualized rate during the quarter and was up 6.2% from the year earlier. Year-over-year, Managed Consumer Loans were up 26% to $176 billion while Commercial Loans were down 13% to $91.0 billion. Curiously, Derivative Receivables were up 34% y-o-y to $93.6 billion, surpassing Total Commercial Loans for the first time during the second quarter. Bank of America reported record Net Income of $2.74 billion, up 23% y-o-y. The company posted record mortgage originations ($40 billion), while “mortgage banking income increased 305 percent to $559 million. Card income increased 23% to $762 million... Credit and debit card purchase volumes increased 9 and 19 percent…” Total Assets surged $89.4 billion during the quarter, or 53% annualized, to $769.2 billion. Total Assets were up 20% y-o-y. During the quarter, Available-for-sale Securities jumped $38.7 billion to $114.3 billion. Total Loans and Leases expanded at a 20% annualized rate during the period, up from the first quarter’s 1% and the fourth quarter’s 2%. Examining Average Loans, Total Commercial Loans contracted at an 11% rate during the quarter and were down 10% y-o-y to $139.1 billion. Total Consumer Loans expanded at a 16% annualized rate and were up 17% y-o-y to $211.2 billion. Residential Mortgages expanded at a 25% rate during the quarter to $120.8 billion, and were up 27% from the year earlier. The company repurchased 30 million shares during the second quarter, while “29 million shares were issued in the second quarter of 2003, mostly due to stock incentive plans.” From Wells Fargo: “The double-digit loan growth was generated primarily by the continued strong consumer demand for residential first mortgage and home equity loans and other revolving credit and installment loans… On a combined basis, average consumer loans and real estate first mortgage loans increased almost $29 billion, or 33 percent, from the same period last year. The Company also had strong loan growth in other key consumer areas, including personal loans and lines of credit, which saw funded balance growth of 46 percent in second quarter 2003, compared with second quarter 2002.” Quarter-over-quarter, “Real Estate 1-4 family first mortgage” loans expanded at a 34% annualized rate (up 42% y-o-y), with home equity loans growing at a 42% annualized rate (up 30.4% y-o-y). Commercial Loans declined at a 4.7% rate during the second quarter. Year-over-year, Total Loans were up $30.4 billion (16.4%), with Commercial Loans increasing $164 million (0.3%). From Washington Mutual: Highlights include “record loan volume of $120.32 billion, up 108 percent from the second quarter of 2002 and 13% higher than the first quarter… Home equity loans and lines of credit and multi-family loan volume increased by 30 percent from the first quarter of 2003 to $9.46 billion and 80 percent from the second quarter of 2002’s $5.27 billion.” Total assets increased at a 9% rate to $283.2 billion. Countrywide enjoyed a phenomenal quarter. “Total fundings were $130 billion for the second quarter, advancing 209% over last year.” From CEO Angelo Mozilo: “Mortgage banking results have been exceptional. Year-to-date fundings were $233 billion, which compares favorably to $252 billion in fundings for all of calendar 2002…” Countrywide’s Total Assets expanded a record $18.2 billion, or 99% annualized. Year-over-year, Total Assets were up 119%. “Bank total assets are now at $13 billion, up from $5 billion at December 31, 2002. The regulator-approved business plan has a goal of $17 billion in total assets by December 31, 2003.” Total Assets are up 480% over the past ten quarters. And with the recent back-up in rates, it is worth noting that the company ended the quarter with $35.7 billion of “mortgage loans and mortgage-backed securities held for sale” and another $10 billion of “trading securities.” New Century Financial (the king of variable-rate non-prime mortgages) saw originations jump 24% from the first quarter to $5.8 billion (up 120% from the year earlier quarter). FastQual, the company’s online product, accounted for $3.3 billion of originations, double the first quarter and compared to $424 million during Q2 2002. “Use FastQual, the fastest automated underwriting system in the non-prime market. Don’t wait all day for loan answers! Just submit loans online at www.NewCentury.com with FastQual, and we’ll give you loan approval answers in just 12 seconds!” “80/20 Combo - Loan amounts to $700,000K fico 580+” Total Assets expanded by $1 billion during the quarter, or almost 150% annualized, to $3.8 billion. Total assets were up 150% y-o-y. June highlights from Fannie Mae: “Total business volume was a record $142 billion, up from $129 billion in May. Fannie Mae’s book of business grew at an extremely strong compound annual rate of 33.1 percent, up from 18.1 percent in May.” For the second quarter, Fannie saw its Book of Business (mortgages retained and guaranteed) surge by a record $126.4 billion, or 26% annualized, to $2.05 Trillion. For comparison, Fannie’s Book of Business expanded $58.1 billion during last year’s comparable quarter. The company’s Book of Business has now ballooned $613 billion, or 43%, over the past 24 months, and has doubled since surpassing $1 Trillion for the first time during September 1998. Year-to-date, Fannie’s Book of Business has surged $230 billion, or at a 25% growth rate. Outstanding Mortgage-backed Securities have expanded at a 40% growth rate to $1.24 Trillion. There are few places where one can find a 40% growth rate on a base of a trillion dollars. From Alan Greenspan’s prepared comments last week before the House Committee on Financial Services: “The prospects for a resumption of strong economic growth have been enhanced by steps taken in the private sector over the past couple of years to restructure and strengthen balance sheets… Nowhere has this process of balance sheet adjustment been more evident than in the household sector. On the asset side of the balance sheet, the decline in longer-term interest rates and diminished perceptions of credit risk in recent months have provided a substantial lift to the market value of nearly all major categories of household assets. Most notably, historically low mortgage interest rates have helped to propel a solid advance in the value of the owner-occupied housing stock… On the liability side of the balance sheet, despite the significant increase in debt encouraged by higher asset values, lower interest rates have facilitated a restructuring of existing debt.” Our Fed chairman continues to propound dubious analysis; financial historians will not be kind. For one, he confuses cause and effect. Household sector asset prices - real estate in particular - are inflating specifically because of incessant household sector borrowing excesses and aggressive financial sector expansion. Keep in mind that household sector debt increased by more than $3 Trillion to $8.6 Trillion since the end of 1997, or 55% in just over five years. To claim that household balance sheets have been “strengthened” is simply one more ridiculous statement by our top central banker. Curiously, during the late nineties, when equities were the inflating asset of choice, the Fed at least paid lip service to the important issue of asset Bubbles. Today, with much more dangerous (and conspicuous) asset inflation running rampant, the Greenspan Fed has conveniently abandoned the issue. The above quarterly results from some of our major financial institutions indicate it is quite likely that second-quarter household mortgage borrowings will be even stronger than the first quarter’s 12% annualized pace. As we are again witnessing, asset Bubbles are incredibly seductive specifically because everything – including ballooning balance sheets – appears just marvelous; that is as long as additional Credit excess is forthcoming. But just as the telecom sector experienced post-Bubble, things can sour quickly when Credit Availability falters, asset values reverse, and bloated liabilities wreak increasing havoc on stressed balance sheets. If it were not silly enough to trumpet that (asset inflation-induced) “net worth of households is estimated to have risen 4 ½ percent” during the first half, Mr. Greenspan further pushed the envelope of acceptable central banking with the following: “Is it important for an economy to have manufacturing? There is a big dispute on this issue. What is important is that economies create value, and whether value is created by taking raw materials and fabricating them into something consumers want, or value is created by various different services which consumers want, presumably should not make any significant difference so far as standards of living are concerned because the income, the capability to purchase goods is there. If there is no concern about access to foreign producers of manufactured goods, then I think you can argue it does not really matter whether or not you produce them or not.” Again, future financial historians will not be impressed. This returns us to the critical issue of the “Quality of Output.” And it is similar to how companies can inflate earnings (“quality of earnings”) for quite some time seemingly without consequences, until the inevitable day arrives when it is discovered that assets have been overvalued. If assets are worth less than liabilities, crisis is then unavoidable. I have argued that a service sector economy is in reality a monetary economy. And, yes, as long as money and Credit are fabricated in great abundance, we do command the wherewithal to provide “services” to one another, seemingly without a hitch. We can treat each other to massage, consulting and legal services, brokerage inflating home and security transactions, and prepare each other’s meals. There is also nothing stopping us from gleefully boasting of our “economic output” and miraculous "productivity." But, at the end of the day, there’s a balance sheet problem: there’s no getting around the reality that we are creating (inflating) financial claims with little true economic value supporting the market value of this debt. We are simply playing an illusion with imputed market values detached from true wealth creation. Mr. Greenspan is dead wrong on this most important issue. It matters tremendously that our economy continues to lose its capacity to create sufficient manufactured goods. First, we are no longer self-sufficient, and are vulnerable to price inflation and availability issues for energy and an increasing array of products. Second, we have lost the capability for mutually beneficial trade and balanced global growth – sustainable trade of goods for goods. Instead, we trade new financial claims for goods, building up a mountain of foreign liabilities, while fearing the day our creditors question the financial integrity of their holdings. There is the crucial issue of financial fragility: as an economy we are massively inflating financial claims without the backing of tangible assets or the capacity to produce true economic wealth. Moreover, the longer the Credit Bubble is allowed to inflate, the greater the economy’s shift away from (profit constrained) manufacturing to (currently more profitable asset-inflation based) services. And the longer this inflation is fostered, the more the rising domestic cost structure impedes our global competitiveness. It is simply unbelievable that Mr. Greenspan does not appreciate these critical dynamics. Yet it does help to explain why there is little concern with our financial system’s fixation on asset and consumption-based lending, as opposed to financing business and capital investment. Apparently, the quality of financial assets matters about as much as the quality of economic “output.” Well, the nature of output is vitally important when its creation is being financed by new financial claims. And the quality of financial assets matters tremendously when they are being accumulated by foreign creditors. Fed Governor Ben Bernanke’s speech Wednesday was similarly unimpressive and dishearteningly detached from today’s critical issues. His opening sentence: “Achieving and maintaining price stability is the bedrock principle of a sound monetary policy.” If Mr. Bernanke focused on broad price stability, including real and financial asset prices, then we might begin by sharing some common ground. But for his definition of “price stability” he is content with an ultra-narrow focus on “Core CPI.” Especially considering the dynamics of contemporary market-based financial systems and asset inflation-centric economies, it is simply flawed central banking to fixate on such an inconsiderable component of total prices within an economic system. Instead, “the bedrock principle of sound monetary policy” should today be financial stability and balanced economic growth. Dr. Bernanke, a long-time proponent of inflation targeting, also made interesting comments regarding the Fed’s May 6th policy statement: “A crucial element of the statement was an implicit commitment about future monetary policy; namely, a strong indication that, so long as a substantial fall in inflation remains a risk, monetary policy will maintain an easy stance. Particularly at very low inflation rates, a central bank’s ability to make clear and credible commitments about future policy actions--broadly, how it plans to adjust the short-term interest rate as economic conditions change--is crucial for influencing longer-term interest rates and other asset prices, which are themselves key transmission channels of monetary policy.” I am reminded of Hyman Minsky’s brilliant proposition that “stability is destabilizing”: A protracted period of economic and financial tranquility increasingly foments destabilizing behavior (borrowing, spending and speculating excess, for three). Following this line of reasoning, a policy that “makes clear and credible commitments about future policy actions” - for today’s speculative-rife financial markets - is a recipe for serious trouble. Indeed, Dr. Bernanke would like to implement a process (“inflation targeting”) whereby monetary policy becomes quantitative and mechanical, dictated by core CPI prices. But such certainty and predictability, as we have witnessed, only incites destabilizing excess (If we are confident that rates are going to stay low, why not take huge leveraged bond positions financed by cheap overnight funds?). “The main purpose of this quantification of price stability would be to provide some guidance to the public as they try to forecast FOMC behavior… the Fed could make use of this quantitative guidepost to signal its expectation that rates will be kept low for a protracted period…” Ironically, such a “guidepost” would only be a more formidable adversary to financial stability. The Fed would be advised to withdraw from the business of “influencing longer-term interest rates and other asset prices.” With an enterprising leveraged speculating community of unprecedented dimensions, Fed efforts to manipulate the marketplace are both destabilizing and increasingly dangerous. Yet I do recognize that the Fed is now fully immersed in desperate measures to perpetuate a (John Law-style) financial scheme/Bubble. This past October, with the corporate debt crisis spiraling out of control and threatening to engulf the vulnerable consumer debt sector, the Fed saw little alternative than to resort to desperate measures. They (again) incited a major “reliquefication,” while at the same time talking “deflation” and the possibility of adopting measures to push long-term rates lower. Well, this clever approach proved too “successful.” The speculator crowd all rushed to the other side of the boat. Financial markets then turned over-liquefied and long-term rates collapsed. The Mortgage Finance Bubble ran completely out of control, with borrowing rates collapsing in market dislocation. Mr. Greenspan was forced to take notice. So things are becoming more interesting. The bond Bubble has been pricked, which draws our keen attention as to the ramifications for the historic Mortgage Finance Bubble. Things become all the more fascinating with troubles brewing at the GSEs, as rumors (noted by the Financial Times) circulated this week, “that the European Central Bank had recommended central banks cut their holdings of so-called agency debt…” Well, well, well, just wait until the GSEs are faced with the specter of inevitable post-Bubble Credit losses. Noting that agency spreads have widened signficantly of late, we recall how telecom debt spreads began to widen back in mid-1999 (and a few marginal companies began to quietly falter). And while there was little on the surface to cause great concern back then – after all, the Bubble was raging out of control and manic behavior would be sustained for several more quarters – an important inflection point in market dynamics had passed. Borrowing costs began to rise for the marginal companies, while Credit Availability began to tighten on the fringes. The huge speculator community, having inundated the sector with liquidity, was finding it more difficult to achieve expected heady gains. Some began to suffer losses. Importantly, speculative flows began to slow, setting in train the failure of the next marginal company. Credit availability became more restrictive and speculative losses began to mount. Eventually a full-scale retreat of speculative finance from the sector ushered in spectacular collapse. There was one more facet to the technology boom worth contemplating. Many sophisticated players recognized clearly that the tech sector was a major speculative Bubble. They were, nonetheless, determined to play it for all it was worth - that’s what they do for “a living.” Yet they were fully expecting to front-run the crowd to the exit when things began to unravel (the greatest gains, after all, are achieved during the final speculative blow-off!). Many were run over, overstaying the game and miscalculating how quickly greed can be transformed to fear (and illiquidity). The point being that I believe many of the sophisticated global players keenly appreciate the nature of the U.S. agency/mortgage finance/dollar Bubbles. They will play it for all its worth – especially with the confidence that Team Greenspan/Bernanke will stop at nothing to perpetuate the Bubble – but they will have one eye on the exit. This week saw agency debt prices weaken significantly, with spreads increasing to the widest level in four months. Over the past two weeks, 10-year U.S. Treasury yields have gone from 20 basis points less than 10-year German yields to almost 20 basis points higher. And this week the dollar rally abruptly reversed, with gold enjoying its strongest weekly gain in 17 months. There are, as well, calls at home and abroad to devalue the dollar against the Chinese currency. Why do we sense this is playing with fire? And while there is understandable complacency regarding the ramifications of a weak dollar for today’s liquid stock market, there are a few things to keep in mind. First, with market perceptions seemingly of the view that the dollar has experienced the worst of its self-off, any serious return of dollar weakness could catch players (speculators, derivative players, and foreign investors) unprepared. Second, weak private demand has necessitated foreign central banks to acquire enormous dollar holdings over the past several months. Is this sustainable and have foreign central bankers been shaken by the unexpected backup in rates? Third, we don’t see Inflationist Team Greenspan/Bernanke instilling much market confidence, especially to our foreign creditors. Their deflation and “unconventional measures” intimations play much better when bond prices are rising. And finally, it is worth noting that dollar weakness over the past 18 months has run concurrently with a virtual melt-up in bond prices. Foreign holders of Treasury and agency securities have enjoyed huge capital gains to off-set currency losses. There was also the (reliquefication-induced) collapse in spreads helping to mitigate dollar weakness. We operate today in an extraordinarily unsettled financial environment dominated by leveraged speculation and U.S. foreign liabilities of unprecedented amounts. It is our sense that the “leveraged speculating community” has been rattled by wild equity, currency, and bond market volatility. With this in mind, we should be prepared for heightened volatility. We have always believed that systemic stress would be most aggravated in an environment where the dollar weakened, bond prices declined, and spreads widened. Such a scenario exposes the speculators, derivative players, and our foreign creditors to the greatest risk of abrupt and significant losses (and resulting acute financial fragility). Such a scenario is, all of the sudden, not a low probability event. Dr. Bernanke may trumpet the death of core CPI inflation, but acute financial instability is alive and extraordinarily vibrant.