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).

06/09/2005 Q1 2005 'Flow of Funds' *

The U.S. stock market was mixed.  For the week, the Dow gained about 0.5%, with the S&P500 posting a small advance.  The Transports were hit for 3%, while the Utilities added 1%.  The Morgan Stanley Cyclical and Morgan Stanley Consumer indices were slightly negative.  The broader market rally carried on.  The small cap Russell 2000 and S&P400 Mid-cap indices posted gains of less than 1%.  At the same time, the technology rally stumbled.  The NASDAQ100 declined 1.5%, and the Morgan Stanley High Tech and Semiconductor indices fell about 1%.  The Street.com Internet Index declined 2.5%, and the NASDAQ Telecommunications index lost 1%.  The Biotechs were down slightly.  The Broker/Dealers gained 1%, and the Banks were about unchanged.  With bullion up $4.60, the HUI gold index added 1%. A little froth came off the bond market.  For the week, two-year Treasury yields jumped 12 basis points to 3.69%.  Five-year government yields rose 11 basis points, ending the week at 3.84%.  The 10-year Treasury yield was 7 basis points higher for the week to 4.05%.  Long-bond yields added 4 basis points to 4.32%.  The spread between 2 and 30-year government yields dropped 8 to 63.  Benchmark Fannie Mae MBS yields rose 5 basis points.  The spreads (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note and Freddie’s 5% 2014 note were unchanged at 31.  The 10-year dollar swap spread declined 0.25 to 41.25.  Corporate bonds performed well, with auto bond and CDS enjoying a solid week.  Junk spreads narrowed marginally.  The implied yield on 3-month December Eurodollars jumped 15.5 basis points to 3.965%.  It was another strong week of corporate issuance.  Investment grade issuers included Exelon $1.7 billion, Comcast $1.5 billion, Caterpillar $800 million, Chesapeake Energy $600 million, LG Electronics $600 million, Prudential $550 million, Countrywide $500 million, Masco $500 million, MGM Mirage $500 million, Reed Elsevier $700 million, Marriot $350 million, Pacificorp $300 million, John Deere Capital $300 million, Keycorp $250 million, Diamond Offshore $250 million, Pepco $250 million, and TTX $100 million.      June 10 – Bloomberg (David Russell):  “Qwest Communications International Inc. and DirecTV Group Inc. led companies that sold $4.3 billion of junk bonds this week, the most since February, after a two-week decline in borrowing costs induced companies to issue debt.” Junk bond fund inflows declined to $110 million (from AMG).  Junk issuers included Qwest Communications $1.75 billion, Ford Motor Credit $1.5 billion, DirectTV $1.0 billion, Service Corp $300 million, Tekni-Plex $150 million and Sierra Pacific Resources $100 million.    June 8 – Financial Times (Gillian Tett ):  “The cost to investment grade companies of raising funds through the syndicated loan market is at its lowest for eight years in the US and Europe, data from Dealogic, a market research group show.  This follows a striking fall in the cost of borrowing for these so-called investment grade companies in recent months, and offers further evidence of the high levels of liquidity that are still swirling around global banks and capital markets. Steven Victorin, a managing director at Citigroup, said: ‘We are operating in an environment where there is an extraordinary amount of liquidity, it is very competitive out there.’  …Dealogic’s data suggest that in the second quarter of this year, US and European investment grade companies were on average paying 64 basis points and 54 basis points, respectively, over Libor to raise loans a rate last seen in 1997.” Foreign dollar debt issuers included CIE $200 million and Braskem SA $150 million.       Japanese 10-year JGB yields declined 2 basis points to 1.215%.  Emerging debt markets stumbled a bit.  Brazilian benchmark dollar bond yields jumped 36 basis points to 7.88%.  Mexican govt. yields ended the week up 7 basis points to 5.43%.  Russian 10-year dollar Eurobond yields rose 6 basis points to 6.04%.  Freddie Mac posted 30-year fixed mortgage rates dropped 6 basis points to 5.56%, the lowest level since March 2004 and down 74 basis points from one year ago.  Fifteen-year fixed mortgage rates declined 6 basis points to 5.14%.  One-year adjustable rates fell 5 basis points to 4.21%.  The Mortgage Bankers Association Purchase Applications Index rose 3.6%.  Purchase applications were up 11% compared to one year ago, with dollar volume up almost 24%.  Refi applications jumped 6.5%.  The average new Purchase mortgage rose to $240,000.  The average ARM surged to a record $351,100.  The percentage of ARMs declined to 31.7% of total applications.     Broad money supply (M3) jumped $23.8 billion to $9.622 Trillion (week of May 30).  Year-to-date, M3 has expanded at a 3.6% rate, with M3-less Money Funds growing at 5.3% pace.  For the week, Currency added $1.3 billion.  Demand & Checkable Deposits rose $19.8 billion.  Savings Deposits dropped $26.6 billion. Small Denominated Deposits gained $3.9 billion.  Retail Money Fund deposits dipped $1.1 billion, while Institutional Money Fund deposits rose $16.2 billion.  Large Denominated Deposits jumped $16.1 billion.  For the week, Repurchase Agreements declined $3.1 billion, and Eurodollar deposits dipped $2.8 billion.                 Bank Credit jumped another $31.6 billion last week, increasing the year-to-date expansion to $419.8 billion, or 14.7% annualized.  Securities Credit is up $156 billion, or 19.2% annualized, year-to-date.  Loans & Leases have expanded at a 12.7% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 19.3%.  For the week, Securities increased $12.3 billion.  C&I loans dipped $0.9 billion.  Real Estate loans rose $12.9 billion.  Real Estate loans have expanded at a 13.4% rate during the first 22 weeks of 2005 to $2.69 Trillion.  Real Estate loans were up $313 billion, or 13.2%, over the past 52 weeks.  For the week, consumer loans declined $1.7 billion, while Securities loans increased $11.2 billion. Other loans dipped $2.2 billion.    Total Commercial Paper rose $8.9 billion last week to $1.517 Trillion.  Total CP has expanded at a 16.5% rate y-t-d (up 12.9% over the past 52 weeks).  Financial CP expanded $9.8 billion last week to $1.367 Trillion, with a y-t-d gain of $82.3 billion (14.5% ann.).  Non-financial CP dipped $0.9 billion to $150.7 billion (up 37% ann. y-t-d and 22.9% over 52 wks). ABS issuance surged to a record $30 billion, breaking the two-week old record of $23 billion by 30% (from JPMorgan).  Year-to-date issuance of $320 billion is 27% ahead of comparable 2004.  At $201 billion, y-t-d home equity ABS issuance is 32% above the year ago level.   Fed Foreign Holdings of Treasury, Agency Debt rose $5.3 billion to $1.432 Trillion for the week ended June 8.  “Custody” holdings are up $95.9 billion, or 16.2% annualized, year-to-date (up $203.5bn, or 16.6%, over 52 weeks).  Federal Reserve Credit dipped $2.5 billion to $790.0 billion.  Fed Credit has declined 0.2% annualized y-t-d (up $43.6bn, or 5.8%, over 52 weeks).  International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi - were up $563.93 billion, or 17.5%, over the past 12 months to $3.778 Trillion.  India’s foreign reserves were up 18.4% over the past year to $134 billion.  China’s broad measure of money supply (M2) was up 14.6 percent from one year ago to 26.9 trillion yuan, or $3.3 Trillion. Currency Watch: The dollar index gained 1%.  Curiously, despite the dollar’s rise the commodity currencies generally performed well.  The South African rand gained 1.5%, the New Zealand dollar 0.8%, and the Australian dollar 0.7%.  The Iceland krona gained 1%.  On the downside, the Brazilian real declined 2.0%, the Swedish krona 1.9%, the Swiss franc 1.3%, and the Euro 1.0%. Commodities Watch: June 8 – Bloomberg (Bunny Nooryani):  “Statoil ASA, Norway’s largest oil company, said a shortage of skilled workers in the oil and gas industry may hamper global development of petroleum fields in the next five years, as demand for energy rises.  ‘A shortage of competence is a far bigger hindrance to developing the oil and gas industry than the need for capital,’ Statoil Chief Executive Helge Lund said…” June 9 – Bloomberg (Maria Ermakova):  “Russia will raise crude oil exports to China by 50 percent next year, Interfax reported, citing China National Petroleum Corp. President Chen Geng. Russia’s oil exports to China will increase to 15 million tons in 2006 from 10 million tons planned this year…” June 10 – Bloomberg (James Cordahi):  “China’s imports of iron ore, an ingredient in steelmaking, surged 34 percent in the first five months from a year earlier to 110 million metric tons…” July crude oil slumped $1.49 to $53.54.  For the week, the CRB declined 1.4%, reducing y-t-d gains to 6.5%.  The Goldman Sachs Commodities index slipped 0.5%, as the 2005 gain fell to 19.7%.  China Watch: June 10 – XFN:  “China’s exports for the first five  months rose 33.2% year-on-year to $276.4 bln and imports were up 13.7% to $246.38 bln, the Xinhua news agency said, citing customs figures.” June 10 – Bloomberg (Philip Lagerkranser):  “China’s producer prices rose in May at the quickest pace this year as rising demand in the world’s fastest-growing major economy pushed fuel costs higher.  The producer price index rose 5.9 percent from a year earlier…” June 6 – XFN:  “Retail sales will grow 12.5% in 2005, rising to 40% of GDP, the (Chinese) Ministry of Commerce forecast… It predicted that auto sales will rise 15% over last year, and sales of residential properties will rise 20%.” June 8 – XFN:  “China’s passenger car sales, including  sedans, multiple-purpose vehicles and sport-utility vehicles, rose 24% year-on-year to 249,624 units in May, the Shanghai Daily reported.” June 7 – Bloomberg (Philip Lagerkranser):  “Hong Kong’s retail sales growth accelerated in April, beating economists' forecasts, as falling unemployment and rising wages made consumers more willing to spend. Sales gained 8.5 percent from a year earlier to HK$17 billion ($2.2 billion) after climbing a revised 6.2 percent in March…” Asia Boom Watch: June 8 – Bloomberg (John Stebbins):  “Worldwide semiconductor sales are expected to rise 6 percent this year because of demand for personal computers and cellular telephones, a trade group said, revising its forecast for little to no change in sales.” June 10 – Bloomberg (Cherian Thomas and Kartik Goyal):  “India’s industrial production grew faster than expected in April as rising incomes and the cheapest credit in 32 years boosted sales…  Production at factories, utilities and mines in April rose 8.8 percent…” June 10 – Bloomberg (Anand Krishnamoorthy):  “India’s automobile sales rose 20 percent in May after Maruti Udyog Ltd., the nation's biggest carmaker, and other automakers boosted discounts to lure buyers in Asia’s fourth-biggest automobile market….” June 8 – Bloomberg (Debarati Roy and Matthew Craze):  “Mittal Steel Co. may build a 300 billion-rupee ($6.9 billion) steel mill and iron-ore mine in India’s Jharkhand state to tap new ore deposits amid a surge in raw material costs.” June 8 – Bloomberg (Seyoon Kim):  “South Korean household debt posted its biggest increase in 19 months in May as consumers borrowed more to buy properties and stocks, a central bank report showed.” June 7 – Bloomberg (Theresa Tang and Yu-huay Sun):  “Taiwan’s exports grew in May at the slowest pace in two years as high oil costs damped overseas demand  for the island’s laptop computers, flat-panel displays and mobile phones. Shipments rose 4 percent from a year earlier to $16.3 billion…” June 7 – Bloomberg (Stephanie Phang):  “Malaysia’s industrial production rose at a faster than expected pace in April as manufacturers boosted output to meet growing domestic demand. Production at factories, mines and utilities increased 6.8 percent from a year earlier, compared with revised growth of 5.8 percent in March…” June 7 – Bloomberg (Kyunghee Park and Ron Madison):  “Johor Port Bhd., Malaysia’s second-biggest port operator, expects to handle 24 percent more containers this year, helped by an increase in global trade. ‘We expect to do 1 million this year,’ Johor Port Chairman Taufik Abdullah said in an interview today. The port handled 805,689 20-foot standard containers in 2004.” June 8 – Bloomberg (Anuchit Nguyen):  “Thailand’s tax revenue rose 23 percent in May as higher corporate profits and rising employment helped boost collections.” June 6 – Bloomberg (Anuchit Nguyen):  “Thailand’s economy shrank for the first time in four years in the first quarter as a drought parched crops and tourists stayed away after the Dec. 26 tsunami. Gross domestic product fell a seasonally adjusted 0.6 percent from the fourth quarter…” June 7 – Bloomberg (Francisco Alcuaz Jr. and Jun Ebias):  “Philippine inflation stayed near a six-year high for the fourth month in May, increasing the chances of the central bank raising its key overnight rate again this year.  The consumer price index rose 8.5 percent from a year earlier…” Unbalanced Global Economy Watch: June 6 – Bloomberg (Lily Nonomiya):  “Japanese companies increased investment at a faster pace in the first quarter, suggesting the government will raise its estimate for growth in the world's second-largest economy. Capital spending rose 7.4 percent from a year earlier to a record 13.7 trillion yen ($130 billion), the Ministry of Finance said… That compares with growth of 3.5 percent in the previous three months.” June 10 – Bloomberg (Alexandre Deslongchamps):  “Canadian employers added 35,400 workers in May, more than twice the expected gain, led by retailers and wholesalers. The unemployment rate remained at a four-year record-low of 6.8 percent.” June 9 – Bloomberg (Halia Pavliva):  “Russia’s trade surplus rose to $10.5 billion in April as exports outpaced imports because of the high price of oil, the country's major source of revenue, the central bank said… Exports rose 37.2 percent in April from the same month a year ago, to $20.2 billion, while imports increased 27 percent to $9.7 billion…” June 9 – Bloomberg (Harry Papachristou):  “Greek bank lending accelerated for a second month in April, the Bank of Greece said, as both business and household borrowing increased. Loans to households and businesses grew at an annual rate of 15.6 percent…” June 9 – Bloomberg (Victoria Batchelor):  “Australian employers unexpectedly added workers in May for a ninth month…Employment rose 14,000 last month, the Australian Bureau of Statistics said… The unemployment remained at a 28-year-low 5.1 percent.” Latin America Watch: June 7 – Bloomberg (Guillermo Parra-Bernal):  “Brazil’s industrial production in April grew at the fastest pace in four months, the government said. Industrial output rose 6.3 percent from a year earlier, compared with growth of 1.7 percent in March…” June 6 – Bloomberg (Heather Walsh):  “Chile’s economic growth accelerated in April after manufacturers boosted production at the fastest pace this year following a jump in orders.  The economy grew 6.3 percent, compared with 5.1 percent in the 12 months to March…” June 8 – Bloomberg (Eliana Raszewski and Daniel Helft):  “Argentina is considering further measures to discourage speculators from investing in local capital markets, Economy Minister Roberto Lavagna said. ‘Investments are welcome, but we are working to stop speculative capital inflows.  We are not interested in them.’  On May 26, Lavagna said Argentina would require investors to keep money in the country for at least 12 months. The measure aims to discourage capital inflows and curb a rise in the peso…” June 7 – Bloomberg (Alex Kennedy):  “Venezuelan vehicle sales jumped 54 percent in May on consumers' concern the country's quickening inflation will trigger a decline in purchasing power.” Dollar Consternation Watch: June 8 – MarketNews:  “It is ‘quite irrational’ to demand that developing nations shoulder the burden of adjustments needed to correct global economic imbalances, assistant governor of the People’s Bank of China Ma Delun said… Further, it is ‘unconstructive’ for the International Monetary Fund to focus so much on achieving greater currency flexibility in some regions of the world when instability is due more to an oversupply of -- and fluctuations among -- major reserve currencies, chiefly the dollar, Ma said… In a hard-hitting address, Ma lashed out at the United States without identifying it by name, suggesting that US macroeconomic policy is in large part to blame for current problems. ‘The diversification of international reserve currencies has been the source of instability of the international monetary system, while the economic policies of the issuing countries of the reserve currencies have been the origins of major contravention,’ said Ma… ‘The dominating reserve currency issuing country has the ability to run a chronic trade deficit with almost negligible cost of issuing money.  This fact reveals the privilege and benefits enjoyed by the reserve currency issuing country, rather than an unfavorable trade status as [is] being complained.’ Ma added: ‘If the value of the reserve currency is unstable, all the other countries will be in a dilemma -- they will either import inflation and deflation, or bear the cost of exchange rate fluctuation. It is fair to say that since the reserve currency issuing countries have already enjoyed the privilege and benefit of issuing currencies in credit, they should shoulder the related responsibility of maintaining stable exchange rates among themselves. Over-fluctuation of exchange rates among reserve currencies are important sources of financial instability.’  According to Ma, the IMF should therefore treat the surveillance of reserve currency issuing countries ‘as its first priority, with an aim of maintaining stable exchange rates among these currencies.’” Bubble Economy Watch: June 9 – Bloomberg (James Cordahi):  “Millionaires in the U.S. increased their number by 9.9 percent last year as the stock market rallied. Today, almost one in every 110 Americans has more than $1 million of shares, bonds and other financial assets, according to a report by Capgemini and Merrill Lynch & Co. When including those in Canada, their riches rose by 10.2 percent to $9.3 trillion…” At $57.0 billion, April’s Trade Deficit was up 18% from one year ago.  Goods Imports were up 15% from April 2004 to $136.8 billion, with Goods Exports up 13% to $74.5 billion.  May Import Prices were up 5.7% from one year ago. June 7 – Washington Post (Albert B. Crenshaw):  “Although the financial markets have been on the upswing recently from their post-boom low, many of the nation's private pension plans have been sinking deeper into the hole, according to new figures from the government's pension insurance agency. The 1,108 weakest pension plans -- those whose assets are at least $50 million below the value of the benefits they promise -- were short by an aggregate $353.7 billion at the end of last year, figures from the government’s Pension Benefit Guaranty Corp. show. That was 27 percent more than the shortfall a year earlier, contrary to the hopes of many that funding would improve as the economy strengthens.” June 8 – Wall Street Journal (Sheila Muto):  “Foreign and institutional investors are bidding up prices for office properties in the nation’s biggest markets, paying more than private investors and real-estate investment trusts are willing to offer, a real-estate research firm says.  Los Angeles, New York, San Francisco and Washington, D.C., are among the areas where foreign and institutional investors have been the most active in the past year. Competition for office properties has been fierce in those markets among all investors because of strong or improving leasing activity and rising rental rates.” June 9 – MarketNews (Gary Rosenberger):  “Imports roared in April following their steep March drop, suggesting any narrowing of the trade gap was but a one-month blip prompted by Asian factory shutdowns during the Lunar New Year, say cargo and port officials… Oil-related imports rose in April, with total imports of crude oil and derivatives up 6.1% from a year ago in pure volume terms…April’s import resurgence was accompanied by a sharp rise in exports, which should temper some of the near-certain widening.” California Bubble Watch: June 3 – San Diego Unition-Tribune (Emmet Pierce):  “The state’s booming housing market has generated $1 trillion in increased home equity since 2000, triggering billions of dollars in consumer spending, the California Building Industry Association reported... In addition to strengthening the economy, the gain in home values makes it highly unlikely that widespread mortgage defaults will occur in the event of a sharp economic downturn, said Alan Nevin, the association’s chief economist… Refinancing has enabled homeowners to buy goods and services ‘they wouldn’t have been able to afford otherwise,’ he said.” June 5 – Bloomberg (Daniel Taub):  “The cost of renting a home in Los Angeles or elsewhere in Southern California is rising because of growing demand from people unable to buy. Rental prices in Los Angeles rose 4.6 percent in the fourth quarter to an average $1,408 a month, spurred by a 20 percent increase in the price of previously owned homes, according to a report issued yesterday by the Los Angeles County Economic Development Corp.” Mortgage Finance Bubble Watch: Countrywide enjoyed a big May.  At $2.77 billion, average daily application volume was the highest in almost two years.  Total Fundings were up 23% from one year ago to $39.0 billion.  The company’s Loan Pipeline was up 42% from May ’04 to $70.5 billion.  Purchase Fundings were up 36% from one year ago, with Home Equity up 61% and Subprime 9%.  ARMs were 56% of total fundings.  Bank Assets surged $5.5 billion during the month to $61.5 billion (up 140% y-o-y). June 8 – National Association of Realtors:  “Lower-than-expected mortgage interest rates will push home sales to a fifth consecutive record in 2005… David Lereah, NAR’s chief economist, said long-term interest rates look very favorable. 'Not only have mortgage interest rates declined, but an expected rise in the second half of the year will be slower than in earlier projections.  As a result, we now expect to set records for both existing- and new-home sales this year.’  Existing-home sales are forecast to rise 1.6 percent to a total of 6.89 million this year from a record 6.78 million in 2004, while new-home sales are seen to grow by 3.2 percent to 1.24 million in 2005. At the same time, housing starts are projected to increase 3.4 percent to just over 2.02 million units, the highest level since 1973.  The national median existing-home price for all housing types is expected to rise 8.8 percent in 2005 to $201,500, while the typical new-home price should increase 5.7 percent to $233,600. NAR president Al Mansell…said a rapid growth in the number of mortgage products and loan options is helping buyers to overcome downpayment hurdles…    The U.S. gross domestic product is expected to grow 3.5 percent in 2005, with the unemployment rate holding around 5.2 percent for the rest of the year. Inflation-adjusted disposable personal income is seen to grow 3.3 percent in 2005…” June 8 – American Banker:  “Appraisals that inflate home values are becoming more common and threaten access to credit, according to a report released this week by the national Community Reinvestment Coalition.  ‘Problematic appraisal practices exist as a serious impediment to responsible lending, impede fair housing and equal access to credit, and place the American dream of homeownership and safety and soundness of the mortgage marketplace at risk…’ Most of the blame lies with lenders who want inflated appraisals so they can make bigger loans with larger interest payments…” Q1 2005 Z.1 “Flow of Funds:” The Credit Bubble remains in a period of spectacular blow-off excess.  First quarter Non-financial Debt increased at a 10.0% seasonally-adjusted annualized (SAA) rate.  This was up from the fourth quarter’s 8.2%.  One must go all the way back to 1986 (when 10-year Treasury yields averaged 7.66%) for a year of stronger Non-financial Debt growth (11.9%).  It is also worth noting that the first quarter growth rate was almost double the ‘90s 5.37% average annual rate.  First quarter Non-Financial Debt expanded a record $2.411 Trillion SAA.  This compares to 2004’s $1.918 Trillion, 2003’s $1.668 Trillion, 2002’s $1.321 Trillion, 2001’s $1.115 Trillion and 2000’s $836 billion.  During the decade of the nineties, Non-financial Debt expanded on average $700 billion annually.  Blow-off Credit creation excess is now more than three times this pace. The Credit system is certainly firing on all cylinders.  Federal Government borrowings expanded 13.8% SAA, Households 9.3%, Corporate 7.5%, and State & Local 16.2%.  Non-federal debt expanded 9.1% annualized, the strongest quarterly growth since Q2 2000.  Non-financial Debt was up 8.9% y-o-y.  For the quarter, Total Credit Market Debt (non-financial and financial) expanded at a 6.9% pace to $37.31 Trillion (306% of GDP).  The growth of Financial Sector Credit Market borrrowings slowed to a rate of 4.8%, as GSE asset growth turned negative.  However, GSE stagnation was more than offset by a surge in Bank Credit expansion - bank asset growth predominantly financed by deposits, repos and other non-“Credit Market” borrowings. Bank Credit expanded an amazing $1.054 Trillion seasonally-adjusted annualized during the quarter to $7.0 Trillion.  This was a growth rate of 13.4%.  One has to go all the way back to inflationary 1978 (13.6%) to find a year of stronger Bank Credit expansion.  Bank Credit expanded at an 11.6% rate during the past six months.  This is up from 2004’s blistering 9.2% increase and compares to the average annual 7.2% expansion during the five-year period 2000-2004.  Bank Credit expanded by an average 6.2% annually during the (supposedly “disinflationary”) ‘90s and 8.5% during the (conspicuously inflationary) ‘80s.  The first quarter’s record nominal Bank Credit increase of $225.6 billion exceeds the $215 billion average annual growth during the decade of the ‘90s (and there has been no letup in bank Credit growth during the second quarter!). Bank Loans expanded at a 9.5% rate during the quarter and were up 9.9% y-o-y.  Bank Loan growth averaged 5.8% annually during the ‘90s.  Bank Loans were up 17.5% during the most recent two-year period.  Bank Mortgages expanded at a 14.5% rate during the quarter to $2.69 Trillion, with a 12-month gain of 15.4% and two-year rise of 28%.  For comparison, Bank Mortgage loans expanded an annual average 6.9% during the ‘90s.  Bank Mortgage holdings have increased $360 billion over the past year.  This compares to the nineties annual average of $72.5 billion (2000-2004 average $220bn).  Or, from a different angle, Bank Mortgage loans expanded $727 billion during the past 10 quarters, compared to an increase of $725 billion during the ten years of the nineties.  Bank Credit has now doubled over a period of just less than 10 years. On the Bank Liability side, Total Bank Deposits expanded at a 9.0% rate ($113bn) during the quarter to $5.14 Trillion.  Deposits were up 10% over the past year and 19% over two years.  Certainly helping to explain the subdued monetary aggregates, Federal Funds and Securities RP (repo) expanded at a 20% rate during the quarter ($49.3bn) to $1.02 Trillion.  In addition, Credit Market Instrument liabilities grew at a 19.7% rate ($36.4bn) to $775.2 billion and were up 10.2% over one year and 23.5% over two years.  Bank Bond borrowings were up 17% over the past year to $456.3 billion. Security Broker/Dealer Assets expanded 21% annualized ($436bn SAA) to $1.941 Trillion.  Broker/Dealer Assets have expanded at a 23% pace over the past nine months.  Broker/Dealer Assets increased $555 billion ($277.5bn annually) over two years, or 40%.  This compares to total asset growth during the nineties of $764 billion ($76.4bn annually).  Assets have almost doubled (up 94%) since the beginning of 2000.  Increasing $96 billion during the quarter, the Liability “repo” expanded to finance all of Broker/Dealer Asset growth.  “Repo” Liabilities were up $247.4 billion over the past three quarters to $623 billion.  "Repos" were up 32% over the past year and 86% over two years.  Miscellaneous Assets expanded $52.6 billion during the quarter to $1.047 Trillion. Total Federal Funds and Security Repurchase Agreements (with bank and broker “repo” assets and liabilities netted) surged $137.4 billion – or 33% annualized – during the quarter to $1.788 Trillion.  “Fed Funds and Repo” was up 10.5% y-o-y and 31.3% over two years.  During the first quarter, REIT (real estate investment trust) Assets expanded at a 21% pace to $258.7 billion.  REIT assets began 2002 at $83.9 billion.  REITs expanded 53% over the past year and 137% over two years.  REIT holdings of Home Mortgage assets more than doubled from one year ago to $103.7 billion.  “Funding Corp” Assets expanded at a 17.5% rate to $1.286 Trillion (up 4.8% y-o-y).  Finance Company Assets declined at an 8.8% rate to $1.424 Trillion.  Credit Union Assets expanded at a 9.5% rate to $670 billion.  Life Insurance Assets expanded at a 3.3% pace to $4.166 Trillion.    Asset-Backed Securities (ABS) ballooned a torrid $480.8 billion SAA during the quarter (17.2% rate) to $2.685 Trillion.  For comparison, ABS grew $168.6 billion during 2000, $243.2 billion during 2001, $195 billion during 2002, $239.5 billion during 2003, and $309.2 billion during 2004.  ABS was up 16.7% over the past year and 32% over the past nine quarters.  It is interesting to note that (non-GSE) Mortgage holdings by ABS pools comprised 39% of ABS growth during 1999 and 47% during 2000 and 2001.  During the first quarter (as well as full year 2004), the increase in Mortgage holdings was greater than the growth of outstanding ABS.  Since the end of 2002, (“private-label”) mortgages have increased from 42% to 61% of total ABS assets.  The ABS market has ballooned 88% since the beginning of year 2000. The explosion of non-Government Sponsored Enterprise securitizations is coming at the expense of GSE asset and MBS growth.  During the first quarter, GSE Assets contracted at a 1.0% rate to $2.872 Trillion, reducing one-year growth to 2.6%.  GSE MBS expanded at a 0.6% rate to $3.548 Trillion, with 12-month growth of 1.1%.  Since the beginning of year 2000, GSE assets have expanded 67% and MBS 55%. First quarter Total Mortgage Debt expanded at a $1.127 Trillion seasonally-adjusted annual pace to $10.774 Trillion.  For Comparison, Total annual Mortgage Debt growth averaged $270 billion during the nineties.  Household Mortgage Debt (HMD) expanded at a 9.1% rate during the quarter to $8.282 Trillion.  HMD was up 13.1% over the past year, 28% over two years, and 103% over seven years.  Commercial Mortgage Debt (CMD) expanded $213.4 billion SAA during the quarter to $1.742 Trillion (up 12% y-o-y).  For comparison, CMD grew $111.0 billion during 2000, $114.7 billion during 2001, $102.8 billion during 2002, $129.7 billion during 2003 and $177.1 billion during 2004.  Rest of World (ROW) holdings of U.S. financial assets increased $1.170 Trillion SAA during the first quarter, compared to nineties average growth of $388 billion.  Holdings increased 17% annualized during the quarter to $9.72 Trillion, down slightly from the fourth quarter’s 20.2%.  ROW holdings were up 13% over the past year and 27% over two years.  Holdings of U.S. Credit Market Instruments expanded $848.6 billion SAA to $4.88 Trillion.  This compares to 2000’s increase of $241.9 billion, 2001’s $305.3 billion, 2002’s $422.8 billion, 2003’s $538.2 billion, and 2004’s $776.7 billion.  Holdings of Treasuries increased at a $372.6 billion annual pace and Corporate Bonds (includes ABS) at a $281.6 billion pace. ROW Credit Market Instruments holdings were up 40% in two years.  “Official” holdings expanded at a 7.3% pace to $1.46 Trillion (up 15.8% y-o-y).  Foreign Direct Investment (FDI) increased by an annualized $188 billion, which if it continues for the year would be the strongest FDI since 2000.  “Other” ROW U.S. assets expanded at a $480 billion annualized pace. Household Sector (including Non-profits) Assets increased $483.4 billion (3.3% annualized) during the quarter to $59.7 Trillion.  The value of Household Financial Assets dipped $108.8 billion, or 1.2% annualized, to $36.5 Trillion.  Meantime, Real Estate holdings surged $505.6 billion (11.4% ann.) to $19.25 Trillion.  Real Estate holdings were up 26% over the past two years and 93% over seven years.  And with Liabilities increasing $155 billion, Household Net Worth rose $327.9 billion (2.7% ann.) during the quarter to $48.8 Trillion.  Net Worth was up $3.69 Trillion over the past year (8.2%) and $9.17 Trillion over two years (23%).  Credit inflation-enhanced GDP expanded 6.6% annualized during the first quarter to $12.19 Trillion.  First quarter Personal Consumption Expenditures were up 6.0% from Q1 2004, with Durables up 4.8% to $1.02 Trillion, Non-durables up 7.5% to $2.49 Trillion, and Services up 5.5% to $5.03 Trillion.  Gross Private Investment was up 14.6% to $2.08 Trillion, with Residential Investment up 13.6% to $709 billion.  National Income was up 7.5% from Q1 2004, with Compensation of Employees up 7.4% to $6.967 Trillion.  First quarter federal government expenditures were up 6.4% from Q1 2004, with State & Local spending up 5.7%. To summarize the first quarter, Total Mortgage Debt ($1.127TN), Bank Credit ($1.276TN), and Rest of World Holdings of US Financial Assets ($1.170TN) each expanded at more than $1.0 Trillion annualized.  This continuation of blow-off Credit and liquidity-creating excess goes a long way toward explaining the current extraordinary inflationary asset boom (includiing bond prices/yields!).  The only conundrum is with respect to when and how this historic Bubble meets its fate.  There are indications that recent yield declines have stoked the Mortgage Credit Fire.  And the attentive homeowner has surely been listening to Wall Street pundits.  He can be forgiven for turning a tad giddy - watching his home price go up and up, and now believing that inflation and mortgage rates will remain low forever.  If it’s too good to be true…  But for now, don’t be surprised when he goes out and spends some of this housing and Credit inflation “wealth creation.” Chairman Greenspan famously sorts through reams of economic data during his morning bath.  I often ponder how much time he spends soaking in the “flow of funds.” From Monday’s International Monetary Conference in Beijing:  Question:  “Could I ask you to elaborate on your best guess as what force does explain the phenomenon (of low global interest rates) and, in light of that, its likely durability, please?” Alan Greenspan:  “The problem I have is that there are a whole series of hypotheses all of which are credible.  But clearly, while some of them can be concurrently functioning, it’s also conceivable – I can conceive of hypotheses which are mutually contradictory.  The reason we are having trouble fully understanding this process is that we’ve never run into anything like this before.  This is the first time – despite a half-century of globalization – following World War II - that we have really begun to see the movement, of not only goods and services, but of capital and debt instruments, all sorts of exotic new types of financial innovations going across boarders and integrated worldwide.  The behavior of the American interest-rate structure for the last fifty years, in the context of what we’re looking at.  So I do think that the most relevant likely reason why we are dealing with what we are dealing with are new forces at work in the international market, but their nature and their behavior is not something we are going to fully understand, if ever, certainly except in retrospect.” ECB President Jean-Claude Trichet:  “It is really striking that we (have) the same forward indexed bond yields and it is a clear demonstration that we are living in a single world much more than before, because we did have this proximity before, but we have been living in that world for a long period of time.  What is a little bit more striking is the most recent period of time where we could see further falling down of interest rates, which is very difficult to explain, I have to say.  As we have all the reasons that Alan [Greenspan] has listed as possible explanations which were all non-totally significant, I would say perhaps, Alan, small streams make big rivers.  And when you add up the purchases of Treasuries coming from a number of central banks, in particular in Asia, plus the pension funds, plus the insurance companies that are more involved in fixed-interest instruments, and when you add on the explosion, if I may, of the hedge funds and the chase for yield and so forth, perhaps all these together might explain what we have in front of us and which remains very, very challenging, I have to say, intellectually.” Later in the week from Mr. Trichet:  “The ECB singles out money in its monetary analysis in recognition of the fact that monetary growth and inflation are correlated in the long term. However, the monetary analysis also contributes to assessing the extent to which excess creation of liquidity and over-extension of credit can be a driving force behind excessively valued assets. ‘Detecting and understanding this link helps the ECB form an opinion on whether an observed movement in monetary aggregates and their counterparts might already reflect the inflating of an asset price bubble.  It is then clear that a case by case analysis based on sound information on the monetary variables (mainly broad money and credit), on the counterparts of monetary aggregates (including the net external asset position of monetary and financial institutions) and on the related functioning of the asset market is indispensable.” Indispensable, indeed!  Study your Z.1 report, Federal Reserve Governors – and get back to the basics of sound monetary management.