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Tipping Point?

I feel too young to have so many grey hairs. For the week, the Dow and S&P500 jumped 3%. The Transports and Morgan Stanley Cyclical index gained almost 5%. The Utilities and the Morgan Stanley Consumer indices added 2%. The broader market was exceptionally strong, as the small cap Russell 2000 jumped 6% and S&P400 Mid-cap index gained better than 4%. The tech sector caught fire (again), with the NASDAQ100s 5% advance bringing y-t-d gains to 40%. The Morgan Stanley High Tech (up 52% y-t-d), Semiconductors (up 55% y-t-d), and The Street.com Internet (up 66% y-t-d) indices added about 6% for the week. The NASDAQ Telecommunication index's 7% rise increased 2003 gains to 52%. The Biotechs added 4% (up 39% y-t-d). The Broker/Dealers jumped 4%, increasing y-t-d gains to 48%. The Banks added 3% this week (up 20% y-t-d). Dropping $13.30 today, gold suffered its worst session in six years. The HUI Gold index held its own, declining 1% for the week.

The Credit market was as volatile as the equity market. For the week, 2-year Treasury yields jumped 16 basis points 1.64%. Five-year yields surged 22 basis points today and ended the week with yields up 20 basis points to 3.10%. Ten-year yields jumped 20 basis points today and ended the week up 20 basis points at 4.20%. The long-bond saw its yield jump 16 basis points today (and for the week) to 5.09%. Benchmark Fannie Mae mortgage-backs were hammered today, with yields up 25 basis points (30 for the week). The spread on Fannie's 4 3/8 2013 note widened 1 to 44, while the spread on Freddie's 4 ½ 2013 note widened 2 to 44. The 10-year dollar swap spread jumped 4 to 45. The implied yield on December 2004 3-month Eurodollars surged 26 basis points today to 2.34%. Corporate debt has been more volatile, but thus far spreads are remaining narrow.

Investment grade issuance was solid to begin the fourth quarter. Sales included Berkshire Hathaway $1.5 billion, Popular North America $600 million, Pepsi Bottling Group $500 million, Encana $500 million, Camp Pendleton $475 million, Norske Skogindustrier $400 million, Power Receivable $450 million, Verizon New England $300 million, Centex $300 million, Huntington National $300 million, OneAmerica Financial $200 million, J Paul Getty Trust $250 million, Weatherford International $250 million, Universal Corp. $200 million, Amerenue $200 million, Scotts Company $200 million, and Allstate Global $150 million.

Junk bond funds saw small inflows of $79.75 billion (from AMG). Dynegy Holdings issued $1.525 billion, Intrawest $350 million, Videotron $335 million, Koppers $320 million, Houghton Mifflin $265 million, IMCO Recycling $210 million, BE Aerospace $175 million, and Parker Drilling $175 million.

Convertible issuance included Pharmaceutical Resources' $200 million. According to Merrill Lynch, US converts were up 1.2% in September to increase y-t-d gains to 17.2%. Speculative Grades were up 1.8% for the month, with 2003 gains of 26.7%.

October 1 - Associated Press: "Japan spent more than 4 trillion yen ($36.2 billion) over the last month intervening in currency markets, adding to a record figure it has spent this year in an aggressive yen-weakening campaign that has been criticized by its trading partners... That brought the total for the year to a 13.48 trillion yen ($122.01 billion)."

Despite massive purchases, the yen is trading at near 33-month highs.

October 3 - Bloomberg: "Taiwan's foreign-currency reserves, the third-highest in the world, rose to a record $190.6 billion in September (up from August's $185.7 billion)."

October 1 - Market News International (Matthew Saltmarsh): "The changing balance of G-3 fundamentals means that the yen is likely to continue appreciating, probably testing the key Y100 level against the dollar at some point, according to Eisuke Sakakibara, a former senior Japanese official... 'I am afraid that something quite destabilising may be coming in the next months', he said in an interview on the sidelines of a conference of Asia-Europe region building here. Sakakibara noted that the effectiveness of Japan's currency interventions has 'declined dramatically,' and as a result, 'the yen will shoot up towards Y100 and the euro will continue to increase -- and that will really tilt the balance in the international financial arena.' 'Intervention alone cannot hold the (yen's) rate. Intervention with the wind works, but leaning against the wind doesn't work, and now the Japanese interventions are leaning against the wind.' Over the last six months, the Bank of Japan's dollar buying has been able to stem the yen's rise up to a point, but that has been 'because of market uncertainties.' 'The perception of the recovery in Japan was not strong. But within the last two months or so there has been a sudden admission that Japan is recovering.'"

A continued torrent of financial inflows powered the Taiwan dollar to its ninth weekly gain. The Thai baht traded to a 3-year high (up 9% for the year). The South African rand traded to 38-month highs.

The CRB added about 2% this week. Crude oil traded to a one-month high. Copper traded to a 30-month high and Nickel to a 3 ½ year high. Soybeans surged to six-year high.

Global Reflation Watch:

The Brazilian Bovespa surged 8% this week to a 32-month high (up 51% y-t-d). Up 58% y-t-d, the Argentine Merval index this week traded to a 2003 high. The major index in Chile is up 48% y-t-d, 111% in Venezuela, 46% in Peru, 30% in Columbia and 26% in Jamaica. Major indices are up 55% in Pakistan, 63% in Sri Lanka, 56% in Thailand, 46% in Indonesia, 35% in India, and 28% in the Philippines. The Russian RTS index is up 66% so far this year, with Turkey up 34%, the Czech Republic 35% and Poland up 39%.

October 1 - Bloomberg: "Sales of bonds and shares worldwide rose 34 percent in the third quarter to $894.6 billion... Bond offerings, which reached $2.98 trillion in the first nine months, may break 2001's record of $3.48 trillion... [Societe Generale] has revised its estimate of euro-denominated bond sales by non-financial companies to as much as 60 billion euros ($185 billion) by the end of the year, a 15 percent increase over 2002. Earlier in the year Societe Generale was forecasting a 10 percent decrease for 2003... Sales of non-investment grade bonds were also buoyant, with junk bond sales totaling $37.4 billion in the quarter, $30.9 billion higher than the year-earlier period. Sales so far this year are $108.6 billion, making it the busiest year for high-yield bonds since at least 1999, when companies raised $118.4 billion... Equity-linked bond sales reached $40.4 billion in the quarter, bringing the year's total to $123.7 billion, up from $79.7 billion in the first three quarters of 2002."

October 1 - Dow Jones (Mike Esterl): "Emerging market stocks and bonds racked up another round of robust gains in the third quarter, pushing 2003 returns to levels not
seen in years as yield-seeking investors place growing bets on a global economic recovery. Equities surged 14% in dollar terms in the three-month period ended Tuesday...according to Morgan Stanley's MSCI index. Emerging market shares are up a whopping 29% thus far in 2003 after three straight years of declines... Bondholders meanwhile booked 2.4% in new profits during the third quarter, lifting year-to-date returns to 22%, according to J.P. Morgan's Emerging Markets Bond Index Plus. Spreads on the 19-country EMBI+ narrowed to less than 500 basis points over U.S. Treasurys in late August, the first time that's happened since May 1998. After a steady stream of currency devaluations and debt defaults that began in the mid-1990s and culminated with Argentina's meltdown in late 2001, the stars finally appear perfectly aligned for the famously volatile asset class as rock-bottom interest rates and high liquidity across developed markets prompt a search for juicier returns elsewhere. Loose monetary policy in Washington, Japan and Frankfurt also is fueling hopes of a global economic rebound that developing nations, rich in commodities and reliant on export markets, are particularly well positioned to capitalize on."

October 1 - Bloomberg: "U.K. manufacturing activity grew at its quickest pace in 16 months during September, a survey showed, adding to evidence British industry is recovering from its worst slump in a decade. An index measuring manufacturing activity rose to 52.9 in September, from 52.2 the month before, according to a survey by the Chartered Institute of Purchasing & Supply and Reuters Group."

A U.K. construction index - the Chartered Institute of Purchasing & Supply - increased during September at the strongest pace since July 2001. The Euro September Purchasing Managers index added one to 50.1, with New Orders up 2 to 52.

September 30 - Bloomberg: "Canada's economy expanded 0.6 percent in July, the biggest increase in 15 months, led by rebounding factory production and higher consumer spending. Gross domestic product, or the total value of goods and services produced, rose for the third straight month to an annualized C$1.02 trillion ($756 billion), Statistics Canada said in Ottawa... Factory production, which accounts for 17 percent of GDP, rose 0.8 percent, the biggest increase in 12 months... Demand for housing remained at record levels, driving a 0.7 percent increase by the construction industry and a 5.7 percent rise at real estate agents and brokerages."

September 30 - Bloomberg: "Irish mortgage lending growth rose to a 32-month high in August, spurred by the lowest borrowing costs in more than half a century, Ireland's central bank said. The value of outstanding mortgage loans rose 24.2 percent to 49.2 billion euros ($57.5 billion) in August from the same month a year earlier."

Japan's September Tankan survey (of almost 8,300 companies) rose to a positive 1 from August's negative 5, the first positive reading since December 2000. This is up from the March's reading of negative 38. Japan's Monetary Base (coins and banknotes and reserve balances) was up 20.9% in September from a year ago.

India's economy (Asia's third-largest) grew at a 5.7% rate during the second quarter, up from the first quarter's 4.9%. Indian bonds traded to an all-time low this week of 5.16%.

Australian September auto sales were up 17.8% y-o-y. Italian auto sales were up an unexpected 9.8% from September of last year.

Domestic Reflation Watch:

September 30 - Dow Jones (Stan Rosenberg): "Low interest rates and continued financial pressure on state and local government budgets are driving new long-term municipal bond issuance toward a new annual volume record. Issuance for the first nine months of 2003 already has surged 13.2% from the same period last year to $285.4 billion this year, according to Thomson Financial... That's a record volume for the period, up from $252 billion in the comparable nine months of 2002. At that rate, state and local governments are issuing $31.7 billion a month. If that pace continues, long-term municipal new issuance would weigh in at $380.4 billion for the year, eclipsing last year's record $357.1 billion... California was the No. 1 issuing state, with $46.6 billion in proceeds from 820 issues, accounting for 16.3% of the industry total..."

October 1 - UPI: "Rising tuition rates and poor market returns have resulted in many states altering their pre-paid college tuition plans. The plans allow parents to set up accounts to pay for their young children's college tuition at any of the state's eligible colleges or universities at today's prices. States have either started suspending enrollments or raising contribution levels, reports Stateline.org. Most states are facing double-digit tuition hikes, not the 5 percent to 7 percent increases that the states banked on when they developed their prepaid plans..."

September 30 - Bloomberg: "Ken Skadow endured frigid weather, losing teams and 20-minute waits for the restroom to watch the Chicago Bears play football at Soldier Field for three decades. While the renovated version of the stadium might shorten the restroom line, it hasn't pleased Skadow, a construction worker in suburban Melrose Park, Illinois. The $606 million reconstruction has about 5,000 fewer seats and higher ticket prices than the old stadium... The opening of the new Soldier Field last night, a 38-23 loss to the Green Bay Packers, is the latest in a decade-long building boom in which 24 of 32 NFL teams have opened new stadiums costing $7.5 billion... The cost in Chicago, which includes two new parking garages and development of 17 acres of surrounding parkland, tops the $512 million the Philadelphia Eagles spent for Lincoln Financial Field, which opened last month..."

October 2 - USAToday: "California businesses are screaming about the high cost of operating in a state of high taxes, pricey real estate, mandates from Sacramento and a mountain of state budget red ink that someone will have to cover."

Broad money supply (M3) declined $26.1 billion during the week of September 22. Currency increased $1.9 billion and Demand and Checkable Deposits gained $8 billion. Savings Deposits declined $13.7 billion and Small Denominated Deposits declined $2.0 billion. Retail Money Fund deposits dropped $5.3 billion ($15.4 billion over four weeks), while Institutional Money Fund deposits increased $2.7 billion. Large Denominated Deposits declined $10.4 billion. Repurchase Agreements decreased $6.3 billion and Eurodollars declined $1.0 billion. Foreign ("custody") Holdings of U.S. and Agency Debt held by the Fed jumped $10.2 billion. "Custody" holdings are up $37 billion over the past eight weeks to $973.5 billion (up 20% y-o-y). Elsewhere, Total Commercial Paper declined $6.6 billion ($30.5 billion over three weeks). Financial CP declined $6.9 billion.

Total Bank Assets declined $42.9 billion, with Loans and Leases down $37.2 billion. Real Estate loans declined $32.8 billion and Commercial and Industrial loans dipped $3.9 billion. Bank Securities holdings were about unchanged.

Weekly bankruptcy claims dipped to 30,552.

While there is certainly room for debate, September jobs data are a notable improvement from recent months and could prove a near-term turning point for employment. Not only did non-farm payrolls increase 57,000 (first gain in 8 months), Total (adjusted) Private jobs increased 72,000. This was the strongest gain in over a year. Manufacturing lost 29,000 jobs, its "best" showing since January (down 640,000 over twelve months!). Construction jobs increased 14,000 and were up 109,000 over the past year. Private Sector Service jobs increased by 89,000 (up 200,000 over 12 months). Within Services, Retail Trade added 10,000 and Finance & Insurance gained 10,000 (up 115,000 from a year earlier). Professional, Business Service jobs jumped 66,000, led by the 33,000 gain in Temporary Help. Notably, Temporary Help has now added 146,000 jobs since May. It is difficult not to view the surge in Temporary Employment as a positive sign for future job growth. Health, Social Assistance added 15,000 jobs, with 12-month gains of 251,000.

Tuesday's disappointing drop in the Chicago Purchasing Managers index to 53.2 captured the bond market's imagination. At 53.7 (down 1 point from August), the National ISM index was more impressive. New Orders added 0.8 to 60.4 (strongest since last December) and Prices Paid added 3 to 56. An index of Arizona business conditions increased 1.5 points to 60.4, the highest reading since September 2000. The index bottomed out at 38.5 during November of 2001. The Milwaukee PMI index added 2 to 56, with New Orders surging 10 points to 63. The Austin area Purchasing Managers Index was about unchanged during September at 64.5. This is up from April's reading of 43.2. New Orders increased 1 to 72.5, after being below 50 (contracting) in April.

Today's ISM Non-manufacturing index was strong at 63.3. Prices Paid jumped 4.4 point (up 9.5 in two months) to 60.1, the strongest reading since March. Backlog gained 5.5 points to a record 57. New Orders were down 7.7 points from August, but remain at a robust 59.9.

August Personal Income was up 0.2%, while Personal Spending jumped 0.8%. Personal Income was up 3.1% y-o-y, although the devil is in the detail. Private Industry Wage & Salary was up only 1.4%. Manufacturing Wages declined 1.8% y-o-y, while Services wages were up 2.7%. Government wages were up 4.0% y-o-y. Transfer payments surged 6.5% y-o-y. Disposable Income was up 5.7% y-o-y, while Personal Spending increased 5.4%.

August Construction Spending was reported up 4.0% y-o-y to a near record. Private Residential Construction Spending was a record $453.4 billion annualized, up 7% from the year earlier. Residential spending was up 15% from two years ago and 58% from August 1997. And while the residential sector booms, Private Construction Spending on Manufacturing was down 9.2% and Office was down 16% y-o-y. Educational was up 11.9% and Health Care was up 6.7%. Transportation was down 13.7% and Communication down 11.5%. Public sector Construction spending was up 3.2% y-o-y.

Freddie Mac posted 30-year fixed mortgage rates sunk 21 basis points this past week to 5.77%. Long-term fixed mortgage rates have dropped 67 basis points over four weeks to the lowest level since July. 15-year rates dropped 20 basis points to 5.10%, with rates down 67 basis points in four weeks. Adjustable rates dipped 5 basis points to 3.72%, down 26 basis points over four weeks.

While still likely impacted by the mess left by Isabel, Mortgage Application volume was up slightly last week. Refi applications were up 3.2%. Purchase Applications were down slightly last week, although volume was up 9.3% from one year ago. By dollar volume, Purchase Applications were up 22.3% from the year earlier. The average loan amount was $181,100, with the average adjustable-rate mortgage at $266,600.

I continue to find the detail of monthly auto sales interesting. GM sales were up 13% compared to September 2002, with Truck sales up 15%. Ford sales were up a better-than-expected 5% (individual retail sales up 8%, while fleet sales were down 11%). Ford F-Series truck sales enjoyed their best September in 55 years. Chrysler sales were down a dismal 15%. Foreign nameplates sales continue to sizzle. Toyota announced its best-ever September and third quarter, with September sales up 10.5% from Sept. 2002. "The Lexus Division also enjoyed a record September of 18,944 units, an increase of 12.4 percent over the same period last year." BMW reported that record nine-month sales were up 9% from the year ago period. Mercedes-Benz nine-month sales are at record pace, up 3.7% y-o-y. Up 25.5% from Sept. 2002, Volvo sales set a new September record. Saab is enjoying its best year ever in the U.S., with y-t-d sales up 23% (Sept. sales were double Sept. 2002). Jaguar and Land Rover also set September records. Nissan sales were up 15.9% from one year ago. Infinity sales were up 40.7%. September capped off a model year record for Honda, with comparable y-o-y sales up 9.4%. Hyundai enjoyed record September sales up 7% from Sept. 2002. Volkswagen sales were up 1.5% over last September.

October 2 - Dow Jones: "In a $140 million federal lawsuit filed Wednesday, Lehman Brothers accused two real estate developers of using phone appraisals, fictitious buyers, and falsified credit reports to finance inflated mortgages on houses in posh areas of California. About $60 million of the fraudulent loans were sold to the Federal Home Loan Bank of San Francisco before Lehman discovered the scam this spring. It originally packaged the loans with other 'super jumbo' and jumbo mortgages and sold them to the FHLB in mortgage-backed securities valued at $2 billion..."

October 2 - American Banker: "The House of Representatives voted on Wednesday to appropriate $400 million in down-payment assistance under the American Dream Downpayment Initiative for fiscal years 2004 and 2005... The measure would turn 80,000 low-income families into homeowners... Congress appropriated $75 million for the program for fiscal 2003."

September 30 - Bloomberg: "Former Treasury Secretary Robert Rubin said the U.S. faces a 'day of reckoning' because of a federal budget deficit that poses 'a very serious threat to the future of our economy.' Rubin also said a strong dollar is necessary to attract foreign capital to invest in U.S. financial assets such as government debt securities... Rubin said that the deficit in coming years could push up the yield on the 10-year bond by 2.5 percentage points from the current level to about 6.5 percent. He did not predict the timing of such an increase. 'These effects are hugely consequential, but the effects could be far more severe if the markets decide that this fiscal imprudence is going to continue and that we are in a situation where the government may try to inflate its way out of these deficits rather than deal with them through fiscal discipline.'"

President of the Dallas Fed Robert McTeer responding to a question after his speech Wednesday at the Kanaly Trust Company Distinguished Lecture reception:

"What is my opinion of the current account deficit? Just to define the terms a little bit, the trade deficit is the excess of our imports of goods over our exports of goods. The current account deficit adds services and some other things in the balance of payments. It's a better measure of our trading relationship with the rest of the world. In college in the 1960s when you studied things like that the answer was that a fairly large and sustained current account deficit - if you have a floating exchange rate - will cause the exchange rate to decline until it brings about equilibrium.

The U.S. is a little bit of an exception to that, in that its dollar is used all over the world as a currency by a lot of people and it's held by central banks all over the world as a reserve currency. To some extent, the world has long been willing to hold the excess dollars that we put out by buying more than we sell to the rest of the world. And we get sort of a free ride. Sort of like we're in a poker game and we never have to cash in our chips. In the late nineties, when we were doing so, we had such a dynamic economy, particularly compared to the Eurosclerosis in Europe, there was a lot of funds floating to the United States from Europe that sort of artificially held up our dollar and made the current account deficit larger. In the 1960s you learned that trade was independent and capital flows were the financing mechanism - they were sort of passive.

But these days capital flows are kind of independent too, and one could almost argue, not that our capital inflow is financing our current account deficit, one could almost argue that our current account deficit is financing our capital inflows. So long as that is happening, and as long as we are regarded as the dynamic economy and the best place in the world to invest, our large current account deficit is not going to cause us any problem. The problem will come when people change their mind about all that and they've decided, maybe suddenly, that the world has too many excess dollars and they'd like to sell a lot of them all at once in the foreign exchange market. If they did that all at once, we would experience an exchange rate crisis. We'd do no telling what to react to it. I don't know exactly what would happen, but it wouldn't be good. But we've had the potential for that to happen for several years now and it hasn't. Most of the countries that own a lot of the dollar balances don't have any real incentive to trigger a crisis like that. They would perhaps be hurt as much as anybody else by such a crisis. What is it they say: "If you owe the bank a little money, you've got a problem. If you owe it a lot of money, the bank's got a problem." We might be in that situation."

This was an unusually candid discussion from one of our prominent central bankers. I would furthermore argue that it is curiously germane. Mr. McTeer - with comments such as late-nineties flows "artificially held up the dollar;" that "suddenly" it may be a case that "the world has too many excess dollars;" and that "If you owe (the bank) a lot of money, the bank's got a problem" - is a man after our own analytical hearts. With his above comments in mind, let's take a step back and try to make a little sense out of an extraordinarily challenging environment.

I have argued that the Death of King Dollar "changes everything." The late nineties presented an atypical environment conducive to a major Dollar Bubble. A dysfunctional dollar reserve global financial system had wreaked liquidity-induced boom/bust havoc around the world. Yet here at home, an historic stock market Bubble was running out of control. With major real economy and financial effects, an historic boom was running rampant throughout the U.S. technology sector. The U.S. economy was dramatically outperforming the global economy, with foreign investors clamoring for U.S. assets and direct investment to play the U.S. "miracle economy." It was an amazing confluence of factors that came together. Importantly, many Credit systems around the globe were in tatters after a spectacular domino collapse. Southeast Asia had been decimated, along with scores of emerging market financial systems including Russia, Turkey and throughout Latin America. Strong demand for dollar assets (real and financial) reinforced American economic and market relative out-performance and exacerbated (over)demand for U.S. assets. Internationally, there really was only one game working: King Dollar.

Along with our King Currency, we also enjoyed the fruits from our benefactor Master Central Banker. No other central bank in the world could basically guarantee vibrant and liquid financial markets. No other central bank had the capacity/audacity to collapse interest rates and flood their domestic financial systems with liquidity to stem any unfolding crisis. Certainly, there was at that point no other central bank with the immense power to mitigate the negative consequences of bursting Bubbles by fueling larger ones. And although the bursting of a rather conspicuous stock market Bubble posed systemic risk, Fed chairman Greenspan was brazenly signaling that the Fed would aggressively cut rates in the event of significant stock market weakness. The enticement dangled in front of the speculators and dollar holders was a distinct possibility for a once-in-a-lifetime bond market play. Especially after being burned in so many other markets, the global leveraged speculating community came to appreciate that there was only One Game in Town: King Dollar financial assets. The Fed enjoyed credibility with the speculator community like no central bank in history and was pleased by it all.

Unbeknown to most, the linchpin to Federal Reserve "credibility" was located with the government-sponsored enterprises. Fannie Mae, Freddie Mac and The Federal Home Loan Bank system -- with the market readily assenting to implicit government backing on GSE debt -- enjoyed the phenomenal capacity to expand their liabilities (increase Credit), virtually without limit and virtually on demand. The GSEs -- and Wall Street "Structured Finance" to a lesser degree -- garnered their immense power from their extraordinary capacity to create endless perceived safe liabilities - a capability historically enjoyed only by the government monetary "printing press." The GSEs and Wall Street had evolved to the point of creating a mechanism for generating systemic liquidity on demand and they were not bashful about employing it.

It was this capacity for aggressively expanding U.S. financial sector balance sheets (ballooning assets) during a crisis that provided the cornerstone to the market's perception that the Fed could so easily reliquefy the system to mitigate financial tumult. The 1994 and 1998 episodes, in particular, had emboldened the leveraged speculating community. They learned that if the markets moved decisively against them/Credit market liquidity began to wane, an aggressive buyer (happy to pay top dollar) was only a phone call to Fannie or Freddie's trading desk away. Why would anyone not believe this would fuel unprecedented excess?

So market psychology and financial innovation combined to nurture the Great U.S. Credit Bubble. Yet as fast as our ballooning trade deficits spewed dollar liquidity throughout the global financial system, these Bubble Dollars were recycled right back into U.S. financial assets and the real economy. Perceptions solidified that King Dollar was a permanent fixture of the global financial landscape and that trade deficits no longer mattered. We had to spend the money that was (and would always be) thrown our way.

But things always change, and manic delusions inevitably disenchant. With everyone zealously playing King Dollar and caution thrown to the wind, the game was at its end. To be sure, Credit and speculative excess always sow the seeds of their own destruction. On the one hand, there are resulting real economy effects (distortions to pricing, investment, the nature of demand, etc.) On the other, financial excess nurtures financial fragility. Both deleterious effects were all of the sudden conspicuous. Last year's accounting scandals didn't help, nor the near dislocation in the U.S. corporate bond market. The unfolding crisis quickly had its sights set on the vulnerable indebted consumer sector. The Fed responded by cutting rates to 1% and intimated "unconventional" measures to preserve the Credit Bubble. This incited a massive, leveraged speculation-induced reliquefication. This inflation, however, sealed King Dollar's fate. Quietly, but importantly, Non-dollar asset began outperforming as dollar claims inflation accelerated.

Considering the degree of unrelenting excess pervading the U.S. Credit system (and consequent internal and external imbalances), an immediate dollar crisis would have been expected. But this is not your grandfather's financial system, domestically or internationally. The GSEs have evolved to assume the crucial role of Buyers of First and Last Resort - assuring excessive and unending liquidity for the U.S. financial system. And, to this point, they have been able to accomplish this feat more successfully than any central bank in history. In the same vein, foreign central banks (largely Asian) have evolved as Bubble Dollar Buyers of First and Last Resort, assuring unending liquidity for dollar sellers, along with resulting excess liquidity globally. They lap up the liquidity created in such gross excess by the GSE-led U.S. financial sector, assuring Bubble perpetuation.

Global central bank actions gave the U.S. Credit Bubble free rein. And the prospering and ballooning speculators, with one eye on the GSEs and the other on the foreign central banks, have operated confidently and aggressively. Uncontrolled excesses -- Credit, speculative and economic -- have gone to truly astonishing extremes. All the while, the eager optimists have been emboldened. As analysts, it is today critical to appreciate the unparalleled financial and economic landscape that has evolved with GSEs as domestic financial backstop and foreign central banks as GSE and global financial backstop.

With Credit excess going to new extremes concurrently with waning demand for U.S. assets, foreign central banks accumulated dollar securities like never before. The Bank of Japan has purchase in the ballpark of $100 billion over the past year, with the Chinese and other Asian banks not all that far behind. Ominously, this has accomplished only an orderly general dollar decline. Yet, central bank purchases have played a pivotal role in keeping U.S. rates low. It is one more irony of this aberrant environment that a weak dollar supports the U.S. bond market. This is, as well, one more anomaly that repudiates the economic laws of market price-based self-regulation. And striving to front run the central banks, we have now reached the point where dollar weakness fosters speculative buying of U.S. Credit instruments (while the dynamically trading derivative players try to stay ahead of the speculators). As constructive as these central bank Treasury and agency purchases may appear on the surface, the upshot of this huge artificial support is that it only bolsters GSE and speculative finance-led domestic Credit excess (and resulting financial fragility and economic maladjustments).

There are myriad serious issues with this increasingly symbiotic GSE/foreign central bank "alliance." For one, from deep domestic and international structural weaknesses/imbalances/distortions has emerged a (manic and uncontrollable) liquidity-induced expansionary environment. Second, the GSE and central bank financing mechanisms have all seductive appearances of being rock solid and sustainable. Third, this financial backdrop exacerbates already unprecedented leveraged speculation and untenable derivative expansion. Fourth, the GSE/foreign central bank "alliance" combines for the most powerful liquidity creation mechanism ever known to global finance. Surely, speculative excesses have never been as endemic to the global financial system, never - encompassing developed markets, emerging markets, equities, Credit market instruments and interest rates, Credit insurance and Credit default swaps, real estate, commodities, a derivative Bubble and so on. That such excess runs out of control in a global environment so susceptible to severe structural frailties recalls the seductively catastrophic environment of the closing years of the Roaring Twenties.

The truly frightening aspect of these circumstances is that both the GSEs and central banks have succumbed to Bubble dynamics. Individually and in concert, it is Inflate or Die. With the parlous mortgage finance Bubble, an incredibly leveraged Credit system, and a hopelessly distorted Bubble economy requiring massive and unrelenting Credit inflation/currency debasement, it is a safe assumption that dollar vulnerability is here to stay. Moreover, the out-performance of non-dollar assets (real investment and economies, financial markets and assets, and basic commodities) will augment dollar liquidation. And just as King Dollar foreign inflows were self-reinforcing during the late-nineties, there is evidence that non-dollar flows (investment and speculative) are now increasingly fueling self-reinforcing expansions overseas. This is especially the case throughout Asia (including India), Russia, Eastern Europe, Australia and elsewhere. This is the essence of my now weekly "Global Reflation Watch" and keen focus on foreign economies and markets. Global reflation is a dollar problem and central bank problem.

I do see relative strong performance sufficient to sustain major non-dollar flows. Foreign central banks, then, will continue to have no attractive alternative other than further dollar "Buyers of Last Resort" accumulation. We "owe (them) a lot of money, the banks' got a problem;" a huge and ballooning problem. In reality, foreign central banks can't turn off the Credit/liquidity spigot any more than the GSEs can turn it off. It's out of control domestically and internationally. The speculative marketplace fully appreciates this dangerous dynamic, as the perception of endless global liquidity solidifies.

Mr. McTeer provided an additional candid and pertinent comment Wednesday night:

"One of the great things about moving to Texas after the banking crisis was that Texans are willing to talk about their bank failures, their own failures, and there's no embarrassment about it whatsoever. It's a very entrepreneurial country and we're in the center of the entrepreneurial part of the country. And we'll survive whatever they throw at us. I don't know what the next external shock might be. It might just be that the current account deficit finally reaches a tipping point."

Current account deficit reaching a Tipping Point? Are such thoughts even allowed at the Federal Reserve? Well, there is absolutely no doubt we are heading toward a major dollar crisis. The issue is only when. There is no doubt in my mind that the GSE Bubble will burst, and there are certainly enough issues unfolding to keep our analytical interest. These institutions and the marketplace are seemingly doing everything possible to ensure that this inevitable financial dislocation will be historic. I also have no doubt that the foreign central bank dollar Bubble will come to a most unpleasant end. That the interplay of these two ultra-powerful financing mechanisms has evolved to foster unprecedented Credit and speculative excess throughout the world is a deeply despairing worst-case-scenario unfolding right before our eyes.

To wrap this up, it appears we have entered what will be a wildly unstable environment, as we meander towards some type of financial "resolution." Yet there is today an atypically fine line between financial dislocation (likely related to the dollar) and abundant global liquidity unlike anything seen in our lifetimes. There is a fine line between a "Tipping Point" break in dollar confidence and desperate foreign central bank dollar purchases (unprecedented global liquidity injections). There is similarly a thin line between endless liquidity supporting our leveraged Credit system and consequences of incessant liquidity excess at some point terrorizing it. And it does today appear reasonable to presuppose that things may look absolutely wonderful to most right up until the proverbial "wheels come flying off." Most financial crises develop as liquidity disappears over a period of time. But the nature of the runaway GSE/central bank financial Bubbles may dictate that enormous over-liquidity works its seductive magic until it abruptly doesn't work anymore: a systemic crisis of confidence.

In the meantime, there is this massive speculative community placing leveraged bets on stocks, bonds, currencies, commodities, Credit, spreads, and God knows what else. Additionally, there will be an unfolding Battle Royal as bets are placed as to how this all plays out, only ensuring greater chaos in the markets. An incredibly unstable environment has been nurtured, and we are today forced to be on guard for extreme price movements across the spectrum of now highly interrelated markets. This week had the "feel" of a commencement of some type of systemic dislocation, with an initial convulsion to the upside, at least for stocks. I wonder what Larry Kudlow would think of this week's Bulletin?

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