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A True Paradigm Shift

My now habitual apology for an unedited Bulletin.

It was another unsettled week for global equity, currency, Credit and commodity markets. For the week, the Dow, S&P500, Transports, Morgan Stanley Consumer and Morgan Stanley Cyclical indices all declined about 1%. The Utilities added 1%. The more speculative areas of the market performed the worst. The small cap Russell 2000 declined 3%, while the S&P400 Mid-cap index dipped 1%. The NASDAQ100 and Morgan Stanley High Tech indices declined 2%, while The Street.com Internet index shed 3%. The Semiconductors declined 2% and the NASDAQ Telecommunications index lost 1%. The Biotechs mustered a 1% advance. The Broker/Dealers declined about 2%, while the resilient banks declined less than 1%. With bullion surging $16.90, a 7-year high, the HUI gold index jumped almost 9%.

Interest rate markets were pleased to see some equity weakness. For the week, 2-year Treasury yields declined 13 basis points to 1.73%. The 5-year yield sank 18 basis points to 3.15%, while the 10-year Treasury yield dropped 16 basis points to 4.23%. The long-bond saw its yield decline 13 basis points to 5.12%. Benchmark Fannie Mae mortgage-backed yields declined 15 basis points. The spread on Fannies 4 3/8% 2013 note narrowed 2 to 41, the spread on Freddie's 4 ½% 2012 note narrowed 2 to 40, and the spread on the FHLB 10-year note widened 2 to 35. The 10-year dollar swap spread narrowed 1.5 to 42.

With domestic and international borrowers salivating at abundant dollar liquidity, this week marked the strongest debt issuance in five weeks. According to Bloomberg, foreign issuers accounted for 52% of the week's $16.7 billion issuance. Investment grade issuers included Telecom Italia's $4.0 billion, General Electric $2.0 billion, HBOS $1.75 billion, Citigroup $1.0 billion, Depfa ACS Bank $1.25 billion, Bear Stearns $750 million, Safeway $650 million, HRPT Properties $250 million, and Duke Realty $100 million.

Junk bond inflows declined to $212 million (from AMG). Issuers included Keystone Automotive $175 million, Oxford Automotive $280 million, Genesis Healthcare $225 million, Paramount Resources $175 million, Inn of the Mountain Gods $200 million, and Fisher Scientific $150 million.

October 21 - Dow Jones: "The Mescalero Apache Tribe of Southwest New Mexico's $200 million high-yield offering for the Inn of the Mountain Gods Resort and Casino was priced Tuesday via sole underwriter Citigroup... Last week, its size was increased from originally planned $185 million..."

Convert issuers included Grey Global Group's $125 million.

October 21 - Bloomberg: "Heineken NV, the world's No. 3 brewer, has neither a track record in the bond market nor a credit rating. Investors were still so eager to purchase the 1.1 billion euros ($1.3 billion) of bonds it sold today that the company cut the yields on offer. Demand for corporate bonds from investors seeking yield has driven down the premium, or spread, euro-denominated corporate bonds pay over government debt to its narrowest since March 2000... Demand for the bonds outstripped the supply 'several times...'"

October 23 - Bloomberg: "Poland, the biggest of 10 nations joining the European Union next May, raised $1 billion, more than initially planned, in its first sale of dollar-denominated bonds in more than a year. The 10-year bonds were priced to yield 0.96 percentage point more than 10-year U.S. Treasury notes... Poland planned to raise as much as $700 million through the bond sale... Poland is tapping international bond markets as it struggles to trim its budget deficit to qualify to adopt the euro from 2007."

October 22 - Bloomberg: "China raised almost $1.5 billion in its first overseas bond sale in two years, luring investors with the promise of the world's fastest-growing major economy and record foreign currency reserves. China sold $1 billion of 10-year dollar bonds at a yield of 53 basis points more than U.S. Treasuries of similar maturity, lower than the earlier-planned 55... "

Global Reflation Watch:

October 21 - Bloomberg: Quoting European Central Bank board member Vitor Constancio: 'We have a very unbalanced situation in (the world) economy, and in fact so unbalanced that it is difficult to see that it can be corrected only by movements in the exchange rate, because the U.S. budget deficit is in fact a structural deficit. It's not only nominal, which means that even with an economic recovery in the United States, it will not go away...' Comparisons with the 1980s, when the U.S. also had historically large budget and trade deficits: 'The situation is in many ways more difficult now and that's why one has to be more careful in dealing with it. But the situation in my view does not call for a more interventionist policy on the part of governments regarding the exchange rate policy.'"

October 23 - Bloomberg: "Wheat futures in Chicago surged more than 4 percent, their biggest gain in five months, after a U.S. Agriculture Department report showed strengthening overseas demand for the grain."

October 23 - Bloomberg: "Cotton futures in New York surged to a seven-year closing high after China made its biggest purchase of U.S. cotton since 1995."

October 23 - Bloomberg: "China's soybean imports in September rose to their highest this year... China has been increasing its purchases of U.S. soybeans to lock in prices that have risen 47 percent since the end of July, as a drought in the U.S. Midwest devastated crops. China said it plans to buy about 22 million tons of the oilseed worldwide in the current marketing year, up 10 percent from last year."

October 24 - The Asian Wall Street Journal (Peter Wonacott): "From steak to iron ore to cotton to diamonds, China's rising urban incomes and changing consumer tastes are reshaping the world's commodity markets. The country's emergence as a major importer of raw materials is driving global prices higher and catching some suppliers flat-footed... 'China has sucked the cupboard bare of raw materials,' says Jim Lennon, executive director of commodities research at Macquarie Bank Ltd.... And because of its fast growth, Mr. Lennon cautions, China 'is starting to place severe strains on the global raw-materials supply chain.' Already, prices of many natural resources and metals are surging. In the past year and a half, the cost of alumina, used to make aluminum, and nickel, which is used to make standard steel, has doubled, according to metals traders and analysts. World-wide metal inventories are at their lowest level ever, because big metal suppliers were reducing their capacity due to the economic slowdown in the U.S., Japan and Europe. But now, these companies are rushing to fill China's voracious needs. Global shipping-freight rates have skyrocketed in response to Chinese demand. China's auto and construction craze is underpinning the voracious global metals buying. Aside from iron ore, the country is so starved for copper that Chinese companies are importing French francs and melting them down, according to a Beijing official..."

Japan's September imports were up 9.2% y-o-y, as its Trade Surplus rose to the highest level in three years. Japanese third quarter Consumer Confidence rose to the highest level since the second quarter of 2001 (biggest monthly gain in 4 ½ years!).

October 23 - Bloomberg: "Taiwan's export orders grew last month at their fastest pace in a year, climbing to a record as overseas stores stock up with computers, cell phones and plasma televisions ahead of the Christmas and Lunar New Year holidays. Orders -- indicative of shipments in one to three months -- rose a fifth from a year earlier to $15.4 billion after climbing 11 percent in August... That's more than the median 12 percent gain forecast..." (September money supply growth was at a 2-year high.)

October 22 - Bloomberg: "French consumer spending rose in September by the most in more than four years, rebounding from August's slump and increasing the chances that Europe's third-largest economy escaped recession."

October 21 - Bloomberg: "Australian business confidence rose to a 16-month high in the third quarter, as companies forecast they would employ extra workers and invest more in the next three months, a survey showed." "U.K. manufacturers' confidence improved this month to the highest since July last year..."

October 20 - Bloomberg: "New Zealanders bought a third more homes in September than a year earlier, after a fall in interest rates the past year, according to the Real Estate Institute of New Zealand. Prices rose 16 percent. House sales rose 35 percent to 10,687 in September from 7,943 a year earlier..."

The New Zealand dollar traded this week to its highest level since December 1997 and the Australian dollar to the highest since November 1997. The British pound rose to a 5-year high, the Canadian dollar near a 10-year high, and Chile's peso rose to an 27-month high

Oct. 21 (Bloomberg) -- Yukos, Russia's biggest oil producer, kept more cash this year in Russian rubles and ruble-denominated securities rather than dollars, as its home currency heads for its first-ever yearly gain against the dollar. 'This year we have been keeping a larger portion of our investment portfolio in rubles than what we had in the past, simply because of the appreciating ruble,' Bruce Misamore, Yukos's chief financial officer, told reporters in Moscow. The Russian currency has gained 6.8 percent against the dollar this year..."

The CRB index surged 2.5% this week to trade at its highest level since March. Yesterday corn futures enjoyed their "biggest gain in 30 years" and wheat the strongest gain in five months (from Bloomberg). Cotton traded to the highest level in 7 years, soybeans six years, and rubber (traded in Tokyo) 6 ½ years.

I continue to read pundits dismissing the importance of stubborn and broadening dollar weakness; gold, energy, industrial and general commodity price resiliency; and the Chinese/Asian boom. There is a pardonable hesitancy to appreciate that the world financial and economic landscape is in the midst of historic fundamental change: A True Paradigm Shift from perceptions of Perpetual King Dollar to the reality of Immutable Anemic Dollar.

Domestic Credit Inflation Watch:

October 22 - New York Times: "The nation's public universities raised tuitions by 14 percent this year, the steepest increase in at least a quarter century, if not significantly longer, according to the latest annual survey by the College Board. Tuition at community colleges across the country also rose 14 percent, the second largest increase since 1976..."

Reading through financial sector earnings reports, I am again reminded that "An Economy is How its Financial Sector Lends." I see nothing encouraging.

Wells Fargo reported third-quarter Net Income up 8% (reduced by special charges) from Q3 2002, with total Revenue up 19%. Total Assets surged $21.2 billion, or 23% annualized, to $390.8 billion. Total Assets were up 17% y-o-y. (Average Assets were up 21% y-o-y) For the quarter, Total Loans increased $16.45 billion, or 30.6% annualized, to $231.8 billion (up 24% y-o-y). Commercial Loans were up $143 million (up 1.9% y-o-y). Home Equity loans increased at a 43.5% annualized rate and were up almost 35% y-o-y. Credit Card loans expanded at an 11% rate. One-to-four family real estate loans expanded at a 95% annualized rate (up 77% y-o-y). "The number of Wells Fargo SBA (Small Business Administration)-guaranteed loans rose from 2,256 in 2002 to 3,181 in 2003, up 41%."

From Citigroup: Consumer Loans were up $45.3 billion, or 15.4%, y-o-y, while Corporate Loans declined $7.3 billion, or 6.6%. During the third quarter, Consumer Loans expanded at a 10.8% annualized rate, while Corporate Loans declined at a 21.7% rate.

JPMorganChase saw Total Assets decline by $9.9 billion (5% annualized) to $792.7 billion, this following the previous quarter's $47.5 billion increase (25% annualized). Securities declined by $17.4 billion during the quarter. Loans increased at an annualized rate of 16.5% during the quarter to $231.5 billion. Consumer Loans expanded at a 28.2% annualized rate to $182.1 billion, while Commercial Loans contracted at an annualized rate of 11.6% to $88.4 billion.

BankOne reported third quarter Net Income of $883 million, up 7.3% from Q3 2002. Total Retail Loans were up 11% y-o-y to $54.7 billion. During the quarter, Retail Loans expanded at a 14% annualized rate, while Commercial Loans contracted at a 20% annual pace. "Home equity loan production was $4.7 billion, up 24% from the prior year. This growth led to a 37% increase in average home equity balances to $24.5 billion... [Credit card] Managed average loan balances increased $6.1 billion, or 9%, over the prior year... Corporate banking end-of-period balances were down $3.8 billion, or 12%, partially due to lower utilization."

CapitalOne saw Total Assets expand at a 31% annualized rate to $43.4 billion, with six-month growth at 29% annualized. Total Assets were up 18% y-o-y. Total Assets have ballooned almost 300% since September 1999.

Leading California adjustable-rate mortgage lender GoldenWest Financial saw Total Assets expand at a 22% annualized rate during the quarter to $76.2 billion. Total Assets were up 16.2% y-o-y.

Early indications have the REIT Bubble inflating rapidly. Mortgage REIT Thornburg expanded asset by $2.1 billion during the quarter, or 56% annualized, to $17.3 billion. Total Assets were up 71% y-o-y. Thornburg ended the quarter with Shareholders' Equity of $1.1 billion. Total Assets are up 225% over two years.

Mortgage REIT Redwood Trust increased assets by $4.5 billion during the quarter to $14.9 billion (175% annualized growth rate). Shareholders' Equity ended the quarter at $566 million. Total assets are up four-fold over six quarters.

From Countrywide Financial: "Consolidated net earnings for the third quarter reached $1.1 billion, a gain of 187 percent over the prior record set last quarter and 381 percent more than the third quarter last year... Total fundings were $126 billion for the third quarter, increasing 98 percent over last year. The servicing portfolio rose to $606 billion, up over $200 billion compared to last year." Total Asset growth slowed during the quarter following a doubling of assets during the preceding three quarters. Total Assets were up 104% y-o-y. Bank Deposit liabilities expanded at a 55% rate during the quarter to $9.2 billion and were up almost 200% y-o-y. Countrywide's Total Assets increased almost 5-fold over the past 11 quarters.

"New Age" mortgage lender New Century doubled assets (up 400% annualized) during the quarter to $7.6 billion. Total Assets were up 313% y-o-y. Originations were almost 50% higher than the previous quarter and were up better than 200% from the year ago like quarter. Total Assets are up better than 500% over the past two years.

October 23 - San Francisco Chronicle (Kelly Zito): "Nearly 12,000 Bay Area homes sold last month, a 15-year high for sales in September, as buyers rushed into the market to beat out rising interest rates, a real estate information firm reported Wednesday. The median price for a single-family home in the nine-county region reached $465,000 in September, up about 8 percent from the same month last year but down slightly from August's median of $469,000, La Jolla's DataQuick said."

Freddie Mac posted 30-year fixed mortgage rates were unchanged for the week at 6.05%. Fifteen year fixed mortgages were at 5.39%, up 3 basis points. One-year adjustable mortgage rates declined 3 basis points to 3.76%.

Weekly bankruptcy filings dropped to 29,438 but were up 3% from the comparable week one year ago.

Bank Total Assets increased $28.7 billion for the week ended October 15. Securities holdings increased $5.3 billion. Loans and Leases added $2.1 billion, with Commercial & Industrial Loans increasing $2.1 billion. Real Estate Loans declined $9.9 billion. Elsewhere, Commercial Paper borrowings increased $2.9 billion. Non-financial CP declined $1.7 billion, while Financial CP added $4.6 billion (up $16.3 billion over three weeks).

Broad money supply (M3) declined $14.3 billion for the weekend of October 13. Demand and Checkable Deposits dropped $20.1 billion. Savings Deposits added $19.2 billion (up $29.4 billion in two weeks). Small Denominated Deposits dipped $0.7 billion. Retail Money Fund deposits declined $4.2 billion, while Institutional Money Fund deposits added $3.5 billion. Large Denominated deposits declined $12.5 billion (down $22.7 billion over 5 weeks). Repurchase Agreements declined $4.9 billion and Eurodollars added $4.0 billion. Elsewhere, Foreign "custody" Holdings of U.S. debt increased $4.6 billion.

Correction: Fannie AND Freddie Liquefy the World:

Freddie Mac's September Monthly Summary was released today. Oh my... Freddie's Retained Portfolio expanded by a record $26.0 billion, or an annualized growth rate of 50.6%. This follows August's 41.9% growth rate. Freddie's total Book of Business (Retained Portfolio and non-retained mortgage-backeds guaranteed) surged $60 billion over two months (28% annualized) to $1.35 Trillion. For the third quarter, Freddie's Retained Portfolio jumped $55.6 billion, or 38% annualized. When combined with Fannie Mae's extraordinary expansion, the numbers become truly incredible. For September, Fannie and Freddie's Total Retained Portfolios increased an unprecedented $79.9 billion, or 64.8% annualized, to $1.56 Trillion. For the quarter, the combined Retained Portfolios ballooned $160.2 billion, or 46% annualized. To put this number into perspective, Total Home Mortgage borrowings increased $258 billion during the entire year of 1997. Year-over-year, combined Books of Business were up $476 billion, or 16%, with Retained Mortgage Portfolios ballooning $277 billion, or 22%. Out of control...

The captivating world of "money supply" has recently been garnering more than its usual amount of attention and commentary. I'll throw in my two cents worth. First of all, we must constantly remind ourselves that the contemporary financial system is a much different animal than conventional thinking gives it credit for. Traditionally, the financial system was essentially the banking system. This is simply no longer the case, as the banks share center stage with the Wall Street financial conglomerates, the GSEs, and securities markets generally. Importantly, contemporary "money" is anything but limited to government issued currency and bank created deposits. Moreover, the banking system no longer dominates the issuance of monetary liabilities (depositor assets) or commands the payment system. We have today the powerful money market fund complex, as well as instruments such as repurchase agreements and Eurodollars. Traditional money - currency and bank deposits - no longer exclusively represents "liquidity," and a strong argument can be made that non-bank Credit creation (liability expansion by the GSEs, Wall Street, and foreign monetary authorities) is the driving force behind contemporary financial market-based "liquidity."

Today, it is the nature of financial sector liability expansion that we must carefully monitor to garner clues for important systemic liquidity developments. There has been a recent notable stagnation of money supply after several months of heady growth. During the past 12 weeks, M3 has declined $37 billion, or 1.9% annualized. This is a dramatic reversal from the preceding 12-week period (weeks of April 28 to July 21) when M3 surged $220 billion, or 11% annualized. Digging into monetary component detail, we see that over the past 12 weeks Money Fund Deposits have declined almost $78 billion (Retail Money Fund deposits down $35.5 billion and Institutional Money Fund deposits down $37.3 billion), or 15.4% annualized. Meantime, Savings Deposits expanded $70.6 billion, or almost 10% annualized, with y-o-y year expansion of $466 billion (17%). Recent money supply stagnation is essentially explained by the decline in Money Market Fund deposits.

Clearly, there has been a tremendous flight to risk assets this year (out of the money market funds), but that doesn't help much in explaining the dramatic monetary boom turned recent stagnation. There is also the issue of the collapse of the Refi boom that has played a role in the composition and holders of financial sector liabilities over the past several months. But talk of a collapse in net mortgage lending is poor analysis. Yet I do believe we can look directly to the recently mushrooming Fannie and Freddie balance sheets. They provide the best explanation for the abrupt stagnation of "money," especially Money Fund deposits.

The GSEs have aggressively ballooned their holdings (mainly buying mortgages and mortgage-backs), providing liquidity to the banks, hedge funds, and Wall Street community. And, importantly, to finance this extraordinary balance sheet expansion, the GSEs have been issuing non-monetary IOUs/liabilities - long-term agency bonds (that are not a component of the "money supply"). Thus, we must appreciate that agency debt (as opposed to bank or money fund liabilities) has been over the past few months a predominant financial sector liability created in the unrelenting financial sector expansion (liquidity creation). The system has experienced tremendous liquidity creation resulting in little expansion of money supply components. This is a very atypical development in quite unusual times.

So I would tend to have my own view of the current liquidity situation: I believe the recent money supply stagnation is NOT indicative of generally faltering systemic liquidity. Indeed, it could be just the opposite. There is today a strange paradox of GSE induced over-liquefication financed by the issuance of agency bonds. Large quantities of these agency securities have been purchased by foreign central banks and international players recycling the raging surplus of global dollar balances. The Overriding issue remains Unrelenting Dollar Liquidity Excesses - an out of control Bubble of dollar financial claim creation. (At the same time, the grossly speculative and inflated U.S. stock market is a liquidity-Bubble accident in the making.)

This acute dollar over-liquidity view may be counterintuitive and even controversial, but there is certainly ample supporting evidence. I can point to continued over-liquefied Credit markets. Credit spreads domestically and internationally remain extraordinarily narrow (they've collapsed!), and demand for dollar denominated global risk assets (debt instruments) remains unprecedented. Credit availability could seemingly not be easier at home or abroad. The case for abundant dollar liquidity is also supported by surging gold and commodity prices, as well as a dollar that just cannot find its footing. Moreover, that "commodity" currencies -- the Australian dollar (up 25%), South African rand (up 24%), Brazil real (up 23%), Canadian dollar (up 20%), and Argentine peso (up 18%) -- are the leading global currencies this year lends especially strong support to my dollar over-liquidity/global reflation thesis.

It has been fascinating to witness truly historic financial evolution over the past decade. I have often attempted to explain how the Fed, GSEs and Wall Street have evolved to the point of having mastered the art of liquefying the market-based U.S. Credit system - Liquidity on Demand in Grand Excess. The nexus of this unparalleled capacity lies in the capacity for virtually unlimited GSE liability creation - insatiable demand for (implicitly guaranteed) GSE debt that can be issued in gross excess with no impact on perceived creditworthiness or investor demand (the "moneyness" of GSE liabilities); the Fed's capacity/audacity to peg short-term interest rates significantly below market rates; the explosion of aggressive leveraged speculation; and, of course, the dollar's role as international reserve currency. These provided a confluence of powerful forces unlike anything experienced in monetary or financial history.

This monetary/liquidity mechanism gained deserved credibility from the tumultuous market episodes of 1994, 1998, 1999, 2001, and 2002 experiences. Over the past several months, this "mastery" has been absolutely flaunted. Credit, liquidity and speculative excesses were taken to a whole new level. Interest rates began to shoot higher in July. Quickly, the highly leveraged and speculation-rife bond and interest-rate derivative markets faltered in near dislocation. But from July through September, Fannie and Freddie expanded their mortgage portfolios by the unprecedented $160 billion (compared to the 2nd quarter's $13.3 billion increase). Problem "resolved."

It is worth briefly rehashing the dynamics of GSE "liquefication." Today, the system is acutely vulnerable to rising interest rates. For one, we face unprecedented leveraged speculation that would be forced into problematic liquidation in the event of a significant and sustained rise in interest rates. Second, there is great systemic risk associated with asset Bubble dynamics (especially throughout mortgage finance) and exceptionally weak debt structures after years of poor and excessive lending (Minsky's "Ponzi Finance"). Third, there is this incredible interest-rate derivatives monster that expands with each new day of Credit and speculative excess. The GSEs, speculators, and other financial operators have purchased derivative protection against rising rates. Sellers of unfathomable quantities of "insurance" must "dynamically hedge" their exposure in the event of rising rates -- they are forced to sell/short Treasuries, agencies and other debt instruments into a declining market to establish positions that will generate the required cash-flow to pay Fannie, Freddie and the rest in the event of a sustained jump in rates.

It is simply difficult to comprehend how our Credit system could avoid dislocation (a liquidity crisis) in the event of sharply higher rates. Everyone knows as much. Yet there is apparently no cause for concern. The Fed, GSEs and Wall Street have mastered the art of manipulating market rates and liquidity. With the first serious episode of spiking rates/speculator liquidation/derivative-related selling, the GSEs immediately commence the ballooning of their balance sheets (buying mortgages and other debt instruments). This accomplishes several crucial things; I'll touch quite briefly on a few. First, it provides the leveraged players a "Buyer of First and Last Resort," thus emboldening the community and keeping them in the game (no liquidation allowed!). Second, by aggressively acquiring mortgage-backed securities, GSE operations mitigate the amount of (duration) hedging that would otherwise be required by holders of these securities in a rising rate environment. And, most importantly, by capping the interest-rate rise, GSE liquidity operations greatly allay the amount of systemic derivative selling that would be necessary if rates were to jump sharply. Or, stated differently, the JPMorgans and Citigroups of the world, with their huge and growing interest-rate derivative positions, can sleep soundly at night with the confidence that the Fed and GSEs enjoy the capacity to manipulate rates lower at their discretion. With this - a guarantee of continuous and liquid markets and "pegged" low rates - a flourishing interest rate derivative market becomes viable. The expansive Fannie, Freddie and speculator community are offered cheap insurance - like buying flood insurance in an environment where the insurance community can carefully control the amount of rainfall.

A truly amazing system has evolved over time. And, let there be no doubt, "The Community" has ably and repeatedly demonstrated its capacity to regulate the amount of "rainfall"/interest rates/liquidity. The Fed can peg short-term rates at 1% and orchestrate a steep yield curve; the GSEs can sit back with the capacity to create enormous liquidity on demand; the leverage speculators can bet with reckless abandon; the financial sector can expand without limitation; inexhaustible liquidity can fuel real estate and securities inflation and resulting economic expansion; and the interest-rate derivative players can write unbounded policies with confidence that rates will simply not be allowed to shoot higher. All the while, the Credit system can expand aggressively with little concern for the endless supply of new dollar financial claims created. A Trillion here and a Trillion there, and there's no downside. Speculative demand for securities will meet the ballooning supply, with little if any impact on the "controlled" interest rate markets. Cheap and plentiful Liquidity on Demand Forever!! A truly historic "achievement."

This manipulation has an enviable track record, working so splendidly so many times. But there is a flaw and this failing is and will remain the focal point of my analysis. And this serious flaw goes right to the heart of A True Paradigm Shift. Yes, U.S. interest rates are today controllable and this reality does wonders for the entire fragile financial system and hopelessly distorted U.S. economy. And domestic demand for the endless supply of new Credit - inflated dollar financial claims - can be orchestrated by an expanding U.S. financial sector. But the flaw? Its Wildness Lies in Wait out there in the increasingly distrustful and less compliant global financial arena. The Almighty Fed, the Commanding GSEs and a Powerful Wall Street are today simply not well endowed when it comes to the capacity to manipulate global demand for Bubble Dollar Balances.

The bottom line is that, despite its repeated "successes," this New Age financial control mechanism ("The Great Experiment") has not really been tested. Contemporary U.S. interest-rate/liquidity manipulation basically evolved over the King Dollar period 1995 through early 2002. The confluence of inflating U.S. asset prices, an outperforming economy, international high regard for the U.S. generally, and the impaired global financial system, worked to effortlessly recycle the rising flood of U.S. dollar balances right back to U.S. markets. There was absolutely no limit - no domestic or global constraints - on the amount of Credit creation - dollar claims inflation - generated during these U.S. liquefications. The liquidity jubilantly found its way right back to U.S. assets: the late nineties direct investment boom, the technology and U.S. stock market mania, and the Treasury/agency/"structured finance" securities Bubble. The ease of "recycling" dollar balances - of which everyone has grown so accustomed - was a most seductive aberration.

There are a few dynamics worth pondering. First, with the demise of King Dollar comes significantly reduced private demand for U.S. real and financial assets. Nowadays, relative performance of Non-dollar assets gains by the week, exacerbating non-dollar financial flows. Second, Credit Bubble dynamics dictate (and recent GSE balance sheet ballooning provides evidence) that Credit excess - dollar financial claims inflation - must expand at an accelerating pace to support both levitated U.S. asset prices (real and financial) and an increasingly distorted Bubble economy. Thus, the dynamic of ebbing global demand and the accelerating flow of dollar claims pose a not inconspicuous dilemma. Importantly, however, global central banks have for the past year filled the void. This is not sustainable, and it is worth noting that dollar demand has been supported during this period by strong financial markets and a recovering economy. Things can easily get much worse, and I would warn that there is a major problem with the markets complacency regarding the risk associated with dollar weakness.

I will return to the fascinating issue of mushrooming derivative positions and systemic risk. In the above discussion regarding interest rate risk, I made the point that derivative players - writers of interest rate protection - operate with the comfort that the Fed, GSEs and Wall Street command control over interest rates. And while it would be absolutely impossible for the $100 Trillion-plus interest-rate market to function as advertised, Financial Armageddon is apparently forever held at by the New Age U.S. financial system's capacity to manipulate interest rates/liquidity.

The Big Flaw in Market Perceptions, however, is that similar manipulative dynamics operate with regard to dollar risk -- that a currency derivative crisis can be similarly averted. It is my view that such a currency crisis is today unavoidable. U.S. interest rates, in the New Age American financial system, are a domestic, manipulable (through the inflation of additional Credit) issue. Global currency markets are not. No matter what egregious quantity of U.S. Credit excess or financial sector leveraging, potential disaster can seemingly be resolved by low rates and only greater excess. The unfathomable mountain of interest rate derivatives have, through the wonders of financial manipulation, become a financial disaster scenario Moot Point. But these very same dynamics are nurturing runaway dollar claims/Credit inflation, and virtually assure incessant dollar devaluation going forward. I believe global markets - currency, gold, general commodities - are beginning to sense as much.

Over the past decade the dysfunctional global financial system has experienced repeated currency collapses. And from Mexico, to the SE Asian dominoes, to Russia, Turkey, Brazil and the spectacular Argentine meltdown, derivatives have played an instrumental role in all currency dislocations. Over and over we witnessed how a confluence of developments -- domestic financial excess, resulting booming economies, and exaggerated speculative flows -- all worked to nurture ballooning markets for insurance protection against faltering local currencies. Moreover, market dynamics generally dictate that in the manic late stages of the boom -- when Credit excess and foreign speculative flows go to extremes -- currency derivative positions mushroom. Demand for protection surges, while the escalating price of this insurance coupled with a speculative mindset entices (thinly capitalized) financial operators to write currency derivative contracts. In many instances, as was certainly the case in Russia and Argentina, the readily available currency insurance plays an instrumental role in prolonging Credit and speculative excess. Disaster is assured.

When the unavoidable run on the currency finally arrives (and, especially in the case of Argentina, it does often take longer than one would expect) there is absolutely no marketplace liquidity available for the writers of currency protection. Derivative players are simply unable to hedge their exposure. As dynamic hedgers, their computer models dictated heavy selling into declining markets. Such a scenario quickly elicits crowds of sellers and a buyers strike. Markets dislocate and collapse.

Granted, the U.S. does not today have vulnerable currency peg. I would argue, however, that unprecedented foreign central bank dollar purchases have to this point played the pivotal role in stemming currency dislocation. But these extreme measures have only bought some time. Importantly, U.S. domestic interest-rate/liquidity manipulation ensures an unrelenting flood of new dollar balances to be accumulated by our foreign Creditors. This is growing exposure that they would surely prefer to hedge against. Meanwhile, the Great U.S. Credit Bubble dictates that gross excess goes to only more unimaginable extremes. And all of this guarantees that the ballooning mountain of dollar derivative positions becomes only more intractable. All the Fed, GSEs and Wall Street can do at this point is make things worse. And are they ever doing it.

Any other Credit system would impose higher interest rates to help support their faltering currency. Higher market rates would work to quell financial excess and Credit inflation, the forces of currency devaluation. The Big Flaw in our New Age system of manipulated interest rates/liquidity creation is that we have mindlessly sacrificed the capacity to rein in Credit and liquidity excess. We simply can't turn down dollar devaluation and have no intention of doing so. "It's our currency, your problem." The Fed and market players apparently believe that the dollar will calmly find some level commensurate with fair value. But low rates and Credit Bubble dynamics dictate dollar devaluation as far as the eye can see. Such dynamics simply beckon for an eventual run on the dollar. And such a scenario would quickly overwhelm global central bankers already with massive dollar holdings they don't know what to do with. I believe acute dollar vulnerability is here for the duration: A True Paradigm Shift in Global Finance, and certainly not one for the faint of heart.

October 22 - MarketNews International quoting ECB Chief Economist Otmar Issing: "There would be nothing worse than if monetary policy were to undertake and try to influence the economy directly."

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