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Compounding the Problem

This is an abbreviated and UNEDITED Bulletin.

The liquidity and speculation-driven U.S. stock market came to life again. For the week, the Dow and S&P500 added about 2%. The Utilities and Morgan Stanley Consumer indices also gained about 2%. Economically sensitive issues outperformed, with the Transports gaining 3% and the Morgan Stanley Cyclical index increasing 4% (up 38% y-t-d). The S&P Homebuilding index jumped 5% this week, increasing y-t-d gains to 98%. The S&P Retail Stores index added 3% this week, with 2003 gains of 44%. The broader market caught fire. The small cap Russell 2000 jumped almost 4%, increasing year-to-date gains to 43%. The S&P400 Mid-cap's 3.5% increased 2003 gains to 32%. The NASDAQ100 added almost 4% and Morgan Stanley High Tech almost 5%, with respective y-t-d gains of 45% and 61%. The Semiconductors and The Street.com Internet index indices gained 5%, increasing 2003 gains to 83% and 71%. The NASDAQ Telecom index's 4% rise increased y-t-d gains to 59%. The Biotechs gained 3% (up 36% y-t-d). Financial stocks rose as well, with the Broker/Dealers adding 3% (up 51% y-t-d) and the Banks 2% (up 26% y-t-d).

Curiously, the bond market was caught flat-footed by this week's strong economic data (paying too much attention to a bungling Federal Reserve!). For the week, 2-year Treasury yields jumped 17 basis points to 1.99%. Five-year Treasury yields surged 21 basis points to 3.36%, with 10-year yields up 17 basis points to 4.33%. The long-bond saw its yield increase 11 basis points to 5.13%. Benchmark Fannie Mae mortgage-backed yields jumped 19 basis points. The spread on Fannie's 4 3/8 2013 note widened 3 to 39, while the spread on Freddie's 4 ½% 2013 note widened 4 to 38. The 10-year dollar swap spread was unchanged at 39.25. Corporate spreads generally narrowed, with junk debt spreads narrowing meaningfully. A Merrill Lynch index of corporate spreads moved to the narrowest margin since 1999. The implied yield on December 2004 Eurodollars rose 29 basis points to 2.62%.

Demand encouraged unusually strong debt issuance for a Thanksgiving week. GE Capital raised $1 billion (up from $750 million), United Healthcare $500 million, Suncor Energy $500 million, PSEG Power $300 million, Penn National $200 million, Consolidated Natural Gas $200 million, and Chevy Chase Bank $175 million.

Junk funds enjoyed inflows of $425 million. Issuers included Jostens $247 million, General Nutrition $215 million, Embratel $200 million, and Stena AB $175 million.

Converts issued: Ciber $150 million and Lion's Gate $50 million.

Dollar Watch:

Monday's abrupt dollar surge quickly faded, with the dollar index trading today at the lowest level since January 1997. It is especially alarming that the dollar traded so poorly in the face of strong economic data. Three straight losing weeks has the dollar at a record low against the euro. The British pound gained 1% this week and today closed at the highest level against the dollar since those dark October 1998 days of the LTCM crisis. Commodity currencies continue to perform well, with the South African rand gaining about 2% this week. The Australian dollar rose against the greenback for the 13th straight week. The Canadian dollar traded to a new 10-year high this week.

Commodities Watch:

Various commodity markets have turned stunningly volatile. The CRB index reversed early weakness to end the week about unchanged. Gold traded above $400 this week, before ending the week up $2.10 to $398.15. Heightened trade frictions with China have commodity traders on edge.

November 27 - Bloomberg: "China Steel Corp., Taiwan's biggest steelmaker, said it plans to raise domestic prices for the first quarter to reflect higher global prices and rising raw material and transportation costs as the global economy recovers... Economic expansion in the U.S., Japan and Europe and China's growing demand are pushing up prices. China steel demand has caused a shortage of almost all products and spurred an increase in prices, driving up costs of raw materials such as coal, metals, scrap steel and steel slabs, China Steel said in a statement."

Global Reflation Watch:

November 27 - Bloomberg: "Money supply growth in the dozen-nation euro region accelerated in October, suggesting the European Central Bank may become more concerned about the inflation outlook as the economy recovers. M3 grew at an annual pace of 8 percent last month after a revised 7.6 percent in September, the ECB said in a conference call. The central bank says M3 above 4.5 percent risks fueling inflation."

November 28 - MarketNews: "The European Commission's Business Climate Indicator (BCI) rose in November to +0.02, the fourth monthly rise in a row and the first positive reading in two and one-half years, according to data released Friday by the EU Commission."

November 27 - Bloomberg: "Manufacturers in France, Europe's third-largest economy, were at their most confident in 11 months in November as demand for exports boosted order books. An index based on a survey of about 2,500 companies rose to 100 from 95 in October, Paris-based statistics office Insee said. Economists had expected a reading of 97... French manufacturers are mirroring improving sentiment in Belgium, Germany and Italy. The Munich-based Ifo institute's German business confidence indicator climbed to a 33-month high this month..."

November 28 - Bloomberg: "Swiss leading economic indicators rose to the highest in more than 2 1/2 years in October, indicating the economy is about to accelerate after emerging from its longest recession in more than a decade."

November 28 - Bloomberg: "Japanese consumer prices rose 0.1 percent in October, increasing for the first time since April 1998 because of higher taxes and more costly rice." (From the 25th) "Sales at Japanese department stores and supermarkets rose in October for the first time in more than a year..."

November 27 - Bloomberg: "The number and value of mortgage loans approved in October rose to a record, the British Bankers' Association said, suggesting the pace of consumer borrowing, which helped prompt an increase in interest rates this month, isn't slowing."

November 28 - Bloomberg: "Irish mortgage lending accelerated in October, as the lowest interest rates in decades spurred more people to buy property, Ireland's central bank said. The value of outstanding mortgage loans rose 24.8 percent to 51.75 billion euros ($62 billion) in October from a year earlier..."

November 24 - Bloomberg: "Taiwan's export orders rose to a record in October, climbing as overseas consumers buy more of the island's laptop computers, flat-panel displays and cell phones. Orders -- indicative of shipments in one to three months -- rose 19.9 percent from a year earlier..." "Taiwan's money supply grew last month at the fastest pace in two years..."

November 25 - Bloomberg: "Hong Kong's exports grew in October at their fastest pace in four months as its ports handled more components en route to factories in China and Chinese-made cell phones, clothes and fridges bound for the U.S., Japan and Europe. Exports rose 9.4 percent from a year earlier..."

November 27 - Bloomberg: "Thailand's economy grew more than 6 percent from a year earlier in the third quarter, led by gains in exports and consumer spending, a senior government official said."

November 26 - Bloomberg: "Singapore's manufacturing rose in October at its fastest pace this year... Manufacturing, which accounts for a quarter of the economy, rose 19.3 percent from a year earlier after gaining a revised 6.2 percent in September..."

November 24 - Bloomberg: "India's economy is expected to grow at an 'explosive' pace as the government sells assets, allows more overseas investments and boosts infrastructure, encouraging consumers to spend more, Finance Minister Jaswant Singh said. 'India's economy is fast approaching the point of criticality and, when it does, growth would be explosive,' Singh told businessmen in New Delhi yesterday. 'The fundamentals in reality have not been better in the last 52 years.'"

November 28 - Bloomberg: "New Zealand house prices rose for a ninth straight quarter in the three months ended Sept. 30... The national house price index provisionally rose 17 percent in the third quarter from the year-earlier quarter..."

November 24 - Bloomberg: "Mexico's exports climbed in October to their highest in three years on rising foreign demand for manufactured goods, helping narrow the country's trade deficit..."

Domestic Credit Inflation Watch:

Despite its interminable accounting woes, Freddie Mac posted strong growth during October. Freddie's Book of Business jumped $38.0 billion for the month, a 33.8% annualized growth rate, to $1.387 Trillion. Over three months, the company's Book of Business surged $96.0 billion, or 29.8% annualized. Freddie's Retained Portfolio expanded at a 27% annualized rate during the month to $655.5 billion. Over the past three months, the company's Retained Portfolio jumped $60.3 billion, or 40.5% annualized. Freddie and Fannie's combined Retained Portfolios increased an unprecedented $169.3 billion over four months (the onset of near Credit market dislocation in July through October), or 36.3% annualized. It is not often in financial history that a $1.5 Trillion portfolio expands at such a pace. Over the past 12 months, Freddie and Fannie's Retained Portfolios have increased $280 billion, or almost 22%. For comparison, total Federal Reserve Assets are up about $25 billion so far this year to $758 billion.

October Existing Home Sales slowed moderately from September's extraordinary pace. At a seasonally adjusted annualized 6.35 million units, year-over-year sales were up 12.8%. And with Average Prices (mean) up 8.4% y-o-y, Calculated Transaction Value (CTV) was up a noteworthy 22.2% from October 2002 to $1.39 Trillion. New Homes sales also moderated from September, although the 1.105 million unit pace was up 10.0% from 12 months earlier (5th highest level on record). And with Average Prices up 8.2%, New Homes CTV was up 18.9% y-o-y to $276.5 Trillion. Combined October New and Existing Home Sales were up 12.4% y-o-y to an annualized 7.455 million pace. Combined CTV was up almost 22% y-o-y to $1.67 Trillion. Combined CTV was up 47% over two years and 97% over six years, providing what should be irrefutable evidence of an historic mortgage finance Bubble.

Freddie Mac posted 30-year fixed mortgage rates increased 6 basis points this week to 5.89% (but down from the year ago 6.13%). Fifteen-year adjustable mortgage rates increased 5 basis points to 5.22%. One-year adjustable mortgage rates increased 5 basis points to 3.77% (down from the year ago 4.19%). The Mortgage Bankers Association application index came to life, although we must be mindful of holiday-week distortions. For the week, Refi Applications surged 42% to the highest reading in 7 weeks. Purchase Applications jumped 15% to a near record, with a 2-week gain of almost 23%. Purchase Applications were up 32% from the year ago level, with dollar volume up 49%.

Interestingly, October was a huge month for the ports of Los Angeles and Long Beach. Combined inbound containers jumped 9% from September to 595,726, a new record (up 43% from strike-impacted October 2002). Combined Outbound containers surged 19% from September to the strongest level in five months. October saw a total of 333,429 empty outbound containers, a new record and 56% of the month's total inbound containers.

November 25 - Dow Jones (Christine Richard): "Large cash-back payments and other incentives have been driving auto sales in the U.S. in recent years, but besides shifting cars out of the showrooms, these deals are also creating riskier auto loans. That's because incentives aren't just being used to discount the price of vehicles. Often, they provide a way to bail customers out of old auto loans, freeing them up to finance new purchases. 'Dealers are very creative,' said Bob Kurilko, vice president of marketing at Edmunds.com, which provides research and information on buying vehicles. 'They do what they have to do to get the deal done.' Sometimes that means giving a hand to buyers who owe more on their current auto loan than the auto's trade-in value - otherwise known as being 'underwater' on a loan. It's a surprisingly common problem. According to the latest data from Edmunds, during August, 29% of all trade-ins in the U.S. were underwater, with the average shortfall between the loan amount and the trade-in value standing at $3,700. That's up from August 2002, when 26% of trade-ins were underwater by an average of $3,280... In California, Texas and Alabama, 40% of all trade-ins were underwater in August. In California, the average shortfall on trade-ins was $4,700, said Kurilko."

Broad money supply (M3) added $3.1 billion this week. Demand and Checkable Deposits declined $6.3 billion, while Savings Deposits added $8.9 billion. Small Denominated Deposits declined $1.6 billion, while Retail Money Fund Deposits inched up $0.1 billion. Institutional Money Fund Deposits dropped $12.4 billion (down $29.5 billion over two weeks). Large Denominated Deposits added $6.4 billion. Repurchase Agreements increased $9.4 billion, while Eurodollars declined $2.3 billion.

"Foreign "custody" holdings of U.S. Debt," Agencies jumped another $14.4 billion to $1.03 Trillion. Custody (the Fed's holdings for foreign accounts) Holdings are up $26.3 billion over the past two weeks. And since the end of July (17 weeks), Custody Holdings have surged an unprecedented $96.8 billion, or 32% annualized.

After last week's $82.8 billion jump, Total Bank Assets declined $50.3 billion for the week ended November 19. Yet, Bank Credit (loans and securities holdings) increased $13.1 billion, with a three-week gain of $50.7 billion! For the week, Securities holdings jumped $15.2 billion, while Loans and Leases dipped $2.2 billion. Commercial and Industrial loans declined $0.9 billion and Real Estate loans dropped $11.7 billion. Consumer loans added $2.5 billion ($34.4 billion over four weeks) and Security loans jumped $14.5 billion ($18.6 billion in two weeks). Elsewhere, Commercial Paper (CP) increased $3.1 billion, with Non-financial CP up $0.6 billion and Financial CP up $2.5 billion.

Bond players' confidence that the economy was slowing to a more moderate pace was rattled this week. October Durable Goods Orders were up 3.3% (estimates of 0.7%), the strongest gain since February 2002. Total New Orders were up 10.5% y-o-y, with Ex-defense up 7.6%. Conference Board Consumer Confidence jumped 10 points in October to the highest level since February 2002. The Current Situation index has surged 20 points in two months to the strongest reading in 14 months. The ABC News/Money magazine weekly consumer confidence index jumped to the strongest reading since September 2002. Initial Jobless Claims declined to the lowest level since January 2001.

The Chicago Purchasing Managers' index surged 9.1 points (largest gain in 20 years) to 69, the highest level since February 1995. New Orders jumped 14.1 points to 73.3, the strongest reading since May 1994. Backlog jumped 12.3 points to 59.6, the highest since November 1999. Prices Paid gained 5.8 points to 67.3, the highest since July 2000. The Milwaukee Purchasers index jumped 11 points to a record 66. The Cincinnati Purchasing Managers index rose to the highest level since February.

Dollar "Problem" Watch:

November 28 - Bloomberg: "Japan sold its currency in November for a ninth month this year, according to the Ministry of Finance, trying to stem gains that threaten the nation's exports and may slow economic growth. The Bank of Japan sold 1.6 trillion yen ($14.6 billion) from Oct. 30 to Nov. 26... It also sold currency last week after the yen strengthened to a three-year high of 107.55 per dollar... The sales totaled about 1 trillion yen... 'We know the BOJ's been around this month,' said Shohgo Nagaya, foreign exchange manager in Tokyo at Nomura Trust & Banking Co., 'All they can do is limit the yen's gains.'"

This afternoon from Bloomberg: "There was speculation yesterday that Warren Buffett and George Soros are building 'short' positions against the dollar, as the British pound remained near a five-year high against the U.S. currency, the Independent reported, citing a hedge fund manager who asked not to be named."

And Wednesday from Bloomberg, quoting ECB council member Ernst Welteke: "On the impact if the euro climbed to $1.20 or $1.25: 'At some stage companies that export to the dollar region can of course reach a pain threshold. But only a seventh of German exports go to this region. 'A lot of companies say that we have hedged ourselves for the time being through swaps. At the moment, the euro's exchange rate is moving in a neutral range. An abrupt drop in the dollar could of course have consequences for the global economy and therefore for us as well. I don't think that will happen.'"

These three anecdotes - "all they can do is limit the yen's gains" BOJ dollar purchases; talk of speculative dollar sales by Soros and Buffett; and Welteke noting that German companies "have hedged" - go right to the heart of what I believe is an unfolding dollar "problem." First of all, aggressive foreign central bank dollar purchases have clearly lost their forcefulness. Ballooning Asian central bank and U.S. "custody" holdings are today only keeping the dollar's slide orderly. And with the ECB (as opposed to the BOJ) not aggressively accumulating dollars, euro sellers are finding it increasingly difficult to find buyers. This is precisely the type of environment that captivates the expansive global speculator community.

Speculative dynamics today find progressively emboldened sellers and discouraged buyers. Things have recently taken a turn for the worst, with this week's strong data and today's rising bond yields offering little in the way of dollar support. Such circumstances should have market participants contemplating the unprecedented derivative hedging positions that are accumulating. Recall the surge in derivative activity during the first half of the year. Dollar hedging has quite likely only escalated over the past few months. Surely, German, Japanese and other exposed manufactures have hedged dollar exposure. And, certainly, scores of global speculators and investors have incorporated more aggressive hedging strategies against their ballooning dollar holdings. But who is on the other side of these trades? Is the market to hedge dollar exposure tenable? I have serous reservations.

There is no doubt in my mind that dynamic hedging strategies play the dominant role in contemporary derivatives markets. Sellers of derivative protection incorporate "sophisticated" computer models that are basically trend-following systems "hedging" (buying rising and selling declining markets) exposure on market insurance written. Instead of learning from the 1987 portfolio insurance fiasco, the Greenspan Fed has been the staunchest supporter of the mushrooming derivative markets. But from analyzing the Mexican, SE Asian, Russian, and Argentina currency collapses, we have absolutely no doubt that the combination of runaway Credit excess, rampant global speculative financial flows, and aggressive (speculative) derivative hedging operations create over time acute currency and financial system fragility.

It would appear to me that we are now quickly approaching a critical point where heightened speculative and dynamic hedging-related selling could overwhelm apprehensive global central bankers. That the U.S. stock market at this time seemingly couldn't care less about the unfolding dollar "problem" is curious. But, then again, the unfolding Mexican, Asian, and Russian meltdowns almost had to hit the U.S. market on its head before there was recognition.

I remember clearly how U.S. financial stocks rallied to new highs in late July 1998, with the Russian and LTCM collapses only weeks away. This, however, is only one of many curious examples of surging markets determined to ignore the inevitable. But, then again, excessive liquidity creation in the face of heightened systemic stress is a most-important dynamic of contemporary (unrestrained) finance. Looking at GSE and foreign central bank balance sheets, both domestic and international liquidity operations over the past four months have gone to new extremes. Accordingly, speculative excess, both domestic and international, has gone to new liquidity-driven extremes. Greater dollar liquidity is only Compounding The Problem. And when the next crisis does arrive, the old "fixes" won't get the job done.

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