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The Dynamically-hedged Economy II

For the week, the Dow jumped 4.4% (down 2.3% y-t-d), and the S&P500 gained 5.9% (up 2.9%). In just five sessions, the Banks surged 36.1% (down 1.3%), and the Broker/Dealers jumped 10.7% (up 30.3%). The Morgan Stanley Cylclicals rose 8.3% (up 21.3%), and the Transports increased 6.3% (down 5.3%). The Morgan Stanley Consumer index gained 4.3% (up 1.9%), and the Utilities increased 2.6% (down 7.7%). The broader market remained strong. The S&P 400 Mid-Caps jumped 5.0% (up 9.0%), and the small cap Russell 2000 gained 5.1% (up 2.5%). Techology lagged this week. The Nasdaq100 was little changed (up 15.1%), and the Morgan Stanley High Tech index dipped 0.8% (up 23.1%). The Semiconductors declined 3.3% (up 17.7%), while the InteractiveWeek Internet index added 0.8% (up 35.2%). The Biotechs increased 1.2% (down 2.0%). With Bullion surging $29, the HUI gold index rallied 13.9% (up 13.5%).

One-month Treasury bill rates ended the week at 14 bps, and three-month bills closed at 18 bps. Two-year government yields rose 7 bps to 0.92%. Five year T-note yields jumped 14 bps to 2.12%. Ten-year yields rose 13 bps to 3.29%. The long-bond saw yields jump 18 bps to 4.26%. At the same time, the implied yield on 3-month December '09 Eurodollars declined 13.5 bps to 1.095%. Benchmark Fannie MBS yields gained only 5 bps to 4.12%. The spread between benchmark MBS and 10-year T-notes narrowed 9 to 83 bps (lows going back to the early nineties). Agency 10-yr debt spreads tightened another 12 to 31 bps (low since January 2007). The 2-year dollar swap spread declined 13.25 to 45.5 bps; the 10-year dollar swap spread declined 2.75 to 12.0. bps; and the 30-year swap spread declined 5.75 to negative 42.0 bps. Corporate bond spreads tightened signficantly. An index of investment grade bond spreads narrowed 27 to a 7-month low 194 bps, and an index of junk spreads narrowed 25 to an almost 6-month low 1,012 bps.

Corporate issuance was exceptionally strong. Investment grade issuers included Dow Chemical $6.0bn, Morgan Stanley $4.0bn, Bank of America $3.0bn, GE Capital $2.0bn, Bank of New York Mellon $1.5bn, US Bancorp $1.1bn, International Paper $1.0bn, Husky Energy $1.0bn, Kinder Morgan $1.0bn, Smiths Group $500 million, Hasbro $425 million, Providence Health $250 million, Cigna $350 million, Coca-Cola Enterprises $550 million, Corning $350 million, Hospira $250 million, and Psychiatric Solutions $120 million.

Junk bond funds saw $778 million of inflows this past week (from AMG). Junk issuers included Tech Resources $4.2bn, Goodyear Tire $1.0bn, Xerox $750 million, Owens-Brockway $600 million, Nalco $500 million, Crown Americas $400 million, Host Hotels $400 million, Inverness Medical Innovations $400 million, DTE Energy $300 million, Gannett $260 million and Silgan Holdings $250 million.

International dollar debt issuers included Royal Bank of Scotland $7.0bn, European Investment Bank $2.5bn, Brazil $1.775bn, Kookmin Bank $1.0bn, Canadian Oil Sands $500 million, and Inter-American Development Bank $100 million.

I saw no convert issuance this week.

U.K. 10-year gilt yields jumped 18 bps to 3.73%, and German bund yields surged 28 bps to 3.45%. The German DAX equities index gained 3.0% (up 2.2%). Japanese 10-year "JGB" yields increased 5 bps to 1.445%. The Nikkei 225 shot 8.1% higher (up 6.5%). Most "developed" global equities markets are now positive for the year. The emerging markets added to already strong gains. Brazil's benchmark dollar bond yields sank 35 bps to 5.94%. Brazil's Bovespa equities index surged 8.7% (up 36.9% y-t-d). The Mexican Bolsa rallied 10.0% (up 7.6% y-t-d). Mexico's 10-year $ yields sank 27 bps to 5.84%. Russia's RTS equities index surged 12.7% (up 48.5%). India's Sensex equities index gained 4.2% (up 23.1%). China's Shanghai Exchange rose 6.0% (up 44.2%).

Freddie Mac 30-year fixed mortgage rates were unchanged at 4.78% (down 127bps y-o-y). Fifteen-year fixed rates were unchanged at 4.48% (down 112bps y-o-y). One-year ARMs were unchanged at 4.77% (down 51bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 6 bps to 6.34% (down 75bps y-o-y).

Federal Reserve Credit dropped $46.2bn last week to $2.041 TN. Fed Credit has declined $205bn y-t-d, although it expanded $1.153 TN over the past 52 weeks (135%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 5/6) jumped $9.6bn to a record $2.660 TN. "Custody holdings" have been expanding at a 16.5% rate y-t-d, and were up $380bn over the past year, or 16.7%.

Bank Credit jumped $137bn to $9.785 TN (week of 4/29). Bank Credit was up $367bn year-over-year, or 3.9%. Bank Credit was down $129bn y-t-d (4.0% annualized). For the week, Securities Credit increased $26.2bn. Loans & Leases rose $110bn to $7.119 TN (52-wk gain of $192bn, or 2.8%). C&I loans increased $6.0bn, with one-year growth boosted to 2.0%. Real Estate loans jumped $105bn (up 7.1% y-o-y). Consumer loans increased $3.7bn, while Securities loans declined $6.9bn. Other loans added $3.1bn.

M2 (narrow) "money" supply jumped $41.6bn to $8.285 TN (week of 4/27). Narrow "money" has expanded at a 3.3% rate y-t-d and 8.8% over the past year. For the week, Currency slipped $0.5, while Demand & Checkable Deposits rose $17.8bn. Savings Deposits surged $33.4bn, while Small Denominated Deposits declined $4.8bn. Retail Money Funds fell $4.6bn.

Total Money Market Fund assets (from Invest Co Inst) declined $11.0bn to $3.787 TN (low since week of 12/17). Money fund assets have declined $43bn y-t-d, or 3.2% annualized. The 52-wk expansion was reduced to $315bn, or 9.1%.

Total Commercial Paper outstanding dropped another $43.2bn this past week to $1.379 TN. CP has declined $302bn y-t-d (52% annualized) and $375bn over the past year (21.4%). Asset-backed CP declined $22.8bn to $623bn, with a 52-wk drop of $133bn (17.5%).

It was a big week for ABS issuance. Year-to-date total US ABS issuance of $39.3bn (tallied by JPMorgan's Christopher Flanagan) is now more than half of the $75.9bn from comparable 2008. U.S. CDO issuance of $22.3bn compares to the year ago y-t-d $13.6bn.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were down $7.0bn y-o-y to $6.699 TN. Reserves have declined $247bn over the past 29 weeks.

Global Credit Market Dislocation Watch:

May 4 - Bloomberg (Lilian Karunungan): "Confidence in the U.S. dollar is 'fraying' and a shift away from the greenback after the financial crisis is inevitable, Nobel Prize-winning economist Joseph Stiglitz told Emerging Markets newspaper. The question is whether the move will be chaotic with regional swap arrangements, semi-currencies or multiple reserve currencies, or done in a more organized way, Stiglitz told the newspaper... The dollar won't remain the world's reserve currency as the inflationary impact of a rapidly expanding Federal Reserve balance sheet has undermined confidence in the greenback, he told the newspaper."

May 8 - Bloomberg (Rich Miller and Matthew Benjamin): "Treasury Secretary Timothy Geithner is betting that U.S. banks can do something their Japanese counterparts were unable to accomplish in that country's "lost decade" of the 1990s: earn their way out of trouble. The stress-test results released yesterday by regulators found that the 19 largest banks face a $74.6 billion capital hole that may be filled mostly by private money."

May 6 - Bloomberg (Kevin Hamlin and Bernard Lo): "The U.S. economy will require further fiscal stimulus to emerge from a long, L-shaped recession, said Kenneth Rogoff, former chief economist at the International Monetary Fund. 'We're going to get to the point where recovery is just not soaring and they're going to do the same again," said Rogoff... 'We're going to have a very slow recovery from here.'"

May 4 - Bloomberg (Scott Lanman): "Most U.S. banks expect loan delinquencies and losses to increase this year, a Federal Reserve report showed... More than 70% of respondents on net said bad loans will rise should the economy progress "in line with consensus forecasts,' the Fed said... More firms made it tougher for consumers to get home and credit-card loans in the past three months than in the previous survey, while fewer tightened terms for businesses... Banks are hoarding a record $1.1 trillion of cash even after the Treasury and central bank made emergency capital injections and set up special lending programs to ensure lenders extended credit to households and businesses."

May 8 - Bloomberg (Lu Wang): "Investors' aversion to risk fell to the lowest level since July 2007... according to a Bank of America Corp. gauge. The Financial Stress Index, which uses 12 components including credit spreads, stock volatility and the price of gold, fell to minus 0.12 today. Values between plus 1 and minus 1 show investors are risk neutral. The measure peaked at 4.68 after Lehman...Inc.'s collapse in September."

May 8 - Bloomberg (Patricia Lui and Garfield Reynolds): "Emerging-market bond funds had their best weekly inflows in more than a year and developing Asia was the biggest recipient of new money put into equity funds, according to data from research firm EPFR Global. Asia ex-Japan equity funds took in $1.62 billion in the week though May 6..."

May 8 - Bloomberg (Michael J. Moore and Hui-yong Yu): "Real estate investment trusts in the U.S. have raised $10.6 billion from share sales this year, almost matching the total for all of 2008... Property companies raised $6.51 billion in April alone as the Bloomberg REIT Index rallied 30%."

May 4 - Bloomberg (Erik Holm and Andrew Frye): "Berkshire Hathaway Inc. Vice Chairman Charles Munger listed leverage, stupidity, 'gross immorality,' and accounting practices among the causes for the current financial crisis... On the U.S. recession: 'This is the worst financial threat since the 30s.' 'There was gross immorality in the derivative-trading business.' 'Rooking your customer with some phony-baloney story when you say it's good for him, when it's really just good for the seller of derivatives -- that's an immoral way to make money.' 'The nature of finance is: the most vulnerable people need protection from the mendacity of their fellow man.' 'The accounting provision has ultimately failed us in the United States.' We have reaped a whirlwind.'"

May 8 - Bloomberg (Gregory Mott): "The Federal Deposit Insurance Corp. said it will open a temporary office in Jacksonville, Florida, this year to manage failed banks and find buyers for the institutions which are in the eastern U.S. The office, with space for as many as 500 employees and contractors, will be staffed based on the number of closings in the region, the resulting receiverships and 'the post-closing workload,' the FDIC said..."

Government Finance Bubble Watch:

May 8 - Bloomberg (Matthew Brockett): "Jean-Claude Trichet has dragged the European Central Bank into a new era by pursuing direct asset purchases over the objections of Germany's Bundesbank. President Trichet... announced the ECB will buy 60 billion euros ($80 billion) of covered bonds, taking markets by surprise after Bundesbank chief Axel Weber had campaigned against such a policy. For a central bank that's been slow to follow counterparts around the world, the move marks a change in mentality toward battling the financial crisis."

May 7 - Bloomberg (Svenja O'Donnell): "The Bank of England said it will add 50 billion pounds ($75 billion) to its program of asset purchases to fight the U.K. recession as policy makers kept the benchmark rate at a record low.

May 4 - Bloomberg (Joi Preciphs): "World Bank President Robert Zoellick said in a CNBC interview that the insitution can provide an extra $100 billion in lending for poor nations. The bank came into the global financial crisis 'well capitalized,' Zoellick told the cable-television network..."

May 4 - Bloomberg (Timothy R. Homan and Adam Brown): "The International Monetary Fund, which has mounted rescues from Hungary to Pakistan in the past six months, approved a $17.1 billion loan for Romania to help the eastern European country get through the global economic crisis."

May 5 - Bloomberg (Shamim Adam and Aloysius Unditu): "Asian nations may resist dipping into their new $120 billion foreign-exchange reserve pool as the region is showing signs of emerging from the worst global recession since World War II, officials and economists said."

Currency Watch:

The dollar index dropped 2.4% this week to 82.53 (up 1.5% y-t-d). For the week on the upside, the New Zealand dollar increased 6.0%, the Mexican peso 5.6%, the Brazilian real 5.4%, the Australian dollar 5.2%, the Swedish krona 5.1%, the Norwegian krone 3.3%, the Canadian dollar 3.0%, the South Korean won 2.9%, and the Euro 2.8%. On the downside, the Taiwanese dollar dipped 0.3%. In the emerging currencies, the Hungarian forint gained 6.4% and the Romanian leu rose 4.1%.

Commodities Watch:

Gold ended the week up 3.2% to $915.35 (up 3.8% y-t-d). Silver surged 11.9% to $13.99 (up 23.9% y-t-d). June Crude jumped $5.39 to $58.59 (up 31.4% y-t-d). June Gasoline rose 12% (up 60% y-t-d), and June Natural Gas surged 22.3% (down 23% y-t-d). Copper added 2.2% (up 52% y-t-d). July Wheat rallied 3.7% (down 3.2% y-t-d), and July Corn increased 1.8% (up 3.4% y-t-d). The CRB index surged 6.2% (up 6.0% y-t-d). The Goldman Sachs Commodities Index (GSCI) jumped 8.6% (up 17.9% y-t-d).

China Reflation Watch:

May 6 - Bloomberg (Kevin Hamlin): "China's central bank said the economy performed 'better than expected' in the first quarter and pledged to keep money flowing into the financial system to sustain growth. The People's Bank of China will ensure an 'ample' supply of money, it said in a quarterly monetary-policy report... New lending surged sixfold to a record in March as banks supported the government's 4 trillion yuan ($585 billion) stimulus package."

May 7 - Bloomberg (Eugene Tang): "Chinese banks made about 620 billion yuan ($90 billion) in new loans in April, Market News International reported, citing two people it didn't identify. It would be the lowest monthly increase in loans since November, when 476.9 billion yuan of loans were made, the news agency said today. Still, April's new loans bring this year's total above the government's full-year target..."

May 4 - Bloomberg (Kevin Hamlin): "China's manufacturing expanded for the first time in nine months after declines in export orders moderated and investment surged because of the government's 4 trillion yuan ($586 billion) stimulus package."

May 8 - Bloomberg (Eugene Tang): "China's passenger-vehicle sales rose 37% last month, the most in three years, as government subsidies spurred demand for minivans and small cars. Local drivers bought 831,000...vehicles in April... Vehicle sales, including buses and trucks, rose 25% to 1.15 million."

Latin America Watch:

May 5 - Bloomberg (Joshua Goodman and Andre Soliani): "Brazil's industrial output fell 10% in March from the same month a year earlier, the national statistics agency said."

Central Banker Watch:

May 7 - Bloomberg (Tasneem Brogger): "Iceland's central bank said it expects the economy to contract 11% this year..."

GSE Watch:

May 8 - Dow Jones: "Fannie Mae's first-quarter loss ballooned on surging credit losses as the company and the Treasury Department reached agreement on a deal that doubled the government's support level to $200 billion. The deal, which Fannie said in a filing with the Securities and Exchange Commission was reached Wednesday, has been keeping the company afloat while under conservatorship as credit losses exploded. Fannie requested another $19 billion Wednesday, which if approved through a preferred-stock purchase would put the total given by the government at $35.2 billion."

Real Estate Bubble Watch:

May 6 - Bloomberg (Bob Ivry and Dan Levy): "The number of U.S. homes valued at more than $729,750, the jumbo-loan limit in the most affluent areas, entering the foreclosure process jumped 127% during the first 10 weeks of this year from the same period of 2008... The rate rose 72% for homes valued at less than $417,000 and 78% for all homes, RealtyTrac said."

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

May 6 - Bloomberg (Matthew Leising): "The Federal Reserve is planning for the first time to break Wall Street's hammerlock on so-called over-the-counter derivatives and bring more regulation to the $684 trillion market. The central bank will require more transparency after the unregulated market contributed to the demise of Bear Stearns Cos. and Lehman Brothers... The biggest sign of the Fed's intentions came when Theo Lubke, the Federal Reserve Bank of New York official responsible for oversight of the market, said the biggest banks shouldn't be allowed to dominate trading of the financial contracts, which let investors hedge against losses or speculate on everything from changes in interest rates to corporate defaults."

Unbalanced Global Economy Watch:

May 6 - Bloomberg (Jennifer Ryan and Svenja O'Donnell): "A U.K. gauge of services industries from banks to computing rose the most since 1999 in April and consumer confidence jumped, adding to evidence the recession has started to ease."

May 5 - Bloomberg (Peter Woodifield): "The deficit in the U.K.'s largest company pension plans almost doubled to 61 billion ($91 billion) in the first quarter as falling stock markets cut the value of their assets, according to Mercer Investment Consulting."

May 4 - Bloomberg (Emma Ross-Thomas): "The European Union cut its forecast for the euro-area economy to show a contraction twice as deep as it projected just three months ago, and said the region's budget deficit will swell to more than double the EU limit. The economy of the 16 countries sharing the euro will shrink 4% in 2009..."

May 6 - Bloomberg (Emma Ross-Thomas): "Spain's industrial production shrank by 25% and bankruptcies almost quadrupled, as the global recession ravaged the economy and put it on course for its worst slump in 60 years."

May 6 - Bloomberg (Alex Nicholson): "Russia's first-quarter trade surplus was $23.4 billion, down 56% from the year-earlier period, the Federal Customs Service said..."

May 6 - Associated Press: "Lance Armstrong's Astana team is fighting through a financial crisis on the eve of the American's first Giro d'Italia. Astana spokesman Philippe Maertens confirmed reports out of Kazakhstan that the team has not been paying its riders recently."

May 5 - Bloomberg (Nasreen Seria): "South Africa's unemployment rate rose to 23.5% in the first quarter from 21.9% in the previous three months..."

Bursting Bubble Economy Watch:

May 6 - Bloomberg (Daniel Taub): "A growing number of U.S. homeowners owe more than their properties are worth after prices extended their two-year decline in the first quarter, Zillow.com said. Almost 21.8% of all owners were underwater as of March 31..."

May 6 - Bloomberg (Rick Levinson): "How much money does it take to feel wealthy these days? About $1.8 million in investable assets, according to a study by Fidelity Investments... The survey found that 46% of Americans who described themselves as millionaires don't feel wealthy, twice as many as last year... Stock market losses were cited by 42% of the respondents as the main reason..."

California Watch:

May 7 - Bloomberg (Michael B. Marois and William Selway): "California's cash shortage may swell to a record $23 billion by October if voters reject tax increases, borrowing and a spending cap Governor Arnold Schwarzenegger seeks, the state's fiscal analyst said. Even if the measures do pass, the state still might need to borrow $17 billion of so-called cash flow notes or warrants and that might not be publicly sellable..."

New York Watch:

May 7 - Bloomberg (Chris Dolmetsch and Michael Quint): "A plan to close a $1.8 billion shortfall at New York's Metropolitan Transportation Authority with a new payroll tax and higher fares was approved late last night by the state Legislature."

Muni Watch:

May 7 - Dow Jones (Ian Salisbury): "While the new Build America Bonds may look tempting to small investors, many of these bonds' features make them better suited for giants like pension funds. In the past several weeks, issuers ranging from the state of California to the New Jersey Turnpike Authority have sold billions of these instruments... Unlike the vast majority of municipal bonds, Build America Bonds are taxable. Their credit isn't backed by the federal government, but Uncle Sam subsidizes about a third of the interest or provides a tax credit to investors."

Speculator Watch:

May 8 - Bloomberg (Saijel Kishan): "Satellite Asset Management LP, a $3 billion New York-based hedge fund founded by former employees of billionaire George Soros, is closing down because of client withdrawals, according to a person familiar with the matter."

The Dynamically-Hedged Economy II:

All attention this week was focused on the bank stress tests. Importantly, market perceptions have shifted dramatically to the view that banking system problems are manageable and that policymakers have found the right balance in their approach. The reported total capital shortfall was nowhere near as dire as, not long ago, many had feared. Indeed, several weeks back no one would have even contemplated Wells Fargo and Morgan Stanley on the same morning tapping the market for a combined $11bn of common equity capital. And with markets having somewhat recovered - and even the impaired financial players having regained access to the capital markets- the marketplace has now largely taken the cataclysmic market "tail" risk scenario off the table. The equities VIX index dropped this week to the lowest level (31) since before the failure of Lehman, mirroring the ongoing collapse in Credit spreads.

My obsession with the Credit system began in the early nineties, as I studied the complex process of impaired banking system rejuvenation. Beginning early in that decade, innovation and rapid expansion propelled Wall Street finance into a major force of system Credit creation. Securitizations, the GSEs, and derivatives markets in particular - contemporary Wall Street risk intermediation - combined to play a momentous role in system reliquefication. This was much to the delight of the traditional banks - first promoting their recovery and later spurring incredible growth in earnings, stock prices and compensation. This new Credit system structure developed into the historic Wall Street finance and mortgage finance Bubbles.

Today, myriad forms of government risk intermediation and market intervention are spurring system Credit creation and reliquefication. I have labeled the most recent phase of risk intermediation distortions and Credit excess the "Government Finance Bubble." One will miss important dynamics by focusing on bank Credit.

It is worth noting first quarter bond issuance data from the Securities Industry and Financial Markets Association (SIFMA). Total Bond issuance (muni, Treasury, mortgage-related, corporate, agency, and ABS) jumped to $1.420 TN during the period. This was a notable 71% increase from a dismal 4th quarter to the strongest issuance since Q2 2008 ($1.598TN). If the first quarter's pace is maintained, total 2009 issuance of $5.680 TN would trail only 2003 and 2007.

First quarter bond sales were actually up 3.2% from Q1 2008, led by a 60% y-o-y increase in Treasury issuance ($326.8bn). On a quarter-over-quarter basis, Agency issuance was up 332% to $413.7bn; Mortgage-Related issuance increased 69% to $364.8bn; and Corporate issuance surged 188% to $215.1bn. Exemplifying the scope of the unfolding Government Finance Bubble, Treasury and Agency debt issuance combined for an incredible $740.5bn during the first quarter, up 59% y-o-y to a record annual pace of $2.962 TN.

This morning Fannie Mae reported a worse-than-expected first quarter loss of $23.2bn. In just three quarters, Fannie has reported losses totaling $77.4bn. No worries, however. Fannie's debt spreads this week tightened another 12 to 31 bps (down from November's 159bps) and Fannie MBS spreads narrowed an additional 9 to 83 (down from November's 232bps). Despite unprecedented losses and massive capital shortfalls, the GSEs have nonetheless become major players in the unfolding Government Finance Bubble. An insolvent Fannie requested an additional $19bn of government assistance.

Today from Fannie: "In March, Fannie Mae provided $93.3 billion in liquidity to the market through Net Retained Commitments of $5.4 billion and $87.8 billion in MBS Issuance... March refinance volume increased to $77 billion, nearly twice the refinancing volume reported in February and our largest refinance month since 2003. We expect that our refinance volumes will remain above historical norms in the near future... Fannie Mae began accepting deliveries of refinance mortgage originations under the Making Home Affordable program in April 2009."

Fannie's "Book of Business" (retained mortgages and MBS guarantees) expanded at a 12.3% rate during March to $3.144 TN (largest increase since February 2008). Fannie MBS guarantees grew at a 15.4% annualized rate during March to $2.640 TN. The $31.4bn increase in guarantees was the largest in 13 months. The company's "New Business Acquisitions" jumped to $92.8bn from February's $53.8bn and January's $28.8bn.

The current wave of mortgage refinancings is the strongest since the powerful - and system reliquefying - 2002/'03 refi boom. The few analysts that even care are generally discounting the systematic impact of refinancings. They argue that there is today dramatically less equity available to extract and spend. From an economic perspective, I don't have a big issue with this analysis. But from a systemic risk perspective, the unfolding refi boom is anything but inconsequential.

By the end of the year, I would not be surprised to see upwards of $1.0 TN of "private" mortgage exposure having been shifted to the various government-related agencies (Fannie, Freddie, Ginnie, FHA, and FHLB). The wholesale transfer of various private sector risks to "Washington" is a key facet of the Government finance Bubble. Nowhere is such redistribution accomplished as effectively and surreptitiously than with a mortgage marketplace incited to refinance by (Fed-induced) collapsing yields. Think in terms of our government placing its stamp of guarantee on hundreds of billions of risky, illiquid and unappealing mortgage securities - transforming them into coveted "money"-like agency securities. Such dynamics work wonders... Previous holders of these mortgages receive cash, while the entire marketplace benefits from higher mortgage prices.

Some years back I titled a Bulletin "The Dynamically-Hedged Economy." The gist of the analysis was that the Financial Sphere was the driving force of the Economic Sphere - and not vice-versa. Derivatives and leveraged speculation "ruled the world." Credit system and speculative Bubble dynamics had nurtured powerful and self-reinforcing dynamics. A financial sector embracing risk and leverage was spurring liquidity excess, higher asset prices, a more robust economic expansion, buoyant confidence, animal spirits, and an only greater degree of self-reinforcing Credit and speculative excess.

As we witnessed last autumn, an abrupt reversal of these dynamics fomented system illiquidity and near systemic breakdown. Selling begat more selling - especially from the expansive derivatives marketplace. There was absolutely no way that system liquidity could absorb the combined selling pressure associated with speculative deleveraging and the hedging of systemic risks.

The system is again rocked by yet another Bubble-related convulsion: today, it's the self-reinforcing unwind of bearish bets and systemic risk hedges. Washington's unprecedented measures to intermediate risk and boost marketplace liquidity have spurred a self-reinforcing wave of bearish positions and hedges liquidation. This dynamic has had a major impact in the Credit, equities and, seemingly, more recently in the currency and commodities markets. I would add that this unwinding process tends to generate liquidity throughout the marketplace. And, let's face it, there is nothing like a big short squeeze to get the animal spirits flowing on the long side. Most will interpret these dynamics bullishly. I would caution that we are witnessing only the latest variant of Acute Monetary Disorder and destabilized markets.

The more bearish analysts argue that current economic underpinnings do not support surging stock and debt prices. Of course they don't, but that's not really the key issue. Rather, the question is whether the return of liquidity and securities market inflation will stoke sufficient confidence (from both spenders and lenders) to spur sustainable economic recovery. Here I must lean heavily on my analytical framework.

In the short-run, I have to presume that major financial sector and market developments will work to stimulate the real economy (as they have repeatedly in the past). At the same time, it's my view that the economy today is unusually susceptible to an artificial and fleeting recovery. The unwind of bearish hedges will at some point have run its course, concluding a period of major artificial liquidity generation. Moreover, I question the sustainability of the Government Finance Bubble (fiscal and monetary) overall.

The markets are setting themselves up for disappointment. I would posit that the more energized the markets and economy the greater the amount of Credit issuance that will need to be absorbed by the markets (debt and currency). So far, it is mainly Treasury yields that are rising. Government Finance Bubble dynamics would seem to dictate, however, that agency debt and MBS yields could provide the key to both artificial economic recovery and inevitable disappointment. And I would not expect a sinking dollar to support agency securities or Treasuries.


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