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Pondering the Two Great Market Stabilizers


U.S. stocks are trading unimpressively. For the week, the Dow dipped about 0.5%, and the S&P500 declined 1%. The Utilities added 1%, while the Morgan Stanley Cyclical index was unchanged. The Transports sank 3%, and the Morgan Stanley Consumer index declined 1%. The broader market is weakening. The small cap Russell 2000 declined 2% and the S&P400 Mid-cap index lost 1%. The NASDAQ100 and Morgan Stanley High Tech indices fell 2%. The Semiconductors were hit for 4%. The Street.com Internet index was unchanged, while the NASDAQ Telecom index declined 2%. The Biotechs were hit for 2%. The financial stocks were mixed. The Broker/Dealers declined 2%, while the Banks were unchanged. With bullion surging $17.10, the HUI gold index gained a modest 3%.

The Treasury market quieted down this after recent strong gains. Two-year Treasury yields dipped one basis point to 1.51%, with 5-year Treasury yields unchanged at 2.74%. Ten-year yields were unchanged at 3.78%, while long-bond yields dipped one basis point to 4.71%. Fannie Mae benchmark mortgage-backed yields rose 4 basis points. The spread on Fannie 4 3/8% 2013 note was unchanged at 27, with the spread on Freddie's 4 ½% 2013 note one wider at 26. The 10-year dollar swap spread was unchanged at 37.25. Corporates were mixed, with investment grade bond spreads about unchanged and junk spreads continuing to widen moderately. The implied yield on December 3-month Eurodollars declined 2 basis points to a contract low 1.54%.

March 17 - Dow Jones (Christine Richard and Tom Sullivan): "Not since the days of giant telecommunications deals has the U.S. corporate bond market been this active. A surge in issuance from finance companies such as Well Fargo and Countrywide Financial Corp., along with a $6.7 billion five-part offering from Pacific Gas & Electric, the utility unit of PG&E Corp., put around $16 billion worth of investment grade debt in the market Wednesday. 'It's been a massive day' said Jim Probert, head of U.S. domestic syndicate at Banc of America Securities.

The mortgage lending behemoths led Wednesday's issuance deluge. Wells Fargo sold $5.5 billion of 3 and 7-year debt (raised from $3.0 billion). Countrywide borrowed $1.35 billion (up from $750 million), and Washington Mutual borrowed $750 million (up from $500 million). For the week, Bloomberg tallied a two-month high $24 billion of corporate issuance.

The week's Investment grade issuers included International Paper $1.0 billion, HSBC Bank $1.0 billion, Bear Stearns $750 million, Liberty Mutual $750 million, Suntrust Bank $1.5 billion, International Lease Finance $600 million, Jetblue Airways $430 million, Mellon Funding $300 million, Potomac Electric Power $275 million, CarrAmerica Realty $225 million, Cooper Cameron $200 million, Aleutian Investments $195 million, Rural Cellular $350 million, and Entergy $100 million.

Junk bond funds saw outflows of $264.8 million for the week (from AMG). Junk issuers included Nextel Communications $500 million, Sierra Pacific Resources $335 million, American Achievement $150 million, and Standard Commercial $150 million.

Booming Convert issuance included Fisher Scientific $330 million, Citadel Broadcasting $330 million, Providian $250 million, CapitalSource $225 million, Greater Bay Bancorp $220 million, Cytyc Corp $220 million, and Saks $200 million.

ABS issuance amounted to $9.0 billion (from JPMorgan), with y-t-d issuance of $118 billion running up 16% from comparable 2003.

Foreign dollar debt issuers included Ispat Inland $800 million, Skandinaviska Enskilda $500 million and Sun Sage $200 million.

Freddie Mac posted 30-year fixed mortgage rates dipped 3 basis points to 5.38%, with a two-week decline of 21 basis points. Fifteen-year fixed-rate mortgages were unchanged at 4.69%. One-year adjustable-rate mortgages could be had at a record low 3.39%, down 2 basis points for the week. One-year adjustable-rate mortgages dropped 5 basis points in the West to 3.22%. The Mortgage Bankers Association Purchase application index rose 5.6% last week to the 5th highest on record. Purchase applications were up 30% from one year ago, with dollar volume up an astonishing 50%. Refi application volume surged almost 40% during the week, with the Refi index now three times the end of year level. The average Purchase mortgage was for $223,400, and the average ARM mortgage was for $335,500.

Fed Foreign "Custody" Holdings of Treasury, Agency debt increased $8.5 billion.

Broad money supply (M3) declined $9.6 billion. Demand and Checkable Deposits dropped $20.4 billion. Savings Deposits jumped $20.7 billion, and Small Denominated Deposits dipped $0.5 billion. Retail Money Fund deposits declined $9.2 billion, and Institutional Money Fund deposits dipped $0.8 billion. Large Denominated Deposits added $6.3 billion. Repurchase Agreements declined $10.9 billion, while Eurodollar deposits added $5.5 billion.

Total Bank Credit surged $55.9 billion. During the first 10 weeks of the year, Total Bank Credit is up $227 billion, or almost 19% annualized. For the week, Securities holdings jumped $25.2 billion. Loans & Leases jumped $30.8 billion. Commercial & Industrial loans dipped $1.1 billion. Real Estate loans jumped $14.8 billion, with 2-week gains of $24.2 billion. Consumer loans added $1.4 billion and Security loans gained $10.9 billion. Other loans rose $4.7 billion. Elsewhere, Total Commercial Paper (CP) declined $11.3 billion. Total Non-financial CP dipped $0.7 billion to $117.7 billion. Financial CP declined $10.6 billion to $1.202 Trillion.

Currency Watch:

With the Bank of Japan apparently vacillating with respect to its dollar intervention strategy, the yen surged almost 4% this week. "Commodity" currencies did well, with the Australian dollar, New Zealand dollar, and South African rand gaining about 2%. The dollar index dropped more than 1%.

Commodities Watch:

March 16 - Bloomberg (Rob Delaney and Jeff Wilson): "China's only soybean-futures market, the Dalian Commodity Exchange, increased trading of the oilseed by 73 percent last year as the country's soaring demand drove global prices to 15-year highs. China has become the world's biggest importer of soybean, which is crushed to make cooking oil and animal feed, amid a 10 percent increase in the average income of the nation's 1.3 billion people. With local production able to meet only about half its needs, China imported 21 million metric tons of soybean in 2003, a tenth of the world supply. The Chicago Board of Trade has set soybean prices since 1936, and crop for May delivery reached a 15-year peak of $9.89 a bushel in Tuesday trading after climbing 86 percent since July..."

March 16 - Bloomberg (Rob Delaney): "China demand for rice, wheat and soybeans has boosted prices of the staple grains in the country by as much as 31 percent in February, mostly in cities, the National Bureau of Statistics said... Soybean prices in China rose nearly a third in February, from a year earlier, while rice prices rose 21 percent and wheat 20 percent, the report said. Soybean oil and peanut oil have risen 24 percent, while rapeseed oil has gone up 25 percent."

March 18 - Bloomberg (Mark Shenk): "Crude oil futures closed above $38 a barrel for the first time since the 1990-91 Persian Gulf War, after the U.S. Energy Department reported a decline in nationwide gasoline inventories... 'Demand just keeps growing in spite of high prices,' said Phil Flynn, senior energy trader for Alaron Trading Corp. 'This is setting us up for a very bad summer driving season.'"

March 18 - Bloomberg (Jeff Wilson): "Soybeans rose above $10 a bushel for the first time in 15 years as insufficient rain in South America dimmed prospects for crops needed to revive supplies, which have been eroded by a surge in demand for animal feed."

Corn traded this week to 6 ½ year highs, tin to 14-year highs, copper a near 8-year high, pork bellies near 3-year high, Coffee a 3-year high, and gasoline a 1-year high. The Goldman Sachs Commodity index this week traded to the highest level since December 2, 1980. Already up almost 10% y-t-d, the CRB commodities index today traded to the highest level since May 25, 1984.

Asia Inflation Watch:

March 16 - Bloomberg (Tian Ying): "China's retail sales rose 10.5 percent from a year earlier in the first two months of this year as rising incomes and easier credit enabled consumers in cities such as Beijing and Shanghai to buy more holidays, cars and cell phones. Sales rose to 878 billion yuan ($106 billion), the Beijing-based statistics bureau said... Sales grew 10.9 percent in December, their fastest pace in 2 1/2 years. The government is trying to stimulate consumer spending to offset the economic impact of a slowdown in investment as it restricts expansion in the steel, cement and aluminum industries to head off possible gluts and reduce power shortages."

March 17 - Reuters (Robin Paxton and Sambit Mohanty): "Record shipping costs fuelled by China's ravenous appetite for commodities have pushed up prices for metals, raw materials and farm products across Asia -- but done little to dampen demand. Spot shipping rates on most Asian routes have more than doubled in the last six months but, such is the region's appetite for commodities, buyers are absorbing the higher freight costs and passing them on to customers, industry officials said. 'Even with the exorbitant freight rates at the moment, demand has not ceased at all. If anything, it's stronger than ever,' said Simon Everett, general manager of Hong Kong-based Trans Orient Ore Supplies... Huge demand for iron ore and coking coal for China's steel sector and alumina to feed new aluminum smelting capacity, plus a rush for grain shipments from the newly harvested South American crop, are behind the huge rise in freight rates."

March 18 - Bloomberg (Alan Patterson): "Corning Inc., the world's largest maker of glass used in flat-panel computer and television displays, said shortages of the material may last until next year because of stronger-than-expected demand... A shortage of parts in the $37.7 billion global flat-panel market boosted prices of some displays by 45 percent..."

Global Reflation Watch:

March 15 - Bloomberg (Daisuke Takato and Yoshiko Matsushita): "Takashimaya Co. Ltd., Mitsukoshi Ltd. and other Tokyo department stores sold 0.3 percent more clothing, food and other goods in February than a year earlier, the first sales gain in 27 months..."

March 17 - Bloomberg (Tian Ying): "China's fixed-asset investment in towns and cities jumped 53 percent in the first two months of this year amid expectations the government would restrict new projects after its March 5 annual policy meeting."

March 16 - Bloomberg (Amit Prakash): "Singapore's exports surged 11 percent in February, led by electronics makers including GES International Ltd., prompting economists to say the government's 5.5 percent economic growth forecast for 2004 is too low. Exports expanded at their fastest pace in eight months in February following a 3.6 percent expansion the previous month..."

March 17 - Bloomberg (Eliana Raszewski): "Argentina's economy grew at its fastest pace in at least 11 years in the fourth quarter as consumer demand and investment surged, the National Statistics Institute reported. Gross domestic product, the broadest measure of a country's output of goods and services, expanded 11.3 percent in the October through December period from the same period in 2002 after growing 9.8 percent in the third quarter."

March 18 - Bloomberg (Heather Walsh): "Chilean retail sales climbed in February at the fastest pace since 1999, as more jobs and record low lending rates encouraged shoppers to spend. Retail sales rose 7.4 percent from a year ago, the fastest increase since December 1999..."

California Housing Bubble Watch:

March 19 - San Francisco Chronicle (Kelly Zito): "Bay Area home prices surged to record highs in February, as hordes of buyers rushed to capitalize on tumbling mortgage rates... The median price for a single-family home in the nine-county Bay Area climbed to $476,000 in February, up about 14 percent from the same month last year, according to DataQuick... That was the biggest year-over-year jump in three years. 'It's a frenzy out there,' said Peter Richmond, a Mill Valley real estate agent who said some choice homes are receiving as many as 20 offers. 'It's a function of small inventory, tons of buyers wanting to buy, and record low interest rates. We're almost, but not quite, where we were in 2000.' ...And with rates hitting nine- month lows this week, that momentum shows no imminent signs of easing. All over the Bay Area, properties are garnering multiple offers for thousands of dollars over the asking price, drawing comparisons to the white- hot real estate market of the dot-com days. And that is happening despite a lackluster employment sector, which lost about 300,000 jobs from 2001 to 2003... But some industry insiders worry that consumers are selecting riskier loan products, putting themselves in a vulnerable position when interest rate inevitably rise. Kevin Clay, a mortgage broker at Reign Financial in San Carlos, said an increasing number of his clients are opting for so-called interest-only loans. Because the initial monthly payments are typically lower than those for traditional amortizing loans, interest-only loans usually allow buyers to qualify for a bigger loan." Prices were up 24.8% y-o-y in Napa County ($443,000), 15.3% in Sonoma County ($411,500), 14.2% in Marin County ($725,000), and 9.8% in San Francisco County ($615,000).

March 16 - Los Angeles Times (Debora Vrana): "Home prices in Los Angeles County rose again last month from the prior year, as a low supply of houses and condominiums for sale and favorable interest rates pushed up demand. The median price of new and existing homes and condos sold in February was $352,000... It was a 24 increase from the median of $284,000 a year earlier (from DataQuick)... During February, 7,723 houses and condos sold in Los Angeles County, a decrease of 3.8% from the 8,030 sold in January but a 2% jump from the same time a year ago. That made the month the second-strongest February of the last 15 years... Still, a chronic shortage of homes for sale in the region is creating tough competition among prospective buyers... But with few homes available, many are walking away frustrated, said Heather Roy, a Coldwell Banker real estate agent. These potential buyers, she said, 'are doing everything right,' including getting pre-qualified by lenders. Yet bidding is fierce. 'You find a home in the [$600,000] range and people come from everywhere because there are so few of them,' she said."

March 17 - Los Angeles Times (Arlene Martinez): "Orange County's median home price in February rose 23.7% in the biggest jump in nearly 15 years, with the pace of sales dipping because of a lack of houses and condos on the market, data showed Tuesday. 'These figures ... were much stronger than we anticipated,' said John Karevoll, an analyst with DataQuick... The median price of a new or existing home sold in Orange County last month was $475,000, up from $384,000 a year earlier. The last time the median home price climbed so sharply was in May 1989, when it increased 24.1%... Condo prices saw the biggest gains, with the median price rising 32.2% to $355,000. Still, the median price for previously owned single-family houses continued to set the pace for Southern California's housing market, with a 28.4% jump to $520,000 from the previous year. That was a 4% increase from January, when Orange County's houses became the first in any Southern California county to sell at a median price of $500,000."

March 17 - Reuters: "Southern California home prices jumped to a new record in February as buyers continued to seize low mortgage interest rates to enter the region's already hot housing market... The median price paid for a Southern California home rose last month to a record high $351,000, up 2.3 percent from January and 20.2 percent from a year earlier (from DataQuick). Low mortgage interest rates and demand exceeding the supply of homes for sale in Southern California -- Los Angeles, San Diego, Orange, Riverside, San Bernardino and Ventura counties -- have fueled a torrid regional housing market in recent years. Since last summer, the monthly median home price in Southern California has increased by 20 percent on a year-over-year basis...the region's home sales in February, totaling 23,004, were the strongest in more than 15 years for that month..."

March 19 - Contra Costa (CA) Times (Rick Jurgens): "February median selling prices rose 4 percent from January in Alameda and Contra Costa counties and 3 percent throughout the Bay Area, reversing small fallbacks seen in January. 'The market is exploding,' said Carol Meyer, chief executive of Greenbriar Homes Communities of Fremont, which has sold 34 new East Bay houses for more than $1 million each this year. While January and February are typically slow months for house sales, during the first two months of 2004 volumes throughout the Bay Area and in Alameda and Contra Costa counties far exceeded average volumes for those months over the past decade... Lenders are also more aggressive, 'making loans to households they wouldn't have five or 10 years ago,' Marshall Prentice, president of DataQuick, said..."

U.S. Bubble Economy Watch:

March 18 - Bloomberg (Joe Miller): "General Motors Corp.'s finance unit,' which had $238.9 billion in debt at the end of 2003, plans to open a federally insured bank in Utah to take advantage of the state's favorable regulations and cut its borrowing costs. The new bank will let General Motors Acceptance Corp. raise funding by selling certificates of deposits backed by the Federal Deposit Insurance Corp. GMAC will use the funds to buy as much as $8 billion in vehicle loan and lease contracts from General Motors dealers in the bank's first three years... 'The rates they'd be paying on their CDs would be quite a bit less' than GMAC's current borrowing rates, said Robert Clarke, a former U.S. comptroller of the currency... 'Raising deposits is really the cheapest form of funding because of the insurance.' ...Utah-chartered industrial loan corporations let the parent companies take advantage of interest rates applied to national banks, without being supervised by the U.S. Federal Reserve, according to the Web site for the Utah Department of Financial Institutions."

March 17 - Dow Jones (Rebecca Christie): "Mortgage bankers are pouring money into technology capital investments, the Mortgage Bankers Association said... Technology capital budgets in the industry grew by 153% in 2003 and are expected to increase by an additional 47% in 2004, the new study said. Also, technology operating budgets in 2003 rose 24% over 2002 and are expected to increase by an additional 12% in 2004. Total 2003 technology spending came to an average of $140 million per firm, the MBA said."

March 15 - "The Mortgage Bankers Association (MBA) today increased its forecast for loan originations during 2004 to $2.5 trillion, up from $2.0 trillion. The MBA said the reason for the increase is a continued low interest rate environment that will result in a record high loan origination market for purchasing homes and a refinance market that is surprisingly strong following the record set in 2003. 'Despite the strong pace of the economic recovery, interest rates have remained low for a variety of reasons. Some borrowers are responding to these rates by purchasing homes and others are making up for missed opportunities to refinance,' said Doug Duncan, MBA's senior vice president and chief economist. 'MBA expects that mortgages for purchasing homes will make up 54 percent of total originations, or $1.4 trillion. Refinancings, which have been boosted by falling interest rates, will post $1.1 trillion in originations. These numbers are up from the $1.1 trillion and $0.7 trillion respectively previously forecast by the MBA. 'In the new forecast, refinancings will comprise 46% of originations in 2004. In comparison, refinancings in the only two years with originations higher than 2004 were 66 percent in 2003 and 62 percent in 2002."

March 16 - Realty Times: "'Las Vegas is still experiencing approximately 7,000 new residents a month and demand for homes and condos is still very strong,' says Realtor Bruce Hiatt. 'We get frequent calls from clients and prospective clients asking how much higher can home prices go. When we think we've seen a residence price point we find ourselves observing how that expensive home three months ago seems like a bargain now. We've seen major appreciation in the past 12 months and now we are seeing builder pricing velocity beyond belief.' Hiatt says, 'On February 28, one major builder in Summerlin held their grand opening and 24 hours later, their new home prices increased a gigantic $150,000!... So in Las Vegas, that 1900 sq ft single story home will now cost you $602,000 before lot premium and before upgrades!' 'We are now seeing hundreds and in some cases thousands of names on waitlists to buy a new home in Las Vegas,' he says.' 'In January of 2004 the price increases have started to accelerate, rising greater than 2 percent in most (1990 and newer) areas,' says Realtor Sean Brown. 'The under $400,000 market is experiencing a severe supply shortage. Builders' waiting lists average an easy nine months, if you can get on a list. Multiple offers is definitely the norm, and most transactions are above list price. It is not unusual to see a house sell $20,000-$60,000 above the listed price.'"

Fannie Mae's Book of Business expanded at a 7.0% rate during February to $2.218 Trillion. Fannie's Retained Portfolio declined at a 6% rate to $882 billion. Outstanding (non-retained) MBS expanded at a 16.6% rate to $1.336 Trillion. There is clearly significant ongoing mortgage Credit expansion. Instead of inflating GSE balance sheets, this Credit growth is occurring with the expansion of bank, hedge fund, and Wall Street holdings.

Tuesday, Lehman Brothers reported record first quarter Net Income of $670 million, up 123% from the year ago quarter. Principal Transaction revenue was up 132% from Q1 2003 to $1.781 billion. Investment Banking revenues were up 39%and Commissions were up 49%. Compensation expense was up 79% from the year ago period to $1.566 billion. Total Assets expanded at a 19% rate during the quarter to $327.0 billion. Total Assets expanded at a 24% rate during the past two quarters and were up 21.9% y-o-y.

Morgan Stanley Total Assets expanded by $54.1 billion, or 36% annualized, during the first quarter to end February at $656.9 billion. That was the strongest growth since the Q3 2002. Total Assets were up 17.4% y-o-y and almost 34% over two years. Morgan Stanley reported first quarter Net Income of $1.226 billion, up 35% from the first quarter of 2003 and up 21% from fourth quarter 2003. Principal Transactions Trading Revenues were up 51% from Q1 2003 to $2.347 billion. Investment Banking Revenues were up 41% to $829 million, Commissions 34% to $901 million, and Asset Management Fees 20% to $1.07 billion. Heady Wall Street expansion is indicative of a major market top.

The office of the Comptroller of the Currency recently reported fourth-quarter U.S. Commercial Bank derivative data. For the quarter, Total Derivative positions (notional value) expanded at a 24% annualized rate to $71.1 Trillion. By type of risk, Interest Rate derivatives expanded at a 25% rate to $61.9 Trillion; Currencies at a rate of 16% to $7.2 Trillion; Credit at a rate of 61% to $1.0 Trillion; and Other at a negative 6% rate to $1.0 Trillion. By Product, Swaps expanded at a 28% rate to $44.0 Trillion, Futures & Forwards at a 20% rate to $11.4 Trillion, and Options at a 12% rate to $14.6 Trillion. Total Derivative positions ballooned 57% over two years, with Interest Rate derivatives up 61% over 24 months. Over the past year, JPMorgan's positions increased 30% to $37.4 Trillion, BofA's 22% to $15.2 Trillion, and Citigroup's 26% to $12.6 Trillion. At the end of 2003, these three major derivative players accounted for 92% of the total. 

Fannie Mae is the largest buyer of derivative insurance. There is considerable controversy as to the size of derivative losses already suffered by Fannie. Some are convinced they have incurred massive derivative losses, while company management is quick to retort that losses on its hedges have been offset by offsetting changes to market values of its assets and liabilities. I will avoid this winless debate - at least while we remain in an environment of historically low interest rates.

In my analysis, the GSE systemic risk debate really boils down to two fundamental issues. First of all, there is a huge and growing Credit issue. Fannie has a sliver of equity backing its $2 Trillion-plus "book of business" exposure. Today, at the halcyon days of extreme Mortgage Finance Bubble excess, Credit losses are minimal. But this will remain the case only as long as the boom is prolonged by the continued expansion of GSE guarantees and holdings. I would caution against extrapolating past performance much into the future. Losses will be enormous come the inevitable bust. I would further argue that future losses grow exponentially at this stage of rampant excess. Credit losses will eventually kill the GSEs.

In the meantime, there is the systemic issue of interest-rate exposure. During 2003, Fannie's Total Assets expanded $122.3 billion, or 14%, to $1.01 Trillion. Yet, throughout the year, long-term borrowings increased only $5.9 billion, or 1%, to $464.5 billion. Short-term debt, on the other hand, surged $100.8 billion, or 26%, to $483.2 billion. And it is worth noting that $173.6 billion of Fannie's long-term debt matures no later than the end of 2006. So this has all the appearances of a quite tenuous (and unprecidented) asset/liability mismatch. Only derivative hedging distinguishes the GSEs from the notorious S&L-style risk profile.

From the company's recently filed 10-K, we see that Fannie's Total Derivative position surged 58% during 2003 to $1.04 Trillion. Total Swaps were up 136% y-o-y to $600 billion. "Pay-fixed" rate swaps doubled to $335 billion, while "Receive-fixed" swaps ballooned from $52 billion to $202 billion. Fannie has the unenviable task of having to try to protect itself from lower (it loses its relatively higher-yielding assets) and higher (the duration of its lower-yielding mortgages lengthens) rates.

Increasingly, Fannie has relied on the swaps market - and its swap counterparties - for protection. Counterparties, then, rely on sophisticated trading strategies which establish positions that will generate the necessary cash flow to pay on swap contracts. These "dynamic hedging" strategies are generally trend-following, where Credit instruments are purchased (by the hedgers) when prices go up (interest-rates decline) and sold/shorted when prices decline (rising rates). It is important to note that systemic risks are anything but symmetrical, as hedging-related buying (generally leveraged) creates liquidity, while selling reduces liquidity. For much too long, the markets have indulged in the environment of declining/ultra-low rates and self-reinforcing liquidity effects.

But we should not lose sight of the reality that the size of GSE balance sheets and the interest-rate swap market have mushroomed since the Fed's last rate increase in May of 2000. And, in many respects, the U.S. financial sector and derivatives industry are unrecognizable to that which existed back during the Fed's last sustained tightening cycle (1994 to early 1995). Recalling Credit market tumult back in 1994 - along with the resulting Mexican financial collapse and Orange County bankruptcy - one need not be a Cassandra to fear the consequences of the next tightening cycle. The Fed is clearly in no rush to commence the process, bring new meaning to "Behind the Curve."

The bond market experienced its first little "recovery" hiccup during March of last year. With reflation dynamics clearly taking hold, 10-year Treasury yields surged 52 basis points in just seven sessions. Understandably worried that rising market rates would stop the "reliquefication" dead in its tracks, the Fed was out quickly with assurances that rates would not be raised anytime soon. This caught many that had commenced preparation for rising yields. Rates quickly reversed, and a self-reinforcing "melt-up" incited a destabilizing bond market buyers' panic and historic refi boom during May (the Fed cut again on May 6th) and June of last year.

I would argue that interest-rate hedging and the swaps market played an instrumental role in fueling May and June's major market overshoot that saw 10-year Treasury yields sink to an incredible 3.12%. The resulting liquidity and wealth effects stoked the fledgling reflation. But as quickly (and automatically) as the dynamic-hedgers and speculators buy - inciting a self-reinforcing yield collapse - they will reflexively sell when the market reverses.  By August 15, 10-year Treasury yields had surged 144 basis points to 4.56%, as destabilizing buyers' frenzy was transformed to destabilizing seller's panic. The cost of buying interest rate protection skyrocketed, and key measures of bond market volatility (and some swap spreads) surged to levels not experienced since the collapse of LTCM. The Fed's trepidation of tightening was reinforced.

As I have highlighted previously, Fannie and Freddie responded by increasing Total Assets by an unprecedented $160.2 billion between July and September, a 46% annualized rate of growth. This massive liquidity-creating intervention stabilized the faltering interest rate markets and stoked an increasingly speculative stock market. GSE intervention played an instrumental role in buttressing and sustaining domestic reflation. The upshot was an enormous flood of dollar liquidity hankering to play non-dollar assets - from emerging market bonds to commodities.

Between September 3 and year-end, the dollar index sank from 99.40 to 87.26. The euro surged from about 107 to 126. And I would contend that dynamics for a self-reinforcing dollar crisis were in play, fostered by a reversal of speculative flows and major derivative-related selling. But, just as the GSEs are to the Great Stabilizers for the U.S. Credit market, Asian central bankers operate in like manner for global currency markets. One major intervention begets the necessity for another.

Between September and February, Japanese authorities increased their (largely dollar) foreign currency reserves by an unprecedented $220 billion. U.S. reflation went global on an unprecedented scale. From September lows, copper prices are up better than 70%, silver 50%, crude oil 45% and the CRB Commodities index almost 20%. In about three month's time, the Hong Kong Hang Seng index surged 25% and Brazilian benchmark government bond yields dropped 300 basis points.

March 19 - Dow Jones: "Japan's government is turning away from massive market intervention to support the dollar against the yen, a former top Ministry of Finance official said Friday. 'It looks to me that their strategy has changed,' Eisuke Sakakibara said... Sakakibara - known as 'Mr. Yen' for the sway he held over exchange rates during his tenure as Vice Finance Minister for International Affairs - said sustained large-scale intervention risked causing 'problems in various markets,' prompting the ministry to reconsider its staunch defense of the dollar. He pointed to the unprecedented scale of Tokyo's recent yen selling: it spent Y10 trillion (in the range of $90 billion) in the first two months of this year, an amount already almost half the record intervention total for all of 2003. 'This is unusual, highly unorthodox, massive intervention, so they've been thinking of exiting from this regime. 'It's very difficult to have a smooth exit, but they seem to be doing it at this moment.'"

Dr. Sakakibara's comments certainly ring true: "This is an unusual, highly unorthodox, massive intervention...It's very difficult to have a smooth exit..." This is as true for the Japanese authorities (and other Asian central banks) as it is for the GSEs.

We are now 18 months or so into the "Greenspan/Bernanke Reflation." For most observers, it has appeared recovery "business as usual" for the U.S. economy and financial markets. Yet it has been anything but usual. The reflation has been fueled by massive Credit creation and leveraged speculation. The most pronounced effect, predictably, has been a bout of historic asset inflation, especially for securities and real estate, and a sinking currency (and rising prices for things non-dollar!)

The problem with such dynamics is that financial and economic systems become only more dependent on Credit and speculative excess - and consequent asset inflation - over the years. Financial fragility and vulnerability become only more acute over time. There is, moreover, no possibility of growing out of the problem - no escaping the dependency, the instability, the worsening financial and economic impairment.

I have rehashed the reflation time line to underscore that, over the past eight months, we have witnessed two massive, highly unorthodox interventions - first orchestrated by the GSEs and then by the Japanese. The dimensions of these operations have been consistent with the enormous scope of underlying U.S. imbalances. It requires massive Credit, liquidity and speculative excess to sustain our maladjusted system. There will be, accordingly, no escaping the recurring necessity for greater market interventions, as authorities work desperately to stabilize the deranged system.

Importantly, the operations of these two critical "buyers of last resort" are now under increased scrutiny. Mr. Greenspan has publicly called for GSE balance sheet growth to be reined in. At the same time, the administration and Washington politicians are clamoring loudly against Asian currency "manipulation." Political season is upon us. Then there is the issue of dangerous housing Bubble dynamics becoming more conspicuous by the week. Globally, surging energy and commodities prices are increasingly problematic. There are now conspicuous risks associated with perpetuating the Great U.S. Credit Bubble, and there will be serious contemplation as to the sustainability of the current course (sustaining U.S. imbalances).

As such, I believe we have reached a decisive point in the reflationary cycle. Seemingly benign inflationary forces - that up until recently were perceived to be benefiting most - have evolved to be increasingly problematic. The illusion of "win-win" has given way to the reality that there are losers to unwieldy inflationary forces and its attendant wealth re-distribution effects.      

The ramifications of this changing landscape could prove momentous for the financial markets. There flourishes today an historic Bubble in U.S. bond and interest-rate markets, and I believe the more sophisticated players fully recognize the dynamics at play. This Bubble has been nurtured by the Fed, the GSEs, and foreign central banks. Aggressive leveraged speculators have played it for all its worth. It is also my sense that recent Japanese currencies interventions played no small part in pushing the marketplace into another bout of self-reinforcing "melt-up" (yield "melt-down") dynamics. Declining rates have forced the mortgage-backed players to hedge and those on the wrong side of hedges and speculations to unwind. Resulting lower yields have incited another wave of refis and more hedging and unwinding - Everyone Forced to the Same Side of the Boat while Leveraged.

The upshot has been an artificial decline in yields. In particular, dysfunctional market dynamics have pushed mortgage rates to destabilizing low levels. This, then, has fomented a "blow-off" period of reckless borrowing excess, over-consumption and consumer-related malinvestment. How quickly we forget the consequences of NASDAQ 1999.

So, I see today significant risk to two possible scenarios. First, if market rates are sustained at these levels - by continued rampant leveraged speculation, financial sector expansion and dollar liquidity excess - there is the clear potential for the dollar bear market to return with a vengeance. The dollar's abrupt reversal and decline this week against the yen portends dollar frailty. It has also been curious to watch commodities basically ignore the dollar's rally.

Second, U.S. interest-rate markets are unusually vulnerable to an abrupt reversal in fortunes. Rates have been pushed to artificially low levels, and a meaningful turnabout would abruptly incite major speculative liquidation/deleverging and frenetic hedging-related selling. The general backdrop is certainly conducive to the Fed re-evaluating its 1% Fed funds policy, and there is the unsolved issue of Japan's resolve to continue their massive dollar buying. The markets are not well-positioned for Pondering Changes in Monetary Policy.

What makes this potential Critical Juncture all the more significant (With A New Twist) is that The Two Great Market Stabilizers - the GSEs in the interest-rate markets and Japan's Ministry of Finance in the currency market - may not be positioned to play the instrumental role in stemming the next fledgling financial crisis. Could that be? After years of nurturing excess culminating in eight months of $100s of billions of interventions, it will prove to be "very difficult to have a smooth exit."

We'll have to follow developments diligently, but it does appear that the markets have again entered a period of heightened risk. Interest-rates at current levels - with attendant Credit and speculative excess - are a clear and present danger to the frail dollar. Higher rates might buttress the greenback, but with a real possibility of inciting deleveraging, illiquidity, and market dislocation (a hint of which was provided in July and August).

We shouldn't have become so accustomed to The Two Great Stabilizers. Is it now even possible to go about our "business" without them? And must the acclimated stock market now contemplate the potential for faltering liquidity and the end to the halcyon days of "easy money" Credit Availability for everyone, everywhere, all the time? Or, if "business as usual" prevails for the time being, is the major worry the next leg of the dollar bear and the ramifications for U.S. market rates if Asian central bankers back away from supporting the dollar? How quickly market environments can change with Global Wildcat Finance operating in these most uncertain of times.

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