UNEDITED!

Equities were successful in focusing on earnings reports and strong economic data, while looking away from the bond market. For the week, the Dow was up slightly, and the S&P500 gained less than 1%. Economically sensitive issued shined, with the Transports up 2% and the Morgan Stanley Cyclical index up 1.5%. The Morgan Stanley Consumer index gained 0.5%, and the Utilities increased slightly. The broader market enjoyed gains, as the small cap Russell 2000 index rose 1.3% (up 6% y-t-d) and the S&P400 Mid-cap index added 1.2% (up 5.5% y-t-d). The NASDAQ100 and Morgan Stanley High tech indices gained 3%. The Street.com Internet Index jumped 4%, raising y-t-d gains to 10%. The Semiconductors gained 2%, with the NASDAQ Telecom index gaining just under 2%. The Biotechs rose 2.5%, increasing 2004 gains to 12%. The financial stocks were generally unimpressive (although arguably resilient in the face higher rates), with the Broker/Dealers dipping 1% and the Banks about unchanged. With bullion down $5.40, the HUI index sank 8%.

The Treasury market was pounded again. For the week, 2-year Treasury yields surged 23 basis points to 2.22%, the highest yield since August 2002. Five-year yields jumped 19 basis points to 3.56%, and 10-year yields increased 11 basis points to 4.45%. The long-bond saw its yield rise 7 basis points to 5.24%. Benchmark Fannie Mae mortgage-backed yields rose 12 basis points, basically in line with comparable Treasuries. The spread on Fannie 4 3/8 2013 note widened 2.7 to 35.7, and the spread on Freddie's 4 ½% 2013 note widened 2.5 to 34.8. The 10-year dollar swap spread added 1 to 44.5, the widest since October. Corporate bonds enjoyed another week of strong relative performance. Investment grade spreads are at 2004 lows, while junk spreads continue to narrow meaningfully. The implied yield on 3-month December Eurodollars jumped a notable 25 basis points to 2.18%.

Bloomberg tallied a respectable $10 billion of corporate issuance this week. Investment Grade Issuers included International Finance Corp $1.0 billion, Royal Bank of Canada $750 million, Statoil $500 million, Premcore Refining $400 million, Leucadia National $300 million, Jersey Central Power & Light $300 million, International Speedway $300 million, Anheuser Busch $250 million, Laclede Group $150 million, Hibernia $100 million, and Entergy Mississippi $80 million.

Continued strong junk issuance included Charter Communications $1.5 million, Invista $675 million, Inmarsat Finance $477.5 million, Amerigas Partners $388 million, CHC Helicopter $250 million, Mueller Holdings $223 million, Curative Health $185 million, and IPCS Escrow $165 million.

Convert issuance included CNET $125 million, Mercury Computer $100 million, and Bank of America $55 million.

Foreign dollar debt issuers included Gazprom $1.2 billion, America Movil $300 million, and Korea Electric $300 million.

ABS issuance amounted to $8 billion (from JPMorgan), with y-t-d issuance of $173 billion running up 27% from comparable 2003.

Freddie Mac posted 30-year fixed mortgage rates jumped 5 basis points this week to 5.94%. Long-term fixed rates were up 54 basis points over four weeks to the highest level since the week of December 5. To puts things in perspective, it is worth noting that 30-year fixed rates are up only 9 basis points from where they began the year. For the week, 15-year fixed-rate mortgages were up 2 basis points to 5.25%. One-year adjustable-rate mortgages could be had at 3.69%, unchanged for the week and up 33 basis points in four weeks. The Mortgage Bankers Association Purchase application index rose slightly. Purchase applications were up 20% y-o-y, with dollar volume up 37%. Refi applications declined 11%. The average Purchase mortgage was for $219,700, and the average ARM was for $288,800.

Broad money supply (M3) expanded $15.2 billion. Year-to-date (15 weeks), broad money is up $240.7 billion, or 9.5% annualized. For the week, Demand & Checkable Deposits declined $10.2 billion. Savings Deposits surged $28.1 billion. Saving Deposits have increased $183.9 billion so far in 2004 (20.2% annualized rate), with a 52-week gain of $440.5 billion (15.2%). Small Denominated Deposits dipped $0.9 billion and Retail Money Fund deposits declined $2.2 billion. Institutional Money Fund deposits added $1.8 billion and Large Denominated Deposits rose $6.5 billion. Repurchase Agreements declined $11.8 billion (down $39.2 billion in two weeks), while Eurodollar deposits gained $2.5 billion.

Total Bank Credit declined $10.7 billion to $6.508 Trillion (week of April 14). Bank Credit is up $262 billion during the first 15 weeks of the year, or 14.5% annualized. For the week, Securities holdings declined $14.2 billion. Loans & Leases added $3.6 billion, with Real Estate loans up $19.8 billion. Real Estate loans are up $133.4 billion y-t-d, or 20.8% annualized. For the week, Commercial & Industrial loans added $1.6 billion and Consumer loans $0.6 billion. Security loans dropped $16.6 billion. Elsewhere, Total Commercial Paper dipped $0.8 billion to $1.321 Trillion. Financial CP declined $4.4 billion to $1.203 Trillion, while Non-financial CP increased $3.5 billion to $117.9 billion. Year-to-date, Total CP is up $52.4 billion, or 13.4% annualized.

Fed Foreign "Custody" Holdings of Treasury, Agency debt rose $5.8 billion to $1.186 Trillion. Year-to-date, Custody Holdings are up $119.4 billion, or 36.4% annualized.

Currency Watch:

April 23 - Financial Times (James Kynge): "China, the second-largest buyer of US Treasury bonds after Japan, is diversifying the portfolio of investments in its foreign currency reserves to include more European and Asian bonds amid market concerns over US dollar weakness. Guo Shuqing, administrator of the State Administration of Foreign Exchange, told the Financial Times that Beijing had recently bought more European, including Italian, government bonds and was considering making similar purchases in Asian markets."

April 22 - ECB President Jean-Claude Trichet: "I can assure you of the quality of the HICP (harmonized index of consumer prices) estimate and I have invited the consumers in the euro area to fully trust the figures which show that inflation is moderate. Households and all other economic agents can be assured that the ECB will preserve the purchasing power of the euro and that future price stability will continue to be ensured in line with our definition."

The dollar index gained better than 1% this week to close at its highest level since late November. "Commodity" currencies, such as the South African rand and New Zealand and Australia dollars, were among the weakest currencies this week (down between 2 and 3%).

Commodities Watch:

April 19 - Bloomberg (Rob Delaney): "China's prices for rice, corn, wheat and other staple grains rose 30 percent in March from a year earlier, pushing overall food prices up by 7.9 percent, the government said. China's edible oil prices rose 26 percent last month while meat prices rose 15 percent and eggs rose 19 percent, the National Bureau of Statistics said... Grain production in China has fallen four consecutive years to a 15-year low of about 431 million metric tons in 2003..."

April 23 - Bloomberg (Wing-Gar Cheng): "China may import about half its crude oil requirement annually by 2010 as local production fails to meet the country's rising demand, Xinhua state news agency said... China may burn about 320 million metric tons of crude oil by 2010, the report said, citing Zhang Zongwei, an official at the oil resources management center... China imported 36.5 percent of its crude oil last year..."

April 22 - Financial Times (Victor Mallet, David Pilling, Richard McGregor): "Japan is urging China and other east Asian nations to build up their scanty oil reserves so that the region is less vulnerable to disruptions in supplies from the Middle East, a senior Japanese energy official said yesterday. Tokyo has already floated the idea of an Asian version of the International Energy Agency - which requires its industrialised country members to keep strategic oil stockpiles - but China's rapid economic growth and growing thirst for energy imports has given Japan's campaign a new urgency... According to Japanese officials and analysts, (Japan's Minister of Trade and Industry) is eager to provide technical assistance to China because Japan's economy is particularly dependent on energy imports and would suffer from any oil supply crisis or sudden increase in the price driven by Chinese buying."

April 19 - PRNewswire: "Trucking fleets may face a budget-busting surprise in the next few weeks. High gasoline prices have received attention as we approach the summer drive season, but wholesale diesel prices are also soaring and those advances have yet to be passed down to the pump. According to Ben Brockwell, senior analyst at Oil Price Information Service, distillate demand has been phenomenal at a time when it should be waning. 'We're coming off of a winter of record consumption. Part of the problem stems from sky-high natural gas prices," Brockwell added. 'It was more economical for utilities to switch to diesel and that put a giant dent in distillate inventories.' The start of the planting season has put even more stress on supply. California and Midwest diesel inventories are at alarming levels. This month, wholesale prices at the Group 3 spot market increased 21% from $0.94/gal to $1.14/gal, and Los Angeles wholesale prices are up 50% to $1.50/gal."

Some commodities are under significant selling pressure after about nine months of spectacular gains. For the week, the CRB index dropped 2.6% and the Goldman Sachs Commodity index declined 1.8%. Recent declines have reduced year-to-date gains to 5.8% and 7.9%, respectively. Yet these gains are impressive in the face of an almost 5% y-t-d gain in the dollar index.

Asia Inflation Watch:

April 20- Bloomberg (Tian Ying): "China's economy is overheating and further measures may be needed to restrain growth, a senior government official said, raising the likelihood that interest rates may rise this year for the first time since 1995. The government will wait 'several months' to gauge the impact of cooling measures implemented so far before deciding whether additional curbs are needed... China's leaders have shied away until now from describing the economy as overheated, saying excessive expansion is limited to industries such as steel, cement and real estate."

April 21 - Bloomberg (Le-Min Lim): "China's economic growth will probably exceed the government's 7 percent forecast this year, the National Bureau of Statistics said... China's economy expanded 9.7 percent from a year earlier in the first quarter, after growing 9.9 percent in the previous three months, and the Beijing-based statistics bureau said growth will remain 'quite high' in the April-June period. The economy grew 9.1 percent last year and ING Bank NV and Goldman Sachs Group Inc. predict growth will accelerate to 9.5 percent this year."

April 23 - Bloomberg (Clare Cheung): "Residential and commercial property prices in China rose 6.7 percent in the first quarter, and investment in real estate climbed by about two-fifths, the National Bureau of Statistics said... Prices for homes, offices and other commercial property rose to an average 2,677 yuan ($323) a square meter (10.764square feet), the agency said. Investment in real estate surged 41 percent to 182 billion yuan in the period... China's total investment in real estate surged 29.7 percent to more than 1 trillion yuan last year, the fastest growth since 1995."

April 22- Bloomberg (Seyoon Kim): "South Korean exports rose 38 percent in the first 20 days of this month from the same period last year, the Ministry of Commerce, Industry and Energy said... Exports climbed to $12.3 billion...Imports rose 30 percent to $12.3 billion..."

April 23 - Bloomberg (Seyoon Kim): "South Korea's national debt rose 24 percent last year, partly because the government sold currency-stabilization bonds, the Ministry of Finance and Economy said. The debt rose 32.1 trillion won ($27.7 billion) to 165.7 trillion won... That was equal to 23 percent of gross domestic product, up from 19.5 percent in 2002, it said. The state sold currency-stabilization bonds, used to raise won for sale in the foreign-exchange market, totaling 12.8 trillion won last year, it said."

April 23 - Bloomberg (Theresa Tang): "Taiwan's export orders had their biggest gain in 3 1/2 years in March as spending picked up in China, the U.S. and Japan, boosting demand for the island's electronic goods, and a strong euro helped boost sales to Europe. Orders - indicative of shipments in one to three months - rose 28 percent from a year earlier to a record $17.2 billion, the Ministry of Economic Affairs said in Taipei. That's their biggest gain since September 2000"

April 22- Bloomberg (George Hsu): "Taiwanese companies' investment in China rose 30 percent from a year earlier in March as companies such as Asustek Computer Inc. and Quanta Computer Inc. expanded their factories in the world's sixth-largest economy."

April 20 - Bloomberg (David Yong): "Malaysia's economy will probably accelerate to 6.7 percent growth this year, helped by higher commodity prices and demand for electronics from the U.S. and China, the Malaysian Institute of Economic Research said. That's a revision from its previous forecast of 5.7 percent growth and higher than the central bank's prediction of 6.5 percent expansion...Malaysia's central bank expects the economy to grow at its fastest pace in almost four years as exports and industrial production have surged in recent months..."

April 20 - Bloomberg (Aloysius Unditu and Claire Leow): "Indonesia's economy may expand as much as 5.5 percent next year, the fastest pace in more than three years, Finance Minister Boediono said."

April 19 - Bloomberg (Cherian Thomas): "South Asia's economy will accelerate this year as improving relations between India and Pakistan boost trade and overseas companies send work to countries such as India where labor is cheaper, the World Bank said. South Asia, which includes India, Pakistan, Bangladesh, Nepal, Sri Lanka, Afghanistan, Maldives and Bhutan, will expand 7.2 percent in 2004, compared with growth of 6.5 percent in 2003, the World Bank said in Global Development Finance 2004 report."

April 23 - Bloomberg (Jason Folkmanis): "Vietnam's inflation rate reached a five-year high this month as bird flu and rice shortages caused food prices to climb. Consumer prices rose 6 percent from a year ago, according to preliminary numbers from the General Statistics Office in Hanoi. That's the biggest gain since April 1999, when Vietnam's inflation rate reached 6.6 percent."

Global Reflation Watch:

April 22 - Bloomberg (Julie Ziegler): "The world economy may expand 4.6 percent this year, the fastest in four years, providing an opportunity for nations to narrow budget deficits, raise interest rates and overhaul banking and pension systems, the International Monetary Fund said. The Washington-based lender last September had forecast 4.1 percent growth for 2004."

April 21 - Bloomberg (Christopher Wellisz): "Japan's economy will extend its recovery, expanding 3.4 percent this year and 1.9 percent next year, the International Monetary Fund said. Stronger-than-expected demand from the U.S. and other export markets might propel faster growth, the Washington-based fund said in its World Economic Outlook. Further advances in the yen, which has gained 11 percent against the dollar in a year, are 'the key downside risk.'"

April 21 - Bloomberg (Lily Nonomiya): "Japan's imports had their biggest gain since October 2000 and exports rose to their second highest on record in March, suggesting rising consumer spending and overseas orders will sustain an economic recovery. Imports gained 6.5 percent, while exports increased 1.3 percent..."

April 20 - Bloomberg (John Fraher): "New orders to Germany's construction industry rose the most in more than a decade during February as construction of residential buildings rebounded. Orders climbed 10.3 percent from January, the biggest gain since December 1992..."

April 22 - Bloomberg (Sam Fleming): "Britain' budget deficit widened to a record last month on higher government spending, adding to pressure on Chancellor of the exchequer Gordon Brown to boost tax receipts or curb expenditure to meet his borrowing targets. The public sector net cash requirement widened to 14.9 billion pounds ($26.3 billion) last month, the highest since the measure began in 1984 and from 11 billion a year ago."

April 22 - Bloomberg (Julia Kollewe): "U.K. mortgage-lending growth accelerated last month, and home-loan approvals also rose, three separate surveys showed, suggesting higher interest rates haven't cooled consumer demand for home loans. Mortgage-lending rose by 6 billion pounds ($10.6 billion) in March, compared with an average rise of 5.5 billion pounds in recent months, according to the British Bankers' Association. The Building Societies' Association reported that mortgage approvals - loans agreed but not yet made - rose to 5 billion pounds last month from 3.8 billion pounds a year earlier. Bank of England policy makers have said they're surprised by the strength of consumer spending."

April 19- Bloomberg (Duncan Hooper): "U.K. house-price inflation in March accelerated to its fastest pace in at least 10 months... Prices rose 14.4 percent last month from a year ago, the fastest pace since May, to 184,582 pounds ($330,000) after an 11.9 percent increase in February, property Web site Rightmove said.... 'The housing market is going with all guns blazing,' said Miles Shipside, commercial director of Rightmove, who predicts price growth in 2004 may be as much as 20 percent. 'The markets in London and the southeast have bounced back.' The Bank of England has raised its benchmark lending rate twice in the last six months to 4 percent, expressing concern that house price growth is 'unsustainable.'"

April 19- Bloomberg (Garfield Reynolds): "Russia's economy expanded by 8 percent in the first three months of 2004, compared with the year-ago period, Interfax reported, citing Economy Minister German Gref... Real incomes, which are adjusted for inflation, grew 13.9 percent from a year earlier, Interfax said."

April 20- Bloomberg (Tracy Withers): "New Zealanders bought more homes for a second month in March and it took less time to sell properties, suggesting an interest rate increase in January did little to slow a housing boom. House sales rose 14 percent (from February)... Central bank Governor Alan Bollard last month left the nation's benchmark interest rate unchanged at 5.25 percent after increasing it a quarter point in January. Some analysts say the housing boom, which has fueled consumer spending and fanned prices, won't slow anytime soon and may prompt Bollard to raise the benchmark rate as soon as next week."

California Bubble Watch:

April 20 - San Francisco Chronicle (Kelly Zito): "Home sales across the Bay Area vaulted 25 percent year-over-year in March and hit a 15-year high, powered by historically low interest rates and strong buyer demand... Prices in all of nine Bay Area counties soared to record highs on the wings of appreciation rates of about 15 percent, said DataQuick, a real estate research company in La Jolla... Although the frenzy could intensify in coming months as buyers rush to get into the market ahead of additional jumps in interest rates, questions remain about whether the region's housing market will remain robust during the next 12 to 18 months -- a period that could bring large-scale political and economic changes. 'If anything, the market is going to become hotter in the next couple of months,' said DataQuick researcher John Karevoll."

U.S. Bubble Economy Watch:

April 22 - American Banker (Damian Paletta): "The Federal Reserve banks in New York, Philadelphia, Cleveland, Richmond, St. Louis, Kansas City, and Dallas said commercial lending increased at banks in their regions from mid-February through early April."

April 22 - American Banker: "General Electric is jumping back into mortgage lending. The Stamford, Conn., conglomerate's consumer lending unit announced a deal Tuesday to acquire the nonprime lender WMC Finance... According to National Mortgage News, WMC was the seventh-largest subprime wholesaler last year."

March Durable Goods Orders surged 3.4%, compared to the consensus estimate of a rise of 0.7%. Orders less Transports were up 3.3%. Year-over-year, Durable Goods Orders were up 13.1%, Ex-transports up 14.2%, and Ex-Defense up 13.7%. Unfilled Orders increased to the highest level since December 2001.

U.S. Financial Sector Bubble Watch:

While there remain a large number of companies left to report, there is no doubt that first quarter earnings reports are strong. And while we will generally somewhat downplay the importance of big earnings increases, it is worth noting that composite revenues of the companies so far reporting are said to be up 12.5% from a year ago. Wow. We are currently in the hotbed of an historic "reflation," and we know precisely where to look for the source of the inflationary fuel.

JPMorgan reported Net Income of $1.93 billion, up 38% from first quarter 2003, and "the highest since the merger of Chase and J.P. Morgan." "The Investment Bank posted its highest quarterly earnings in over three years..." "Investment Management & Private Banking's earnings were the highest since the merger..., driven by 29% revenue growth and 28% growth in assets under supervision..." Total Assets jumped $30.2 billion, or 16% annualized, the strongest growth in three quarters. Debt & Equity Trading Assets jumped $20.4 billion to $189.5 billion. Consumer Loans expanded at a 3.8% annualized rate during the quarter to $528.9 billion, while Commercial Loans contracted at an 18.7% rate to $172.9 billion. Year-over-year, Consumer Loans expanded 7.1%, while Commercial Loans dropped 10.4%. Examining liabilities, "Fed fund and repos" jumped $35.0 billion during the quarter to $148.5 billion. Deposits expanded $10.4 billion, or 12% annualized.

Wells Fargo reported "record net income of $1.8 billion, up 18 percent from prior year's $1.5 billion." Net Income was up 60% from first quarter 2002. "Average loans up 31 percent from prior year." "Loan growth continued to be driven by strong demand for consumer credit, including home equity, credit card, home mortgage, revolving credit and installment loan products. On a combined basis, these consumer loans increased $57 billion, or 52 percent, from first quarter 2003, and $19 billion, or 52 percent (annualized), on a linked-quarter basis." Total Assets increased $9.6 billion, or 10% annualized, to $397.4 billion during the quarter and were up 7% y-o-y. Total Loans expanded at a 17.6% rate during the quarter. Commercial Loans declined at a 5.7% rate during the quarter to $48.0 billion and were about unchanged for the year. Real Estate 1-4 Family loans increased at a 33.7% rate and more than doubled to $90.6 billion over the past year. Home Equity loans expanded at a 40% rate during the quarter to $40.3 billion and were up 21% y-o-y. Credit Card loans were about unchanged for the quarter at $8.4 billion (up 13.6% y-o-y).

ARM lending specialist Golden West Financial enjoyed record quarterly earnings of $300 million, up 15% from first quarter 2003. "The company also reported all-time high first quarter originations of $9.4 billion." "Our loan volume in the first quarter of 2004 was 35% higher than in the same period of 2003, in large part because of the desirability of our primary product, the adjustable rate mortgage..." Interestingly, 98% of originations were adjustable-rate, and refis accounted for 72% of new loans. Average Assets expanded at a 26% rate during the quarter. Quarter-end Total Assets increased $4.1 billion (20% annualized) and were up almost 24% from one year ago (the strongest y-o-y growth since Q1 2001). Total Loans expanded at a 31% pace during March and expanded at a 24.4% rate during the quarter. On the liability side, Advances from Federal Home Loan Banks jumped a record $2.8 billion (50% annualized) to $24.8 billion and were up 31% y-o-y. Deposits increased $657 million during the quarter to $47.4 billion and were up 9% y-o-y.

Washington Mutual earned $1.05 billion during the first quarter, up 10% from the same period a year ago. Adjusted for the sale of Washington Mutual Finance, total assets expanded $9.77 billion (16% annualized) to $280.8 billion. Total Loans expanded at a 27% rate during the quarter to $186.2 billion and were up 28% y-o-y, "reflecting the company's emphasis on originating short-term ARM loans as well as growth in its home equity loans and lines of credit..." "ARM loan volume was 53% of total Mortgage Banking home loan volume, up from 27 percent in the first quarter of 2003 and continuing the upward trend from the fourth quarter of 2003." Examining the liability side of the balance sheet, Deposits expanded at a 20% rate during the quarter to $161 billion. Advances from the Federal Home Loan Bank System surged $10.2 billion to $58.5 billion.

Countrywide Financial reported Net Earnings of $691 million during the quarter, up 112% from last year's first quarter. Total loan production of $76 billion was down from the year ago quarter's $102 billion, although Purchase Fundings jumped 32% to $32 billion. Total Assets increased $2.3 billion, or 10% annualized, to $100.3 billion, with y-o-y assets up 36%. "Bank assets are now at $24 billion, and our goal is to reach approximately $35 billion by the end of the year and $120 billion by 2008."

Credit Card behemoth MBNA reported Net Income of $519.7 million, up 21% from first quarter 2003. Total Assets expanded at a 14% annualized rate to $61.1 billion, the strongest growth in three quarters. Assets were up 12% y-o-y. The company added 2.5 million additional accounts during the quarter.

Capital One reported Net Income of $450.8 million, up 46% from first quarter 2003. Total Assets expanded $2.9 billion, or 25% annualized, to $49.1 billion. Total Assets were up 25% y-o-y. Assets have increased more than 400% since the beginning of 2000.

New Century Financial reported mortgage loan originations of $8.4 billion for the quarter, up 9% sequentially and up 80% from the comparable quarter from one year ago. The company raised its estimate of 2004 originations 20% to $36 billion. Total Assets expanded at a 41% annualized rate during the quarter to $9.8 billion, with y-o-y gains of about 250%. Assets were up over 500% in two years. The company is in the process of converting to a REIT status, and then we can watch the balance sheet really balloon.

March was another slow month for Freddie Mac. The company's "book of business" - total mortgage portfolio - expanded at a 2.2% pace to $1.434 Trillion. First quarter growth was 4.9%. The Retained Portfolio contracted at a 2.7% rate during March and 5.5% rate during the quarter to $635.6 billion. The pace of mortgage purchases, however, is picking up. Retained Portfolio mortgage purchase agreements jumped to $20.6 billion from February's $11.5 billion, the strongest pace of commitments since last August.

Fannie's March was only somewhat stronger. The company's Book of Business expanded at a 5.0% rate to $2.227 Trillion. The Retained Portfolio declined at a 1.6% rate to $880.9 billion, while Outstanding MBS increased at a 9.5% rate to $1.346 Trillion. Fannie's Retained Commitments to purchase mortgages surged to $29.4 billion from February's $12.6 billion, also the highest level since August. From Fannie's "Mortgage Market Highlights: Total Residential mortgage debt outstanding grew by 12.5 percent during all of 2003, the strongest annual rate of mortgage market growth since 1986."

Fannie and Freddie to the Rescue?

During the first quarter, combined Fannie and Freddie Retained Portfolios declined $26.4 billion. Such a contraction causes little market disruption in a declining rate environment, as banks, Wall Street firms, REITS, hedge funds, and the like are more than happy to expand their holdings. Recall that from the yield peak of 4.38% during the first week of January, 10-year Treasury rates declined to a low of around 3.70% near the end of the quarter.

The market environment has since abruptly changed. Ten-year government yields ended today's trading session at 4.45%. This has been the sharpest rate rise since last summer. It should, however, be noted that the 75 basis points or so jump over the past month compares to the 130 basis point increase between June 13 and July 29 of 2003. Yet we are at this point only about four weeks into this bond move.

Last week, I contemplated the possibility for "Tightening Lite" - a Fed that would move especially timidly from recent extraordinarily accommodation, prolonging the period of extreme Credit and liquidity excess. Such a dovish posture received some confirmation yesterday from governor Bernanke. The Fed's line is clear: strong productivity gains, a vulnerable labor market, and a generally benign inflation backdrop afford the Fed the unusual flexibility to "normalize" rates over an extended period of time. This is music to the ears of leveraged players, yet it was today quickly drowned out by another deafening thud of very strong economic data.

For good reason, the bond market fears an increasingly white-hot economy that may force the Fed's hand. Certainly, the character of today's Credit and asset Bubble-induced boom is traditionally anathema to central bankers. And while the Fed may not yet appreciate this harsh reality, the bond market is beginning to.

Yesterday, Dr. Bernanke commented that the Fed has successfully conveyed their intentions: they will move but the Fed does not today feel any sense of urgency: "I think the market heard that message and I think the market is in better sync now than they were last summer." So far, interest-rate markets are adjusting relatively smoothly, in stark contrast to Summer 2003. It is worth recalling that the dollar swap spread spiked from 35 in early July to 65 by the end of the month. Measures of interest-rate risk - the implied volatilities of options on Treasury securities - surged to levels not experienced since the dark days of the LTCM crisis. It was virtual panic, as leveraged players and derivative traders rushed to unload risk. As I have explained previously, the unfolding marketplace dislocation was assuaged by an unprecedented GSE expansion, in concert with Fed promises of a protracted period of extreme accommodation.

And I don't agree with Dr. Bernanke's contention that last year was a case of the markets somehow out of sync with Fed thinking. Rather, the markets had begun to accurately discount the breadth and vigor of the unfolding reflation. At the same time, there was recognition of the inherent vulnerability of the contemporary (anomalous) "interest-rate" marketplace. The over-liquefied economy and asset markets were poised for boom at home and abroad; Credit demand was sure to be significant; and there was a strong inflationary bias throughout mortgage finance (the Mortgage Finance Bubble). And, indeed, the markets had it absolutely right last summer. The Fed, on the other hand, was the party not in sync (actually, way out of sync) with the realities of the environment.

And perhaps it was also a case of the Fed being caught completely flat-footed by the rapidity of the near interest-rate dislocation. Instead of commencing the rate "tightening" process one year ago as warranted, policy-maker fear likely played a role providing Bubble Dynamics only freer rein.

But today, months later, the Fed seems to have its "ducks in order." The Fed is signaling a quite cautious approach to raising rates, and the Credit market is listening. This time around, the Fed is determined to lead, and the marketplace if following (with some understandable unease). And while the 10-year dollar swap spread has widened moderately, there are today few indications of market stress. I see no evidence of any panic and thus far no sign of reduced Credit Availability. There is not much that points to any meaningful de-leveraging or reduced liquidity. Junk spreads are several hundred basis points narrower than a year ago, while issuance remains heavy. The typical "canaries" in the mine continue to flutter about, although what is "typical" doesn't seem all too relevant considering the environment.

In the mortgage arena, Subprime lending is booming. The marginal borrower has virtually unparalleled availability of Credit. There is, as well, a major shift to adjustable-rate mortgages. The Fed has nurtured this trend by leaving the funds rate at 1% and inducing rampant housing inflation (a steep yield curve and high prices are strong inducements for ARMs). This is a significant factor in shifting interest rate risk from the financial sector to households, tucked away to come back to haunt another day. All around, complacency abounds.

Yet, a key issue remains unresolved: In a rising rate environment, where within the financial sector comes the aggressive expansion to sustain requisite huge Credit growth. There is, after all, a Trillion dollars of new mortgage Credit coming this year. Moreover, there will surely be a significant liquidation by the leveraged community, as well as hedge-related selling from the derivative players. Recalling last year's "rescue," Fannie and Freddie combined to expand their Retained Portfolios by an unprecedented $160 billion during the three months of July through September. Are they able and willing to provide a repeat performance?

And while last year's huge balance sheet expansion was in the midst of intensifying scrutiny, the GSEs are directly under the microscope these days. Even Fed chairman Greenspan has recently testified to Congress that he believes GSE debt growth should be restrained. And OFHEO is camped out at Fannie's headquarters. Meanwhile, Freddie is trying to wind down months of piecing together a balance sheet (truly amazing). One could presume Fannie and Freddie are not well-positioned today for aggressive balance sheet expansion, but with these institutions...

A rather intriguing (and probably more in line with their corporate ethos) scenario would have the GSEs tempted (hankering?) to flex their considerable muscle. For months, they've been the shiftless punching bag for unrelenting (and deserved) shots from the Administration, some members of Congress, the regulators, and the Fed. For months, their expansion and buying in the market was not critical. But rates are now moving sharply higher. Accordingly, their purchases are being transformed to the status of "instrumental to marketplace liquidity." And, perhaps, the GSEs are desirous of a little fist-to-cuffs payback. Their opponents may find themselves suddenly and unexpectedly exposed.

And now I will completely regress to outright indecorous conjecture. But it is an election year, and the months are quickly passing. It is already nasty, and why not anticipate a totally ruthless campaign season. And we have Fannie's former revered CEO and Chairman (and old friend of Robert Rubin) heading Senator Kerry's Vice-presidential selection committee. And Fannie's Franklin Raines is a long-time Democrat that served for President Clinton. I surely would not suggest that the GSEs would act in the marketplace with political motivations, although I certainly do protest the fact that these institutions have grown to such enormous size and unparalleled financial power to have the clear capacity to influence political outcomes (including elections).

The GSEs have too much to loose to refrain from their usual "buyer of first and last resort" marketplace liquidity operations. They fully appreciate that the fragile structure of the Credit system is not conducive to an impassioned game of chicken. Yet it does makes sense to me that they would these days enjoy making a forceful point to both the Administration and to the Fed that the GSEs are indispensable players to the current economic and financial boom. As such, they would have a strong incentive to let it be known that they don't appreciate being pilloried and bullied - that it's time to back off. And while their powerful lobby has likely postponed regulatory oversight legislation until next year, they still have much to fight for. They are not the type to be caught unaware of an opponent's soft-spots.

It will be interesting to follow comments from both the Administration and Fed over the coming weeks and months. And looking at the current landscape, I think we can all appreciate better the backlash against powerful financial institutions the wreaked havoc during the Great Depression. Once Bubble dynamics take hold and powerful financial institutions evolve to the point of immense power over markets, asset prices and economic vigor - hence, the political process - the prospects of reining them prior to some type of collapse are slim-to-none.

I will include some notable dialogue from chairman Greenspan's testimony Wednesday before the Senate Joint Economic Committee:

Congressman Paul Ryan: "I think if you look at the last year over monetary and fiscal policy, I think it's a good story that can be told. Number one, when the tax cuts were announced last January the markets responded favorably. When we got more into the serious business of actually writing the legislation in the spring, the markets clearly took that as a serious note. And when they passed in July I think we saw a great recovery where we had the greatest quarter growth in 20 years. Combine that with the fact that we had very accommodative monetary policy, with expansion of the monetary base, I think what you saw last year was a great success story in economic expansion to where we are today, where consumption is growing well, where we have business capital expenditures growing at double digits, the exports growing at double digits, to the point where we are today where the foretold employment expansion to the household survey tells us a good story. And even now the employment survey has shown that we have created 500,000 jobs since January, and to the point where we now see that disinflation or deflation is off of the horizon.

My question to you, Mr. Chairman, is this: Now that we do see that essentially deflation is off the horizon, why does the Fed seem to be ignoring sensitive market signals like gold commodities and the steep upward-sloping yield curve? These signals have traditionally placed advanced warnings of excess liquidity and inflation. Shouldn't the Fed at this time be looking at normalizing the federal funds rate? After all, having an economy that is growing an average of about five percent, and a Fed funds rate at one percent seems to be an unsustainable posture over the long run - shouldn't - wouldn't it be prudent to have small adjustments now, say before gold hits 500, so that we can avoid larger adjustments in the future, such as what took place in 1994?"

Chairman Greenspan: "Congressman, I can't obviously stipulate where the Federal Open Market Committee is going to go or not go, because, one, I can guess, but I'm not sure, and in any event, if I could guess I shouldn't say what I guess. But the crucial difference between now and in the past is an extraordinary productivity acceleration. Remember that if you take the non-financial business structure of our domestic economy, you can disaggregate it in a manner to get the causes of price change. In other words, we know that two thirds of consolidated costs are unit labor costs. We know what proportion are import costs. And if you take the non-energy part of our non-financial business, we know what parts are energy costs, so that we can see the structure of costs moving."

What is different from the past is that in the past we had very little productivity gain and a very rapid response. Here what we are finding is that productivity is running in excess of compensation of employment, or has been, which means that unit labor costs are falling. To be sure, they are falling at a pace less than had been the case last year, but they are still falling. And that means that the price pressures are not anywhere near where they would be under normal circumstances. And when you look at the past, the issue of addressing a particular potential inflationary problem has got to take into consideration all of the various elements involved in that current situation. And remember that any particular monetary policy that you embark upon has risks, and you have to balance the risks against the benefits. When you have the benefit of a very significant increase in output per hour, it means that you can go in a much more measured pace than you would be required to go in the past.

And the reason why we have stayed at one percent federal funds rate over all of this period is not that we thought that inflation had gone away and that it was no longer a problem; it's that we believe that given the underlying structure of costs and prices and profitability that the emergence of inflation at a reasonably rapid pace, which would create great concern on our part, was nowhere on the horizon. And that therefore we could calibrate the structure of monetary policy in a way that we did not have to take undue risks, which invariably you do no matter what the policy is. And that essentially is what our recent history has been. Where we go from here is an issue that the Federal Open Market Committee will address in a couple of weeks and therefore."

Congressman Ron Paul: "I find it interesting that you, as (well as) the previous Chairmen of the Federal Reserve, I remember four total, they've always advocated that we in the Congress spend less, and really the advice hasn't been taken. Currently, our national debt is going up over $700 billion, and we're pursuing, once again, a policy of guns and butter, and nobody seems to have much concern. But I think the Fed participates in this as long as you control a monopoly control over money and credit, and you can accommodate the Congress. I mean, if we spend, and nobody is going to buy those Treasury Notes, we know if you want the interest rates at 1 percent, you're going to buy them. So, in a way, you're complicit in what we do here in the Congress. But I don't see that coming to an end with the monetary system that we have.

I do have a question dealing with your statement in the first paragraph about rising wealth contributing to the recovery. This last recession has been written about quite extensively as being unique. It came about not because you raised interest rates, as it is traditionally for the Fed to raise rates, we go into a recession, then there's liquidation, and debt is wiped off the books, then there's a restoring. This time, it just stopped because people ran out of steam, there wasn't enough consumer purchasing power, and we had a recession. But you very quickly, and efficiently came in and lowered interest rates very aggressively, and prevented the conventional liquidation and the corrections that have come in the previous recessions.

And Congress didn't hesitate for a minute to follow in its Keynesian path and rapidly and excessively raise spending. But, in addition to this, we have this very unusual and unique form of financing for our houses, which has caused tremendous inflation in our housing prices, through the financing of Fannie Mae and Freddie Mac, which in some ways the Fed participates, in some ways foreign central banks participate extensively in this. Anyway, we have a housing bubble, housing prices go up, and that I assume participates in this wealth, because the consumer has gone out and borrowed sometimes more than their equity. Equity prices are soaring. That to me is like saying we had great wealth when the NASDAQ was 5,000, then all of a sudden that great wealth dissipates rather quickly. So I do not see how we can say that we have true wealth without savings that's created artificially by the excitement of easy money, and easy credit, and artificially rising prices, because people go out and get into further debt. To me, it seems like the bubble leaked, and you patched it up quickly, but we're back on the same track again of very excessive spending, excessive borrowing, and we never had the liquidation. What really were you thinking about when you were talking about the rising wealth that has helped in this recovery?"

Chairman Greenspan: "The wealth, the term wealth in this context is a technical, statistical term, which is related solely to the question of the market value of net assets of households. Now, one can argue whether or not the market values that are placed on claims on physical assets are high or low, remember that all judgments of wealth essentially are discounted values of forward expected returns. And that's a people's sense of risk aversion is a critical fact in determining where stock prices are, and hence, where that wealth is. But, having said that, whatever it is does impact by all of the statistical analysis we are able to adduce on consumer expenditures. And the reason for that is that people, when they become wealthy, wealthier in paper terms, as you would put it, do have collateral to borrow and to spend, and they do. And that has, indeed, been an important factor in consumer expenditures over the last decade."

Congressman Paul: "My question is, is it real collateral, that's the question."

Chairman Greenspan: "Well, the point at issue is, it gets to the more fundamental question, if you're sitting out there with a big steel plant, and you say that is wealth, the question is, it's people's judgment as to what are the amounts of steel and the profitability that will be engendered to enable what's the value, the ongoing value of that steel plant. And people's views can change quite dramatically, even if the physical plant doesn't change one iota, even if, indeed, the amount of steel they're producing and selling doesn't change. What I'm trying to get at here is, you're raising the much broader question with respect to how are assets valued in the marketplace, and we have rational or not rational procedures by which those evaluations are made."

Congressman Paul: "I'm afraid we're confusing debt with assets. That's my contention."

Chairman Greenspan: "No, debt and assets are two wholly different things. And the Federal Reserve I would say does not make that mistake."

My comment: The Greenspan Fed specifically avoids the critical issue of true economic wealth creation. Instead, aggressive interventionist policy is focused on the blatant manipulation of financial wealth and asset prices generally. This flawed and reckless central banking has nurtured cumulative monetary disorder, irreparable price distortions, and endemic misallocation of resources. A painful adjustment period - call it financial crisis and Depression - is unavoidable specifically because of the ever-widening disparity between our perceived financial wealth and the true economic wealth creating capacity of our maladjusted Bubble economy.