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Global Reflation Update

For the week, the S&P500 rallied 0.9% (down 3.6% y-t-d), and the Dow gained 0.9% (down 3.2% y-t-d). The broader market was notably stronger. The S&P 400 Mid-Caps rallied 2.7% (down 1.5%), and the small cap Russell 2000 jumped 3.0% (down 2.3%). The Banks slipped 0.2% (up 4.6%), while the Broker/Dealers rose 1.3% (down 3.0%). The Morgan Stanley Cyclicals recovered 2.5% (down 4.2%), and the Transports jumped 2.5% (down 4.4%). The Morgan Stanley Consumer index increased 1.6% (down 2.3%), while the Utilities declined 1.3% (down 8.2%). The Nasdaq100 gained 1.9% (down 4.4%), and the Morgan Stanley High Tech index increased 1.8% (down 5.0%). The Semiconductors jumped 4.0% (down 7.5%). The InteractiveWeek Internet index gained 1.8% (down 4.6%). The Biotechs slipped 0.2% (up 4.6%). With Bullion up $27, the HUI gold index gained 3.2% (down 6.6%).

One-month Treasury bill rates ended the week at 4 bps, and three-month bills closed at 9 bps. Two-year government yields rose 5 bps to 0.74%. Five-year T-note yields jumped 10 bps to 2.25%. Ten-year yields rose 13 bps to 3.70%. Long bond yields rose 13 bps to 4.65%. Benchmark Fannie MBS yields increased 4 bps to 4.34%. The spread between 10-year Treasury and benchmark MBS yields narrowed 9 to 64 bps. Agency 10-yr debt spreads narrowed 2 to 38 bps. The implied yield on December 2010 eurodollar futures increased 5.5 bps to 0.965%. The 10-year dollar swap spread was little changed at 9.75, and the 30-year swap spread was little changed at negative 14.0. Corporate bond spreads were mixed. An index of investment grade bond spreads narrowed 2 to 99 bps, while an index of junk spreads widened 22 to 516 bps.

Investment grade issuers included Life Technologies $1.5bn, Sunoco Logistics $500 million, and GTP Powers $250 million.

The list of junk issuers included GMAC $2.0bn, McJunkin Red Man $1.05bn, Freescale Semiconductor $750 million, Severstal Columbus $525 million, Tops Markets $350 million, Stallion Oilfields $225 million, and NFR Energy $200 million.

Convert issues included Annaly Capital $500 million.

International dollar debt issuers included Sable International Inter-American Development Bank $1.5bn, $500 million, and Dar Al-Arkan $450 million.

U.K. 10-year gilt yields jumped 16 bps to 4.04%, and German bund yields gained 7 bps to 3.19%. Bond yields in Greece sank 47 bps to 6.14%. The German DAX equities index increased 1.2% (down 7.7% y-t-d). Japanese 10-year "JGB" yields declined 4 bps to 1.33%. The Nikkei 225 dropped 2.5% (down 4.3%). Emerging markets were mixed. For the week, Brazil's Bovespa equities index rallied 4.9% (down 4.0%), and Mexico's Bolsa increased 1.2% (down 3.5%). Russia's RTS equities index dipped 0.6% (down 5.4%). India's Sensex equities index jumped 2.3% (down 7.5%). China's Shanghai Exchange rose 2.7% (down 7.9%). Brazil's benchmark dollar bond yields dropped 14 bps to 5.21%, and Mexico's benchmark bond yields declined 7 bps to 5.11%.

Freddie Mac 30-year fixed mortgage rates declined 4 bps to 4.97% (down 19bps y-o-y). Fifteen-year fixed rates fell 6 bps to 4.34% (down 47 bps y-o-y). One-year ARMs jumped 9 bps to 4.33% (down 61bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 2 bps to 5.92% (down 98bps y-o-y).

Federal Reserve Credit increased $1.8bn last week to $2.233 TN. Fed Credit was up $402.8bn, or 22%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 2/10) jumped $9.3bn to $2.956 TN. "Custody holdings" expanded $395bn, or 15.4%, over the past year.

M2 (narrow) "money" supply increased $7.0bn to $8.471TN (week of 2/1). Narrow "money" expanded 1.8% over the past 52 weeks. For the week, Currency added $1.1bn, and Demand & Checkable Deposits rose $14.0bn. Savings Deposits increased $1.5bn, while Small Denominated Deposits declined $3.5bn. Retail Money Funds fell $6.1bn.

Total Money Market Fund assets (from Invest Co Inst) declined $6.7bn to $3.198 TN. Over the past year, money fund assets dropped $705bn, or 18.1%.

Total Commercial Paper outstanding increased $11.0bn last week to $1.134 TN. CP dropped $420bn over the past year (27%).

International reserve assets (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.099 TN y-o-y, or 16.4%, to $7.820 TN.

Global Credit Market Watch:

February 11- Bloomberg: "China's lending surged to 1.39 trillion yuan ($203 billion) in January and property prices climbed the most in 21 months as banks extended more credit in anticipation the government will tighten monetary policy. Lending was more than in the previous three months combined... Property prices in 70 cities rose 9.5% from a year earlier... China's 9.35 trillion yuan of loans in the past year has added to the risk that the world's fastest-growing major economy may overheat..."

February 10 - Bloomberg (Achmad Sukarsono): "Billionaire investor George Soros, who made $1 billion in 1992 correctly betting against the British pound, said he expects Greece will be able to remain in the euro region. 'I'm actually confident Greece will do whatever is necessary to meet conditions to remain a member of the euro to qualify for financing by the ECB for Greek government bonds," Soros told reporters..."

February 9 - Bloomberg (Caroline Salas and Pierre Paulden): "Investors in the lowest rated corporate bonds are looking past concern that worsening government finances will derail the economy, paying prices that imply the fastest drop in defaults in more than a decade. The amount of so-called distressed securities, or bonds yielding at least 10 percentage points above benchmark rates, fell to $117 billion from $250 billion six months ago, according to Bank of America Merrill Lynch index data. The market is pricing in a default rate of 0.3% in a year, down from 10.2% in December, JPMorgan Chase & Co. says."

Global Government Finance Bubble Watch:

February 11 - Bloomberg: "China's central bank signaled a 'gradual' exit from monetary stimulus as the recovery in the world's third-largest economy gains momentum. The People's Bank of China will 'gradually guide monetary conditions back to normal levels from the counter-crisis mode,' it said in a quarterly monetary policy report... The central bank repeated a call for global coordination of stimulus exits. 'Before major developed economies fully exit their abnormal policies, global liquidity may remain ample and keep pushing up asset prices... But once major developed economies start to exit, global capital flows may reverse and global asset prices, especially asset prices in emerging markets, may see volatilities.'"

February 11 - Bloomberg (Jody Shenn): "Fannie Mae and Freddie Mac's plan to step up purchases of delinquent loans may boost prepayments on their securities... Freddie Mac said yesterday that it would buy 'substantially all' loans with payments late by 120 days or more from its securities in the next month. Fannie Mae said later that it will 'increase significantly' its buyouts, setting a less aggressive timeline. The value of Freddie Mac's delinquent loans is $70 billion, while Fannie Mae has $130 billion of the debt... 'This is going to be a wad of cash coming into the fixed- income markets and it's not immediately clear where it's going to be reinvested,' said Jim Vogel, head of agency-debt research at FTN Financia..."

February 10 - Bloomberg (Scott Hamilton): "Bank of England Governor Mervyn King said it's 'far too soon' to say whether officials have halted their bond-purchase program and the central bank forecast inflation will undershoot its target over the next two years... 'It is far too soon to conclude that no more purchases will be needed,' King told reporters... 'The Committee will keep its options open, and further purchases will be made if they prove necessary to keep inflation on track to meet the target in the medium term.'"

February 9 - Bloomberg (Gabi Thesing): "The European Central Bank may be forced to delay the withdrawal of emergency lending measures because it could inflame financial-market concerns about Greece, Spain and Portugal, economists said."

February 11 - Bloomberg (Camilla Hall): "Saudi Arabia has spent about half of its $400 billion five-year economic development plan and may finish the program ahead of schedule, Finance Minister Ibrahim al-Assaf said... 'We'll see the expenditure accelerating' this year, al- Assaf said... 'I think we'll be ahead of the timetable.' The kingdom, the world's largest oil exporter, announced the spending program in 2008 to bolster the economy."

February 8 - Bloomberg (Ambereen Choudhury): "Global investment banking revenue climbed 12% to $66.3 billion in 2009... according to a report from International Financial Services London."

February 8 - Bloomberg (Scott Reyburn): "Russian collectors and a U.K-based diamond dealer emerged as big buyers in this month's record-breaking London art auctions. They battled for trophies by 20th- century artists... pushing up prices and the sales' total to double last year."

Currency Watch:

The dollar index dipped 0.3% this week to 80.22 (up 3.0% y-t-d). For the week on the upside, the Swedish krona increased 2.8%, the Australian dollar 2.2%, the Canadian dollar 2.0%, the South Korean won 1.6%, the Mexican peso 1.6%, the Norwegian krone 1.4%, the Brazilian real 1.3%, the South African rand 1.2%, and the New Zealand dollar 1.2% For the week on the downside, the Japanese yen declined 0.8%, the Euro 0.3%, and the Swiss franc 0.3%.

Commodities Watch:

February 10 - Bloomberg: "China, the world's second-largest energy consumer, set a January record for crude oil imports as a recovering economy bolstered demand for fuels. Shipments reached 17.1 million metric tons last month...33% more than the year- earlier month."

February 12 - Bloomberg: "China's five largest steelmakers proposed to one of the world's top three suppliers that they pay a provisional 40% more for contract iron ore than a year ago, UBS AG said..."

February 9 - Bloomberg (Christian Schmollinger and Kyoungwha Kim): "China Investment Corp., the nation's sovereign wealth fund, invested for the first time in the U.S. Oil Fund, an exchange-traded crude-futures fund, joining Morgan Stanley & Co. and Goldman Sachs Group among the top holders."

The CRB index rallied 3.6% (down 5.5% y-t-d). The Goldman Sachs Commodities Index (GSCI) jumped 4.2% (down 5.5% y-t-d). Gold gained 2.5% to $1,093 (down 0.4% y-t-d). Silver recovered 4.2% to $15.447 (down 8.3% y-t-d). March Crude gained $2.94 to $74.13 (down 6.6% y-t-d). March Gasoline increased 2.3% (down 6.0% y-t-d), while March Natural Gas dipped 0.9% (down 1.9% y-t-d). May Copper surged 8.0% (down 7.3% y-t-d). March Wheat gained 2.8% (down 10.2% y-t-d), and March Corn rallied 2.8% (down 12.8% y-t-d).

China Bubble Watch:

February 10 - Bloomberg: "China's imports climbed for a third straight month in January... Imports climbed a record 85.5% from a year before, a jump that was influenced by a shift in the lunar new year holiday to February this year... Exports rose 21%..."

February 9 - Bloomberg: "China's passenger-car sales more than doubled in January after the government extended economic stimulus measures... Sales of cars, multipurpose vehicles and sport-utility vehicles increased to 1.32 million units... Total vehicles sales, which include buses and trucks, more than doubled to a record 1.66 million units."

February 12 - Bloomberg: "China's January electricity consumption jumped 40.1% from a year earlier as an economic recovery in the world's second-biggest power producer spurred demand from factories. Power use reached 353.1 billion kilowatt-hours last month, 2.7% higher than in December..."

February 10 - Bloomberg: "China, under international pressure to reduce its trade surplus, may choose to shrink it through raising workers' wages rather than letting the yuan appreciate, Credit Suisse Group AG said. Higher labor costs would cut Chinese export competitiveness while boosting domestic spending power and sustaining economic growth..."

February 7 - Financial Times (Tom Mitchell and Geoff Dyer): "A decision by the province that is China's second-biggest exporter to raise minimum wage rates has heightened expectations that other provinces and cities will soon follow... Eastern Jiangsu province, which exports more than Brazil and South Africa combined, raised its monthly minimum wage rate 13% to Rmb960 ($140) last week... The potential round of minimum wage increases comes amid signs that inflationary pressures are picking up in the Chinese economy after a rapid recovery in the second half of 2009... 'This could be a red flag about wage inflation," says Arthur Kroeber, editor of China Economic Quarterly. 'Inflation in China is becoming systemic because of rising wages caused by a tighter labour market.'"

Japan Watch:

February 10 - Bloomberg (Keiko Ujikane and Tatsuo Ito): "Japanese machinery orders rose the most in nine years from a record low... Domestic orders... climbed 20.1% in December from a month earlier..."

India Watch:

February 12 - Bloomberg (Kartik Goyal): "India's industrial production rose in December at the fastest pace in 16 years, strengthening the case for Finance Minister Pranab Mukherjee to withdraw stimulus. Output at factories, utilities and mines jumped 16.8% from a year earlier after gaining 11.8% in November..."

February 9 - Bloomberg (Vipin V. Nair and Tushar Dhara): "India's passenger car sales gained in January to a record as economic growth and cheaper loan rates helped boost demand. Local sales rose 32% from a year earlier to 145,905 units..."

Asia Bubble Watch:

February 8 - Bloomberg (Chinmei Sung): "Taiwan's exports climbed in January by the most in more than 30 years as holiday spending in China before the Lunar New Year fueled demand for the island's computers and mobile phones. Shipments abroad increased 75.8% from a year earlier..."

February 10 - Bloomberg (Seyoon Kim and Cesilia Han): "South Korea's central bank may keep the benchmark interest rate at a record low as the government presses policy makers to stoke the economy before elections."

February 10 - Bloomberg (Aloysius Unditu and Novrida Manurung): "Indonesia's economy grew at the fastest pace in a year last quarter... Southeast Asia's largest economy expanded 5.4% in the three months to Dec. 31 from a year earlier..."

February 10 - Bloomberg (Shamim Adam and Michael J. Munoz): "Malaysia's industrial production climbed the most in 22 months in December... Production at factories, utilities and mines rose 8.9% from a year earlier..."

February 10 - Bloomberg (Karl Lester M. Yap and Max Estayo): "Philippine exports rose at the fastest pace in almost four years in December... Shipments abroad increased 23.6% from a year earlier..."

Latin America Bubble Watch:

February 10 - Bloomberg (Carla Simoes and Iuri Dantas): "Brazil may invest up to 20 billion reais ($11bn) to revive state-owned telephone company Telecomunicacoes Brasileiras SA and increase competition by offering broadband services for half the price charged by local carriers, an official said."

Unbalanced Global Economy Watch:

February 8 - Bloomberg (Greg Quinn): "Canadian housing starts rose to a 15-month high in January, exceeding economists' forecasts..."

February 9 - Bloomberg (Christian Vits): "German exports unexpectedly jumped in December, notching their fourth successive monthly gain... Sales abroad... increased 3% from November..."

U.S. Bubble Economy Watch:

February 10 - Bloomberg (Daniel Taub): "More than a fifth of U.S. homeowners owed more than their properties were worth in the fourth quarter... according to Zillow.com. In the fourth quarter, 21.4% of owners of mortgaged homes were underwater, up from 21% in the previous three months..."

Central Bank Watch:

February 11- Bloomberg (Craig Torres and Christopher Condon): "The Federal Reserve is in talks with money-market mutual funds on agreements to help drain as much as $1 trillion from the financial system as policy makers prepare for the first interest-rate increase since June 2006, according to a person familiar with the discussions. The central bank is looking to the $3.2 trillion money- market mutual-fund industry because the 18 so-called primary dealers that trade directly with the Fed have a capacity limited to about $100 billion, estimates Joseph Abate, a money-market strategist at Barclays Capital..."

February 9 - Bloomberg (Jacob Greber): "Efforts by policy makers to halt future asset bubbles and credit booms forming may be futile if borrowing costs are kept too low for too long, according to Australia's central bank Governor Glenn Stevens. 'If the root problem is simply that interest rates are too low, experience suggests that efforts to handle the problem by regulation aimed at constraining balance-sheet growth won't work for long,' Stevens wrote..."

February 8 - Bloomberg (Paul Abelsky and Maria Levitov): "Russia's central bank views credit risks and the possibility of an equity market bubble as the main threats to the economy, the central bank's head of bank regulation and supervision said."

Real Estate Watch:

February 8 - Bloomberg (Jody Shenn): "U.S. prime jumbo mortgages at least 60 days late backing securities reached 9.6% in January from 9.2% in December, the 32nd straight increase for 'serious delinquencies,' according to Fitch Ratings... The rate almost tripled in 2009, Fitch said."

February 8 - Wall Street Journal (James R. Hagerty): "Like millions of American households, the Mortgage Bankers Association found itself stuck with real estate whose market value has plunged far below the amount it owed its lenders... On Friday, CoStar Inc., a provider of commercial real estate data, said it had agreed to buy the MBA's 10-story headquarters building in Washington, D.C., for $41.3 million. That is well below the $79 million the trade group agreed to pay for the glass-walled building in 2007..."

Muni Watch:

February 12 - Bloomberg (Jeremy R. Cooke): "State and local government bond sales climbed by almost 30% to about $6.1 billion this week, led by an expanded Hawaii offering that matched a record low for 10-year Build America borrowing costs."

California Watch:

February 10 - Associated Press (Judy Lin): "The state controller's office found that California taxpayers are on the hook for more state government retiree health benefits than previously thought. Controller John Chiang's office issued a report... showing the growing divide between what the state owes retirees for health and dental benefits and what it has saved so far. The gap has grown to nearly $52 billion, about $3.6 billion over last year's estimate."

Crude Liquidity Watch:

February 9 - Bloomberg (Fiona MacDonald): "Kuwait plans to boost spending by more than 34% in the fiscal year starting April 1 and is projecting a deficit of 6.46 billion dinars ($22.4 billion)..."


Global Reflation Update

China's bank loans expanded $202bn - in January. This must be the greatest month of loan growth for a national banking system in the history of mankind. On the back of about $1.3 TN of loan expansion, Chinese home prices were up 9.5% y-o-y. January crude imports were up 33% y-o-y, while copper imports were up 25% y-o-y. January power consumption was up 40% from a year earlier (against a weak comparison). With GDP and real estate prices expanding at around double-digit rates, one would typically expect policymakers to be preparing to slam on the brakes. These are atypical times.

The People's Bank of China raised bank reserve requirements 50bps today, the second such hike in the past month. This heightened market fears that Chinese authorities are determined to implement real monetary tightening. For an economy experiencing unprecedented "hot money" inflows, bank lending, and "animal spirits", count me skeptical that marginal changes in reserve requirements will be all that effective in reining in systemic excesses.

Two-year bank deposit rates remain at about 2%, while lending rates are significantly below the rate of real estate inflation. Indeed, I suspect that the Chinese are at this point intent on tightening reserve requirements in lieu of the large rate increases justified by the degree of current overheating. With the world these days awash in cheap liquidity, higher Chinese interest rates would likely only exacerbate both inbound financial flows and general Monetary Disorder. Raising capital requirements must be about the easiest decision for Chinese monetary authorities.

Yesterday from Bloomberg: "The People's Bank of China will 'gradually guide monetary conditions back to normal levels from the counter-crisis mode,' it said in a quarterly monetary policy report... The central bank repeated a call for global coordination of stimulus exits. 'Before major developed economies fully exit their abnormal policies, global liquidity may remain ample and keep pushing up asset prices... But once major developed economies start to exit, global capital flows may reverse and global asset prices, especially asset prices in emerging markets, may see volatilities.'"

If Chinese policymakers are waiting for the "developed economies" to exit their extremely loose monetary stance, it could prove a rather expanded wait. The Bernanke Fed appears determined to exit over a period of years. And in light of the Greek debt crisis and other fiscally troubled EU countries (Spain, Portugal, Ireland...), it is unlikely that the ECB will move to meaningfully tighten financial conditions for some time to come. In short, global policymakers have no stomach whatsoever for crisis.

The basic premise of my Global Government Finance Bubble thesis is that policymakers everywhere will err on the side of extreme fiscal and monetary stimulus - that global monetary conditions will remain extraordinarily loose. Policymakers see enormous risks in global Credit systems and economies - and little in the way of inflation risk. The structurally maladjusted U.S. economy ensures ongoing massive federal deficits, loose monetary policy, huge current account deficits - and a structurally unsound dollar. Serious financial and economic issues at the "Core" (U.S.) have unleashed Credit systems at the "Periphery" (i.e. China, Brazil, India, Asia, and the "emerging markets"). There is no global monetary anchor, and it's inflationism as far as the eye can see.

Ultra-loose monetary policies notwithstanding, are Chinese "tightening" and European debt problems in the process of derailing global reflation? Does the dollar rally and unwind of the so-called "dollar carry trade" point to reemerging deleveraging and global deflationary forces? Global Credit systems and economies remain extraordinarily vulnerable, no doubt about that. And highly speculative global risk markets were overdue for some painful retrenchment. But are we witnessing a fundamental shift in the preference for global finance to flow back to the "Core" and away from the "Periphery?" Such a dynamic that would imply acute vulnerability to "Periphery" Credit systems and economies - and put global reflation in jeopardy.

I struggle with the issue of the "dollar carry trade." Clearly, there were huge leveraged bets - short dollars and long myriad "undollars" - going into 2008. The global financial crisis incited a dramatic dollar short squeeze, along with associated massive deleveraging both throughout global markets and within the "leveraged speculator community." Granted, global policymakers somewhat bailed out the leveraged players with their aggressive systemic stabilization measures (the EU must these days be wondering if saving the hedge funds was such a good idea). Did the speculators rush right back out and implement aggressive leveraged strategies?

It's fair to say that dollar sentiment turned quite negative toward the end of 2009 - and that animal spirits were running quite high in the "undollar" markets - i.e. emerging debt and equities, gold, energy, commodities, and foreign currencies. There were, no doubt, huge second-half flows into "undollar" markets. Yet it is unclear as to what extent borrowing/leverage was behind these flows. It is thus not clear to me to how susceptible the global system is today to a 2008-style, self-reinforcing dollar rally and deleveraging.

Sure, greed can abruptly turn to fear throughout the global currency and risk markets. It is not necessarily an extraordinary development when speculative flows reverse and mete out pain to market participants. But it would be a major issue if this reversal fomented the unwind of market borrowings and reduced marketplace liquidity. After all, deleveraging and illiquidity are at the heart of market contagion effects and systemic crisis. The analysis of deleveraging and marketplace liquidity is today as challenging as it is critical.

Brazilian 10-year (dollar-denominated) government yields were down 14 bps this week to 5.21%. Bonds yields in both Brazil and Mexico (5.11%) have thus far been little affected by European debt tumult, the dollar rally, or general risk aversion. Recall that their yields approached 7% last March. Actually, emerging debt markets in general have remained notably resilient. The JPMorgan EMBI index (emerging bonds spread to Treasuries) narrowed 18bps this week to 319, down from last March's high of 734. I would expect emerging debt markets to be under pressure if the global system were in the midst of deleveraging.

The "commodities currencies" were crushed during the 2008 deleveraging. So far in 2010, the Canadian and Australian dollars have been notably resilient. They have given back little of their big 2009 gains. Thus far, the "commodities" and "emerging" currencies have not traded as if global deleveraging was in the offing. And while commodities prices have been under pressure, this follows spectacular gains posted in 2009.

The U.S. Credit system has also been resilient. While junk spreads have widened somewhat over the past couple weeks, they remain near 15-month lows and significantly below crisis levels. Investment grade spreads ended the week at about 100bps, down from a crisis high of 280 bps. GSE MBS spreads narrowed to 66 bps yesterday, the low since 1992. Corporate and municipal debt issuance has been strong.

While attention this week was fixated on Europe and China, there were important domestic developments supportive of global reflation. At $40.2bn, December's Trade Deficit was much worse-than-expected and the largest in a year. And then Wednesday Freddie Mac announced that it intends to purchase tens of billions of delinquent loans from its guaranteed MBS trusts. Fannie plans to do the same, an operation that will significantly expand the companies' already bloated balance sheets.

February 12 - Bloomberg (Jody Shenn): "Traders are driving relative yields on Fannie Mae and Freddie Mac mortgage bonds that most influence the interest rates consumers pay to the lowest in 17 years, speculating cash the companies use to buy delinquent loans will be recycled back into the securities... Investors turned to the securities after the government-supported companies said they would buy about $200 billion of loans out of their mortgage bonds... The shift will leave investors with cash to reinvest as the Federal Reserve's purchases of $1.25 trillion of home-loan debt ends next month. 'It'll be a cushion for the end of the Fed program,' said David Cannon, global co-head of asset- and mortgage-backed securities at RBS Securities..."

Also this week, chairman Bernanke released his prepared statement (appearance postponed due to weather) before the House Committee on Financial Services, "Federal Reserve Exit Strategy." A more thorough analysis will have to wait for another day. But I will say there is nothing in his prepared remarks that changes my view that the Bernanke Fed is prepared to err on the side of maintaining excessive system liquidity and ultra-low interest rates. The market already knows as much. And, in the near-term, this supports the markets' view that U.S. policymakers enjoy extraordinary flexibility to continue to bolster Credit and economic recovery (and underpin U.S. securities and asset markets). At the same time, I would posit that this policy course in the intermediate and longer-term remains dollar bearish and global reflation bullish.

Last week I posed the question: "Is the recent pullback in global risk markets the beginning of the end for global reflation or the pause that refreshes?" A definitive answer is impossible today. Volatile markets in the context of a quite fragile global financial backdrop imply unusually high risk. At the same time, I see few indicators that suggest deleveraging and receding global liquidity. Many suggest liquidity over-abundance. And, until proven otherwise, I'll assume the Fed and ECB are hamstrung.

Global reflation is not without serious challenges. While some type of short-term resolution to the Greek debt crisis is in the offing, the European debt issue will not be resolved anytime soon. The speed at which the marketplace reassessed Greek creditworthiness should sound alarms for profligate governments around the world. But when it comes to global reflation, the big question mark would appear to be China.

I have written my view that China has commenced its "terminal phase" of Credit Bubble excess. There is ample evidence supporting this analysis. Chinese policymakers have begun to respond, and jittery global markets are worried. The risks - domestic and global - of a bursting Chinese Bubble are enormous. Yet when ("terminal") Bubble risks turn quite high, policymakers tend to turn more timid. I expect this to be the case in China - but I could be wrong. And there is certainly the possibility that even gingerly policy "tightening" could set in motion unintended consequences including faltering asset markets and bursting Bubbles.

But my analytical framework forces me to give the historic Chinese Bubble the benefit of the doubt. First of all, authorities are sitting on an incredible war chest of $2.4 TN of reserves. This hoard today provides virtually unlimited capacity to recapitalize its vulnerable banking system. This hoard also provides unusual protection against a run on the Chinese currency. Never, it seems, has a Credit system enjoyed such flexibility to run so hot for so long. At this point, I have to believe that the policy objective is not to rein in excess as much as it is to slow bank lending to what is believed to be a more sustainable $1.1 TN annual pace. And another year of Trillion-plus Chinese Credit growth would be expected to sustain global reflation dynamics.


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