For the week, the S&P500 rallied 2.2% (up 1.8% y-t-d), and the Dow gained 2.3% (up 1.8%). The S&P 400 Mid-Caps jumped 4.3% (up 8.6%), and the small cap Russell 2000 recovered 6.3% (up 11.0%). The Morgan Stanley Cyclicals jumped 4.4% (up 7.0%), and the Transports gained 4.4% (up 9.5%). The Morgan Stanley Consumer index rose 1.8% (up 3.4%), and the Utilities gained 2.4% (down 3.9%). The Banks jumped 3.1% (up 24.7%), and the Broker/Dealers increased 1.5% (down 1.8%). The Nasdaq100 increased 3.1% (up 2.5%), and the Morgan Stanley High Tech index gained 2.1% (down 2.1%). The Semiconductors rose 2.1% (down 1.7%). The InteractiveWeek Internet index jumped 4.5% (up 4.1%). The Biotechs rallied 3.7%, increasing 2010 gains to 15.3%. With bullion jumping $22, the HUI gold index surged 7.9% (up 13.4%).

One-month Treasury bill rates ended the week at 14 bps and three-month bills closed at 14 bps. Two-year government yields declined 3 bps to 0.72%. Five-year T-note yields fell 3 bps to 2.10%. Ten-year yields increased 3 bps to 3.46%. Long bond yields rose 6 bps to 4.34%. Benchmark Fannie MBS yields declined 7 bps to 4.20%. The spread between 10-year Treasury and benchmark MBS yields narrowed 10 bps to 74 bps. Agency 10-yr debt spreads declined 3 bps to 44 bps. The implied yield on December 2010 eurodollar futures declined 4 bps to 0.855%. The 10-year dollar swap spread declined 1.25 to 3.5. The 30-year swap spread increased 2.25 to negative 18.5. Corporate bond spreads were mixed. An index of investment grade bond spreads narrowed 15 to 103 bps. An index of junk bond spreads widened 27 to 516 bps.

Investment grade issuers included Enterprise Products $2.0bn, Morgan Stanley $1.75bn, Citigroup $1.5bn, CVS Caremark $1.0bn, Kinder Morgan $1.0bn, Burlington Northern $750 million, XCEL Energy $550 million, PNC Funding $500 million, Pearson Funding $350 million, Cigna $300 million, FPL Group $250 million, and San Diego G&E $250 million.

May 14 - Bloomberg (Shiyin Chen): "High-yield bond funds posted the largest outflows in five years and emerging-market equity funds had a second straight week of redemptions as Europe's sovereign- debt crisis dented demand for riskier assets, EPFR Global said."

Junk issuers included Mylan $1.25bn, MCE Finance $600 million, Omnicare $400 million, Wireco Worldgroup $275 million and Kratos $225 million.

I saw no converts issued.

International dollar debt sales included Inter-American Development Bank $1.0bn, Metinvest $500 million, Kazatomprom $500 million, and Renhe Commercial $300 million.

U.K. 10-year gilt yields declined 6 bps to 3.75%, while German bund yields rose 6 bps to 2.86%. Greek bond yields collapsed 470 bps to 7.70%, and 10-year Portuguese yields dropped 163 bps to 4.63%. The German DAX equities index rallied 6.0% (up 1.7% y-t-d). Japanese 10-year "JGB" yields rose 3 bps to 1.30%. The Nikkei 225 recovered 0.9% (down 0.8%). Emerging markets recovered some of last week's decline. For the week, Brazil's Bovespa equities index gained 0.9% (down 7.5%), and Mexico's Bolsa rose 1.0% (down 1.0%). Russia's RTS equities index gained 4.8% (down 0.6%). India's Sensex equities index gained 1.3% (down 2.7%). China's Shanghai Exchange added 0.3% (down 17.7%). Brazil's benchmark dollar bond yields dropped 17 bps to 4.83%, and Mexico's benchmark bond yields sank 43 bps to 4.78%.

Freddie Mac 30-year fixed mortgage rates dropped 7 bps last week to 4.93% (up 7bps y-o-y). Fifteen-year fixed rates fell 6 bps to 4.30% (down 22bps y-o-y). One-year ARMs declined 5 bps to 4.02% (down 69bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 15 bps to 5.63% (down 64bps y-o-y).

Federal Reserve Credit dipped $1.2bn last week to $2.310 TN. Fed Credit was up $90.3bn y-t-d (11.1% annualized) and $193.7bn, or 9.2%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 5/12) declined $11.8bn to $3.064 TN. "Custody holdings" have increased $108bn y-t-d (10.0% annualized), with a one-year rise of $380bn, or 14.2%.

M2 (narrow) "money" supply was up $34.3bn to $8.504 TN (week of 5/3). Narrow "money" has declined $8.1bn y-t-d. Over the past year, M2 grew 1.4%. For the week, Currency added $0.8bn, and Demand & Checkable Deposits surged $40.7bn. Savings Deposits declined $4.0bn, and Small Denominated Deposits fell $5.0bn. Retail Money Fund assets added $1.9bn.

Total Money Market Fund assets (from Invest Co Inst) jumped $24.2bn to $2.878 TN, the first rise since February. In the first 19 weeks of the year, money fund assets have dropped $416bn, with a one-year decline of $912bn, or 24.1%.

Total Commercial Paper outstanding added $0.9bn last week to $1.103 TN. CP has declined 67$bn, or 15.7% annualized, year-to-date, and was down $195bn from a year ago (15%).

International reserve assets (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.297 TN y-o-y, or 19.4%, to a record $7.986 TN.

Global Credit Market Watch:

May 12 - Bloomberg (Tim Catts and Pierre Paulden): "Europe's sovereign debt crisis is punishing corporate borrowers, with bond issuance tumbling as investors doubt a $1 trillion bailout plan will be enough to bolster confidence in government finances for the region. Borrowers worldwide have sold $15 billion of corporate debt this month, a 62% decline from the same period in April and 83% less than the average for the past year... The extra yield investors demand to own corporate debt instead of government bonds soared last week to the highest in more than four months... 'This is a fix and not a resolution,' said Jason Brady, a managing director at Thornburg Investment Management... 'Investors have seen volatility and that makes it harder to get excited about longer-dated assets paying a fixed return.'"

May 11 - International Herald Tribune (Andrew E. Kramer): "As the financial markets try to absorb news of a rescue package for Greece and other teetering euro-zone countries, some bankers and economists see parallels to Russia's meltdown in 1998. A decade ago Russia was walking in the same shoes as Greece is today, striving to restore confidence in government bonds by seeking a huge loan from the International Monetary Fund and other lenders. Then, as now, the debt crisis was roiling global financial markets. And big hopes were pinned on a bailout -- one that in Russia's case did not work. 'Greece creates a remarkable sense of déjà vu,' Roland Nash, the head of research for Renaissance Capital, an investment bank in Moscow, wrote..."

May 11 - Finanacial Times (David Oakley and Ralph Atkins): "Investors on Tuesday warned that the European Central Bank would have to introduce quantitative easing to stave off the worst crisis in the eurozone since it was launched 11 years ago. The ECB has resisted following the Bank of England and the US Federal Reserve in expanding the money supply by buying government bonds because it fears that it could stoke inflation. Although eurozone central banks bought eurozone government bonds this week for the first time as part of the international rescue plan, this is not QE as the ECB is funding this by selling German bunds or using commercial bank deposits."

May 11- New York Times (Landon Thomas Jr. and Jack Ewing): "Like the giant financial bailout announced by the United States in 2008, the sweeping rescue package announced by Europe eased fears of a market collapse but left a big question: will it work long term? Stung by criticism that it was slow and weak, the European Union surpassed expectations in arranging a nearly $1 trillion financial commitment for its ailing members over the weekend and paved the way for the European Central Bank to begin purchases of European debt on Monday... The premium that investors had been demanding to buy Greek bonds plunged... And as details crystallized of the package's main component -- a promise by the European Union's member states to back 440 billion euros, or $560 billion, in new loans to bail out European economies -- the wisdom of solving a debt crisis by taking on more debt was challenged by some analysts. 'Lending more money to already overborrowed governments does not solve their problems,' Carl Weinberg, chief economist of High Frequency Economics...said..."

May 12 - Bloomberg (Tim Catts and Pierre Paulden): "Europe's sovereign debt crisis is punishing corporate borrowers, with bond issuance tumbling as investors doubt a $1 trillion bailout plan will be enough to bolster confidence in government finances for the region. Borrowers worldwide have sold $15 billion of corporate debt this month, a 62% decline from the same period in April and 83% less than the average for the past year..."

May 14 - Wall Street Journal (Ianthe Jeanne Dugan): "Federal regulators and state officials are examining Wall Street's role in trading derivatives that essentially bet the municipal bonds they sold would go bust. The Securities and Exchange Commission has launched a preliminary inquiry into banks' trades of municipal credit-default swaps that allow investors to short-sell, or bet against, municipal bonds... The probe is exploring potential conflicts of interest by banks that sell municipal bonds and then poise themselves to profit if those bonds fail, these people said. A main thrust of their investigation is whether firms use their own money to bet against the bonds they sell and, if so, whether that activity is properly disclosed to bond buyers."

May 14 - Bloomberg (Christine Harper): "Goldman Sachs... is ceasing proprietary trading in one type of structured debt... A group of traders who were focused on making bets on collateralized loan obligations with the New York-based firm's own money are now handling trades for clients..."

May 12 - Bloomberg (Takahiko Hyuga and Finbarr Flynn): "Morgan Stanley Chief Executive Officer James Gorman denied allegations the U.S. bank misled investors about mortgage derivatives it sold them. The firm is being probed by U.S. prosecutors over whether the bank misled clients when it sold them collateralized debt obligations as its own traders bet that the value of the securities would drop... Wall Street firms are facing unprecedented scrutiny from lawmakers and prosecutors over whether they missold CDOs linked to the subprime mortgages that caused the credit crisis."

Global Government Finance Bubble Watch:

May 12 - Bloomberg (Abigail Moses and John Glover): "The cost of saving the world from financial meltdown has been bloated by 'hyperinflation' since Long Term Capital Management LP's rescue in 1998... rising price of bailouts since the $3.5 billion pledged to hedge fund LTCM after it was crushed by Russia's default, and the almost $1 trillion committed to halt the European Union's sovereign debt crisis this week. It cost just $29 billion to sooth markets in March 2008 when Bear Stearns Cos. was taken over, and $700 billion for the Federal Reserve to save the banking system with the Troubled Asset Relief Program in October that year. 'We haven't had any kind of normal inflation in the last decade, but we've had hyperinflation in writedowns and the magnitude of bailouts,' said Jim Reid, head of fundamental strategy at Deutsche Bank... 'You have to do more to get a similar effect every time.'"

May 12 - Bloomberg (David Mildenberg and Dawn Kopecki): "Four of the largest U.S. banks, including Citigroup Inc., racked up perfect quarters in their trading businesses between January and March, underscoring how government support and less competition is fueling Wall Street's revival. Bank of America Corp., JPMorgan Chase & Co. and Goldman Sachs Group Inc., the first, second and fifth-biggest U.S. banks by assets, all said in regulatory filings that they had zero days of trading losses in the first quarter... 'The trading profits of the Street is just another way of measuring the subsidy the Fed is giving to the banks,' said Christopher Whalen, managing director... Institutional Risk Analytics. 'It's a transfer from savers to banks.'

Currency Watch:

The dollar index jumped 2.1% this week to 86.249 (up 10.8% y-t-d). For the week on the upside, the South Korean won increased 2.2%, the Mexican peso 2.1%, the Brazilian real 2.0%, the South African rand 1.3%, the Canadian dollar 1.1%, and the Singapore dollar 0.6%. For the week on the downside, the euro declined 3.1%, the Danish krone 3.0%, the Swiss franc 2.2%, the British pound 1.8%, the Swedish krona 1.35, the New Zealand dollar 1.1%, the Japanese yen 0.9%, the Norwegian krone 0.3%, and the Australian dollar 0.2%.

Commodities Watch:

May 12 - Bloomberg (Stuart Wallace): "There has been a 'significant' surge in sales of gold coins and bars, particularly in Germany, Ross Norman, one of the founders of TheBullionDesk.com, said... 'The last time we saw this level of grass-roots activity was in October 2008 when the economy was on the brink and the retail gold buying community effectively drained gold from the market," the former bullion dealer said in the report."

May 10 - Financial Times (Jack Farchy): "Silk ties and handkerchiefs are forecast to rise in price after the cost of silk jumped to its highest level in at least 15 years as rapid industrialisation in China, the world's largest supplier, robs the sector of valuable farmland. The price of silk cocoons... has doubled since the start of 2009..."

The CRB index declined another 1.1% (down 8.8% y-t-d). The Goldman Sachs Commodities Index (GSCI) slipped 0.4% (down 4.4% y-t-d). Spot Gold jumped 1.8% to $1,230 (up 12.1% y-t-d). Silver surged 4.6% to $19.30 (up 14.6% y-t-d). June Crude sank $3.18 to $71.93 (down 9.4% y-t-d). June Gasoline 0.6% (up 4% y-t-d), and June Natural Gas jumped 7.7% (down 22% y-t-d). July Copper declined 0.8% (down 7% y-t-d). May Wheat sank 7.3% (down 14% y-t-d), and May Corn declined 2.2% (down 14% y-t-d).

China Bubble Watch:

May 11 - Wall Street Journal Asia: "The direction of China's economy is set. The question troubling investors is whether policy makers have set their course, too. With consumer-price inflation rising to 2.8% in April, real interest rates have moved farther into negative territory... More inflation is in the pipeline. The producer-price index rose 6.8% year-to-year in April, up from 5.9% in March. Higher manufacturing costs should eventually feed through to consumers. The latest housing-market data adds to fears of overheating, with prices up 12.8% year-to-year across 70 of China's larger cities. New bank lending was up, too, with $113.3 billion more loans pumped into the economy in April -- back to around the average monthly level during 2009's credit bonanza. Against this backdrop, Beijing's tightening measures to date are inadequate."

May 13 - Bloomberg (Peter Woodifield): "China is set to overtake Japan as the largest Asia-Pacific commercial real estate market next year following a surge in values, according to property adviser DTZ Holdings Plc."

India Watch:

May 13 - Bloomberg (Unni Krishnan): "India's food inflation rate climbed... An index measuring wholesale prices of agriculture products... rose 16.44% in the week ended May 1 from a year earlier..."

May 12 - Bloomberg (Kartik Goyal): "India's industrial production grew more than 10% for a sixth straight month, adding to inflation pressures even as Europe's debt crisis threatens to undermine the global economic recovery.

Asia Bubble Watch:

May 12 - Bloomberg (David Yong): "Asian interest-rate swaps show traders are betting central banks will be less aggressive in raising borrowing costs because of the European Union's sovereign-debt crisis. 'The euro crisis has hurt market confidence and liquidity,' Matthew Huang, an interest-rate strategist... at Barclays Capital Plc, said... 'If liquidity freezes up, Asian policy makers will likely choose to leave monetary conditions looser for longer.'"

May 10 - Wall Street Journal Asia (Alex Frangos): "The European bailout plan could be too much medicine for an overheating Asia. Before the Greece crisis intensified last week, policy makers in China and elsewhere in Asia said too much growth and an abundance of capital inflows were pushing real-estate and other asset prices dangerously high. While Asian markets welcomed the 750 billion euro ($955 billion) bailout plan, economists and analysts warned that the rescue package could end up bringing even more capital to Asian markets... Loose monetary policy in Europe and the U.S. has already helped to inflate assets prices in Asia, especially for emerging-market bonds and real estate."

May 12 - Bloomberg (Eunkyung Seo): "South Korea's unemployment rate declined in April for a third straight month... The jobless rate fell to 3.7% from 3.8% in March... 'Jobs market conditions are improving on the economic recovery,' Lee Sang Jae, an economist at Hyundai Securities... said... 'But there remains some weakness, supporting policy makers' views that the economy isn't strong enough to endure higher borrowing costs.'"

May 13 - Bloomberg (Shamim Adam and Manirajan Ramasamy): "Malaysia's economy grew at the fastest pace in at least 10 years last quarter... Gross domestic product increased 10.1% in the three months ended March 31 from a year earlier..."

Latin America Bubble Watch:

May 12 - Bloomberg (Jens Erik Gould): "Mexico's industrial production rose the most in almost four years in March on surging demand for exports to the U.S. Output climbed 7.6% from a year earlier..."

May 12 - Bloomberg (Fabiola Moura and Drew Benson): "Argentine Economy Minister Amado Boudou said last week's jump in bond yields may prompt the government to shelve plans to sell as much as $1 billion of bonds, its first international offer since defaulting in 2001."

Unbalanced Global Economy Watch:

May 10 - Bloomberg (Bob Willis and Thomas R. Keene): "The fallout from the European debt crisis raises the risk of a 'double dip' recession for the global economy, said Stephen Roach, chairman of Morgan Stanley Asia Ltd. 'When you have a vulnerable post-crisis economic recovery and crises reverberating in the aftermath of that, you have some very serious risks to the global business cycle,' Roach said... 'This concept of the global double dip which no one wants to talk about... is alive and well.'"

May 12 - Bloomberg (Svenja O'Donnell): "U.K. unemployment climbed to a 16- year high in the first quarter, underlining the fragility of the recovery as Conservative David Cameron begins his premiership."

May 12 - Bloomberg (Simone Meier): "Europe's economy expanded at a faster pace than economists forecast in the first quarter as a global recovery boosted exports... Gross domestic product in the 16 euro nations rose 0.2% from the fourth quarter..."

May 12 - Bloomberg (Christian Vits): "Germany's economy unexpectedly grew in the first three months of the year as rising exports and company investment outweighed the effects of the cold winter. Gross domestic product... rose 0.2%..."

May 12 - Bloomberg (Maria Levitov): "Russia faces a 'massive' capital influx as investors look for alternatives to Europe's crisis- ridden debt markets, said Mikhail Dmitriev, president of the Center for Strategic Development. That's putting pressure on Russian policy makers to implement capital controls soon to stem the flows and avoid ruble volatility, Dmitriev, whose think tank conducts research for the government, said in an interview... 'The government is unarmed against the distortions that may result from massive capital inflows,' said Dmitriev, who is also a former First Deputy Economy Minister. 'Russia's balance of payments and internal macroeconomic stability would undoubtedly be at risk.'"

May 14 - Bloomberg (Paul Abelsky): "Russia's economy expanded for the first time since 2008... Gross domestic product rose an annual 2.9% in the first quarter after contracting 3.8% in the last three months of 2009..."

May 13 - Bloomberg (Jacob Greber): "Australia's job growth accelerated in April, propelled by full-time employment... The unemployment rate held at 5.4%."

May 13 - Bloomberg (Tracy Withers): "New Zealand's manufacturing industry expanded at the fastest pace in more than five years in April amid rising production and orders."

U.S. Bubble Economy Watch:

May 12 - Bloomberg (Shobhana Chandra): "The trade deficit in the U.S. widened in March to the highest level in more than a year as imports climbed faster than exports, adding to evidence of the global recovery from the worst recession in the post-World War II era. The gap grew 2.5% to $40.4 billion..."

May 13 - Bloomberg (Ryan J. Donmoyer): "White House budget director Peter Orszag predicted Congress would approve higher taxes on managers of private equity firms, real estate funds and other investment partnerships in the coming weeks. Orszag, speaking yesterday..."

May 10 - Bloomberg (Terrence Dopp): "New Jersey's Democratic lawmakers plan to introduce legislation to resurrect an income-tax surcharge on residents who earn $1 million a year or more..."

Derivatives Watch:

May 11 - Bloomberg (Phil Mattingly): "The Federal Deposit Insurance Corp. advanced a proposal aimed at overhauling part of the $4 trillion asset-backed securities market and introduced a rule that would require the biggest U.S. banks to submit 'funeral plans' to handle their possible collapse... 'Now is the time to put some prudent controls in place to make sure we don't get into some of the problems we saw in the past,' Bair said...

Real Estate Watch:

May 13 - Bloomberg Dan Levy): "U.S. home repossessions rose to a record level in April while foreclosure filings dropped in a sign mortgage lenders are working off a backlog of seized properties, according to RealtyTrac... 'Right now it appears that the banks are focusing on processing the loans already in foreclosure, and slowing down the initiation of new foreclosure proceedings as a way of managing inventory levels,' Rick Sharga, RealtyTrac's executive vice president, said... A record 92,432 bank repossessions were reported in April, up 45% from a year earlier..."

Central Bank Watch:

May 13 - DPA: "The European Central Bank (ECB) on Thursday defended its decision to intervene in European bond markets, rejecting claims that this threatened the bank's independence. 'These measures are designed not to affect the monetary policy stance,' the ECB wrote in its monthly report of its decision to buy debt from troubled eurozone members. ECB chief economist Juergen Stark said this was a 'temporary emergency measure,' to which there was no alternative after the euro currency had come under attack. Stark said the bank was not responding to political pressures... 'The credibility of the ECB does not just hinge on the question whether or not we buy government securities, but whether we fulfill our central task, which is ensuring price stability,' Stark said. The economist said there was no doubt that 'an attack' on individual eurozone countries was being carried out by "anonymous market sources.'"

May 10 - Bloomberg (Mayumi Otsuma): "Central banks from the U.S., Japan and Europe will participate in temporary U.S. dollar swap agreements amid heightened tension in global financial markets, the Bank of Japan said. 'In response to the re-emergence of strains in U.S. dollar short-term funding markets in Europe' the central banks of Canada, England and Switzerland will also participate in the re- establishment of currency swaps that were implemented during the financial crisis, the BOJ said... 'These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers.' Central banks 'will continue to work together closely as needed to address pressures in funding markets' the BOJ said."

May 10 - Bloomberg (Saburo Funabiki): "The Bank of Japan said it would pump 2 trillion yen ($21.7bn) into the financial system for a second day to help reassure markets after the Greek fiscal crisis set off a slump in stocks worldwide."

GSE Watch:

May 10 - Bloomberg (Nick Timiraos): "Fannie Mae asked the U.S. government for an additional $8.4 billion in aid after posting an $11.5 billion net loss for the first quarter, the latest sign that the bailout of the mortgage investor and its main rival, Freddie Mac, is likely to be the most expensive legacy of the U.S. housing-market bust... The company has now racked up losses of nearly $145 billion, or nearly double its profits for the previous 35 years."

Fiscal Watch:

May 13 - Bloomberg (Vincent Del Giudice): "The U.S. posted its largest April budget deficit on record as receipts declined in a month that typically sees an increase in individual income tax payments. The excess of spending over revenue rose to $82.7 billion last month compared with a $20.9 billion gap in April 2009... April marked a record 19th straight monthly shortfall... Deterioration in the government's balance sheet in coming years raises the risk of higher interest rates even as an improving economy helps lift tax receipts. 'With the recovery in place, we should be seeing higher revenue and lower outlays, not the other way around,' said Win Thin, senior currency strategist at Brown Brothers Harriman... The government's April budget deficit compares with a median forecast of $57.9 billion... The last time the U.S. had back-to-back April deficits was 1963-1964... For the fiscal year that began in October, the budget deficit totaled $799.7 billion compared with $802.3 billion during the same period last year."

May 12 - Associated Press: "President Obama's new health-care law could potentially add at least $115 billion more to government health care spending over the next 10 years, if Congress approves all the additional spending called for in the legislation, congressional budget referees said... That would push the 10-year cost of the overhaul above $1 trillion..."

California Watch:

May 11 - Bloomberg (Michael B. Marois and William Selway): "California Governor Arnold Schwarzenegger will seek 'terrible cuts' to eliminate an $18.6 billion budget deficit facing the most-populous U.S. state through June 2011... California's revenue in April, when income-tax payments are due, trailed the governor's estimates by $3.6 billion, or 26%."

May 14 - Bloomberg (Michael B. Marois and William Selway): "California Governor Arnold Schwarzenegger proposed a new round of budget cuts, including eliminating the state's main welfare program for families, to close a $19.1 billion budget deficit for the year starting July 1. The $83.4 billion plan calls for $12.4 billion in spending reductions, $3.4 billion in additional federal aid and $3.4 billion in fund shifts, fees and assessments..."

Speculator Watch:

May 14 - Bloomberg (Jody Shenn and Michael J. Moore): "In June 2006, a year before the subprime mortgage market collapsed, Morgan Stanley created a cluster of investments doomed to fail even if default rates stayed low -- then bet against its concoction. Known as the Baldwin deals, the $167 million of synthetic collateralized debt obligations had an unusual feature... Rather than curtailing their bets on mortgage bonds as the underlying home loans paid down, the CDOs kept wagering as if the risk hadn't changed. That left Baldwin investors facing losses on a modest rise in U.S. housing foreclosures, while Morgan Stanley was positioned to gain. 'I can't imagine anybody would take that bet knowingly,' said Thomas Adams, a former executive at bond insurers Ambac Financial Group Inc. and FGIC Corp... 'You're overriding the natural process of risk-mitigation.'"

May 12 - Bloomberg (Tomoko Yamazaki and Komaki Ito): "Japanese hedge funds, the world's worst performers last year, returned 6.7% in the first four months of 2010, the best year-to-April return in six years, according to Eurekahedge Pte."

Dysfunctional Markets

It scrolled by quickly Wednesday afternoon on my Bloomberg screen: a one-line headline quoting ECB Executive Board member Jose Manuel Gonzalez-Paramo: "Central Banks Can't Work if Markets Dysfunctional." My efforts to located Mr. Gonzalez-Paramo's complete comments on the issue were unsuccessful; we'll have to assume the context. I do believe strongly that many things these days can't work because global markets are hopelessly dysfunctional.

I was never a big fan of the simplistic analytical fixation on the so-called "shadow banking system." Key components of this "system" - i.e. the Wall Street securities firms, ABS, CDOs, SIVs, private-label MBS, etc. - have been reined in. This would imply a more stable financial backdrop, which is nowhere to been seen. I am similarly not a subscriber to a "new normal" thesis. Again, the focus seems to detract from today's key issues. I have posited a "Newest Abnormal" thesis - that the long process of market distortions and economic imbalances has actually accelerated. Things go from bad to only worse. Things may look somewhat different, but there's nothing new.

From my analytical perspective, the heart of the problem lies with this dysfunctional dynamic between global marketable debt and derivatives markets, policy-induced distortions, and unfettered speculative finance. Unique in history, we continue to operate with a global financial "system" functioning without limits to either the quantity or quality of new Credit created. There's way too much Credit backed by little more than government assurances or perceptions of government insurance. And never before has an enormous global "leveraged speculating community" so dominated the markets for debt instruments and, in the process, so relied on faith in the efficacy of government market interventions. It's global wildcat banking in its purest ever form.

These days, entities all over the world issue enormous quantities of tradable debt instruments. This debt, in large part, is purchased by sophisticated market operators earning unimaginable compensation for achieving "above market" returns. When market psychology is bullish, there is essentially unlimited demand for marketable debt - a significant portion acquired through the use of leverage. And as long as demand for new marketable securities remains robust, underlying positive fundamentals appear to support a high market valuation for this debt (irrespective of the quantity issued). But Katy bar the door whenever the crowd moves to cut exposure - either through liquidating positions or acquiring market "insurance."

Eurozone policymakers look foolish these days for not having reined in profligate Greek borrowing and spending. To many, the ECB looks foolish for Sunday's decision to purchase in the open market debt issued by Greece, Portugal, Spain and other troubled European countries. Others believe the ECB was foolish for not having had initiated a Federal Reserve-style monetization plan before the debt crisis spiraled out of control. I sympathize with the ECB. Dysfunctional global markets placed them in a winless situation. Greek 10-year bond yields were below 5% for much of 2009. The market was happy to accommodate profligacy - until it wasn't. If only well-functioning global markets disciplined borrowers rather than emboldening them.

The sea change in global finance gained unstoppable momentum in the early nineties. The Greenspan Federal Reserve nurtured marketable debt as a mechanism to help overcome severe banking system impairment. There was no stopping the historic boom in market-based Credit once unleashed. The problem was clear by the time of the 1994 bond and mortgage securities dislocation. But it was politically and monetarily expedient to allow GSE Credit (with its implicit government guarantee) to evolve into a mechanism for stabilizing the Credit system and spurring economic expansion.

The rapidly escalating scope of the problem was illuminated with the collapse of LTCM. Yet, the Greenspan Fed supported this new financial infrastructure with only more powerful words and deeds. Pegging short term interest rates and aggressively intervening to rectify market tumult incited unprecedented leveraged speculation throughout the Credit system. Dr. Bernanke's 2002 "helicopter money" and "government printing press" speeches sealed the fate of runaway Bubbles in both marketable debt and leveraged speculation.

Especially during the Bubble years 2004 through 2007, massive U.S. current account deficits worked to unleash U.S. Credit Bubble dynamics upon the entire world. The more Bubbles became ingrained in the financial architecture the deeper market perceptions became that policymakers wouldn't tolerate a bust. Worse yet, policymakers resorted to using the debt markets and the market's propensity for leveraged speculation as mechanisms for increasingly aggressive monetary reflation.

Global policymakers and Credit markets have been fueling Bubbles and accommodating profligacy for years now. It would have taken a concerted effort by global central bankers to rein things in. The Greenspan/Bernanke Federal Reserve would have had no part of it. Quite the contrary. It was fundamental to Greenspan/Bernanke doctrine to deal with market and economic fragility through the aggressive reflation of system Credit. This doctrine of inflationism was instrumental in nurturing Credit and speculation excesses that worked over time to increasingly distort the pricing of finance, the quantity of Credit created, and the allocation of real and financial resources. The ECB's big mistake was not to forcefully fight the Fed.

We're now two years into the greatest expansion of global government debt in the history of mankind. Manic-depressive debt markets have pulled the rug out from under Greece and periphery Europe, but in the process have further accommodated profligate government borrowings here at home. It is frightening to think of how distorted the Treasury market has become - and how things might play out down the road.

My bearish thesis on our markets and economy is based upon the view that the financial fuel for our recovery has been unsound, unstable and unsustainable. This "Monetary Process" is now in jeopardy. The Global Government Finance Bubble, which lunged into its terminal phase of excess with the collapse of the Wall Street/mortgage finance Bubble, has been pierced. Greece's debt crisis marks a momentous inflection point. And, yes, some government markets - certainly including Treasuries - are benefiting from Greek and periphery European debt woes. Yet key Bubble dynamics percolate under the surface.

I have argued that the Global Government Finance Bubble has been the biggest and most precarious Bubble yet. The incredible scope of global sovereign debt expansion over the past couple years has been rather obvious. Less apparent are related distortions - to the pricing and allocation of finance throughout international markets - based specifically upon the market perception that politicians and central bankers would act aggressively and successfully to forestall future crises. This policy-induced market distortion fostered an incredible bout of risk-taking - especially considering the fundamental backdrop - and a resulting massive flood of finance out to the risk markets. This perception has been blown to smithereens in Europe and has quickly become vulnerable everywhere.

Global markets in sovereign Credit default swap (CDS) protection have flourished on the assumption that policymakers would thwart any debt crisis. In the post-Greek debacle era, writing insurance against a government default is no longer free money. New realities have profoundly changed the risk and reward profiles of operating in this key market - and I'll assume some profoundly less attractive marketplace liquidity dynamics going forward. And a faltering market for sovereign debt insurance significantly changes the risk profile of owning the underlying sovereign debt. To be sure, changing perceptions in the market for government debt work to corrode market confidence in the capacity of policymakers to stem financial and economic crises generally. This implies a major adjustment in the markets' perception of risk in various markets, including corporate, municipal and mortgage instruments.

But I'm getting somewhat ahead of myself. Thus far, dislocation in Greek debt has fed powerful contagion effects throughout European debt and CDS. This has forced a major market reassessment of the relative stability of the euro currency, which has unleashed bloody havoc throughout the currency and "carry trade" arena. Currency and "carry trade" tumult has forced market reassessment as to near-term prospects for both the dollar (upward) and global growth (downward). This has caused trading liquidation and de-leveraging havoc in the enormous global "reflation trade" and in risk markets more generally. And there's nothing like liquidation and forced de-leveraging to really bring out the animal spirits for those seeking to make nice speculative profits from others' misfortune.

The dollar and Treasuries have benefited. This has supported the bullish view that this is largely a European issue. It has also helped dampen the impact to our markets from changing global perceptions with respect to the capacity of policymakers to stem crises. Here in the U.S., Credit spreads and risk premiums (corporates, MBS, municipals, etc.) have widened some. Yet faith still runs deep that Washington won't allow a crisis. This confidence must hold for sufficiently loose U.S. finance to continue to support our fragile recovery.

The confluence of global financial crisis and intense financial sector scrutiny here at home will at some point prove confidence in Washington overly optimistic. For now, when it comes to pricing risk and disciplining profligate borrowers, our debt markets remain dysfunctional.