For yet another volatile week, the S&P500 ended little changed (down 1.2% y-t-d), while the Dow added 0.4% (up 0.4%). The Banks gained 1.5% (up 13.9%), and the Broker/Dealers jumped 1.9% (down 7.2%). The Morgan Stanley Cyclicals declined 0.8% (up 3.4%), while the Transports rose 1.2% (up 7.9%). The Morgan Stanley Consumer index slipped 0.3% (up 0.9%), while the Utilities fell 0.6% (down 2.4%). The S&P 400 Mid-Caps dipped 0.4% (up 4.6%), and the small cap Russell 2000 ended the week unchanged (up 4.1%). The Nasdaq100 declined 0.6% (up 0.2%), and the Morgan Stanley High Tech index fell 1.4% (down 3.9%). The Semiconductors dropped 4.3% (down 3.1%). The InteractiveWeek Internet index fell 1.4% (up 4.1%). The Biotechs gained 0.7%, increasing 2010 gains to 12.5%. With bullion $, the HUI gold index fell 2.0% (up 3.0%).

One-month Treasury bill rates ended the week at 14 bps and three-month bills closed at 14 bps. Two-year government yields fell 5 bps to 0.52%. Five-year T-note yields sank 17 bps to 1.52%. Ten-year yields fell 9 bps to 2.91%. Long bond yields dipped 2 bps to 3.99%. Benchmark Fannie MBS yields dropped 18 bps to 3.47%. The spread between 10-year Treasury yields and benchmark MBS yields narrowed 9 bps to 56 bps. Agency 10-yr debt spreads narrowed 6 bps to 18 bps. The implied yield on December 2010 eurodollar futures fell 8.5 bps to 0.435%. The 10-year dollar swap spread declined 2.5 to negative 1.0. The 30-year swap spread declined 3 to negative 27.5. Corporate bond spreads narrowed. An index of investment grade spreads narrowed 2 to 104 bps.

Debt issuance was brisk. Investment grade issuers included AT&T $2.25bn, Crown Castle Towers $1.55bn, Alcoa $1.0bn, McDonald's $750 million, Commonwealth Edison $500 million, Safeway $500 million, Union Pacific $500 million, and Kimberly-Clark $250 million.

Junk issuers included Ford Motor Credit $1.25bn, Texas Industries $650 million, AMD $500 million, Range Resources $500 million, Inventive Health $275 million, and Tenneco $225 million.

Converts issuers included Gilead Sciences $2.2bn.

International dollar debt sales included Canadian Imperial Bank $4.25bn, UBS $2.5bn, Turkey $2.0bn, Brazil $1.5bn, Air Canada $1.1bn, Chile $1.0bn, Westpac Banking $3.0bn, Offshore Group $1.0bn, Noble Group $750 million, Berau Capital Resources $450 million, Viterra $400 million, Aircastle $300 million, Banco BMG $250 million and Barbados $200 million.

U.K. 10-year gilt yields dropped 11 bps to 3.32%, and German bund yields declined 4 bps to 2.67%. Greek 10-year bond yields fell 12 bps to 10.28%, and 10-year Portuguese yields sank 35 bps to 5.18%. The German DAX equities index slipped 0.3% (up 3.2% y-t-d). Japanese 10-year "JGB" yields were little changed at 1.06%. The Nikkei 225 gained 1.1% (down 9.6%). Emerging markets were mixed to higher. For the week, Brazil's Bovespa equities index rose 1.8% (down 1.6%), while Mexico's Bolsa declined 1.5% (up 3.7%). Russia's RTS equities index increased 2.3% (up 2.7%). India's Sensex equities index fell 1.4% (up 2.3%). China's Shanghai Exchange rallied another 2.5% (down 19.5%). Brazil's benchmark dollar bond yields declined 4 bps to 4.25%, and Mexico's benchmark bond yields sank 11 bps to 4.19%.

Freddie Mac 30-year fixed mortgage rates declined 2 bps last week to 4.54% (down 71bps y-o-y). Fifteen-year fixed rates fell 3 bps to 4.00% (down 69bps y-o-y). One-year ARMs dropped 6 bps to 3.64% (down 116bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up one basis point to 5.45% (down 91bps y-o-y).

Federal Reserve Credit declined $3.4bn last week to $2.312 TN. Fed Credit was up $92.4bn y-t-d (7.2% annualized) and $302bn, or 15.0%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 7/28) jumped another $13.9bn (6-wk gain of $65.9bn) to a record $3.146 TN. "Custody holdings" have increased $190bn y-t-d (11.2% annualized), with a one-year rise of $353bn, or 12.6%.

M2 (narrow) "money" supply expanded $11.9bn to $8.614 TN (week of 7/19). Narrow "money" has increased $103bn y-t-d, or 2.2% annualized. Over the past year, M2 grew 2.1%. For the week, Currency added $1.3bn, while Demand & Checkable Deposits slipped $0.2bn. Savings Deposits increased $13.6bn, while Small Denominated Deposits declined $3.9bn. Retail Money Fund assets increased $1.0bn.

Total Money Market Fund assets (from Invest Co Inst) increased $3.6bn to $2.802 TN. In the first 30 weeks of the year, money fund assets fell $492bn, with a one-year decline of $832bn, or 22.9%.

Total Commercial Paper outstanding increased $1.5bn to $1.101 TN. CP has declined $69bn, or 10.2% annualized, year-to-date, while it was up $36bn from a year ago.

International reserve assets (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.421 TN y-o-y, or 20.2%, to a record $8.445 TN.

Global Credit Market Watch:

July 26 - Bloomberg (Andrew MacAskill): "European Union stress tests found banks need to raise 3.5 billion euros ($4.5 billion) of capital, about a tenth of the lowest analyst estimate, leaving doubts about whether regulators were tough enough. 'The stress tests are a helpful step forward in a number of areas,' Huw van Steenis, head of European banks research at Morgan Stanley... said... 'But they are not going to be the game changer that we were really hoping and in some cases are a missed opportunity.'"

July 30 - Wall Street Journal (Mark Gongloff, Chris Dieterich and Alex Frangos): "The global corporate-bond boom is gathering steam as companies rush to take advantage of some of the lowest borrowing costs in history. Companies from global giants McDonald's Corp. and Kimberly-Clark Corp. to Indonesian telecommunications company PT Indosat Tbk are rushing to sell debt. This month has been the busiest July on record for sales by U.S. companies with junk-credit ratings. Asia's debt market is on pace for a record year, and European companies are also raising money apace."

July 30 - Bloomberg (Sapna Maheshwari and Tim Catts): "U.S. corporate bond sales soared 31% this month, the busiest July on record... Issuance of $85.7 billion exceeded the previous high for the month of $71.1 billion set last year... Global issuance of $223.9 billion this month trails June's total of $226.3 billion..."

July 30 - Bloomberg (Jason Webb): "Emerging-market bonds are heading for their biggest monthly rally since September, cutting yields to a record low, as accelerating economic growth and Argentina's debt restructuring spur confidence. Developing nation bonds rallied 4.3% in July, reducing the average yield to 5.89%..."

July 28 - Bloomberg (Yalman Onaran): "Banks worldwide applauded changes to proposed capital and liquidity standards that relaxed aspects of the rules and gave lenders as much as eight years to comply. Lobbying groups in Europe and the U.S. praised the changes announced July 26 by the Basel Committee on Banking Supervision as steps in the right direction, while firms including Deutsche Bank AG and UBS AG welcomed the softening of rules proposed by the committee in December. European and Japanese bank stocks surged. 'To a large extent, the committee has taken into account the concerns of the industry,' said Charles Dallara, managing director of the... Institute of International Finance... 'It's too early to reach a firm conclusion because they still haven't finalized many issues, but the announcement included a series of important clarifications.'"

July 28 - Bloomberg (Bradley Keoun): "Citigroup Inc. may move a team of proprietary traders into its hedge-fund unit, one of at least three alternatives the U.S. bank is studying to comply with the Dodd-Frank Act... The bank would set up the traders as hedge-fund managers and seed their funds, then raise money from outside investors to redeem its stakes, the people said. 'This may be a way of keeping a high-margin capital- markets business in the fold, within the language of the law,' said David Hendler, a senior analyst at... CreditSights Inc. 'They would be transforming it from an- interest-plus-capital-gain business into a fee business.'"

July 27 - Bloomberg (Patricia Kuo): "Leveraged loans prices climbed to the highest in nine weeks as investors shifted money out of equity into debt. The average bid price for actively-traded European leveraged loans rose 45 bps to 94.3%... Fixed-income funds had $122.9 billion of inflows this year while $4.2 billion of assets left stock funds, according to U.S. research firm EPFR Global."

July 28 - Bloomberg (Alex Kowalski and Tom Keene): "Economist David Rosenberg and investor Marc Faber have wagered a bottle of scotch whisky on whether U.S. 10-year Treasury yields can go lower than 2%. Rosenberg, chief economist at Gluskin Sheff & Associates Inc., predicted yields on the 10-year note will drop to less than 2%. Faber, the publisher of the Gloom, Boom & Doom report, said he doesn't believe they'll fall to less than December 2008's low of 2.08%."

Global Government Finance Bubble Watch:

July 30 - Bloomberg (Michael McDonald and Esme E. Deprez): "New York City will sell $470 million of Build America Bonds next week with the amount of the federally subsidized securities issued on pace to total $165 billion by year-end, when the program is set to expire... Build America Bonds became the fastest-growing part of the $2.8 trillion municipal bond market after they were created last year in President Barack Obama's economic-stimulus package. More than $124 billion of the securities have been sold so far... The federal government pays 35% of the interest cost of Build Americas, saving states and cities money on public works projects... The subsidy helps issuers offer higher yields on the taxables than on tax-exempt debt, making them attractive to international investors and others who aren't seeking tax shelters."

Currency Watch:

July 26 - Bloomberg (Yasuhiko Seki and Hiroko Komiya): "The yen may climb next month as tighter regulations force Japanese households controlling about $76 billion in daily exchange trading to unwind bets on higher-yielding currencies, analysts said. The government will cap debt used to boost trading bets, or leverage, at 50 times committed cash from August 2010, down to 25 times in 2011... 'If margin traders decide to discontinue highly leveraged transactions, it will put upward pressure on the yen as those positions are unwound,' said Yuji Kameoka, senior economist... at Daiwa Institute of Research..."

July 26 - Bloomberg (Matthew Brown): "The combination of growing confidence in Europe's economy and mounting evidence of a slowdown in the U.S. is driving euro bears into hiding... Goldman Sachs Group Inc. and Wells Fargo & Co. raised their estimates in the past two weeks, joining HSBC Holdings Plc and Deutsche Bank AG in predicting a stronger euro."

July 26 - Bloomberg (Frances Yoon): "The dollar will fall against the yuan, euro and yen as China sells excess U.S. currency so that its reserves reflect trade flows, Faros Trading LLC said... 'The net effect of China rebalancing its reserves in a slow and deliberate manner will result in a lower U.S. dollar,' said Douglas Borthwick... managing director and head of trading at Faros. 'We believe the foreign-exchange markets are at the beginning of a significant shift.'"

July 26 - Bloomberg (Daniel Kruger and Rebecca Christie): "For all the criticism of record budget deficits, President Barack Obama can take comfort knowing that for the first time in half a century, government bond yields are declining during an economic expansion and Treasury Secretary Timothy F. Geithner is selling two-year notes with the lowest interest rates ever. The combination of record-low yields on two-year notes, 10- year rates below 3% and a deficit projected to surpass $1.4 trillion for a second consecutive year is a signal that the bond market is less concerned with government spending than with getting the economy back on track."

The dollar index fell 1.1% to 81.546 (up 4.7% y-t-d). For the week on the upside, the South African rand increased 1.9%, the British pound 1.7%, the Norwegian krone 1.6%, the South Korean won 1.4%, the Swedish krona 1.4%, the Swiss franc 1.3%, the Japanese yen 1.1%, the euro 1.1%, the Danish krone 1.1%, the Brazilian real 1.0%, the Australian dollar 1.0%, the Singapore dollar 0.7%, the Mexican peso 0.7% and the Canadian dollar 0.7%. For the week on the downside, the New Zealand dollar declined 0.2%.

Commodities Watch:

The CRB index jumped 2.9% (down 3.2% y-t-d). The Goldman Sachs Commodities Index (GSCI) gained 1.8% (unchanged y-t-d). Spot Gold was down 0.7% to $1,180 (up 7.6% y-t-d). Silver declined 0.5% to $18.005 (up % y-t-d). September Crude slipped 19 cents to $78.79 (down 1% y-t-d). September Gasoline added 0.2% (up 3% y-t-d), and September Natural Gas jumped 7.6% (down 12% y-t-d). September Copper jumped 3.9% (down 1% y-t-d). September Wheat surged 10.9% (up 22% y-t-d), and September Corn jumped 5.8% (down 5% y-t-d).

China Watch:

July 30 - Bloomberg (Shamim Adam): "China sees little need for an imminent increase in interest rates, standing apart from Asian counterparts that are raising borrowing costs... People's Bank of China officials said 'that with a benign inflation outlook there was less need for higher nominal interest rates at this point,' the International Monetary Fund said...after annual consultations with the Chinese government. 'Also, they were concerned that higher interest rates could risk fueling capital inflows.'"

July 27 - Bloomberg: "The Chinese government's fiscal revenue rose 27.6% in the first six months of the year to 4.3 trillion yuan, according to a statement from the Ministry of Finance..."

July 26 - Bloomberg: "Chinese banks may struggle to recoup about 23% of the 7.7 trillion yuan ($1.1 trillion) they've lent to finance local government infrastructure projects, according to a person with knowledge of data collected by the nation's regulator. About half of all loans need to be serviced by secondary sources including guarantors because the ventures can't generate sufficient revenue..."

July 27 - Bloomberg: "Credit ratings assigned to yuan- denominated bonds issued on behalf of local governments in China are misleading and don't reflect risks investors face, Dagong Global Credit Rating Co.'s chairman said. Local government-backed borrowers shop around for the best rankings from Chinese ratings companies and 'whoever gives them a better rating gets the business,' Guan Jianzhong, chairman of privately owned Dagong... 'This is very dangerous.'"

July 27 - Financial Times (Jamil Anderlini): "China's banks are facing serious default risks on more than one-fifth of the Rmb7,700bn ($1,135bn) they have lent to local governments across the country, according to senior Chinese officials. In a preliminary self-assessment carried out at the request of the country's regulator, China's commercial banks have identified about Rmb1,550bn in questionable loans to local government financing vehicles - which are mostly used to fund regional infrastructure projects."

July 27 - Bloomberg: "China's banking regulator tried to ease concern over risks from bank lending to local government financing vehicles, saying such loans won't necessarily go bad. The China Banking Regulatory Commission said in a statement that risks can be contained through measures to secure repayment... Chinese banks may struggle to recoup about 23% of the 7.7 trillion yuan ($1.1 trillion) lent to finance local infrastructure projects..."

July 29 - Financial Times (Robert Cookson): "China's quest to transform the renminbi into an international reserve currency - and thereby challenge America's dominance of the global monetary system - may take decades, if it happens at all. But this month, for the third time this year, China took another big step in that direction. Regulators lifted a raft of restrictions blocking the free flow of renminbi in Hong Kong... '[The new rules are] a big step in promoting the international use of the renminbi," said Frances Cheung, a strategist at Crédit Agricole in Hong Kong."

Japan Watch:

July 27 - Bloomberg (Toru Fujioka): "Japan's government will ask ministries to cut their budgets by 10% for the year starting April 2011 as Prime Minister Naoto Kan tries to rein in the world's largest debt load. The reductions will help the government keep spending at this year's 71 trillion yen ($813 billion)..."

July 26 - Bloomberg (Keiko Ujikane): "Japan's exports rose faster than economists estimated... Shipments abroad advanced 27.7% in June from a year earlier..."

July 29 - Bloomberg (Wes Goodman and Garfield Reynolds): "Japanese bond yields are approaching the lowest in seven years as the nation's aging population snaps up securities in the world's biggest debt market... 'Older people are reluctant to take risk, and they love Japanese government bonds,' said Tsutomu Komiya, who helps oversee the equivalent of $106 billion at Daiwa Asset Management... 'The relationship between the bond yield and the age of the population is very strong.'"

India Watch:

July 27 - Bloomberg (Kartik Goyal): "India's central bank increased a key interest rate more than economists forecast, battling to contain a surge in inflation that's led to strikes and street rallies. The central bank raised the reverse repurchase rate a half point to 4.5%, and the repurchase rate to 5.75% from 5.5%..."

Asia Bubble Watch:

July 26 - Bloomberg (William Sim and Eunkyung Seo): "South Korea's economy grew faster than expected in the second quarter, bolstering the case for a further increase in interest rates as Asia weathers global risks. Gross domestic product increased 1.5% from the previous three months..."

Latin America Watch:

July 28 - Bloomberg (Jonathan Levin and Andres R. Martinez): "Mexico's central bank maintained its forecast for economic growth of 4% to 5% this year, bank Governor Agustin Carstens said."

Unbalanced Global Economy Watch:

July 29 - Bloomberg (Simone Meier): "European confidence in the economic outlook rose to the highest in more than two years in July and German unemployment declined for a 13th month as exports sustained a recovery in the region."

July 30 - Bloomberg (Simone Meier): "European inflation accelerated to the fastest pace in more than 1 1/2 years on rising energy costs and unemployment held at the highest in almost 12 years. Euro-area consumer prices rose 1.7% from a year earlier in July... The jobless rate remained at 10% for a fourth month in June... That's the highest since August 1998."

July 27 - Financial Times (Ralph Atkins): "Eurozone mortgage borrowing surged last month to the highest level in almost two years in a sign that bank lending across the 16-country region may be flickering back to life. Lending for house purchases rose at an annual rate of 3.4% in June... The acceleration pointed to a revival in consumer confidence and an increased willingness by banks to fuel the economic recovery with loans to the private sector."

July 30 - Bloomberg (Candice Zachariahs and Lisa Pham): "Spain will probably lose its Aaa credit rating after the country was put under review for possible downgrade in June, and the U.S. needs a 'clear plan' to tackle its deficit, Moody's... said."

July 29 - Bloomberg (Flavia Krause-Jackson): "Italian business confidence advanced to a two-year high in July after the economy returned to growth and exports benefited from the euro's decline."

U.S. Bubble Economy Watch:

July 27 - Bloomberg (William Selway): "U.S. local governments may cut almost 500,000 jobs through next year to cope with sliding property taxes, a decline in state and federal aid and added need for social services, according to a report... The report, a result of a survey by the National League of Cities, the U.S. Conference of Mayors and the National Association of Counties, showed local governments are moving to cut the equivalent of 8.6% of their workforces from 2009 to 2011... 'Local governments across the country are now facing the combined impact of decreased tax revenues, a falloff in state and federal aid and increased demand for social services,' said the study... They called on Congress to pass a bill that would provide $75 billion in the next two years to local governments and community-based groups to stoke job growth and forestall deeper cuts."

July 27 - New York Times (Nelson D. Schwartz): "By most measures, Harley-Davidson has been having a rough ride. Motorcycle sales are falling in 2010, as they have for each of the last three years. The company does not expect a turnaround anytime soon. But despite that drought, Harley's profits are rising — soaring, in fact... Many companies are focusing on cost-cutting to keep profits growing, but the benefits are mostly going to shareholders instead of the broader economy, as management conserves cash rather than bolstering hiring and production."

July 28 - Bloomberg (Bob Willis): "Americans in the second quarter tapped the smallest amount of home equity in a decade... Owners took out $8.3 billion while refinancing prime home loans...Twenty-two percent chose to reduce loan principal, matching the third-highest rate since records began in 1985."

July 27 - Bloomberg (Prashant Gopal): "U.S. apartment landlords are seeing a surge in rentals as mounting foreclosures reduce homeownership and an improving job market for young adults encourages them to find their own places to live. The number of occupied apartments increased by 215,000 in the 64 largest U.S. markets in the first half of the year, according to MPF Research, almost twice the units added in all of 2009 and the most since the firm began tracking the data in 1992. The vacancy rate declined to 6.6% last month from 8.2% in December. 'Overall demand is pretty stunningly strong in the first half,' Greg Willett, a vice president at the... research firm, said..."

Central Bank Watch:

July 29 - New York Times (Sewell Chan): "A subtle but significant shift appears to be occurring within the Federal Reserve over the course of monetary policy amid increasing signs that the economic recovery is weakening. On Thursday, James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the Fed's current policies were putting the American economy at risk of becoming 'enmeshed in a Japanese-style deflationary outcome within the next several years.' The warning by Mr. Bullard... comes days after Ben S. Bernanke, the Fed chairman, said the central bank was prepared to do more to stimulate the economy if needed... Mr. Bullard had been viewed as a centrist and associated with the camp that sees inflation, the Fed's traditional enemy, as a greater threat than deflation. But with inflation now very low... and with the European debt crisis having roiled the markets, even self-described inflation hawks like Mr. Bullard have gotten worried that growth has slowed so much that the economy is at risk of a dangerous cycle of falling prices and wages. Among those seen as already sympathetic to the view that the damage from long-term unemployment and the threat of deflation are among the greatest challenges facing the economy, are three other Fed bank presidents: Eric S. Rosengren of Boston, Janet L. Yellen of San Francisco and William C. Dudley of New York. As the Fed's board of governors shifts, the doves are getting more attention."

July 29 - Bloomberg (Steve Matthews): "Federal Reserve Bank of St. Louis President James Bullard said the central bank should resume purchases of Treasury securities if the economy slows and prices fall rather than maintain a pledge to keep rates near zero. 'The U.S. is closer to a Japanese-style outcome today than at any time in recent history,' Bullard said... 'A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.'"

July 28 - Bloomberg (Jennifer Ryan and Svenja O'Donnell): "Bank of England Governor Mervyn King said there may be a 'considerable' way to go before U.K. interest rates return to 'normal' as policy makers debate when to start withdrawing emergency stimulus from the economy. 'There will come a point when we will certainly need to ease off the accelerator and return Bank Rate to more normal levels,' King told lawmakers..."

Muni Watch:

July 27 - Bloomberg (William Selway): "U.S. state governments project revenue will climb in the current fiscal year after they raised taxes and cut spending to close budget gaps of $84 billion, a report from the National Conference of State Legislatures found. Revenue will increase 3.7%, after falling 1.5% in fiscal 2010. Even so, deficits of more than $12 billion may open for at least 29 states should Congress fail to extend extra aid, while two-thirds already forecast fiscal 2012 gaps of $72 billion... 'The revenue chasm was so deep that climbing out of it is going to take some time.'"

California Watch:

July 28 - Los Angeles Times (Shane Goldmacher): "As California staggers toward the fifth week of the fiscal year without a spending plan, a month of closed- door talks in the Capitol have produced little but tension and finger-pointing. The calendar is flipping toward August with no resolution in sight. Top officials don't even publicly agree about what they agree upon. The two parties are staging stunts at the Capitol and trading barbs in dueling radio addresses, each side accusing the other of being dug in or disengaged, or both. Gov. Arnold Schwarzenegger has demanded overhauls of the public pension system, the state tax code and the budgeting process, on top of the annual budget-balancing struggle. He has said he won't sign a spending plan that lacks those things, and California could languish without one until he leaves office -- in 2011... Meanwhile, California's unpaid bills are piling up, the state's worst- in-the-nation credit rating faces another downgrade and the prospect of printing IOUs for the second time in as many years threatens on the horizon... The state's $19.1-billion shortfall remains despite a temporary increase in taxes last year and lawmakers' slashing of billions from school budgets. Tuition at public universities has skyrocketed, and healthcare and other services for the poor have been scaled back."

Real Estate Watch:

July 27 - Bloomberg (Kathleen M. Howley): "About 18.9 million homes in the U.S. stood empty during the second quarter as surging foreclosures helped push ownership to the lowest level in a decade... The ownership rate... was 66.9%, the lowest since 1999."

July 29 - Bloomberg (Dan Levy): "Foreclosure filings climbed in three-quarters of U.S. metropolitan areas in the first half... according to RealtyTrac... Notices of default, auction or bank seizure rose more than 50% in areas including Salt Lake City; Savannah, Georgia; and Atlantic City... 'Foreclosures are spreading out from areas that had been hardest hit,' Rick Sharga, senior vice president... at RealtyTrac, said..."

July 28 - Bloomberg (Sharon Smyth): "Greek island homes, long coveted by millionaires and Hollywood stars such as Tom Hanks, are being marked down by as much as 45% as the country's debt crisis destroys demand for holiday getaways. A half-built villa on Mykonos, an island in the Aegean Sea known for its all-night beach parties, is being offered by brokers... for 2 million euros ($2.6 million) after the price was reduced by 500,000 euros."

Quantitative Easing Two

Not even a week had passed since ECB President Trichet's article, "Stimulate No More - It Is Now Time to Tighten," before Federal Reserve Bank President James Bullard thrusts himself into the debate with his paper, "Seven Faces of 'The Peril.'"

Dr. Bullard's concluding sentences: "To avoid [the Japanese] outcome for the U.S., policymakers can react differently to negative shocks going forward. Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities."

The New York Times (Sewell Chan) had a reasonable spin on Bullard's piece: "A subtle but significant shift appears to be occurring within the Federal Reserve over the course of monetary policy amid increasing signs that the economic recovery is weakening.... James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the Fed's current policies were putting the American economy at risk of becoming 'enmeshed in a Japanese-style deflationary outcome within the next several years.' The warning by Mr. Bullard... comes days after Ben S. Bernanke, the Fed chairman, said the central bank was prepared to do more to stimulate the economy if needed..."

Reading Dr. Bullard's paper - and listening carefully to his comments - recalls Dr. Bernanke's historic speeches back in late-2002: "Asset-Price 'Bubbles' and Monetary Policy"; "On Milton Friedman's Ninetieth Birthday"; and "Deflation: Making Sure 'It' Doesn't Happen Here." Dr. Bernanke fashioned the backdrop - erudite academic justification for aggressive "activist" monetary management - and today the Federal Reserve appears poised to embark only farther into perilous uncharted waters. Last week, I presumed that Mr. Trichet's stark warning against further stimulus was in response to market clamoring for additional quantitative easing from the Fed. It would now appear his comments may have been directed squarely at our central bank.

"The Peril" in Dr. Bullard's title is in reference to a 2001 academic article "The Perils of Taylor Rules." In simple terms, many accept the thesis that there is potential "peril" confronting a monetary management regime at the point when policymakers have lowered rates to near zero - yet the inflation rate remains stuck in negative territory ("deflation"). Japan is used as a contemporary example of how policymakers failed to act convincingly to ensure operators throughout the markets and real economy understood that deflationary pressures would not be tolerated.

From Bullard: "The policymaker is completely committed to interest rate adjustment as the main tool of monetary policy, even long after it ceases to make sense (long after policy becomes passive), creating a second steady state for the economy. Many of the responses to this situation described below attempt to remedy this situation by recommending a switch to some other policy in cases when inflation is far below target. The regime switch required has to be sharp and credible. Policymakers have to commit to the new policy and the private sector has to believe the policymaker."

Ten-year Treasury yields dropped to 2.92% today. Benchmark MBS yields sank 15 bps in two sessions to 3.49%. The markets are taking Dr. Bullard's talk of a "sharp and credible" regime switch - Quantitative Ease Two - seriously. The dollar dropped another 1.1% this week and the CRB Commodities index jumped 2.9 %. The market backdrop is increasingly reminiscent of the summer of 2007. The initial '07 eruption in subprime incited market weakness and volatility, an aggressive Federal Reserve response, a weak dollar and quite a run for commodities markets.

Back in 2002, I thought (and wrote as much) Dr. Bernanke's monetary views were radical and dangerous. He burst onto the scene as the right guy at the right time to lead an epic battle against the scourge of deflation. I view the period 2001 through 2006 as a historic period of faulty analysis and failed monetary management. In short, zealous policy measures were implemented from a flawed analytical framework. While fighting so-called deflation risk, our central bank accommodated a perilous Bubble throughout mortgage and Wall Street finance. The Fed's "activist" approach was an unmitigated disaster. Dr. Bullard's paper addresses this period from an opposing perspective: "2003-2004... This period was the last time the FOMC worried about a possible bout of deflation."

From Bullard: "The Thornton [St. Louis Fed economist] analysis emphasizes how the FOMC communicated during this period, and how the market expectations of the longer-term inflation rate responded to the communications. At the time, some measures of inflation were hovering close to one percent, similar to the most recent readings for core inflation in 2010. At its May 2003 meeting, the Committee included the following press release language: .... 'the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.' At several subsequent 2003 meetings the FOMC stated that '...the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future."

During the three-year period '02-'04, benchmark MBS yields averaged 5.22%, down significantly from the 7.16% average from 2000-'01. The Fed was "successful" in jawboning rates lower, in spite of the unprecedented surge in demand for mortgage borrowings. "Activist" monetary policymaking circumvented market forces, allowing a huge increase in the demand for mortgage Credit to be satisfied at historically low market yields.

Well, you either believe that the market forces of supply and demand should be left to determine the price (market yield) of finance - or you don't. And you either appreciate that the price of finance plays a fundamental role in the effective allocation of financial and real resources in a Capitalistic system - or you disregard this critical dynamic. Inarguably, Federal Reserve rate policy and communications strategy were instrumental in distorting market prices (MBS, real estate, stocks, etc.) and perceptions of risk and, in the process, fomenting the great mortgage/Wall Street finance Bubble.

Focusing instead on the general price level, or "inflation," Dr. Bullard comes to a very different conclusion with respect to policy performance during this crucial period: "In the event, all worked out well, at least with respect to avoiding the un-intended steady state. Inflation did pick up, the policy rate was increased, and the threat of a Japanese-style deflationary outcome was forgotten, at least temporarily. Was this a brilliant maneuver, or did the economic news simply support higher inflation expectations during this period?"

Regular readers know that I use the terms "Keynesian" and "inflationism" interchangeably. Inflationism has been an influential concept for a very long time; Keynes just created the most sophisticated and alluring conceptual framework. I argued against the Keynesians earlier in the decade. The critical flaw in their theoretical construct is that the Federal Reserve somehow controls "THE" general price level. This is a dangerous myth perpetuated by those committed to activist monetary management.

The Keynesians take Credit for thwarting the deflationary forces from earlier this decade. After declining to about a 1% y-o-y rate during the first half of 2002, inflation was a "safer" 4% or so by 2006. This, it was said, provided policymakers the latitude they required to ensure the U.S. did not succumb to the Japanese predicament. In the process, total U.S. mortgage Credit almost doubled in just six years. The aggregate of consumer prices may have been reasonably tame, but asset prices were not. The Fed used mortgage Credit to reflate the system and, not surprisingly, we now face a much worse predicament.

The problem with inflationism has always been that once it gets ingrained within the system - in the Credit system, the real economy, within market perceptions, expectations and asset prices - there's just no turning back. The more protracted the inflationary Credit boom - and the more problematic the associated Bubbles - the more unpalatably painful the bust is viewed in the minds of politicians and central bankers. Historically, it often became a case of "just one more bout of money printing to get us over the hump." Just get through the pressing crisis and then it will be time to find monetary religion.

It is the nature of protracted Credit Bubbles that devastating busts are held at bay only through increasingly expansive monetary stimulus. Invariably, this corrosive process destroys the soundness of system debt and the underlying currency. Too often, a crisis of confidence in private debt incites a dangerous cycle of public Credit ("money") inflation. Commenting this morning on CNBC, Dr. Bullard stated, "In monetary policy, you can never say you're done." This is precisely the nature of inflationism.

Dr. Bullard makes passing mention of Bubble risk: "The FOMC's near-zero interest rate policy and the associated 'extended period' language has caused many to worry that the Committee is fostering the creation of new, bubble-like phenomena in the economy which will eventually prove to be counterproductive. One antidote to this worry may be to increase the policy rate somewhat, while still keeping the rate at a historically low level, and then to pause at that level."

When I read (and listen) to such comments from our leading central bankers, I can only scratch my head and ponder the degree to which they appreciate financial and economic history - including recent financial crises. Dr. Bullard's paper suggests that the Japanese predicament of long-term substandard growth is the worst-case scenario for the U.S. economy. It is more likely the best-case.

And I find myself increasingly frustrated by the ongoing "inflation vs. deflation debate." With today's low level of consumer price inflation, those arguing that deflationary forces are the paramount systemic risk now dominate policy dialogue. Most tend to be inflationists. Most argue for additional stimulus and see little risk in such activist policymaking.

I see risks altogether differently. We are in the late-phase of a multi-decade historic Credit Bubble. The greatest risk at this point is that massive issuance of non-productive governmental debt foments a crisis of confidence at the very heart of our monetary system. The top priority must be to ensure that such a devastating outcome is avoided - and at significant unavoidable cost. It is imperative that we as a nation come to the recognition that real financial and economic pain must be endured to protect the long-term viability of our monetary system. The inflation rate is not the key issue. And efforts to try to inflate our way out of structural debt problems are a lost cause. We must instead move forcefully to rein in our deficits and avoid further debt monetization in order to protect the soundness of our money and Credit - or else risk a financial crash.

Most regrettably, Washington policymaking (fiscal and monetary) is on a trajectory that will inevitably destroy the creditworthiness of our nation's vast liabilities. With ominous parallels to the mortgage/Wall Street finance Bubble, Federal Reserve policies have fostered Bubble dynamics throughout our Treasury, agency and debt markets, more generally. Instead of market dynamics working to discipline Washington's profligate debt expansion, Federal Reserve interventions ensure that a distorted marketplace again accommodates perilous Credit excess. Our central bankers should heed Mr. Trichet's warning. Additional quantitative ease will only fuel the Bubble and risk calamity.