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Revisiting Financial Arbitrage Capitalism

Wow, what a week. Global equities were hammered, while bond prices spiked higher. Here at home, the Dow and S&P500 were hit for 3%. Economically sensitive issues sank, with the Transports and Morgan Stanley Cyclical index pounded for 5%. But the homebuilders were the strongest S&P group this week, gaining 3%. Up 1% for the week, the Philadelphia Utilities index traded today to the highest level since June 2002. The Morgan Stanley Consumer index dipped 2%. The broader market came under heavy selling pressure. The small cap Russell 2000 sank 6%, and the S&P400 Mid-cap index dropped 5%. The technology rout ran unabated. The NASDAQ100 dropped 6%, and the Morgan Stanley High Tech index and Semiconductors were hit for 7%. The Street.com Internet index lost 7% and the NASDAQ Telecom index fell 6%. The Biotechs were hit for 7%. The Broker/dealers dropped 4%, and the Banks declined 2%. And despite bullion's $9.00 advance, the HUI Gold index declined 1%.

Panic buying returned to the interest-rate markets. For the week, 2-year Treasury yields collapsed 30 basis points to 2.38%. Five-year Treasury yields sank 31 basis points to 3.38%. Ten-year yields dropped 26 basis points to 4.21%, the lowest yield since April 9. Long-bond yields ended the week at 5.03%, down 17 basis points on the week. Benchmark Fannie Mae MBS yields sank 23 basis points. The spread (to 10-year Treasuries) on Fannie's 4 3/8% 2013 note dipped 1 to 36, and the spread on Freddie's 4 ½ 2013 note declined 1 to 35. The 10-year dollar swap spread narrowed 0.75 to 48.0. Corporate bond spreads generally widened today and were somewhat wider for the week. The implied yield on 3-month December Eurodollars dropped 25 basis points to 2.11%, the lowest rate since April 22.

Corporate debt issuance totaled a decent $12.3 billion (from Bloomberg). Investment grade issuers included Procter & Gamble $3.0 billion, Suntrust Bank $1.0 billion, Simon Property Group $900 million, ASIF Global $850 million, Safeway $750 million, Xerox $500 million, Plains Pipeline $350 million, Canadian Oil Sands $250 million, Lennar $250 million, Liberty Property Trust $200 million, La Quinta Properties $200 million, Avery Dennison $150 million, Oklahoma Gas & Electric $140 million, Travelers Life $100 million, Farmers Exchange Capital $100 million and Sheffield Steel $80 million.

Junk bond funds reported outflows of $29.4 million for the week (from AMG). Junk issuance included Marquee Holdings $750 million, Crompton $600 million, US Oncology $575 million, Borden US Finance $475 million, Alderwoods Group $200 million, United Refining $200 million, Innophos $190 million, Blount $175 million, and Stanadyne $160 million.

Convert issuance included Henry Schein $200 million and SFBC International $125 million.

August 5 - Dow Jones (Liz Rappaport): "Hedge funds are expanding their dominance in the U.S. market for convertible securities, and they are increasing the amount of leverage they take on to add to their fire power. Convertibles are hybrid securities that pay interest, like a bond, but convert into the issuers' equity under certain conditions. Hedge funds have long been seen as dominating the convertibles market, although there is no way to determine exactly how many funds participate. Estimates based primarily on trading volumes put hedge funds' market share at around 80%, according to some Wall Street firms."

Foreign dollar debt issuers included Mexican United States $1.5 billion, and Export-import Bank of Korea $500 million.

August 4 - Dow Jones: "Asian investors took a shine to the $3 billion global two-year offering sold Wednesday by the FHLB (Federal Home Loan Bank), accounting for 44% of the issue, according to preliminary data from the FHLB."

Japanese 10-year JGB yields dropped 14 basis points for the week to 1.69%, the largest weekly price gain in 5 months (from Bloomberg). Brazilian benchmark bond yields dropped 14 basis points to 10.37%. Mexican govt. yields sank 31 basis points this week to 5.53%, the lowest since April 26. Russian 10-year Eurobond yields dropped 20 basis points to 6.40%.

August 6 - Bloomberg (Ramya Venugopal): "Indian bonds plunged after a government report said inflation accelerated at the fastest since February 2001, fuelling concern the central bank may be prompted to raise interest rates... The yield rose 13 basis points, or 0.13 percentage point, to 6.38 percent."

Freddie Mac posted 30-year fixed mortgage rates declined 9 basis points this week to 5.99%. Fifteen-year fixed mortgage rates, also declining 9 basis points, dropped to 5.40%. One-year adjustable-rate mortgages could be had at 4.08%, down 9 basis points last week. The Mortgage Bankers Association Purchase application index added 1.6% last week. Purchase applications were about unchanged from one year ago, with dollar volume up 7%. Refi applications dipped 3%. The average Purchase mortgage was for $215,000, and the average ARM was $288,000. ARMs accounted for 33.5% of applications last week. All eyes on Purchase applications over the coming weeks.

Broad money supply (M3) rose $12 billion (week of July 26). Year-to-date (30 weeks), broad money is up $471.8 billion, or 9.3% annualized. For the week, Currency added $1.0 billion. Demand & Checkable Deposits jumped $18.1 billion. Savings Deposits dropped $21.8 billion. Saving Deposits have expanded $255.7 billion so far this year (14% annualized). Small Denominated Deposits dipped $0.5 billion. Retail Money Fund deposits declined $2.2 billion. Institutional Money Fund deposits gained $9.4 billion ($17.5 billion in two weeks). Large Denominated Deposits rose $6.9 billion (up $36.5 billion in five weeks) to $1.04 Trillion. Repurchase Agreements and Eurodollar deposits were both about unchanged.

Bank Credit added $2.7 billon for the week of July 28. Bank Credit has expanded $304.8 billion during the first 30 weeks of the year, or 8.4% annualized. Securities holdings dropped $40.8 billion, while Loans & Leases jumped $43.5 billion. Commercial & Industrial loans gained $1.3 billion, while Real Estate loans declined $7.6 billion. Real Estate loans are up $171.1 billion y-t-d, or 13.3% annualized. Consumer loans surged $31.1 billion for the week, and Securities loans rose $12.1 billion. Other loans increased $6.7 billion. Elsewhere, Total Commercial Paper dipped $1.0 billion to $1.351 Trillion. Financial CP added $2.8 billion, while Non-financial CP declined $3.8 billion. Year-to-date, Total CP is up $82.0 billion, or 10.8% annualized.

ABS issuance totaled $9.4 billion (from JPMorgan) this week, with y-t-d issuance of $356 billion 36% ahead of comparable 2003. Year-to-date Home Equity ABS issuance of $215 billion is running 77% above a year ago.

Fed Foreign "Custody" Holdings of Treasury, Agency Debt rose $8.5 billion to $1.248 Trillion. Year-to-date, Custody Holdings are up $181.2 billion, or 29% annualized. For comparison, Federal Reserve Credit has expanded $11.1 billion so far this year, or 2.5% annualized, to $757.6 billion.

Currency Watch:

One piece of economic data was all it took to take away most of the dollar's recent rally, with the dollar index sinking almost 2% for the week. The South African rand and Norwegian krone, gaining about 3%, were this week's strongest currencies. The Euro, Danish krone, Swiss franc, and Swedish krona rose better than 2%. The Argentine peso dropped 2.5%. The Brazilian real rose 1.5% today, enjoying its strongest gain in two months.

Commodities Watch:

August 5 - Moody's John Lonski: "Some forget that the latest climb by energy prices is part of a general upturn by industrial commodity prices. Crude oil prices are higher not only because of potential supply disruptions, but also because of faster global economic growth. The latest run-up by industrial metals prices testifies to the latter. Alongside the latest +38.0% year-to-year surge in the price of crude oil, the industrial metals price index (IMPI) was recently up by an even steeper +50.1% from a year ago, while an index of lumber product prices was higher by +27.6% annually. Slowly, but surely, price inflation appears to be fanning out."

August 3 - Bloomberg (Ravil Shirodkar): "China imported 97.75 million metric tons of iron ore in the six months ended June, 35 percent more than in the year-earlier period, Tex Report said, citing data from China's Customs Office. China's iron ore imports have been expanding at a rate of 195.5 million tons a year..."

August 5 - Bloomberg (Rob Delaney): "China's coking coal imports rose fivefold in the first half of this year to 3.1 million metric tons while thermal coal imports fell 58 percent to 1.4 million tons..."

August 5 - Bloomberg (Manash Goswami): "India's crude oil imports in the fiscal first quarter ended June rose 13 percent from a year earlier to 25.8 million metric tons, the Press Trust of India news agency reported... Crude oil imports in June rose 48 percent...as refiners bought more oil on concern that global prices may surge further..."

For the week, the CRB index added 0.3%, with y-t-d gains of 5.2%. September crude rose another 15 cents to $43.95. The Goldman Sachs Commodities index dipped 0.9%, with year-to-date gains of 16.9%.

China Watch:

August 4 - Bloomberg (Allen T. Cheng): "Some 60 percent of top economists in China expect inflation to accelerate in the next six months, according to the latest economics confidence survey released by the National Bureau of Statistics..."

August 5 - Bloomberg (Allen T. Cheng): "China collected a record 88 billion yuan ($10.6 billion) in personal income taxes in the first half, up 20.6 percent from a year ago..."

August 2 - Bloomberg (Jianguo Jiang): "China's four million restaurants had combined first-half sales of 337.3 billion yuan ($40.7 billion), an increase of 24.5 percent from a year earlier, as more people dine out, the China Cuisine Association said... Second-quarter sales jumped 34.2 percent to 163.1 billion, the association said. This followed a 16.6 percent first-quarter increase to 174.2 billion yuan..."

August 4 - Bloomberg (Allen T. Cheng): "Investment in China's factories, roads and other fixed assets will slow further this quarter as a result of government lending curbs, a state research unit said. Fixed-asset investment, which accounts for about half of China's economy, will probably rise 26 percent from a year earlier in the July-September period, the Beijing-based China Economic Information Network said... Official figures show that investment rose a revised 31 percent in the first half and 48 percent in the first quarter."

Asia Inflation Watch:

August 5 - Bloomberg (Theresa Tang and Yu-huay Sun): "Taiwan's inflation gathered pace in July as food costs jumped after a typhoon destroyed farmland. The consumer price index rose a seasonally adjusted 0.9 percent from June, when it gained 0.4 percent, the statistics bureau said... Vegetable prices soared 55 percent, without adjusting for seasonal factors. From a year earlier, consumer prices increased 3.3 percent, marking their biggest gain since November 1998..."

August 5 - Bloomberg (Heejin Koo): "South Korean producer prices rose in July at their fastest pace in more than five years as the hottest summer in a decade reduced vegetable supplies and increases in bus and air fares prompted service costs to rise. Producer prices rose 7 percent from a year earlier after climbing 6.8 percent in June, the central bank said in a statement in Seoul. That's their biggest increase since November 1998, when prices rose 11 percent."

August 5 - Bloomberg (Francisco Alcuaz Jr.): "Philippine consumer prices rose in July at their fastest pace in almost three years, prompting the central bank to say it may raise interest rates. Prices jumped 6 percent from a year earlier after climbing 5.1 percent in June, the National Statistics Office said in Manila."

August 3 - Bloomberg (Anuchit Nguyen): "Thailand's inflation rate rose in July at its fastest pace in more than five years on higher prices of fuel, fruits and other foods, raising the chances that the central bank may increase the key lending rate to keep prices in check. The consumer price index, which measures the cost of goods and services, rose 3.1 percent from a year earlier..."

August 4 - Bloomberg (Wahyudi Soeriaatmadja and Soraya Permatasari): "Indonesia's inflation may average more than 7 percent this year because of election-related spending and higher-than-expected crude oil prices, central bank Governor Burhanuddin Abdullah said."

August 4 - Bloomberg (Alan Ohnsman and Kae Inoue): "Asian automakers increased their U.S. market share in July, led by Toyota Motor Corp. and Nissan Motor Co., as customers spurned the record discounts given by General Motors Corp. and Ford Motor Co. Asian companies boosted their combined U.S. market share to 35.3 percent in July, a gain of 2.1 points and just 0.1 point below the monthly record, according to Autodata Corp."

August 2 - Bloomberg (Lindsay Whipp): "Japanese land price declines eased in 2003, with signs of renewed demand in central Tokyo insufficient to stop a 12th straight year of overall drop. Nationwide land prices decreased 5 percent to 115,000 yen ($1,037) per square meter..."

August 2 - Bloomberg (Tatsuo Ito and Lily Nonomiya): "Japan's tax revenue rose 11 percent in June from a year earlier, the Ministry of Finance said."

August 5 - Bloomberg (Yoolim Lee): "South Korea's consumer confidence fell to its lowest in more than three years in July, the latest evidence that slumping domestic demand will hold back growth in Asia's third-largest economy."

August 1 - Bloomberg (Sangim Han and Seyoon Kim): "South Korean exports rose more than expected in July, helped by surging sales of cars, computer chips and cell phones to China, the U.S. and Japan. Shipments rose 38 percent from a year earlier to $21.4 billion after climbing 39 percent to a record in June..."

August 4 - Bloomberg (Francisco Alcuaz Jr.): "Philippine exports rose for a seventh straight month in June as electronics makers shipped more disk drives and computer chips to factories in Japan and China. Exports, about two-thirds of which are electronics, increased 8.3 percent to $3.31 billion after climbing 15 percent in May..."

August 3 - Bloomberg (Stephanie Phang): "Malaysia's exports rose faster than expected in June as the country's manufacturers shipped more semiconductors, disk drives and other electronics goods to Japan, China and the U.S. Exports rose 22.2 percent from a year earlier to 39.8 billion ringgit ($10.5 billion), accelerating from May's 20.5 percent increase..."

August 3 - Bloomberg (Stephanie Phang): "Malaysia's economy is expected to expand faster than the central bank's forecast of as much as 6.5 percent growth for the year, Prime Minister Abdullah Ahmad Badawi said. The latest indicators suggest that we stand a good chance of achieving, if not surpassing, growth forecasts for 2004,' he said..."

August 2 - Bloomberg (Victoria Batchelor): "Australian retail sales surged 2.1 percent in June, the biggest increase in three years, as more than A$2 billion ($1.4 billion) in government family assistance payments spurred spending at department and clothing stores."

Global Reflation Watch:

August 2 - Bloomberg (Jennifer Ryan): "Sales of European corporate bonds rated below investment grade, at so-called high-yield or junk status, may reach a record in 2004, according to a report by the High Yield Capital Markets Team at Goldman Sachs... New issues by European corporate borrowers rated below Baa3 by Moody's...and BBB- by Standard & Poor's have totaled the equivalent of $16.7 billion so far this year, only $1 billion less than the issuance for all of 1999, the last record year..."

August 4 - Bloomberg (Sam Fleming): "U.K. house price inflation accelerated to 1.3 percent last month, HBOS Plc said, suggesting four interest- rate increases have yet to cool the housing market. The average cost of a home grew to 161,831 pounds ($294,621) in the month after a 1.2 percent rise in June. In the three months to July house prices increased 22.1 percent compared with the same period last year, the fastest pace since May 2003."

August 5 - Bloomberg (Duncan Hooper): "The growth in demand for U.K. workers accelerated to a 3 1/2 year high in July, a survey conducted by NTC Research showed."

August 3 - Bloomberg (Fergal O'Brien): "Irish manufacturers increased production at the fastest pace in four years in July as a pickup in global economic growth, led by the U.S. and Asia, boosted demand for exports."

August 5 - Bloomberg (Dara Doyle): "Sweden's economy in the second quarter unexpectedly grew at the fastest pace since 2000, as exports of goods such as Ericsson AB phone gear and Volvo AB trucks surged."

August 2 - Bloomberg (Eduard Gismatullin): "Russia boosted crude oil production 10.2 percent in the first seven months of the year, compared with the year-earlier period, the Industry and Energy Ministry said...Oil output rose to 263 million tons (9.1 million barrels a day) in the period. July production rose 9.7 percent to 39.5 million tons of crude oil."

August 3 - Interfax: "The Russian Economic Development and Trade Ministry has increased its GDP growth forecast for 2004 from 6.6% to 6.7%, a ministry official told a briefing on Tuesday."

August 2 - Bloomberg (Ben Holland): "Turkey's exports rose 34 percent in July from a year earlier, the Turkish Exporters' Association said... The country had exports of $5.7 billion in the month... Exports for the January-July period were up 35 percent from 2003..."

August 3 - Bloomberg (Khalid Qayum): "Pakistan's tax collection in the first month of the fiscal year started July 1 rose 22 percent, helped by an economy expected to grow at the fastest pace in 13 years."

August 5 - Bloomberg (Heather Walsh): "The United Nations raised its forecast for economic growth this year in Latin American and the Caribbean as a strengthening global economy boosts demand for the region's exports. The region will post growth of 4.5 percent, triple last year's 1.5 percent expansion..."

August 6 - Bloomberg (Guillermo Parra-Bernal): "Brazil's industrial production grew at its fastest pace in four years in June as companies such as Volkswagen AG ran factories at near capacity to meet demand for machinery and cars. Output jumped 13 percent, the 10th consecutive month of year-on-year increase and the fastest growth since a 15.8 percent surge in February 2000..."

August 2 - Bloomberg (Guillermo Parra-Bernal): "Brazilian imports held near their highest level in six years in July as manufacturers such as Deere & Co. boosted purchases of raw materials and machinery to meet rising orders. Imports totaled $5.51 billion in July...the highest since September 1998... Imports have surged 26.7 percent this year, signaling growth in South America's largest economy is quickening..."

August 5 - Bloomberg (Heather Walsh): "Chile's economy expanded 5 percent in June from a year earlier after lending rates at a record low spurred spending and demand climbed for copper, Chile's top export."

August 5 - Bloomberg (Mike Cohen): "South Africa's annual house price inflation accelerated to a record 26.4 percent in July, as five interest rate cuts last year boosted demand for property..."

California Bubble Watch:

August 3 - Los Angeles Times (Annette Haddad): "Home builders just can't seem to dig California out of a hole fast enough. Data released Monday by the California Building Industry Assn. suggests that by year's end, builders will have obtained more than 200,000 new-home permits, the most since 1989. In June alone, 19,841 permits were issued for single-family and multifamily units  21% more than in June last year. The new-home market continues to excel,' said Alan Nevin, chief economist for the building association. But in this state, that's not enough. Nevin and other economists figure that 225,000 to 250,000 new homes would have to be built each year to keep up with demand as the population swells."

U.S. Bubble Economy Watch:

August 2 - Bloomberg (Catherine Larkin): "Almost 9 million U.S. workers under the age of 65 lost employer health benefits in the aftermath of the 2001 recession, a national survey found."

Mortgage Finance Bubble Watch:

August 2 - American Banker (Jody Shenn): "Wells Fargo Home Mortgage which was usurped last year as the top originator, is one of several major lenders planning to aggressively recruit retail loan officers as the market moves from refinacings to purchases. Though some companies have been scaling back - most notably Washington Mutual Inc. - or even left the business, Wells said Thursday that it plans to double its 10,000 or so commissioned retail salespeople... Countrywide Financial Corp., which overtook Wells as the No. 1 originator in the fourth quarter, is expanding across all sales channels, adding hundreds of retail loan officers a month. Its goal is to nearly triple its 4,200 reps by 2008."

August 5 - USAToday (Sue Kirchhoff): "With sketchy credit histories, underreported income and mistrust of banks, many immigrants have trouble qualifying for conventional mortgages. To get homes, many are paying higher rates and fees  from a couple of percentage points to far more  on subprime' loans. To offset the risk of lending to people with less than the best credit, lenders want more money. Realtors and buyers say immigrants also are increasingly using adjustable-rate loans, which have lower monthly payments at least until rates adjust, or taking out 100% financing because they have no down payment.... Nearly 40% of first-time immigrant buyers are spending at least 30% of their monthly income on housing costs, compared with 28% of U.S.-born first-time buyers, according to the Harvard Joint Center for Housing Studies. Subprime mortgage lending rose 25% a year from 1994-2003..."

UBS performed some interesting analysis on the subprime home equity mortgage market. While early 2004 data are limited, the average loans size has jumped to $153,000. This is up from 2003's $144,500, 2002's $122,800, 2001's $105,100, 2000's $89,400, and 1999's $84,600. California accounted for 31.4% of the loans, up from 1999's 18.5%. This year, ARMs are running at 70.3% of total loans, up from 1999's 47.8%. There were $172.7 billion of subprime originations last year, up from 2002's $104.9 billion, 2001's $67.7 billion, 2000's $49.0 billion, and 1999's $51.9 billion.

Revisiting Financial Arbitrage Capitalism

I think a lot about Hyman Minsky on days like today. Back in December 2001, I wrote a piece titled "Financial Arbitrage Capitalism." The nature of the analysis - "updating" the brilliant Minsky's concept of Money Manager Capitalism - is among my personal favorites. While it is not my habit to dip into the archives, the environment beckons for some "Minskian" analysis.

Minsky's Money Manager Capitalism:

"The welfare state big government managerial capitalism largely but not completely divorced business profits (cash-flows) from private investment...It followed that the margin of safety which entered into the building of liability structures which reflected earlier experience were too big: the safe level of indebtedness was higher in the postwar economy than hitherto...the independence of operating corporations from the money and financial markets that characterized managerial capitalism was thus a transitory stage. The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy. However, unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits...As managed money grew in relative importance, more and more of the market for financial instruments was characterized by position-taking by financial intermediaries. These positions were bank-financed. The main financial houses became highly-leveraged dealers in securities, beholden to banks for continued refinancing. A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market...The question of whether a financial structure that commits a large part of cash flows to debt validation leads to a debacle such as took place between 1929 and 1933 is now an open question"

"In the present stage of development the financiers are not acting as the ephors of the economy, editing the financing that takes place so that the capital development of the economy is promoted. Today's managers of money are but little concerned with the development of the capital asset of an economy. Today's narrowly-focused financiers do not conform to Schumpeter's vision of bankers as the ephors of capitalism who assure that finance serves progress. Today's financial structure is more akin to Keynes' characterization of the financial arrangements of advanced capitalism as a casino. The Schumpeter-Keynes vision of the economy as evolving under the stimulus of perceived profit possibilities remains valid. However, we must recognize that evolution is not necessarily a progressive process: the financing evolution of the past decade may well have been retrograde." (Minsky, 1993, p. 113)

And I wrote in late-2001: "It is my contention that the essence of the American (and in many respects the American-dominated global) system evolved significantly and then diverged so profoundly over the past few years from Minsky's "Money Manager Capitalism" that it is today appropriate to distinguish an entire new stage of capitalistic financial development - the age of "Financial Arbitrage Capitalism." Whether this new stage is "retrograde" and untenable - as is our view - is the key economic issue of our time. At the minimum, this most unusual cast of financial institutions and structures provides a good basis for making sense out of the anomalous divergences in sectoral economic performance (record home and auto sales, as capital goods investment plummets), extreme disparities in relative pricing and profits throughout the economy and markets ("inflation vs. deflation" quandary), and general acute financial and economic fragility."

More than two and one-half memorable years later, there is absolutely no doubt in my mind that Financial Arbitrage Capitalism is both "retrograde" and untenable. That this reality remains unappreciated is truly today's paramount economic issue. And I will go further, arguing that the past 18 months have been a period of "blow-off" excess in myriad strategies of leveraged speculation, and its gone full-blown global (Global Wildcat Finance). The recent inhospitable market environment marks the conclusion of the temporary respite from financial instability.

For several years, the system has experienced a most extreme episode of financial "profits" dictating lending, speculating, investing and spending patterns. Economic profits - as the genesis of sound and sustainable lending, investing, income growth, and resource allocation - have become only more irrelevant; a relic from a bygone era. The predictable consequences include myriad unwieldy Bubbles (Credit, asset, mortgage finance, leveraged speculation...). The financial system has become only more leveraged and dysfunctional, and the economic system more distorted and imbalanced. These dynamics are nowadays in full bloom.

Today's data and market reaction provided rather conspicuous evidence of the economic vulnerability and financial fragility associated with runaway financial speculation ("arbitrage" Capitalism). Near panic buying of Treasuries and foreign currencies was incited by additional evidence of weak job growth. Gold surged $6.90, and the dollar lost significant ground to virtually every currency, including the "developing economy" currencies. Benchmark Fannie Mae MBS yields sank 18 basis points to 5.25%, the lowest level since early April. California homes prices likely gained a couple thousand dollars to yet another new record.

If I believed that weak employment gains were the consequence of a typical economic slowdown, my analysis would go in a much different direction. But the current environment has nothing to do with tightened Credit conditions, reduced lending, or faltering spending. Rather, we are in the midst of ultra-easy Credit availability, gross lending excess, over-abundant liquidity, and record total Credit growth.

Total system spending remains robust, although there has been a marked shift in the nature of expenditures (as inflation effects tend to impose). Energy, imports, and housing are taking an increasingly disproportionate share, where enormous increases in nominal dollar expenditures have little impact on American job creation. A torrent of liquidity flows to California and other real estate markets (stoking financial "profits" for homeowners and lenders, along with an income windfall for real estate, mortgage and insurance brokers). Unprecedented dollar liquidity flows globally to pay for exports and to play higher-returning non-dollar assets. Here at home, an inflated cost structure throughout much of the economy restrains (jobs-producing) productive investment. Meanwhile, and importantly, the amount of liquidity and Credit necessary to sustain systemic Bubbles is problematic and approaching precarious. Again, the key issue is not economic weakness but spectacular structural imbalances and distortions.

If today's dismal jobs report emanated from diminishing Credit excess, I would be much less concerned with dollar vulnerability. But our currency is hamstrung by severe structural distortions in both the economic and financial spheres. Years of Credit inflation and escalating Monetary Disorder have severely impacted U.S. global competitiveness (hence, productive investment). Yet, "blow-off" Financial Arbitrage Capitalism excesses (shorting Treasuries to leverage subprime MBS, for example) dangerously over-liquefy real estate markets, while stoking asset Bubbles and consumption. And it is the unrelenting expansion of non-productive debt (Credit inflation) that continues to impose great risk upon dollar and financial stability. In all respects, Fed "reflationary" policies have exacerbated the problem.

I would strongly argue that the last thing the system - and the vulnerable U.S. dollar - need right now is a collapse in market yields. But, then again, this is why I use the adjective "dysfunctional" to describe the U.S. financial system. Indeed, it is the very nature of Financial Arbitrage Capitalism - where financial "spread" profits reign supreme - to surreptitiously corrupt the market pricing mechanism (excessive speculative demand for debt instruments creates its own supply, nurturing self-reinforcing asset inflation).

Today - with massive shorting of Treasuries for hedging interest-rates and to finance purchases of higher-yielding instruments - weaker economic data incites an exaggerated (and self-reinforcing) decline in yields. Sinking yields - in the face of an acute inflationary "blow off" bias throughout mortgage finance - will only stimulate greater non-productive debt expansion. This Credit inflation will further pressure the dollar, pressuring foreign central banks to buy dollars, hence Treasuries. This dynamic will only exacerbate the shortage of Treasuries required for the Great Mortgage Spread Trade, along with providing speculators a very enticing bet of going long Treasuries ahead of the central banks and hedgers. What a mess.

But there is a critical aspect of today's speculative dynamics that remains at this point uncertain. The speculators are clearly licking their wounds. But will stock market losses set in motion a general reversal of speculative flows, fomenting a domino breakdown of other trades? Are commodities and emerging market debt vulnerable to speculative unwind, with significant ramfications for the global economy and pricing environment? Or, are these trades instead golden in a faltering dollar environment? Most importantly, are Credit market spread trades increasingly vulnerable? Are we in the early stages of an unwind of speculations and system de-leveraging? Or, on the other hand, will sinking yields and a nervous Fed be perceived as one final boon for leveraged speculation?

Especially after this week's yield collapse, I am not yet willing to write off the U.S. and global economies. I will wait for signs of faltering liquidity and less profligate Credit Availability that could now develop any point. But I will say that when financial crisis arrives - when Financial Arbitrage Capitalism falters - the U.S. Bubble economy will prove shockingly vulnerable. I still find it amazing that after 70 years the economic community still lacks appreciation for the Acute Systemic Fragility that had evolved over the two decades preceding the 1929 stock market crash. The Crash rather abruptly brought to an end dysfunctional Monetary Processes. Leveraged speculation had over years evolved into the key source of finance/liquidity for both the markets and Bubble economy - going to (Fed-induced) "blow-off" excess during the critical 1927-1929 period. The unavoidable reversal of speculative financial flows - and resulting de-leveraging - exposed deep structural imbalances and distortions. Inflated asset prices sank, boom-time spending patterns were altered dramatically, investment collapsed, financial flows went absolutely haywire, and the global currency system unraveled. We're not there yet, but that doesn't mean we are not careening in that direction.

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