The rally was abrupt, ferocious, and broad-based. For the week, the Dow and S&P500 rose about 3%. The Transports jumped 4%, increasing y-t-d gains to 16%. The Utilities added 3%, with 2004 gains of 14%. The Morgan Stanley Cyclical index gained 4%, and the Morgan Stanley Consumer index added 3%. The S&P Homebuilding index surged almost 11%, increasingly 2004 gains to almost 13%. The broader market was strong, as both the small cap Russell 2000 and S&P400 Mid-cap indices gained about 3% (increasing respective y-t-d gains to 5%). The technology rally continues, with the NASDAQ100 and Morgan Stanley High Tech indices gaining 3% for the week. The Semiconductors increased 4% and The Street.com Internet index jumped 5% (increasing y-t-d gains to 22%). The NASDAQ Telecommunications index gained 3%. The Biotechs surged 5%. Financial stocks were also strong, with the Broker/Dealers jumping 5% and the Banks 4%. With bullion up $4.32 to $428.55, the HUI gold index increased 1%.

Considering the stock market rally, Treasury market performance was again impressive. For the week, 2-year Treasury yields added 2 basis points to 2.53%. Five-year Treasury yields rose 3 basis points to 3.28%. Ten-year Treasury yields gained 5 basis points to 4.02%. Long-bond yields ended the week at 4.79%, up 4 basis points on the week. Benchmark Fannie Mae MBS yields rose 6 basis points. The spread (to 10-year Treasuries) on Fannie's 4 3/8% 2013 note narrowed 3 to 27, and the spread on Freddie's 4 ½ 2013 note narrowed 3 to 26. The 10-year dollar swap spread increased 0.5 to 43.0. Corporate bonds generally performed well. The implied yield on 3-month December Eurodollars rose 5 basis points to 2.325%.

Corporate debt issuance increased to about $16 billion this week (from Bloomberg). Investment grade issuers included SBC Communications $3.0 billion, Citigroup $4.25 billion, General Electric Capital $2.0 billion, Fifth Third $1.75 billion, CIT Group $500 million, Westfield Capital $2.6 billion, Pitney Bowes $450 million, Cincinnati Financial $375 million, Centex $300 million, Intergas $250 million, Northwestern Corp $225 million, and NiSource $80 million.

Junk bond funds reported inflows of $57 million (from AMG). Issuers included Dobson Cellular $825 million, Advertising Direct $170 million, RMCC Acquisition $150 million National Mentor $150 million, Choctaw Resort $150 million, Levitz Home Furnishings $130 million, Imco Recycling $125 million, Hawk Corp $110 million, and Omega Healthcare $60 million.

Convert issuers included Armor Holdings $300 million, Quicksilver Resources $130 million, Isolagen $75 million and Option Care Inc. $75 million.

Foreign dollar debt issuers included American Movil $500 million and Chohung Bank $400 million.

Japanese 10-year JGB yields added 1 basis point to 1.49%. Brazilian benchmark bond yields dropped 9 basis points to 8.61%. Mexican govt. yields ended the week at 5.18%, up 6 basis points. Russian 10-year Eurobond yields rose 5 basis points to 5.83%.

Freddie Mac posted 30-year fixed mortgage rates were down 5 basis points this week to 5.64%, with yields now down 68 basis points since the week of June 18. Fifteen-year fixed mortgage rates were down 6 basis points to 5.01%. One-year adjustable-rate mortgages could be had at 3.96%, down 6 basis points for the week. The Mortgage Bankers Association Purchase application index declined 4.4% last week. Yet Purchase applications were up about 21% from one year ago, with dollar volume up 37%. Refi applications increased 3.6% during the week. The average Purchase mortgage rose to $225,500, while the average ARM increased to $306,900. ARMs accounted for 34.9% of total applications last week, with dollar ARM volume now about 50%.

Broad money supply (M3) rose $20.9 billion (week of October 18), recovering somewhat from the previous two-week declined. Year-to-date (42 weeks), broad money is up $462 billion, or 6.5% annualized. For the week, Currency added $500 million. Demand & Checkable Deposits gained $3.8 billion. Savings Deposits surged $22.9 billion, increasingly year-to-date gains to $344.1 billion (13.5% annualized). Small Denominated Deposits increased $500 million. Retail Money Fund deposits declined $5.1 billion, and Institutional Money Fund deposits were about unchanged. Large Denominated Deposits expanded $11.6 billion. Repurchase Agreements dropped $14.6 billion (down $47.6bn in three weeks), while Eurodollar deposits added $1.0 billion.

Bank Credit added $3.9 billion for the week of October 20 to $6.71 Trillion. Bank Credit has expanded $440 billion during the first 42 weeks of the year, or 8.7% annualized. For comparison, Bank Credit expanded by about $420 billion during all of 2003. For the week, Securities holdings jumped $9.5 billion ($21.4bn in two weeks), while Loans & Leases declined $5.7 billion. Commercial & Industrial loans gained $2.3 billion, while Real Estate loans slipped $1.8 billion. Real Estate loans are up $255 billion y-t-d, or 14.2% annualized. Consumer loans rose $2.1 billion for the week, and Securities loans added $900 million. Other loans dropped $9.2 billion. Elsewhere, Total Commercial Paper surged $14.6 billion to $1.37 Trillion (up $41.8bn in four weeks), the highest outstanding CP since September 2002. Financial CP rose $9.7 billion to $1.23 Trillion, expanding at a 7.4% rate thus far this year. Non-financial CP gained $4.9 billion (up 36% annualized y-t-d) to $140 billion. Year-to-date, Total CP is up $103.5 billion, or 9.9% annualized.

This week's ABS issuance came to $13 billion (from JPMorgan). Total year-to-date issuance of $523 billion is 40% ahead of comparable 2003. 2004 home equity ABS issuance of $333 billion is running 84% ahead of last year's record pace.

Fed Foreign "Custody" Holdings of Treasury, Agency Debt rose $4.8 billion to $1.30 Trillion. Year-to-date, Custody Holdings are up $232.3 billion, or 26% annualized. Federal Reserve Credit was about unchanged for the week to $770.6 billion, with y-t-d gains of $24.0 billion (3.9% annualized).

Currency Watch:

The dollar index declined better than 1%, closing today below 85 for the first time since February. For the week, the South African rand gained 2%, the South Korean won 1.25%, and Norwegian krone 1%. The Japanese yen gained 0.9% to a 6-month high. The New Zealand dollar reversed sharply, ending the week down 2%.

Commodities Watch:

October 25 - Bloomberg (Matthew Craze): "Rising tin-can prices will increase costs for H.J. Heinz Co., Campbell Soup Co. and Nestle SA next year, forcing the companies to consider charging more for baked beans and Alpo pet food or seek alternative packaging. Crown Holdings Inc. of Philadelphia and Netherlands-based Impress Holdings BV, the world's two biggest makers of food cans, plan to raise prices in the $13 billion market by almost 20 percent in 2005, after steelmakers...said they will boost tinplate prices by about a fifth in January."

October 28 - Bloomberg (Xiao Yu and Chia-peck Wong): "Copper demand in China, the world's largest consumer of the metal, may grow as much as 14 percent next year as the country uses more of the metal in power generators it plans to build to ease electricity shortages, said China's largest metal trader."

October 26 - Bloomberg (Claudia Carpenter): "Copper prices in New York rose for the first session in three as global inventory fell close to a 14-year low, renewing concern about dwindling supplies available to manufacturers of wire and pipe. Stockpiles monitored by the London Metal Exchange plunged 85 percent in the past year. Wolverine Tube Inc., a maker of pipes used in homes and appliances, said customers reduced purchases when prices reached a 15-year high early this month."

With December crude declining $3.39 to a $51.78, the Goldman Sachs Commodities index dropped 4.5% for the week. This reduced year-to-date gains to 36%. The CRB index lost 1 %, reducing y-t-d gains to 11.1%. Copper surged almost 7% today, leading a strong recovery in base metal prices.

China Watch:

October 29 - Bloomberg (Rob Stewart): "China's central bank said its decision to end a cap on lending rates is part of a plan to bring its banks more in line with international standards and give them more freedom to lend. 'By scrapping a limit on interest rates, we gave greater autonomy to commercial banks to decide which customers to lend to,' Bai Li, a spokesman at the People's Bank of China... 'With greater autonomy comes greater responsibility.'"

October 25 - XFN: "China's urban fixed-asset investment in the first nine months rose 29.9% year-on-year to 3.8 trillion yuan, with rural investment rising 16.9% to 707.4 million yuan, the National Bureau of Statistics (NBS) said."

October 25 - Bloomberg (Jianguo Jiang): "China's property prices in the first nine months rose 13 percent, a pace close to the fastest in eight years, the National Bureau of Statistics said. Prices for homes, offices and other commercial real estate rose to an average 2,777 yuan ($335) a square meter (10.8 square foot), the Beijing-based bureau said."

October 25 - XFN: "China's overall housing prices rose 9.9% year-on-year in the third quarter to September despite government efforts to cool down the real estate market, Xinhua news agency reported, citing the National Bureau of Statistics. Land prices rose 11.6%..."

October 25 - Bloomberg (Le-Min Lim): "China's factories, including steel mills and chemical plants, charged 8 percent more for their products last month to defray higher fuel costs, the National Bureau of Statistics said. Steel factories charged an average 17 percent more for their products last month, the bureau said..."

October 26 - Bloomberg (Tian Ying): "Chinese industrial companies' profit growth picked up in September as production gathered pace. Earnings rose 40 percent from a year earlier to 809 billion yuan ($98 billion) in the first nine months, according to Beijing-based Mainland Marketing Research Co. (China), which releases figures on behalf of the National Bureau of Statistics."

October 26 - Bloomberg (Koh Chin Ling): "China's restaurants had sales of 68 billion yuan ($8.2 billion) in September, up 19 percent from a year ago, the commerce ministry said..."

October 26 - Bloomberg (Philip Lagerkranser): "Hong Kong's exports rose in September at their slowest pace in six months as government lending restrictions cooled demand in mainland China, which accounts for the bulk of the city's trade. Exports rose 14 percent from a year earlier..."

Asia Inflation Watch:

October 29 - Bloomberg (Lily Nonomiya and Marco Babic): "Japanese housing starts rose at their fastest pace in over a year in September, the Ministry of Land, Infrastructure and Transport said in Tokyo. Housing starts rose 7.3 percent to an annualized 1.259 million units in September..."

October 29 - Bloomberg (James Peng): "Taiwan's gross domestic product may grow as much as 6 percent this year, more than the government forecast... Minister of Economic Affairs Ho Mei-yueh said. Ho said she expects growth to exceed the 5.9 percent pace forecast because of private investment, which grew 29 percent in the first half."

October 29 - Bloomberg (Bharat Ahluwalia): "India's banks may raise interest rates on home loans by as much as half a percentage point as funds with lenders declined... Interest rates on homes loans may rise by as much as 50 basis points to 7.75 percent... Mortgage lending in India has risen at average annual pace of 35 percent in the past six years, making it the fastest "growing segment of the banking industry.'"

October 26 - Bloomberg (Cherian Thomas and Sumit Sharma): "India's central bank unexpectedly raised a key interest rate for the first time in four years, saying record oil prices and rising corporate demand for credit threaten to fuel inflation..."

October 29 - Bloomberg (Seyoon Kim): "South Korea's current-account surplus widened to $2.9 billion in September as the country sold more mobile phones, steel products and computer chips overseas, the central bank said."

October 27 - Bloomberg (Seyoon Kim): "South Korean companies' overseas investment rose 34 percent in the past nine months as companies such as Hyundai Motor Co. expanded in China to take advantage of cheap labor and tap rising demand in the world's seventh-largest economy."

October 26 - Bloomberg (Laurent Malespine): "Thailand's exports rose 22 percent last month from a year earlier, led by sales of automobiles, rubber and rice, the Commerce Ministry said."

Global Reflation Watch:

October 27 - Bloomberg (Thomas Mulier): "The number of people visiting another country rose 12 percent in this year's first eight months as concern about travel safety receded, the World Tourism Organization said. International tourist arrivals climbed to about 526 million from 468 million a year earlier, the Madrid-based agency of the United Nations agency said..."

October 26 - MarketNewsInt.: "Home construction in France remained buoyant in September, as 3Q housing starts posted a 19.3% rise on the year, while permits for the same period were up 20.2%, according to non-seasonally adjusted data released Tuesday by the Construction Ministry. For the month of September alone, starts were up 23.2% on the year..."

October 28 - Bloomberg (Sandrine Rastello): "Manufacturers' confidence in France, the second-biggest economy in the euro region, unexpectedly rose this month as orders climbed and inventories declined. An index based on a survey of about 2,500 companies rose to 108, the highest since March 2001..."

October 29 - Bloomberg (Duncan Hooper): "U.K. mortgage lending in September rose at the slowest pace since April last year, while home-loan approvals declined for a fourth month, the latest evidence of a cooling in the property market."

October 28 - Bloomberg (Duncan Hooper): "U.K. house prices fell for the first time in three years in October, Nationwide Building Society said, extending a slowdown in the housing market. House prices declined a seasonally-adjusted 0.4 percent to 152,159 pounds ($278,763), the first drop since October 2001 and the biggest decline since February of that year..."

October 28 - Bloomberg (Todd Prince): "Russia's foreign currency and gold reserves had the largest weekly gain in six years, rising to a record $105.2 billion and nearing the country's total foreign debt. The central bank said reserves rose $5.1 billion in the week to Oct. 22, gaining for the ninth week. That's the largest jump since the central bank received $5.6 billion in the week ending July 28, 1998. About $4.4 billion of that was from an International Monetary Fund loan."

October 27 - Bloomberg (Alex Emery): "Peruvian exports rose in September, led by a surge in sales of copper, textiles and fishmeal. Exports jumped 39 percent to $1.09 billion from $776 million in September 2003, the government said. September was the third month in which Peru had exports over $1 billion. August's exports of $1.13 billion were a record high."

California Watch:

October 28 - San Francisco Chronicle (Tanya Schevitz):"The California State University Board of Trustees will vote today on a $4 billion budget that includes an 8 percent fee increase for undergraduate students and a 10 percent increase for graduate students...fees for undergraduate students rose 14 percent this fall and are expected to rise another 8 percent for the next two years."

Mortgage Finance Bubble Watch:

October 27 - American Banker (Jody Shenn): "The integrity of the appraisal process has broken down, three former federal housing policymakers told reporters Monday... Loan officer pressure on appraisers is nothing new, but 'it's now reached new heights,' former Housing and Urban Development Secretary Andrew Cuomo said at a press conference during the Mortgage Bankers Association's annual convention. Lending executives have been lulled into ignoring the business risks and their regulatory responsibilities, because a decade of rising home prices has allowed most loans with inflated appraisals to perform well..."

Housing activity remains on record pace, with stronger-than-expected New and Existing Home Sales reported for September. Existing Sales of 6.75 million annualized were up strongly from August to the third-highest on record. Average Prices were up 9.5% from one year ago to $237,300. And with sales volume up 1% from a strong year ago level, Calculated Transaction Value (CTV) was up 10.7% to $1.6 Trillion. CTV was up 43% over two years (prices 22%, volume 18%), 73% over 3 years (prices 35%, volume 28%), and 102% over six years (prices 35%, volume 49%). Year-to-date sales are running 8.3% ahead of last year's record, with y-t-d CTV running up 17%.

September New Home Sales jumped strongly from August to an annualized rate of 1.206 million (up 7% from Sept. 2003), also to the third-strongest on record. At $255,100, average prices were down $14,200 for the month and were up only slightly from one year ago. Year-to-date sales are running 9.7% above last year's record, with y-t-d CTV running 21% ahead. CTV is up 35% over two years (prices 14%, volume 28%), 77% over three years (prices 41%, volume 25%), and 95% over six years (prices 40%, volume 40%). The inventory of unsold new homes increased 5,000 units to 404,000, the highest level since 1979.

Liquidity:

My quest for a better grasp of money, Credit and contemporary finance will always amount to a work-in-progress. Admittedly, there will forever be holes in our understanding, but the gaps are what keep us digging and contemplating. There are, as well, the critical and especially challenging issues of financial innovation and "evolution." Things, they are always changing. So it is an exciting area to study, appreciating that there is so much to learn and always and everywhere new twists and turns to wrestle with.

I recall back to the early nineties when I just couldn't accept the traditional and hardened consensus view that only banks create Credit. As an old CPA, I would draw out T-accounts on my note pad and do battle with scores of debits and Credits. It took awhile, but after tireless rehash it did sink in that what we were really dealing with at a fundamental level are electronic debits and Credits in a massive financial system general ledger. The banking system definitely does not hold a monopoly position within the financial sector when it comes to issuing electronic IOUs. Yet I had little success in recreating my epiphany for others. Frustratingly, analytical hostility seemed to flow more freely.

I was eventually able to break through on the non-bank Credit creation issue, but it was more a "Fine, non-banks might be able to create Credit, but they certainly can't create money!" So the nature of the debate evolved. I tried to frame the "discussion" on the reality that myriad financial institutions within the Credit system create debits and Credits (issuing IOUs), while defining contemporary "money" in the context of "special" IOU's (Credit instruments) that were perceived to be safe (stores of nominal value) and highly liquid. Contemporary "money" is generally more of an intellectual concept within an analytical framework than it is a practical tool.

I have always emphasized that contemporary "money" is a subcategory of total Credit. "Money" is Credit, but Credit is not necessarily "money" - most of it is not. As it has been throughout history, money must be shepherded and safeguard as its special attributes nurture over-issuance. It is worth noting that contemporary "money" is, as well, highly "intermediated," meaning that its perceived safety and liquidity is dependent upon risk intermediation by various banking institutions, governments, the GSEs, Wall Street, ABS/MBS trusts, derivatives, Credit insurers, and others. There is little doubt in my mind that the huge mushrooming of contemporary "money" poses a potentially devastating systemic risk in the event of a breakdown in the perception of "money's" safety and liquidity.

In the spirit of the great Mises (and traditional Austrian monetary analysis), my focus is always on a broader definition of financial claims ("fiduciary media") that operate with a similar economic functionality to traditional narrow money. Today, this would include a broad array of Credit instruments including deposits from banks, savings and loans, as well as depository accounts in other institutions such as money market funds, insurance companies, and security brokers. "Repo" assets also fit within the definition, as do short-term liquid instruments issued by the Treasury, the GSEs, ABS/MBS trusts and highly rates finance companies. But this evening I don't want to get bogged down in formulating a list of contemporary "money" or attempting its quantification.

I will, though, briefly discuss its expansion, and I will begin by recalling the traditional bank "money multiplier" example. A bank can increase its deposits (money) by simply debiting/increasing its asset Loans, while crediting/increasing it liability Deposits. This is money creation out of thin air, but it is actually an exercise of little practical significance. Not until the depositor takes this newly created deposit and does something with it (creating purchasing power) does this money expansion have a real effect. It may be spent on consumption or investment, or placed on deposit elsewhere or invested in marketable instruments. And remembering back to the "money multiplier" exercise, the multiplying of money occurs when this deposit finds its way to another bank. There it provides immediately available funds that can then be lent (additional debt and Credit entries) - thus creating new deposits that can be lent again, funding additional deposits ("immediately available funds") elsewhere. Today, with effectively no reserve requirements, bank deposit IOU's can be lent, deposited, re-lent and deposited with little if any constraint ("infinite multiplier effect").

I will address two issues: First, money creation is of less overriding analytical concern in this process compared to when this bank IOU (deposit liability) is "on the move" generating purchasing power - creating Liquidity. The nature and effect of the Liquidity creation and increased purchasing power (inflationary manifestations) is of much greater analytical significance than the quantity of monetary inflation. Second, the IOU in this example can these days find its way directly to myriad financial institutions/"intermediaries"/instruments where it provides immediately available funds that are then lent or invested (additional journal entries expanding IOUs and Liquidity in the process). This bank IOU could "flow" directly to a money market fund, providing funds to finance Fannie's portfolio expansion, purchases by an ABS trust, or to fund security speculation through a "repo" (repurchase agreement) transaction. Or the deposit could bypass the managed funds altogether and go directly to institutions such as the GSEs, the REITs, GE Capital, or even Countrywide (creating, perhaps, commercial paper IOUs).

Importantly, various financial sector assets and liabilities are created by debiting and crediting accounts throughout the clearing process. Some of these IOUs would be captured in the monetary aggregates, while others would not. Nonetheless, the issuance of financial claims that creates purchasing power augments system Liquidity. And it is not that there is any "money" physically moving through the financial system, but only an ongoing re-accounting and inflation of (electronic journal entry) financial claims. To stubbornly focus narrowly on some perceived special role and mystical power of bank deposits is to miss the very essence of contemporary finance.

It is also worth pondering the radical transformation of contemporary payment systems. In the past, the payment clearing mechanism was basically monopolized by commercial banks, with various transaction balances cleared through the transfer (through journal entries) of deposit asset and liabilities between banks (with bank reserve accounts at the Federal Reserve playing an instrumental role). In such a payments arrangement, one could somewhat accurately refer to the "velocity" of (narrow bank reserves) money as it "circulated" through the banking system and supported Credit expansion (and GDP).

Today, however, the notion of velocity is an anachronism that only impinges upon clear analysis. Rather than narrow bank lending and deposit "money" operating at the core of system (debit and Credit entry) payment clearing, I would strongly argue that various marketable securities and instruments have become the centerpiece for settling transactions involving myriad financial intermediaries (banks, GSEs, global central banks, Wall Street firms, finance companies, ABS/MBS, mortgage lenders, insurers and government entities). Simplistically, the payment clearing system today is dominated by ongoing trading of marketable assets and liabilities between various financial operators (at home and abroad). I would also posit that during this Credit Bubble blow-off period, systemic Liquidity has become precariously divorced from lending to the real economy. Financial sector leveraging and securities lending operations - the Masters of Speculative Finance - have become the epicenter of system Liquidity creation and destruction.

My focus this evening on money, Liquidity, and the contemporary payments mechanism is not an intellectual exercise. Indeed, flawed analyses of these critical issues were responsible for some of the past two years' greatest analytical blunders. Many bright minds were convinced they saw global deflation, only to be blindsided by a spectacular surge in commodity and real estate prices. During last year's fourth quarter, some trumpeted a decline in the monetary aggregates as an indication of faltering Liquidity and Credit contraction. Yet the reality was the opposite - continued massive Credit growth and over-liquefied global markets. To be sure, we don't want to be absolutely wrong about Liquidity. Our analysis must downplay "money" and instead focus diligently on a very complex Liquidity.

The year ago decline in the monetary aggregates can be largely explained by disintermediation out of money market funds and a flight to higher-yielding securities and instruments (a "re-accounting" of investor assets and borrower liabilities from short-term "money" to longer-term "non-money"). Importantly, this contraction of M3 was actually indicative of a surge in marketplace Liquidity. To today categorically associate bank deposits and the monetary aggregates with general market Liquidity conditions is to leave oneself at a significant analytical disadvantage. "Money" is not Liquidity. Liquidity is a "flow" generally created by the expansion of financial sector (including global central bank) liabilities that are used in the process of expanding asset holdings.

So what about today's Liquidity environment and near-term prospects? Well, the analysis is especially challenging these days and definitely nowhere as clear as it was one year ago. First of all, my best gauge of systemic Liquidity conditions is derived from informed guesses as to financial sector (including global central bank and "leveraged speculating community" U.S. holdings) ballooning. And while I can these days produce a list of factors that will work to perturb financial sector expansion - weak dollar, faltering mortgage lending profits, disappearing speculative profits, thin lending margins and Credit spreads, regulatory issues, rising short-term rates and heightened risk aversion - we must be mindful that market dynamics today have the most profound impact on system Liquidity since at least the late 1920s. And, let's face it, market dynamics often prove counterintuitive.

Case in point: While it was reasonable to forecast a major decline in mortgage Credit growth after the collapse of 2003's historic refi boom, the correct analysis was that contracting total mortgage originations would only inspire the bloated mortgage finance super-sector to more aggressively hawk adjustable-rate, interest-only, home equity, 40-year, no down-payment teaser-rate, and subprime lending. Total mortgage Credit expansion did not slow at all from record levels. Rather, market dynamics dictated that an ultra-powerful industry and manic (asset-Bubble-induced) borrowers - together comprising an Acute Inflationary Bias - would sustain "blow-off" lending excesses and facilitate virtually unlimited Liquidity to sustain the Great Credit Bubble. Throughout the lending markets, contracting lending margins can, for awhile, foster a push for volume. Similarly, shrinking spreads can promote more aggressive leveraging - and resulting heightened over-Liquidity - for an overly-competitive and incredibly over-financed leveraged speculating community.

And when it comes to market dynamics, financial innovation and counter-intuitive developments, nowhere are these factors more in play than in the interest-rate markets. One could have expected that a Fed tightening-cycle combined with $425 gold and $55 crude to have had bond managers in a tizzy. Nope, not with the burgeoning TIPs market. Hedge fund managers and REITs worried about how to leverage MBS going forward? No worries; simply entice the homeowner into ARMs and create floating-rate securitizations for the leveraged players. At the same time, the explosion of variable-rate mortgages and floating rate debt does provide the fodder to satisfy demand emanating from the proliferation of higher-yielding short-term "money" funds. And with performance suffering, many bond mangers have unwound interest-rate hedges and, in the process, supported bond prices and systemic Liquidity. Too many positioned for higher rates ensures, in this over-liquefied world in which we operate, virtually assures rates move sharply lower.

And one can be pardoned for presuming that a $600 billion current account deficit would pressure the U.S. bond markets and exert a constraining influence on system Liquidity. It may have been, as well, reasonable to forecast that a rising rate environment would immediately impinge the Credit creating process. But yeoman's work by global central bankers, mortgage lenders, and Wall Street investment bankers has to this point assured more than ample Liquidity. Financial innovation has become - along with his sibling Inflation - Liquidity's best friend.

There is a long history of markets misreading and/or extrapolating unsustainable Liquidity conditions. This can be especially the case at key inflection points and/or manic marketplace dislocations. Blow-off excesses permeated the bond market during 1993's second half, merrily disregarding fundamental developments that were setting the stage for 1994's bond market rout. Abundant Liquidity and spectacular market gains throughout SE Asia were followed shortly by near financial Armageddon. And I will certainly never forget how U.S. bank and financial stocks surged to record highs in July 1998, only to be crushed over the subsequent three months as the U.S. financial system dodged its own financial catastrophe. And then there was the early-2000 historic "blow-off" and Liquidity melee throughout Internet, telecom and technology stocks that were quickly followed by collapse.

Often, faltering fundamentals actually play a role in fostering "blow-off" Liquidity excess. A massive short squeeze definitely was a significant factor in the final manic NASDAQ dislocation, with short covering and a panic unwind of hedges creating a burst of destabilizing marketplace Liquidity. Derivatives also can significantly impact Liquidity. Speculative derivative leveraging through options and other instruments back in 1993 were an instrumental factor in the final destabilizing bond melt-up, as they were throughout SE Asia a few years later. Those that wrote options and/or were on the wrong side of a surging bond market in the summer of 1993 were forced to take leveraged positions to offset escalating risk. It is today certainly worth recalling how a dangerous marketplace dislocation actually exacerbated Liquidity excess.

The end result of the 1993 "blow-off" was rampant Liquidity creation and attendant speculative excess that spilt over to Mexico and other markets. But fundamentals eventually won out. An abrupt reversal caught the markets off-guard, requiring an immediate liquidation of leveraged long positions. Meanwhile, the newly inflated ranks of the unhedged were caught heavily exposed from the dreaded abrupt "V" reversal in bond yields. The market's "V" caused particular havoc for the dynamically-trading derivative players and leveraged MBS speculators. It is also this evening worth recalling how little time passed between over-liquefied market conditions and a near liquidity crisis.

But unlike 1994, the Fed has these days convinced the marketplace that it will move at a very measured pace, with absolutely no intention of doing anything that would disrupt the markets. In short, the Fed has promised Ongoing Easy Liquidity and the markets are positioned for as much. And, yes, making such assurances incites leveraging and financial sector expansion - exacerbating Liquidity Excess. Yet there is no escaping the reality that Ongoing Easy Liquidity poses the greatest risk to financial stability and the soundness of our currency.

To wrap this up, I'll return briefly to theory. System Liquidity is today predominantly created through the process of financial leveraging. Speculative financial market returns are the driving force for monetary expansion, as opposed to financing investment in pursuit of true economic returns in the real economy. The great risk in this mechanism is that gross ("blow-off") market excess can completely corrupt the market pricing mechanism with little hope for adjustment or self-regulation. Left to its own devices, such a maligned and dysfunctional system will self-destruct. The Fed has abandoned its responsibility for regulating an increasingly unwieldy Credit system, seemingly leaving the burden to our foreign Creditors. All the while, economic distortions and imbalances run deeper, financial fragility more acute, and unmanageable foreign liabilities more unmanageable. And as magical as today's Ongoing Easy Liquidity appears to most market professionals, there is no avoiding the reality that it must end - one way or the other - to forestall a dollar collapse.