HIGHLY UNEDITED!

It was a rather uneventful final week to an eventful year. For the week, the Dow was slightly negative and the S&P500 was about unchanged. The Transports and Morgan Stanley Cyclical index were about unchanged, while the Utilities posted a marginal decline. The Morgan Stanley Consumer index rose less than 1%. The broad market held its gains, with the small cap Russell 2000 gaining slightly and the S&P400 Mid-cap index adding 1%. Technology stocks enjoyed a solid week. The NASDAQ100 gained 0.5%, and the Morgan Stanley High Tech index increased 1%. The Semiconductors rose 2% and The Street.com Internet Index added 1.5%. The Biotechs gained 1%. The Broker/Dealers gained 1%, while the Banks were about unchanged. With bullion down $4.20 to 438.45, the HUI gold index was about unchanged for the week (down 11% y-t-d).

For the week, two-year Treasury yields rose 4 basis points to 3.07%. Five-year Treasury rates increased 4 basis points to 3.61%. Ten-year Treasury yields added one basis point to 4.22%. Long-bond yields ended the week at 4.83%, down one basis point for the week. Benchmark Fannie Mae MBS yields increased one basis point. The spread (to 10-year Treasuries) on Fannies 4 5/8% 2014 note narrowed one basis point to 39, and the spread on Freddie's 5% 2014 note was unchanged at 35. The 10-year dollar swap spread was unchanged at 41.50. Corporate bonds performed well, with junk enjoying a strong final week of the 2004. The implied yield on 3-month March Eurodollars was about unchanged at 2.905%.

For the year, 2-year Treasury yields rose 124 basis points (from 1.83%) and the 5-year 36 basis points (from 3.25%). Meanwhile, 10-year Treasury yields actually declined 3 basis points (from 4.25%) and the long-bond saw yields drop 24.5 basis points (from 5.075%). Benchmark Fannie Mae MBS yields declined 6 basis points to 5.21%. According to Merrill Lynch, European government bonds returned almost 7.4% this year to outperform U.S., Canadian, and Australian bonds.

Junk bond funds reported $87.5 million of outflows in the week ended Wednesday. There were basically no corporate issues this week, although Scientific Games snuck in a $275 million convert deal to close the year.

December 27 - Bloomberg (Walden Siew): "The difference in yield between corporate and U.S. government debt held near the narrowest level since 1998... The extra yield investors demand to own investment-grade company debt rather than Treasuries was little changed today at 83 basis points, compared with 95 in January, according to the Merrill Lynch..."

Interestingly, Japanese 10-year JGB yields jumped 8 basis points this week to close the year at 1.43%. According to Merrill Lynch, JGBs posted the lowest returns of all major government debt issues this year (yields up 7.5bps for the year). Brazilian benchmark bond yields declined 3 basis points to 7.69%. In only two years, Brazilian spreads to Treasuries have collapsed from about 2,000 basis points to 400. Mexican govt. yields ended the week at 5.20%, up 7 basis points for the week. Mexico's November money supply data was released this afternoon, with broad money ("M3") up 12.4% y-o-y. Russian 10-year dollar Eurobond yields were unchanged at 5.82%.

Freddie Mac posted 30-year fixed mortgage rates rose 6 basis points this week to 5.81%. Fifteen-year fixed mortgage rates gained 5 basis points to 5.23%. One-year adjustable-rate mortgages could be had at 4.19%, up 2 basis points for the week. The Mortgage Bankers Association Purchase application index rose 2.7% for the week. Purchase applications were up significantly from one year ago, although holidays diminish the usefulness of year-over-year comparisons. Refi applications dropped 7.9% during the week. The average new Purchase mortgage rose to $228,300, while the average ARM declined to $306,200. ARMs declined marginally to 33.8% of total applications.

Broad money supply (M3) rose $13.8 billion (week of December 20) to $9.394 Trillion. Year-to-date (51 weeks), broad money is up $574.3 billion, or 6.6% annualized. For the week, Currency contracted $0.5 billion. Demand & Checkable Deposits jumped $25.5 billion. Savings Deposits dipped $3.0 billion (y-t-d gain of $355.4bn, or 11.5% annualized). Small Denominated Deposits added $0.7 billion. Retail Money Fund deposits declined $0.3 billion, and Institutional Money Fund deposits dropped $10.5 billion. Large Denominated Deposits rose $12.0 billion. Repurchase Agreements fell $7.3 billion, and Eurodollar deposits declined $2.8 billion.

Bank Credit declined $18.5 billion for the week of December 15 (latest data delayed until Monday) to $6.80 Trillion. Bank Credit has expanded $520.8 billion during the first 50 weeks of the year, or 8.6% annualized. For the week, Securities holdings declined $7.9 billion, while Loans & Leases dropped $10.6 billion. Commercial & Industrial loans added $1.7 billion, and Real Estate loans rose $6.1 billion. Real Estate loans are up $306.2 billion y-t-d, or 14.3% annualized. Consumer loans increased $2.0 billion, while Securities loans dropped $11.5 billion. Other loans declined $8.8 billion. Elsewhere, Total Commercial Paper jumped $10.9 billion to $1.414 Trillion. Financial CP surged $16.2 billion to $1.284 Trillion, expanding at a 10.7% rate so far this year. Non-financial CP declined $5.3 billion (up 20% annualized y-t-d) to $129.5 billion. Year-to-date, Total CP is up $145.3 billion, or 11.5% annualized.

December 31 - Bloomberg (Michael Rothschild): "JPMorgan Chase & Co. led banks that arranged a record $2.32 trillion of loans this year, as a surge in acquisitions and declining borrowing costs spurred companies to seek new funds. The amount of loans made rose by 53 percent from last year as companies including Royal Philips Electronics NV...refinanced deals to reduce interest costs... Mergers and acquisitions this year rose to $2 trillion globally, Bloomberg data show. Banks are reducing interest margins and fees for loans as they vie for relationships that will result in additional business such as share sales and advising on takeovers. 'Banks have a lot of money to lend,' said Julian van Kan, head of European loans at BNP Paribas... 'There's the promise of fees from bond and other debt underwriting, derivatives, trade business and advice.'"

Fed Foreign "Custody" Holdings of Treasury, Agency Debt gained $5.7 billion to $1.336 Trillion for the week ended December 29. Year-to-date, Custody Holdings are up $269.0 billion, or 25.2% annualized. Federal Reserve Credit jumped $6.1 billion for the week to $790.6 billion, with y-t-d gains of $44 billion (5.9% annualized). It is worth noting that Federal Reserve Credit expanded $38.4 billion, or 10% annualized, during the second half.

There were two deals totaling $1 billion to conclude a spectacular year for the asset-backed securities business. Total 2004 issuance of $621.8 billion was up 37% from a record 2003. For comparison, ABS issuance totaled $453 billion in 2003, $367 billion in 2002, $286 billion in 2001, and $231 billion in 2000. Home equity ABS was this year's star, with issuance of $412.0 billion up 81% from a record 2003. Student loan ABS issuance was up 30% to $42.3 billion, while auto ABS dropped 18% to $63.2 billion and Credit card ABS sank 30% to $46.5 billion. The boom was not limited to the U.S. European ABS issuance was up 22% from 2003 (and double 2002!) to $272 billion.

Currency Watch:

The dollar index declined slightly this week to end the year at 81.0. The Euro gained 8% against the dollar during 2004. The Polish Zloty rose 24%, the Iceland krona 15.6%, Norwegian krone 10.1%, Swiss franc 9.1%, and the Swedish krona 8.5%. Latin American currencies performed well. The Columbian peso jumped 16%, the Uruguay peso 11%, Brazilian real 9%, and Chilean peso 7% (to a four-year high). The Canadian dollar gained almost 8%, its third straight winning year against the dollar. The Mexican peso gained slightly against the greenback. In Asia, the South Korean won jumped 15%, the Taiwan dollar 7% (to a four-year high), the Indian rupee 4.9%, Japanese yen 4.7%, and Singapore dollar 4.2%. The New Zealand dollar rose 10% and the Australian dollar gained 3.8%. The South African rand surged 18.1%.

Commodities Watch:

December 31 - Bloomberg (Jennifer Itzenson): "Copper prices in New York rose, ending 2004 with a gain of 39 percent, as supplies in storage dwindled and the dollar declined close to a record against the euro. Consumption in China, the U.S. and Japan outpaced production by miners, forcing manufacturers to rely on inventory. Stockpiles of metal in warehouses approved by the London Metal Exchange dropped 1.7 percent today to 49,375 metric tons, extending this year's decline to 89 percent."

December 29 - Bloomberg (Tan Hwee Ann): "Iron ore prices may have their biggest gain in 25 years in the year starting April 1 as Chinese steelmakers continue expansion and drive global raw material costs higher, Sydney-based AME Mineral Economics said. The research company raised its iron ore price gains estimates to the upper end of 20 percent and 25 percent, and said there 'may still be upside'..."

December 29 - Bloomberg (Hector Forster): "Japan, the world's largest consumer of oil after the U.S. and China, said crude oil imports rose for a fifth straight month in November, gaining 18 percent as refiners built stockpiles of kerosene before winter."

January Crude Oil declined 73 cents this week to $43.45. The Goldman Sachs Commodities index declined 2.4% for the week, reducing 2004 gains to 19.2%. The CRB index dipped 0.4%, with 2004 gains of 11.2%.

China Watch:

December 28 - Bloomberg (Clare Cheung): "Hong Kong's exports rose in November at the fastest pace in three months as the city shipped more Chinese-made toys, clothes and computers to the U.S. and Europe. Exports rose 16.8 percent from a year earlier to HK$179.7 billion ($23.1 billion) after climbing 16.1 percent in October..."

Asia Inflationary Boom Watch:

December 29 - Bloomberg: "China and India fueled record sales of stock and bonds in Asia outside Japan this year, luring investors with the world's fastest economic growth rates. Asian companies and governments raised $98.6 billion selling debt and equity, setting records for both types of funding, Bloomberg data show. India, which increased the value of sales tenfold, combined with China to account for a third of the total, a trend bankers say will extend into 2005... International sales of stock and equity-linked securities in Asia outside Japan rose by a third this year to $60.4 billion, eclipsing a high set in 2000... Governments and companies sold $38.2 billion of bonds denominated in dollars, euros or yen, surpassing last year's record by 9 percent."

December 30 - Bloomberg (Heejin Koo): "South Korea's current-account surplus widened to a four-month high of $2.94 billion in November as exports surged to a record and a similar gap is expected this month... The won gained 14.5 percent against the dollar so far this year and is the best performer among 15 Asia-Pacific currencies tracked by Bloomberg."

December 30 - Bloomberg (Anuchit Nguyen): "Thailand's manufacturers increased production 9.5 percent in November, the fastest pace in nine months, to meet growing overseas demand for cars and electronics. The gain from a year earlier compares with a revised 5.3 percent increase in October..."

December 27 - Bloomberg (Anuchit Nguyen): "Thailand's exports rose 22 percent last month to $8.8 billion from a year earlier because of holiday-season demand for goods including automobiles and electronics, the commerce ministry said. Imports in November gained 31 percent to $8.65 billion on rising purchases of crude oil, machinery and raw materials, the ministry said..."

December 31 - Bloomberg (Amit Prakash): "Singapore's economy expanded 8.1 percent in 2004, the fastest in four years, fueled by rising exports..."

December 28 - Bloomberg (Kate Mayberry): "Malaysia's broadest measure of money in circulation expanded 10.3 percent in November as banks extended more loans to companies and consumers... 'Financing activity remained robust in November, underpinned by strong demand for bank financing,' Bank Negara said..."

December 27 - Bloomberg (Jason Folkmanis): "Vietnamese exports to the U.S. are picking up as consumers in the world's largest economy buy more of the Southeast Asian nation's clothing and furniture. Shipments to the U.S. rose 11 percent from a year earlier to $4.35 billion in the 10 months ended Oct. 31..."

Global Reflation Watch:

December 30 - Bloomberg (Brian Swint): " Money-supply growth in the 12 nations sharing the euro, the European Central Bank's barometer of future inflation, accelerated for a fifth month in six in November. M3 grew at an annual pace of 6 percent after expanding 5.8 percent in October... The bank says a rate above 4.5 percent risks fueling inflation. Money-supply growth rates are edging up after dropping to a nearly three-year low of 4.9 percent in May. Borrowing costs are at a six-decade low. The ECB said this month that there is more liquidity than is needed for growth without inflation."

December 29 - Bloomberg (Francois de Beaupuy): "French housing starts rose 19.6 percent in the three months ended in November from a year earlier, the second fastest pace this year, as interest rates near record lows buoyed demand. Building work began on 31,884 homes last month, the Paris-based Housing Ministry said, bringing housing starts in the three-month period to 98,200. Housing permits, a barometer of future demand, rose 16.2 percent from a year ago."

December 31 - Bloomberg (Agnes Lovasz): "Record gains by currencies in the four biggest nations that joined the European Union in May have boosted consumers' spending power and spurred trips to Austria, Germany and beyond for clothes, ski trips and even groceries. The Polish zloty is the world's best-performing currency this year, gaining 16 percent against the euro and 25 percent against the dollar. The Hungarian forint has risen 7 percent versus the euro and 16 percent against the dollar, while the Czech and Slovak koruna are up 6 percent against the euro and 15 percent against the dollar. 'The purchasing power of the people from those new EU countries increased quite markedly and their presence will be felt more on the markets' of Western Europe, said Radek Maly, who follows Eastern European currencies as head of research and treasury at Citibank in Prague. 'They will be able to afford to spend more, either through tourism or by individual spending.'"

December 29 - Bloomberg (Haris Zamir and Khalid Qayum): "Pakistan's economy may beat the government's 6.6 percent growth target in the year ending June 30 on higher domestic demand, led by the construction and automobile industries, the central bank said. The economy may expand as much as 7.1 percent, the Karachi-based State Bank of Pakistan said..."

December 31 - Bloomberg (Mike Cohen): "South African credit growth was an annual 10.51 percent in November, as the lowest interest rates in 23 years continued to boost demand for loans."

December 27 - Bloomberg (Guillermo Parra-Bernal and Denise Barbosa): "Brazilian shopping malls had the biggest Christmas sales increase in at least eight years as a growing economy spurred retailers to keep stores in the biggest cities open overnight for the first time, the head of mall retailers association said. Christmas sales for Spain's Inditex SA's Zara clothing chain, hamburger chain McDonald's Corp. and other shopping mall retailers jumped 15 percent this December, compared with 1 percent last year and 12 percent in 1996..."

December 29 - Bloomberg (Alex Kennedy): "Venezuelan retail sales soared in October as a recovering economy fueled a surge in vehicle purchases. Retail sales jumped 26 percent from October 2003 and rose 3.8 percent from September..."

December 30 - Bloomberg (Alex Kennedy): "Venezuela's economy probably grew more than 10 percent for a fourth quarter in the October-December period as increased government spending bolstered demand, central bank Director Domingo Maza said. Gross domestic product likely expanded between 10 percent and 15 percent in the fourth quarter from the year-earlier period after growing 15.8 percent in the third quarter, said Maza, one of seven central bank directors."

December 31 - Bloomberg (Robert Willis): "Colombia's exports rose 30.2 percent in October, boosted by high prices for oil and its derivatives. Colombian exports rose to $1.5 billion in October from $1.16 billion a year earlier..."

December 29 - Bloomberg (Alex Emery): "Peruvian exports rose in November for the 31st straight month, led by increased sales of copper, gold, fishmeal and coffee. Exports last month jumped 36.6 percent to $1.04 billion..."

December 28 - Bloomberg (Alex Emery): "The average yield gap between Peru's dollar-denominated foreign bonds and U.S. Treasuries fell to a record low today as the country's economic expansion lured investors to its securities. The extra yield investors demand to hold Peruvian bonds instead of Treasuries, or spread, narrowed to as low as 2.11 percentage points today..."

Bubble Economy Watch:

December 27 - Bloomberg (Alex Tanzi): "U.S. spending on Visa brand cards rose last week compared with the same week last year... In the week ending Dec. 24 purchases with Visa debit and credit cards rose 11.7 percent to $4.351 billion compared with the same week last year."

December 29 - Bloomberg (Josh P. Hamilton): "Average weekly pay for Manhattan financial services jobs jumped 27.4 percent to $5,680 in the first quarter, helping drive overall compensation in the borough up 13.6 percent, more than three times the national growth rate, according to a U.S. government report. Pay climbed to an average $1,913 a week for the 2.2 million people working in Manhattan..."

December 29 - Bloomberg (Jeff St.Onge): "Bankruptcy filings by U.S. public companies reached a 10-year low in 2004 as low interest rates and better access to financing helped troubled businesses amass cash and pay debts, according to a research report. This year, 80 public companies filed for bankruptcy, the lowest since 1994..."

December 28 - Bloomberg (Jonathan D. Salant): "Lobbyists spent a record $1.1 billion in the first half of 2004 to influence Congress and the Bush administration, according to documents filed with the U.S. Senate. The Chamber of Commerce led the way with $30 million. The overall amount was the most ever in any six-month period and compares with $963.1 million in the same period last year, said PoliticalMoneyLine..."

December 31 - Bloomberg (Steve Matthews): "U.S. executives and directors sold $51.3 billion of shares in their companies this year, the largest amount since 2000 when shares of Internet-related companies plunged. Microsoft Corp. Chairman Bill Gates topped the list. Sales by so-called insiders rose 20 percent through Dec. 24, while purchases rose 13 percent to $2.11 billion, according to the Washington Service..."

December 31 - New York Times (Patrick O'Gilfoil Healy): "Ocean views, private beaches and 14 bathrooms are fine for some people, but what good is a house in the Hamptons if it doesn't come with a superlative? Stewart Rahr, a pharmaceutical distributor, got one this week when he paid more than $45 million for an 18,000-square-foot waterfront estate in Wainscott, part of East Hampton. Real estate brokers in the Hamptons and Manhattan called it the most expensive home ever sold in New York State."

Mortgage Finance Bubble Watch:

December 29 - Bloomberg (Victor Epstein and Vince Golle): "U.S. 30-year mortgage rates averaged 5.84 percent in 2004, holding near last year's record low and helping drive home sales to all-time highs, Freddie Mac said. The average rate for a 30-year fixed mortgage was almost unchanged from 2003's 5.83 percent, the lowest since Freddie Mac began keeping track in 1972."

December 29 - PRNewswire: "Florida's housing market picked up the pace in November, shaking off lingering effects from the four hurricanes that pummeled the state over a six-week period in August and September. Last month, a total of 17,116 existing single-family homes were sold statewide for a 9 percent increase over last year's sales activity of 15,757 homes, according to the Florida Association of Realtors... The statewide median sales price rose 22 percent in November to $192,400; a year ago, it was $157,400. In November 1999, the statewide median sales price was $103,200, translating to a gain of 86.4 percent over the five-year period." Median prices were up 25% y-o-y in Miami, 20% in Orlando, and 36% in West Palm Beach/Boca Raton.

December 29 - PRNewswire: "Home sales in Illinois rose 18.8 percent in November and the median price of an existing single-family home increased 9.2 percent compared to the same period a year ago, the Illinois Association of Realtors reported... the median price of an existing single-family home in November was $184,000, up 9.2 percent from $168,600 in November 2003... November existing single-family home sales totaled 9,977, up 18.8 percent from 8,398 homes sold in November of 2003... There were a total of 4,161 condominium sales in November, up 26.9 percent from 3,280 sales in the same month last year."

Existing homes sold at a record pace during November out in California. Statewide median prices jumped to $473,260, up 23.1% from November 2003. Median prices were up $88,790 over 12 months, $145,760 (45%) over two years, $194,520 (70%) over 3 years and $276,200 (140%) over six years. Condo prices increased to a record $378,350, up 25.9% from on year ago. Median condo prices have inflated $77,400 in just 12 months, $121,710 (47%) in 24 months, $161,650 (75%) over 36 months, and $220,460 (140%) over 72 months. Strong sales reduced the inventory of unsold homes to 3.4 months, although the average number of days to sell a home increased to 40 days (up from 37 days during October and 27 during November 2003).

Financial Bubble Watch:

December 27 - Bloomberg (David Russell): "General Electric Co. and MGM Mirage were among companies that sold $638.8 billion of debt in the U.S. this year as borrowing costs relative to Treasury notes shrank to the slimmest margin in eight years. Sales of high-risk, high yield bonds set a record as the extra yield investors demand to hold junk bonds instead of Treasuries narrowed 1.35 percentage points to 3.49 percentage points, the least since April 30, 1998..."

December 30 - Bloomberg (Harris Rubinroit): "U.S. high-risk, high-yield loans surged to a record this year as takeovers by companies including MGM Mirage and Constellation Brands Inc. helped fuel the biggest year for mergers and acquisitions since 2000. More than 22 percent of so-called leveraged loans this year funded acquisitions, the biggest share since 2000, pushing the total to $428 billion, according to data compiled by Bloomberg. Leveraged loans are used by companies without investment-grade credit ratings or that pay an interest margin of at least 1.75 percentage points over benchmark interest rates. Mergers and acquisitions in the U.S. jumped 58 percent this year amid rising stock markets and the fastest economic growth since 1999. Banks are providing credit at the lowest interest margins in at least six years, according to Standard & Poor's, as investors flock to floating-rate investments such as loans that allow them to capture rising interest rates."

December 29 - Dow Jones (Ramez Mikdashi): "Structured finance investors chasing higher yields all year have been piling on leverage through ever more complex vehicles known as CDO squareds, the latest innovation to take off in the structured finance market. But with leverage comes risk, and the danger is that these new structured finance products will amplify any correction in the current record tight risk premiums. CDO squareds are vehicles that invest in a pool of collateralized debt obligation tranches, which are themselves securitized pools of other assets. In the case of CDO squareds, the underlying components are typically synthetic CDOs which are based on a pool of credit default swaps. Volume for synthetic CDO tranches distributed and purchased by investors was $260 billion in 2004 compared with $170 billion in 2003, according to JP Morgan research. While no breakdown is available for CDO squareds, researchers at the bank estimate that CDO squared issuance has more than doubled in 2004."

Year in Review: Reflation to Gross Over-Liquefication:

I haven't read anything from the general or business media that does 2004 justice. Most articles mundanely note that equity returns lagged 2003, while bonds posted surprisingly good if not stellar returns. Yet focus on the major equity averages and Treasury returns misses the major story of the year: rampant liquidity excess and rising inflation. For the year, The Street.com Internet index was up 36%. The Dow Jones Transports jumped 26.3%, and the Dow Jones Utilities gained 25.5%. The Morgan Stanley Cyclical index rose 15.4%, and the NASDAQ Industrial index gained 15.8%. The small cap Russell 2000 gained 17%, and the S&P400 Mid index jumped 15%. The Securities Broker/Dealers jumped 15%. The NASDAQ Insurance index jumped 19.8%, and the NASDAQ Other Financial index rose 19.6%. The NYSE Energy index gained 25.5%. The AMEX Composite rose 22.2%. The AMEX Biotechnology index gained 11%. The NASDAQ100 gained 10.5%. The S&P 500 Homebuilding index posted a 2004 gain of 33%. Clearly, sectors and groups that one would expect to be the most sensitive to over-liquidity and inflation have, in most cases, performed exceptionally well.

I realize some analysts continue to note the less than overwhelming 6.5% 12-month expansion in M3. I would like to again emphasize that "money" supply may not always be indicative of system liquidity. Today it is not; liquidity conditions remain overwhelming.

First of all, it is worth noting that M3 less money market fund assets expanded at a 10.3% rate over the past year. Many have had good reason to use bank and money market deposits to purchase some of the inflating quantities of higher-yielding Treasury bills and notes. Generally, there continues a major flight into riskier and higher yielding securities, which fueled record sales of junk bonds, huge record issuance of ABS, and strong issuance of CDOs and other structured products. Also, total Commercial Paper outstanding expanded by 11.5% this year. And with two weeks of data to report, we are about to conclude a record year for bank Credit growth (up $543bn, or 8.6% ann.). Bank loans have expanded at a 10.6% rate, with Real Estate loans increasing at a 14.4% rate. Even C&I (commercial & Industrial) loans will post a small rise (approx. 1.6%) this year, the first gain since 2000. Moreover, second-half C&I growth increased to a 6.2% rate. And, according to the Fed's "flow of funds" data, Broker/Dealer assets expanded at a 12.6% rate during the first three quarters of the year. And, importantly, 2004 will most likely post another record year of $1 Trillion-plus total mortgage Credit growth.

And any discussion of systemic liquidity must also note the ballooning (largely with dollar securities) of Asian central bank balance sheets. The latest data from Bloomberg has Total Asia (Japan, China, Taiwan, Korea, Hong Kong, India, and Singapore) central bank foreign reserve assets up almost $460 billion over the past 12 months (28%) to $2.1 Trillion. (As noted above, foreign "custody" holdings of U.S. securities held at the NY Fed are up 25% this year to almost $1.34 Trillion.) I would argue that liquidity has never been as abundant and that U.S. monetary aggregate growth has been impinged by the nature of current dollar balance "recycling." Instead of foreign exporters holding U.S. liabilities that would be included in M3, foreign central banks are acquiring these balances and recycling them into U.S. Treasuries, agencies, and other securities/instruments that are not components of "money" supply.

The bottom line - and crucial for assessing the financial backdrop - virtually every Credit and risk spread has narrowed to multi-year lows. This is a clear indication of over-liquefied market conditions. It is also worth noting that subprime - the marginal lender to the marginal borrower, and my favorite system liquidity "canary" indicator - had a gangbuster year. The stock of Metris Companies surged 189%, Americredit 55%, Providian Financial 43%, Advanta 74%, Credit Acceptance 67%, and Compucredit 30%. Lending aggressively was rewarded handsomely, as Capital One jumped 38% and Countrywide Financial 48%. The Bloomberg REIT index jumped 26%. Mortgage REITs generally provided investors strong returns. New Century's stock rose 62%, and Impac Mortgage gained 25%.

I will aver that 2004's rampant over-liquidity has had a much greater impact on the underlying structure of the economy than 2003's "reflation." It is worth mentioning that imports expanded at an almost 20% y-o-y pace during the second half (through October). "Luxury" goods have performed very well. In retail, Nordstrom's stock rose 37%, Neiman Marcus 33%, and Coach 51%. Other notable gainers included Starbucks (89%), Whole Foods Market (43%), Guitar Center (64%), and Abercrombie & Fitch (91%). With its slick IPod, Apple Computer enjoyed a 2004 gain of better than 200%. Harley-Davidson rose 29%. Luxury homebuilder Toll Brothers saw its stock jump 72%, with a two-year gain of 240%. Internet stocks were hot, with EBAY up 81%, Yahoo 67%, Research in Motion 148%, Adobe 61%, and Monster Worldwide 54%. The ultra-loose financial environment had this year a major influence on the character of spending, investing, and speculating.

Unprecedented global liquidity ensured that that Chinese boom avoided a 2004 landing (soft or hard). It also stoked multiple booms in "emerging" economies from India to Eastern Europe to Brazil. And now that strong growth and rising expectations have taken hold, considerable effort will be extended to perpetuate these boom-time conditions.

Here at home, rampant liquidity excesses stoked extraordinary housing speculation and inflation, especially along the coasts and virtually everywhere "upper end." The California housing Bubble evolved into a full-fledged mania. OFHEO's index of national home values posted a year-over-gain of 13% during the third quarter. This compares to the 6.0% y-o-y gain reported during the third quarter of 2003, and was the strongest national housing inflation since 1979. During the third quarter, y-o-y price gains jumped to 22.72% in the Pacific region, up from 8.9% during comparable 2003. Mid-Atlantic price gains rose to 15.7%, up from 8.0%, while New England rose to 15% from 7.9%. Third quarter South Atlantic prices rose at a 14% rate, up from 6.4%, and Mountain prices inflated at an 11.4% rate, up from Q3 2003's 3.7%. Through November, total combined new and existing home sales were running almost 9% above 2004's record pace. And with real estate inflation driving consumption, it is no surprise that Personal Spending is increasing at a 5.9% rate, while Personal Income is lagging at a 4.9% pace.

From my analytical framework, liquidity excess is having profound and all-encompassing effects on the financial markets and real economy. Never has over-liquidity been so conspicuous, not even with the technology boom. Crude oil prices rose 34% and energy prices surged during the year; import prices are now up 9.5% from one year ago; CPI and PPI moved solidly higher; and home prices inflated at a pace last seen in the late 70s. Accordingly, a strong case can be made that 2004 be designated The Year of Inflation's Serious Reemergence. Inflation expectations have certainly returned with a vengeance. Speculative interest in a wide range of hard assets - including real estate, commodities, art, myriad collectables, and precious metals - took firm hold during the past year.

Throughout the financial markets, liquidity excess incited The Year of the Blow-off. Junk bond spreads collapsed. Emerging bond spreads collapsed. Credit spreads collapsed. Credit default swap premiums collapsed. Equity option volatilities collapsed. And especially after President Bush secured a second term, the unwind of "bearish" bets and hedges incited virtual melt-up conditions in some sectors of the equity market and speculation throughout. M&A activity went to frothy extremes.

And over-liquidity also can also take Credit for inspiriting The Year it Didn't Matter. Crude prices ran to $55, it didn't matter to bonds. Commodity markets on fire - didn't matter. Sinking dollar - didn't matter. Heightened inflationary pressures - didn't matter. Fed raising rates - didn't matter. Fannie and Freddie with major accounting irregularities - didn't matter. And that was the kind of year it was: major fundamental developments developed with respect to the dollar, inflation, and the integrity of our financial system but all were trumped by rampant system liquidity excess.

To wrap this up this brief "review," we are now 25 months into "reliquefication." As students of inflation would expect, the nature of Inflationary Manifestations has evolved and intensified over time. I would strongly argue that the powerful strain of inflation that has taken hold during 2004 is of the most precarious variety. "Animal spirits" and speculative impulses have been unleashed everywhere. And the problem with extended periods of rampant liquidity is that it becomes only more difficult to wean the levitated financial markets, inflated asset markets, and distorted economy off the stimulant. I expect that The Year it Didn't Matter will be followed by The Year it Does.