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Speculator and Liquidity Unfriendly

The pressure to sell financial assets continued. For the holiday-shortened week, the Dow declined 1.8% and the S&P500 fell 1.6%. The Transports were about unchanged, while the Utilities dropped 1.6%. The Morgan Stanley Consumer index was about unchanged, and the Morgan Stanley Cyclical index declined 2%. Yet the broader market again outperformed the major indices. The small cap Russell 2000 and the S&P400 Mid-cap indices declined about 1%. Technology stocks were somewhat mixed. The NASDAQ100 declined 1% and the Morgan Stanley High Tech index 1.2%. The Semiconductors actually rose 0.4%. The Street.com Internet Index dropped 2.5%, and the NASDAQ Telecommunications index declined 1.4%. The Biotechs gained 1.3%. Financial stocks came under heavy selling pressure. The previously high-flying Broker/Dealer index was clipped for 4%. The Banks dropped 3%. With bullion sinking $14.65, the HUI gold index dropped 3.4%.

Two-year Treasury yields surged 16 basis points this week to 3.85%, the highest level since August 2001. Five-year Treasury yields jumped 14 basis points this week to 4.30%, and ten-year Treasury yields rose 9 basis points to 4.60%. The long-bond saw its yield add 3 basis points to 4.84%. The spread between 2 and 30-year government yields sank 13 basis points to a paltry 99 bps. Benchmark Fannie Mae MBS yields performed poorly, with yields up 17 basis points for the week. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note widened 2 basis points to 35, while the spread on Freddie's 5% 2014 note widened 2 basis points to 32. The 10-year dollar swap spread added 1.5 to 44.75, a high since last October. Corporate bonds were mixed but generally unimpressive. Junk bond spreads widened significantly, albeit from a narrow base. The implied yield on 3-month December Eurodollars jumped 17.5 basis points to 4.315%.

Corporate issuance slowed markedly. Investment grade issuers included Vornado $500 million, BMW Capital $400 million, Keyspan $400 million, Consumers Energy $300 million, and Pogo Producing $300 million.

Junk bond fund outflows surged to $1.494 billion, the largest exodus since last May. Junk issuers included Abitibi-Consolidated $450 million, American Tire $350 million, Tropicana $130 million, IAAI Finance $150 million, Smart Modular $125 million, Ameriqual $105 million, and Affinity Group $90 million.

Convert issuers included Cal Dive $300 million.

Foreign dollar debt issuers included Royal Bank of Scotland $1.0 billion.

Japanese 10-year JGB yields declined 4 basis points to 1.38%. Emerging debt markets were again under pressure. Brazilian benchmark dollar bond yields surged 66 basis points this week to 9.07%, the highest yields since September. Mexican govt. yields ended the week up 30 basis points to 5.83%. Russian 10-year dollar Eurobond yields jumped 40 basis points to 6.41%.

Freddie Mac posted 30-year fixed mortgage rates gained 6 basis points to 6.10% (up 44bps in 6 weeks), the first rise above 6% since July. Fifteen-year fixed mortgage rates jumped 7 basis points to 5.56%. One-year adjustable mortgage rates increased 4 basis points to 4.24%, up only 13 basis points in six weeks. The Mortgage Bankers Association Purchase Applications Index declined 3.5% this past week. Purchase applications were about unchanged from one year ago, with dollar volume up 7%. Refi applications sank 16.5%. The average new Purchase mortgage slipped to $238,800. The average ARM jumped to $331,400. The percentage of ARMs increased to 33.5% of total applications.

Broad money supply (M3) declined $11.8 billion to $9.49 Trillion (week of March 14). Year-to-date, M3 has expanded at a 1.3% rate, with M3-less Money Funds growing at a 4.9% pace (up 8.6% over 52 weeks). For the week, Currency gained $1.8 billion. Demand & Checkable Deposits were unchanged, while Savings Deposits fell $8.9 billion. Small Denominated Deposits rose $2.8 billion, while Retail Money Fund deposits dipped $0.4 billion. Institutional Money Fund deposits declined $5.2 billion. Large Denominated Deposits added $4.4 billion. Repurchase Agreements dropped $5.7 billion, and Eurodollar deposits slipped $0.6 billion.

Bank Credit has expanded a stunning $293.7 billion during the first 11 weeks of the year (20.6% annualized), in what is demonstrating all the characteristics of a classic Credit "blow-off." Securities Credit is up $118.7 billion, or 29% annualized year-to-date. For the week of March 16, Bank Credit surged $40.3 billion to a record $7.04 Trillion. Securities Holdings increased $11.1 billion (up $54.3 billion in 6 weeks). Loans & Leases jumped $29.3 billion, with a year-to-date gain of $171.4 billion (16.8% annualized). Commercial & Industrial (C&I) loans gained $4.3 billion. Real Estate loans added $2.0 billion. Real Estate loans have expanded at a 17.1% rate during the first 11 weeks of 2005 to $2.04 Trillion. Real Estate loans are up $337.9 billion, or 14.7%, over the past 52 weeks. For the week, consumer loans rose $2.8 billion, while Securities loans jumped $11.7 billion. Other loans expanded $8.5 billion.

Total Commercial Paper dipped $1.4 billion last week to $1.450 Trillion. Total CP has expanded at an 11.0% rate y-t-d (and up 11% over the past 52 weeks). Financial CP declined $1.9 billion last week to $1.389 Trillion. Non-financial CP added $0.6 billion to $145.7 billion.

Fed Foreign Holdings of Treasury, Agency Debt rose $3.7 billion to $1.389 Trillion for the week ended March 23. "Custody" holdings are up $52.9 billion, or 17.2% annualized, year-to-date (up $212.5bn, or 18%, over 52 weeks). Federal Reserve Credit declined $1.9 billion for the week to $783.5 billion, down 3.9% y-t-d (up $52.2bn, or 7.1%, over 52 weeks).

Despite the short week, $11 billion worth of ABS were issued (from JPMorgan). Year-to-date issuance of $144 billion is 8% ahead of comparable 2004. At $91 billion, y-t-d home equity ABS issuance is 23% above year ago levels.

Currency Watch:

The dollar index gained better than 2%. The Iceland krona dropped 4%, the New Zealand and Australian dollars 3%, the Norwegian krone 2.25%, and the Swiss franc 1.8%. The Latin American currencies generally outperformed their global counterparts.

Commodities Watch:

March 23 - Bloomberg (Chanyaporn Chanjaroen): "China, the world's largest copper consumer, expanded its demand for the metal by between 10 percent and 15 percent last year, said Norddeutsche Affinerie AG, Europe's biggest copper refiner."

March 24 - AFX: "China's consumption of steel, iron ore, nickel, copper, aluminum and oil will grow at double-digit annual rates for the next five years, CLSA said in a report. Its report on commodity outlooks concludes that while growth in China's hunger for resources has passed its peak, the country will continue to drive global demand growth for almost all commodities."

Heightened global financial stress and a stronger dollar generally pressured commodities this week (gasoline being the exception!). For the week, the CRB index sank 3.9%, reducing y-t-d gains to 8.1%. The Goldman Sachs Commodities index declined 2.7%, with the 2005 gain declining to 20.8%.

Global Financial Stress Watch:

March 25 - Bloomberg (Rodrigo Davies): "Emerging market bonds headed for their biggest two-week decline since July 2002 on concern accelerating inflation will boost the pace of global interest-rate increases, reducing demand for riskier assets. Currencies and stocks also dropped for a second week. The extra yield, or spread, investors demand to hold the bonds of emerging-market nations instead of U.S. Treasury notes on March 24 reached the widest in more than four months... Morgan Stanley Capital International Inc.'s Emerging Market Index of Stocks, an equity benchmark made up of 733 members, fell for nine consecutive days until yesterday, its longest streak of losses since September 2001."

China Watch:

March 21 - UPI: "By announcing measures last week to tighten mortgage lending, China finally appears to have made up its mind in defusing the long-building property bubble. But if the property market has been highlighted by many economists as the top risk for the Chinese economy this year, the latest measures are so mild they are unlikely to prick the bubble. More likely, they are the first of a series of measures to address the property imbalances."

March 23 - Bloomberg (Rob Delaney): "China's number of mobile-phone users rose to 344.1 million last month, the Ministry of Information Industry said..."

Asia Inflationary Boom Watch:

March 21 - Bloomberg (Cherian Thomas): "India's economy may grow as much as 8 percent in the fiscal year starting April 1, Prime Minister Manmohan Singh said. 'India is at cusp in its development trajectory,' Singh told business leaders... 'We have broken fresh ground' and 'we are now at the point where we need to accelerate growth and jump to a 7 percent to 8 percent band. All indicators point out we may deliver growth of 7 percent to 8 percent next year.'"

March 23 - Bloomberg (Young-Sam Cho): "South Korea's economy, Asia's third largest, expanded in the fourth quarter at the fastest pace in a year, fueled by rising exports of products including Hyundai Motor Co. cars and Posco steel."

March 25 - Bloomberg (Arijit Ghosh): "Thailand's construction costs may rise at least 15 percent this year and cut the industry's growth after the government raised the price of diesel, which is used by trucks to transport goods, Bangkok Post said, citing Poomson Rojlertjanya, president of the Thai Construction Association."

March 21 - Bloomberg (Shanthy Nambiar and Soraya Permatasari): "Indonesia proposed raising its inflation forecast in this year's budget after the government raised fuel prices earlier this month, a lawmaker said. The government may raise its inflation assumption in the 2005 budget to an average 7.3 percent from an earlier forecast of 7 percent..."

Global Reflation Watch:

March 25 - AFX: "Japan central government debt stood at a record 751.1 trln yen at the end of 2004, up 6.4 pct since the start of the current fiscal year last April, the Ministry of Finance (MoF) said. Japan's public debt is the largest in the industrialized world, relative to the size of the domestic economy. The ratio stood at 140 pct at the end of 2004..."

March 23 - Bloomberg (Kathleen Chu): "Average residential land prices rose in Tokyo's five main wards last year for the first time since 1987, indicating Japan's slump in property values may be ending. Commercial real estate prices in those five areas also gained for the first time in 14 years."

March 24 - Bloomberg (Daniel Taub and Kathleen Howley): "Tokyo's first rise in commercial property prices in 14 years is likely to add to Japan's attractiveness for overseas real estate investors, U.S.-based brokers and analysts said. Commercial property values in the capital's five central business areas rose an average 0.5 percent in 2004, a government said... Nationwide land prices, which fell 5 percent and extended a 14-year slide, dropped at the slowest pace since 2000."

March 22 - Bloomberg (Alexandre Deslongchamps): "Canadian retail sales rose 2 percent to a record in January as consumers used gift cards received over the December holidays... Excluding automobiles and parts, retail sales climbed 2.4 percent, the most in a decade, Statistics Canada said..."

March 24 - Bloomberg (Victoria Batchelor): "Australian sales of newly built homes surged in February to the highest in seven months, according to the Housing Industry Association, an organization that represents builders. New home sales jumped 35.9 percent from January to 9,789..."

Latin America Watch:

March 24 - UPI (Carlos Alberto Becerril): "At the beginning of the last century, Ramon Lopez Velarde, an extraordinary Mexican poet, wrote in his work 'Gentle Motherland' of the glories of Mexico and 'the gift of the devil' -- the nation's petroleum riches. Lopez Verlade's characterization has entered the 21st century with increasingly greater significance. Mexico's most important fiscal resource is its revenue from its petroleum sales, but the black gold's perennial flow is today beginning to show its limits. Mexico's oil industry is exhibiting signs of deep crisis and unless urgent steps are taken, Mexico paradoxically will slide from being a petroleum exporting country to becoming a fuel importer within the next decade."

March 22 - MarketNews: "Retail sales in Mexico jumped 6.2% in January compared to the same month of 2004, with broad gains across several categories, while wholesale sales increased 4.3%, the National Statistics Institute reported..."

March 23 - Bloomberg (Thomas Black): "Mexico's central bank today raised interest rates for a ninth consecutive month to slow inflation as commodity prices rebound and workers in Latin America's largest economy push for higher wages."

March 21 - Bloomberg (Katia Cortes): "Brazil's federal tax revenue rose 10.6 percent in February to 25.12 billion reais ($9.23 billion) from 22.71 billion reais in the same month a year earlier, the tax and customs agency said."

March 21 - Bloomberg (Julie Ziegler): "Mexican, Brazilian and other Latin American and Caribbean workers living abroad sent a record $45.8 billion last year to families back home in a trend that is helping to lift millions out of poverty, the Inter-American Development Bank said."

March 23 - Bloomberg (Heather Walsh): "Chile, the world's biggest copper producer, had its fastest economic expansion in seven years in the fourth quarter, sparked by a surge in demand for the metal. Gross domestic product grew 7.3 percent after expanding 7 percent in the third quarter..."

Dollar Consternation Watch:

March 24 - Dow Jones (Agnes T. Crane): "Measured isn't a word that only describes Federal Reserve monetary policy. It could also be used when talking about the quiet withdrawal of private Japanese investors from the U.S. bond market, according to research from Goldman Sachs. That the Bank of Japan has run out of 'extra dollars' to recycle into U.S. government securities has been notable since last year, but there's growing evidence that private Japanese investors are also cooling to the idea of holding Treasurys... Goldman Sachs chief interest rate strategist Francesco Garzarelli and strategist Hina Choksy noted...that total net sales of foreign bonds by these investors so far in 2005 has reached Y6.7 trillion ($63 billion) - the largest three-month decline in holdings since March 2002. The economists estimate about half of these sales involved U.S. Treasurys."

Bubble Economy Watch:

March 24 - Bloomberg (Kristen Hallam): "Medicare may raise U.S. seniors' health-insurance premiums by 12 percent next year because of higher payments to doctors, a government report showed. The increase would push premiums for doctor visits deducted from Social Security checks up 49 percent over three years to $87.70 a month..."

March 24 - Bloomberg (Danny King): "The average price of a one-way coach class airplane ticket rose 10 percent since January as many airlines raised prices this week, the New York Times reported, citing airline industry consultant Harrell Associates."

March 22 - The Wall Street Journal (Alex Frangos): "Fred Smith has one of most important jobs in Las Vegas. He supervises the construction of one dozen schools a year to accommodate an annual influx of 12,000 new students -- more seats than the total head count at most U.S. school districts. When steel and cement prices soared in 2004, Mr. Smith planned accordingly. He dug into his reserves and added $60 million to Clark County School District's $300 million building budget for 2005. 'We thought we had accounted for the material prices,' says Mr. Smith... But as the next crop of schools goes to bid, Mr. Smith faces a fresh predicament: Even as material prices settle at new, higher levels, contractors buoyed by strong demand are continuing to raise their prices. 'We are getting fewer bidders, which automatically raises prices,' Mr. Smith says... What does that mean for Mr. Smith's budget projections? 'I don't want to venture a guess' he says. 'It's too scary.' ...The surge in new building across the country is combining with higher prices for everything from copper wire to plastic PVC pipe to inflate the overall cost of construction."

March 22 - The Wall Street Journal (Timothy Aeppel): "The recent rise in oil prices is everberating far beyond the world's energy-intensive industries, spurring cost increases for everything from military tents in Iraq and weed killer in Iowa to shoes and Barbie dolls in China. The continuing surge is causing companies which a year ago saw higher oil prices as a passing phenomenon to rethink their strategies. Many are moving more aggressively to cut costs and raise prices to offset raw material and energy costs that now appear likely to stay high for the foreseeable future."

Mortgage Finance Bubble Watch:

March 23 - Bloomberg (James Kraus): "U.S. building costs rose 10.5 percent last year, as strong demand and higher prices spurred the biggest increase since the early 1980s, the Wall Street Journal reported, citing construction estimator RS Means."

February Existing Home Sales were reported at a slightly stronger-than-expected 6.79 million annualized pace. Sales volume was up 6.1% from February 2004, while average (mean) prices were up 11.9% to $241,700. Annualized Calculated Transaction Value (CTV) was up 18.8% from one year ago (volume up 6.1% and prices up 11.9%) to $1.641 Trillion, with a two-year gain of 35% (volume up 15%, prices up 18%), a three year gain of 47% (volume up 16%, prices up 27%), and six-year gains of 105% (volume up 36%, prices up 51%). Year-to-date sales are running 10% ahead of last year's record pace. The inventory of Existing Homes rose 23,000 units, yet this did not fully recover December's 32,500 decline.

February New Home Sales were at a stronger-than-expected 1.226 million pace. This was up 5.2% from comparable 2004, with average (mean) prices up 9.2%. CTV was up 15% from February 2004. Year-to-date sales area running slightly ahead of last year's record pace. The inventory of New Homes increased another 7,000 during the month to 444,000. This is up 19% from one year ago and 29% from February 2003.

The California Association of Realtors reported that February home sales were up about 3% from one year ago. Median prices declined from January's spike, but were up 20.4% from February 2004 to $471,620. The median price was up $80,070 from one year ago, $144,497 (44%) over two years, $176,760 (60%) over three years, and $273,750 (138%) over six years. Statewide condo sales were down almost 6% from February 2004, while prices were up 21.5% ($68,190) to $384,710. Condo prices were up 46% over two years, 71% over three years, and 134% over six years. Unsold home inventory dropped to 3.8 months from January's 4.2, although is up from the year ago 1.8 months.

March 23 - Sacramento Business Journal: "Sacramento home prices continued their steady climb in February, with the median price of a resold home reaching $351,700, up 26.8 percent from a year ago, and up 1.4 percent from January."

Financial Bubble Watch:

March 22 - PRNewswire: "After a year of somewhat lackluster returns, over 80 percent of the hedge-fund industry leaders, surveyed at the recent GAIM USA conference in Boca Raton, Fla., predicted hedge-fund returns would hold steady or increase in 2005, with over one-third predicting returns above 10 percent."

March 24 - Dow Jones (Marietta Cauchi): "Hedge funds are morphing into buyout players - and the strategy is paying off. Traditionally short-term investors in the public markets, hedge funds are increasingly challenging private equity houses on their own turf. The recent tussle for Toys 'R' Us pitted an investment group including hedge fund Cerberus Capital Management LP against a number of private equity bidders including veteran buyout house Kohlberg Kravis Roberts & Co. And the struggling company was just the latest target for acquisitive hedge funds; fellow retailer Circuit City Stores Inc., nursing home operator Beverly Enterprises Inc. and pharmaceutical company Mylan Laboratories Inc. have all been stalked recently by these new corporate raiders."

Speculator and Liquidity Unfriendly:

A timely article by Motoko Rich and David Leonhardt - "Trading Places: Real Estate Instead of Dot-Coms" - graced the front page of this morning's New York Times. In the same issue was a Floyd Norris (one of my favorites!) piece "Too Much Capital: Why It Is Getting Harder to Find a Good Investment: There is too much capital in the world. And that means that those who own the capital - investors - are in for some unhappy times."

"Unhappy times" do appear in the offing for investors and speculators. Yet I will take exception with the excess "capital" thesis bandied about these days. I actually rarely use the word "capital," choosing instead "finance" or "liquidity." In my view, "capital" is holdover terminology from a bygone era when a close relationship existed between the amount of finance (including "liquid" balances) and underlying economic assets ("capital"). "Money" was largely backed by intrinsic value (gold). And new Credit ("finance") was predominantly generated from the process of funding capital investment through the expansion of bank liabilities (Credits). "Capital" in the Financial Sphere corresponded to - was virtually synonymous with - "capital" in the Economic Sphere. As I said, a "bygone era"...

The fundamental issue I have with contemporary (unfettered) asset-based Credit systems - dominated, as it is, by financial leveraging, "Wall Street Finance," and asset speculation - is that they have nurtured a seductive yet precarious global breakdown in the relationship between "finance" and real economic "capital." No longer is financing economic investment the commanding mechanism for creating finance/liquidity. Instead, additional Credit instruments are financing self-reinforcing asset Bubbles and only more intense financial claims inflation. Unhappy times are inevitable not because of "excess capital," but because of the gross and stretching discrepancy between the massive inflation of perceived financial wealth (endless financial claims, liquidity and rising asset prices) and underlying economic wealth creating capacity.

There are indications that the inevitable transformation of Global Financial Excess and Exuberance to "Unhappy Times" has commenced. It has always been a case of Credit Bubble "Blow-Off" Excess eventually stoking traditional inflation (and central banker ire), as well as fanning contagious speculative "Melt-Ups" in various asset markets. We've witnessed the unfolding of both. This compounds many things, including the analytical challenge we now face. On the one hand, one would expect that rising rates and widening spreads (emerging markets, junk, corporates, and MBS) would begin to restrain Credit excess. On the other hand, the strong inflationary biases that have enveloped underlying economies and asset markets - within the backdrop of continued extraordinarily low global rates - should prove resilient to moderate financial turbulence.

As mentioned last week, I tend toward believing that the robustness of underlying economies and Credit systems will for now buttress the "emerging markets" and the global economy generally. And while rates are poised to rise globally and there will undoubtedly be some liquidation of emerging market positions, I do not envisage the type of regional currency and Credit system vulnerability that would unleash SE Asian and Latin American-type domino collapses. The greatest risk lies not at The Periphery, but at The Core. With this in mind, I will focus my analysis on what I believe is an unappreciated fragility that festers at The Core of Wall Street Finance. I now count a confluence of seven key developments that support the view of mounting Financial Fragility.

1) Rapidly rising interest rates: Two-year Treasury rates are up 125 basis points in five months to 3.85%, while implied yields on June 2006 eurodollar futures have surged to 4.60%. And with general inflationary pressures mounting, a housing mania having taken firm hold, and the Fed having fallen way behind the curve, there is today clear justification for the markets fearing the necessity of significantly higher rates. The market's spell of Fed/rate complacency is being broken. Accordingly, the issues of unprecedented system leveraging, endemic leveraged speculation and unprecedented derivative positions loom large. There is today also the issue of The Downside of Financial Innovation. The proliferation of ARMs, "teaser rates," interest-only, and other mortgage products - coupled with a creative and "mature" structured finance infrastructure - provide an atypical capacity for the system to sustain Credit excess notwithstanding Fed efforts to "tighten." The massive (and expanding) leveraging of MBS and mortgage-related instruments - The Historic Mortgage Spread Trade - is a prime source of potential system vulnerability.

2) Yield curve gyrations: While 2-year government yields are up 125 basis points in 5 months, 10-year yields have increased only 60 basis points. June 2006 implied Eurodollar yields are up 120 basis points. Benchmark Fannie MBS yields have risen only 50 basis points over this period. Such dramatic changes in the shape of the yield curve and unusual spread activity are often indicative of unsuccessful speculations, faltering hedges and general pressure on derivative strategies. This has become an especially important issue with regard to Systemic Financial Stability, in particular as it relates to the Securitization of U.S. Mortgage Finance. Recalling 1994, spiking 2-year rates and yield curve gyrations took early casualties in the mortgage derivative arena. Most notably, Askin Capital Management, with the collapse of its "sophisticated" strategies of leveraging and hedging mortgage IO ("interest-only") and PO ("principal only") derivative instruments. Faltering mortgage hedges then aggravated already mounting speculative losses and fostered full-scale bond market deleveraging. The resulting spike in yields and general market tumult caused many casualties. Orange County - sitting on a highly leveraged (with repos) portfolio of derivatives, Inverse Floaters, and GSE structured notes - suffered catastrophic losses and was forced into bankruptcy. One has to be a devote optimist to disregard the issue of systemic vulnerability associated with speculative leveraging, mortgage-related hedging, and general derivative-related fragility that has compounded significantly over the past decade.

3) There is today The Big Unknown: Are the GSEs effectively hedged? Were their hedging strategies more legitimate than their accounting? And, assuming that they were originally properly hedged (a big "if") against rising rates, what is the likelihood that the unusual rate environment forced an unwind of some of these positions, exacerbating what had been an unanticipated yield collapse? If so, could they now be forced to reconstitute hedges as rates move firmly against them - "The Notorious Market V" so capable of instigating derivative angst? And looking at the GSE derivative issue from a different perspective, who is on the other side of their interest rate hedges? Other unsuspecting Orange Counties, the aggressive hedge funds, Wall Street and/or dynamically-hedged derivative players that will be forced to aggressively short securities to hedge their exposure into a faltering bond market? If (when) serious GSE financial problems materialize, there will also be a major issue of derivative counter-party exposures. For now, the GSEs newfound risk aversion and the demise of the "backstop bid" have major negative implications for system liquidity and resiliency.

4) Surging crude oil and energy markets. Rapidly rising energy and commodities prices have fanned inflationary pressures throughout the global economy and stoked inflationary psychology for international markets. These inflationary pressures - recognizing the highly leveraged global system - have exacerbated economic and financial vulnerability. On the financial side, there are likely significant derivative and hedging losses, in addition to the general financial burden, consequent to the energy price spike. Moreover, the extraordinary price volatility is one more factor weighing against derivative market - hence systemic - stability.

5) GM/Ford bonds and Credit default swaps (CDS): Not unrelated to extreme energy inflation, the auto "manufacturing" risk market has suffered a severe blow. The auto companies now join the airlines as the major initial losers to inflation's wealth transfer, although airline debt does appear rather trivial by comparison. GM and Ford ended 2004 with Total Liabilities of $742 billion (combined Shareholders' Equity of $45bn). And it is worth noting that the market for GM and Ford "risk" played an instrumental role in the 2002 Greenspan/Bernanke Reflation. Unparalleled rate cuts, along with determined talk of helicopter money and "unconventional measures," incited a massive rebalancing of speculative bets: bearish positions in auto bonds and CDS were reversed and leveraged long positions established, in the process providing the marginal source of reliquification for the tottering corporate bond market. Surviving the near-death experience and having received the coveted "all-clear" from the Fed, the Credit default swap market mushroomed and rapidly succumbed to speculative blow-off dynamics. The ballooning CDS market then played a key role in fostering Easy Credit Availability for the entire spectrum of corporate borrowers. We will now follow developments very closely in an effort to gauge to what extent the blow-out in auto spreads and spike in premiums for Credit default protection will have spillover effects throughout the corporate bond arena. Furthermore, the auto sector - with their enormous consumer finance businesses - was also the platform back in 2002 for the corporate debt crisis to nearly cross over to the susceptible consumer sector and, more generally, ABS and "structured finance." Today, at a minimum, this is one more area where speculators and derivative players have been stung, liquidity conditions have been dramatically altered, and risk aversion now holds sway. Contagion effects are quite likely.

6) Emerging Markets, The Dollar Carry Play, and The Reflation Trade: It is difficult to gauge the degree to which cheap U.S. borrowings have been used to finance leveraged holdings throughout emerging debt and equity markets. But considering the dollar's steady and somewhat predictable decline (concurrent with inflating "emerging" securities prices) and the general speculative backdrop, we should assume The Dollar Carry Play is huge. At this point, let's try to keep the thus far moderate sized losses suffered during the past two weeks of market tumult in perspective. But, with the abrupt change in the general environment, we should as well factor in the potential for more problematic losses, forced deleveraging, and market dislocation. Greatly adding to systemic vulnerability, there is the possibility for a destabilizing unwind of dollar short positions that have financed leveraged long positions in emerging markets. The upshot of such a development would likely be wild currency market uncertainly and volatility, further pressuring The Leveraged Speculator Community and the derivatives markets, generally. A panic to the door by the Reflation Trade Crowd would likely prove a decisive marketplace development.

7) Currency Markets/Derivatives: Last, but not least, there are the issues of heightened instability and, of late, increased uncertainty in the currency markets. For about three years now, the declining dollar has provided a speculator-friendly one-way bet. And speculator-friendly is liquidity-friendly. There are today, however, newfound cross-currents and ambiguities. While the massive Current Account Deficit is poised to remain a fixture pointing to dollar vulnerability for some time to come, the degree of speculative dollar-based outflows is becoming less foreseeable. A destabilizing squeeze of dollar shorts positions cannot be ruled out. Yet, a run on the dollar in response to unfolding U.S. financial crisis is anything but out of the picture. Considering the unfolding environment, it is worth pondering the "what could go wrong" scenario involving A Squeeze rapidly followed by A Run. Global central banks would surely welcome a reprieve from dollar (and Treasuries!) buying, but would likely turn to alarmed dollar sellers in response to disorderly declines in their local currencies. At the minimum, it appears we are on an uncertain course where wild currency volatility risks unnerving the dollar shorts, the U.S. and global securities longs, and the derivative players. This is Speculator and Liquidity Unfriendly.

We are in the early first round of what will surely be a challenging period of heightened financial instability and uncertainty. The financial backdrop is changing, although I would expect fits and starts, unpredictability and global market bouts of manic-depressive disorder. It is, however, often a case of crises taking much longer than one would expect to develop, only to unfold rather quickly once in motion. Still, recent views of a U.S. and global slowdown, if they come to be supported by economic developments, would be expected to take some pressure off the U.S. interest rate markets. I am at this point skeptical that growth is poised to slow quickly and sufficiently enough to contain rising inflationary pressures (look at bank Credit!). More likely, I expect continued pressure on interest rates and the leveraged players. That the Leveraged Speculating Community is arguably immersed in The Most Crowded Trades in History leaves one apprehensive. U.S. asset markets have become addicted to low rates and abundant liquidity. The global economy and markets have similarly grown liquidity dependent. Today's market instability and resulting heightened risk aversion are Speculator and Liquidity Unfriendly. And there is always that specter of a whiff of smoke being sniffed in the exceedingly crowded theater.

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