UNEDITED!

While most of the major indices were about unchanged for the week, equities felt worse than that. For the week, the Dow was slightly negative and the S&P500 was slightly positive. The Transports were hit for 1.5%, while the Utilities recovered 2%. The Morgan Stanley Consumer index was slightly negative, and the Morgan Stanley Cyclical index declined 1%. The small cap Russell 2000 declined 0.6%, while the S&P400 Mid-cap index was barely positive. Technology stocks were mixed. The NASDAQ100 was unchanged, and the Morgan Stanley High Tech index slightly negative. The Semiconductors declined 1%, while The Street.com Internet Index was up 1%. The NASDAQ Telecommunications index was unchanged. The Biotechs were hit for almost 4%. Financial stocks were mixed but unimpressive. The Broker/Dealers were unchanged, while the banks gained 0.6%. With bullion up $1.40, the HUI index rallied 2%.

The bond bear took a respite. Two-year Treasury yields declined 12 basis points this week to 3.73%. Five-year Treasury yields dropped 17 basis to 4.12%, and ten-year Treasury yields sank 15 basis points to 4.45%. The long-bond saw its yield drop 12 basis points to 4.72%. The spread between 2 and 30-year government yields was unchanged at 99bps. Benchmark Fannie Mae MBS yields declined 17 basis points for the week, a decent showing. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note widened 2 basis points to 37, while the spread on Freddie's 5% 2014 note widened 2 basis points to 34. The 10-year dollar swap spread increased another 1.5 to 46.25. The corporate bond market remains unsettled, with junk spreads widening again this week. The implied yield on 3-month December Eurodollars dropped 15 basis points to 4.165%.

April 1 - Bloomberg (David Russell): "General Electric Capital Corp. and Berkshire Hathaway Inc. led companies that issued $167.4 billion of debt last quarter, 10 percent less than a year earlier... GE Capital...sold $9.4 billion of debt, and... Berkshire Hathaway...issued $3.75 billion of notes and bonds in its first sale since July. Companies were selling bonds at a faster pace than a year ago until GM, the world's largest automaker, on March 16 said it would have its largest quarterly loss since 1992. Investors then demanded more in yield to own company debt relative to risk-free Treasuries, causing Masonite International Corp., Navarre Corp. and other issuers to delay plans to sell bonds. 'For the first time in over a year, we started to see signs of volatility creep into the credit market,' said James Esposito, head of the investment-grade syndicate desk at Goldman Sachs... 'Issuance has slowed a bit because of recent volatility, not necessarily because interest rates are higher.'...Convertible bond issuance was down 61 percent to $6.6 billion."

March 31 - Bloomberg (Walden Siew): "General Motors Corp. led the worst month for automotive company bonds in at least eight years as lower sales and record-high oil prices made it harder for the manufacturers and parts suppliers to meet debt payments. A Merrill Lynch & Co. index showed that auto sector bonds have given investors a 5 percent loss during March through yesterday, including reinvested interest, compared with a 1.3 percent loss overall for investment-grade debt. GM's 7.75 percent note due in 2036 dropped 23.5 percent... Merrill Lynch's index of investment-grade debt fell 1.34 percent this month, and is down 1.18 percent for the quarter."

April 1 - Dow Jones (Simona Covel): "Shaken by higher interest rates and the seemingly imminent prospect of giant General Motors Corp.'s arrival in the speculative grade market, U.S. high-yield bonds lost more value in March than in any month since July 2002. The junk bond market shed about 2 1/2% in March, the greatest monthly loss since the market plummeted almost 4% in the wake of the WorldCom Inc. accounting scandal nearly three years ago..."

April 1 - Bloomberg (Joe Mysak): "If you thought the pace of municipal bond issuance would slow in response to higher interest rates, think again. More bonds were sold during the first quarter of 2005 than in any other first three months of a year. The estimated $96 billion (the figures are massaged for some time after the quarter ends) sold so far this year eclipses the previous record, which was the $87 billion sold in 2004. In 2003, the market's record year, when $384 billion in municipal bonds were sold, the first quarter amounted to $85 billion... The second quarter of 2003 holds the record for a quarter, at $120 billion. The fourth quarter of 1985, when issuers rushed to market to avoid tax law prohibitions scheduled to go into effect in 1986, saw $110 billion in municipal bonds sold. The fourth quarter of 2002, at $105 billion, the second quarter of 2004, at $104 billion, and the second quarter of 2002, at $98 billion, round out the top five."

April 1 - Bloomberg (Adrian Cox): "U.S. companies sold more shares in initial public offerings in the first quarter than in any similar period for the past five years, as economic growth fueled stock sales and reduced demand for convertible bonds and agency debt. The value of IPOs sold in the first three months of 2005 rose 47 percent to $10.1 billion from a year earlier, the highest amount since a record $18 billion was sold in the first quarter of 2000, data compiled by Bloomberg show. Convertible bond issuance dropped

61 percent to $6.6 billion, a fifth of 2002's level. U.S. agency debt sales fell 40 percent to $177 billion from last year's peak."

Corporate issuance came to a near standstill during the final week of the quarter. Investment grade issuers included Keyspan $300 million, American Standard $200 million, and First Citizens $75 million.

At $1.1 billion, junk bond fund outflows were heavy for the second straight week. Issuers included Sunstate Equipment $125 million.

Foreign dollar debt issuers included National Australia $500 million.

Japanese 10-year JGB yields dropped 4 basis points to 1.33%. Emerging debt markets generally regained their composure, at least for this week. Brazilian benchmark dollar bond yields dropped 44 basis points to 8.66%. Mexican govt. yields ended the week down 18 basis points to 6.07%. Russian 10-year dollar Eurobond yields declined 4 basis points to 6.36%.

Freddie Mac posted 30-year fixed mortgage rates increased 3 basis points to 6.04% (up 47bps in 7 weeks). Fifteen-year fixed mortgage rates added 2 basis points to 5.58%. One-year adjustable rates jumped 9 basis points to 4.33%. The Mortgage Bankers Association Purchase Applications Index rose 5.5% this past week. Purchase applications were up 6% from one year ago, with dollar volume up almost 19%. Refi applications declined 2%. The average new Purchase mortgage jumped to $245,600. The average ARM increased to $336,600. The percentage of ARMs jumped to a record 36.6% of total applications.

Broad money supply (M3) rose $17.9 billion to $9.51 Trillion (week of March 21). Year-to-date, M3 has expanded at a 2.0% rate, with M3-less Money Funds growing at a 5.8% pace. For the week, Currency added $1.3 billion. Demand & Checkable Deposits surged $25.9 billion, while Savings Deposits dipped $3.1 billion. Small Denominated Deposits gained $4.1 billion, and Retail Money Fund deposits gained $2.1 billion. Institutional Money Fund deposits declined $6.4 billion. Large Denominated Deposits dropped $7.2 billion. Repurchase Agreements added $1.6 billion, while Eurodollar deposits dipped $0.3 billion.

Bank Credit has expanded a remarkable $301.8 billion during the first 12 weeks of the year (19.4% annualized). Securities Credit is up $119.4 billion, or 27% annualized year-to-date. For the week of March 23, Bank Credit increased $4.2 billion to a record $7.048 Trillion. Securities Holdings added $0.5. Loans & Leases gained $3.7 billion, expanding at a 16% rate year-to-date. Commercial & Industrial (C&I) loans dipped $0.6 billion. Real Estate loans jumped $9.3 billion. Real Estate loans have expanded at a 17% rate during the first 12 weeks of 2005 to $2.642 Trillion. Real Estate loans are up $347 billion, or 15.1%, over the past 52 weeks. For the week, consumer loans added $0.9 billion, while Securities loans declined $3.8 billion. Other loans dipped $2.2 billion.

Total Commercial Paper dropped $20.2 billion last week to $1.429 Trillion. Total CP has expanded at a 4.4% rate y-t-d (up 8.4% over the past 52 weeks). Financial CP declined $10.9 billion last week to $1.293 Trillion. Non-financial CP dropped $9.3 billion to $136.4 billion.

Fed Foreign Holdings of Treasury, Agency Debt rose $3.0 billion to $1.392 Trillion for the week ended March 30. "Custody" holdings are up $55.9 billion, or 16.7% annualized, year-to-date (up $232.4bn, or 20%, over 52 weeks). Federal Reserve Credit declined $1.1 billion for the week to $782.3 billion, down 4.2% y-t-d (up $44.6bn, or 6.0%, over 52 weeks).

ABS issuance slowed to $6 billion (from JPMorgan). First quarter issuance of $149 billion was about unchanged from comparable 2004. At $93 billion, y-t-d home equity ABS issuance was 6% above year ago levels.

Currency Watch:

The currencies were quite volatile this week, as the dollar index mustered about a 0.5% gain. On the upside, the Brazilian real gained 2.5%, the Iceland krona 2.0%, the South African rand 2.0%, the Colombian peso 1.3%, and the Mexican peso 1.25%. On the downside, the Swedish krona dipped 0.6%, the Philippines peso 0.5%, and the Singapore dollar 0.4%.

Commodities Watch:

April 1 - Bloomberg (Claudia Carpenter): "Commodities prices had their second-biggest quarterly gain since 1988 as oil jumped to a record $57.60 a barrel, copper touched a 16-year high and coffee, soybeans and cotton rose 15 percent or more. Surging demand for raw materials in China and accelerating economic growth in the U.S. helped send the Reuters-CRB Index of 17 commodities up 10.5 percent, the most since an 11.2 percent gain in the 2004 first quarter. The index rose to a 24-year high on March 16 and may reach a record because investors are buying commodities as alternatives to U.S. stocks and bonds. 'We're continuing to see, even with the highs reached in commodities, just a mushrooming in how many institutional investors are allocating new money,' said Robert Leary, 44, a managing director at Wilton, Connecticut-based AIG Financial Products Corp...."

April 1 - Bloomberg (Koh Chin Ling): "China, the world's largest cotton consumer, will probably have a bigger shortfall next year because 2005 cotton acreage may fall about 11.5 percent, the National Development and Reform Commission said... Prices of the fiber are expected to rise this year because global production may drop 9 percent while consumption may rise 2 percent, the commission said...citing international forecasts."

May crude oil jumped $2.43 to $57.27. For the week, the CRB index rose 1.6%, increasing y-t-d gains to 9.8%. The Goldman Sachs Commodities index surged 4.5% to a record high, pushing 2005 gains to an impressive 26.2%.

Global Financial Stress Watch:

March 29 - Dow Jones (Arden Dale): "Investors in emerging-market mutual funds and hedge funds reversed course dramatically in recent days, staging a big pullout due to worries about inflation. A major rout in emerging-market stocks and bonds that began earlier this month is the impetus behind the move, according to analysts. Last week, shareholders in emerging-market stock funds yanked out more money than they have since last May, according to fund tracker Emerging Portfolio Fund Research. Emerging-market bond funds also were hit hard, EPFR said. For the first time this year, investors took more money out of the bond funds during the week than they put in."

China Watch:

March 30 - Bloomberg (Rob Delaney): "China's rising property prices pose a threat to the stability of Asia's second-largest economy and local officials who fail to take measures to rein in growth will be held to account, the country's highest ruling body said. The State Council, China's cabinet, ordered the clampdown in a six-page document...that was circulated to city governments and state media... 'Excessive growth in housing prices has directly undermined the ability of city residents to improve their living standards, affected financial and social stability, and even influenced the health of the national economy,' the document said."

March 28 - AFX: "China's economy will show growth of 8.8 pct year-on-year in the first quarter of this year, down 0.7 percentage point from the fourth quarter of last year, a government think tank research report said. A slowing agricultural sector and decreased investment are the main factors behind the less robust gross domestic product growth..."

March 29 - Bloomberg (Wing-Gar Cheng): "China's consumption of oil this year may rise 10 percent to 354 million metric tons because of surging demand for fuels, the China Petroleum & Chemical Industry Association said. China's reliance on imported oil will increase as local production isn't meeting the country's needs, Tan Zhuzhou, the association's president, said...."

March 29 - Bloomberg (Koh Chin Ling): "China's exports of textiles and garments rose 31 percent in the first two months, more than double the rate analysts say might prevent competitors in the U.S. and European Union from requesting trade limits. Overseas sales of clothing and fabrics rose to $12.5 billion in January-February from $9.6 billion a year earlier..."

March 27 - AFX: "China's electricity consumption is expected to reach 2.42 trln kilowatt hours (kWh) this year, up 12 pct from last year, the Economic Daily reported, citing the chairman of the State Electricity Regulatory Commission. Chai Songyue also said that China's electricity demand this year will increase by 12 pct and that the country's power supply is expected to remain tight due to insufficient coal supply, overloaded power generators and transmission lines."

Asia Inflationary Boom Watch:

April 1 - Bloomberg (Heejin Koo and Young-Sam Cho): "South Korean exports rose faster than economists expected to a record in March, led by European sales of cars made by Hyundai Motor Co. and Kia Motors Corp. Exports gained 14.2 percent from a year earlier to $24.2 billion, accelerating from February's revised 6.7 percent growth... The pickup in exports may help Asia's third-largest economy meet the government's growth target of 5 percent for 2005."

March 30 - Bloomberg (Anuchit Nguyen): "Thailand's economic growth will exceed 5 percent this year as revenue from tourism revives after the Dec. 26 tsunami that killed more than 5,300 people in the Southeast Asian nation, central bank Governor Devakula said. 'Economic growth will remain strong because tourism is good. Economic growth will certainly exceed 5 percent.'"

March 28 - Bloomberg (Stephanie Phang): "Malaysia's broadest measure of money in circulation expanded more than 12 percent for the third straight month in February, the central bank said today. M3, the most closely watched measure of money supply, rose 12.4 percent in February from a year earlier..."

April 1 - Bloomberg (Shanthy Nambiar and Soraya Permatasari): "Indonesia's inflation accelerated to its fastest pace in at least 26 months in March after the government raised fuel prices, increasing pressure on the central bank to raise interest rates. Consumer prices rose 8.8 percent from a year earlier compared with a 7.2 percent gain in February, led by a surge in transportation costs... Accelerating inflation may drive up interest rates, slowing Indonesia's economy, Southeast Asia's largest, after its biggest expansion in eight years in 2004.

April 1 - Bloomberg (Jason Folkmanis): "Vietnam's economic growth accelerated in the first quarter, boosted by services that make up two-fifths of the $40 billion economy. Gross domestic product expanded 7.2 percent from a year earlier, according to preliminary estimates released by the General Statistics Office... That compares with 7 percent growth in the first quarter of 2004. Services expanded 7 percent compared with 6.6 percent growth a year earlier as easy credit fueled business investment. 'You see investment everywhere, renovation of businesses, new buildings going up,' Susan Adams, the International Monetary Fund's senior resident representative in Vietnam. 'People are increasing the quality and variety of the goods that they consume.'"

Global Reflation Watch:

March 30 - AFX: "Average year-end bonuses paid by Japanese companies with five or more employees rose 2.7 pct to 430,278 yen last year, the first increase in eight years, the government reported. Bonuses rose from 1.2 pct to 19.6 pct in seven industries, including the manufacturing, construction, real estate, electricity/gas and mining industries, according to a survey released by the Ministry of Health, Labor and Welfare. Year-end bonuses fell in only two industries -- the wholesale/retail and financial services/insurance sectors."

March 29 - Bloomberg (Harumi Ichikura): "Honda Motor Co., Japan's third-largest automaker, said global production of its cars and light trucks rose 10.5 percent in February compared with the same month last year... Toyota Motor Corp., Japan's biggest automaker, said global production of its cars and light trucks rose 11.6 percent in February from a year earlier... Nissan Motor Co., Japan's second-largest automaker, said global production of its cars and light trucks rose 10.8 percent in February compared with the same month last year."

March 31 - Bloomberg (Alexandre Deslongchamps): "Prices for existing Canadian homes rose to a record in February, buoyed by rising employment and mortgage rates near 50-year lows. The average price for a house or condominium rose 8.3 percent to C$238,778 ($197,326) as sales climbed 2.4 percent to C$9.16 billion, the most ever, according to the Canadian Real Estate Association in Ottawa. The number of units sold rose 3.5 percent to 38,215, the most since September 2004. 'The continuation of low interest rates is keeping housing demand strong, it's that simple,' said Gregory Klump, the association's senior economist. 'Continued job growth has helped sales to continue momentum.'"

March 30 - Bloomberg (Christian Baumgaertel and Brian Swint): "Money supply growth in the 12 countries sharing the euro unexpectedly slowed in February, easing pressure on the ECB to raise borrowing costs. M3 increased 6.4 percent from a year earlier after expanding 6.6 percent in January, the ECB said in Frankfurt today... The bank says a rate above 4.5 percent risks fueling inflation... Credit to households and companies grew 7.3 percent, the same pace as the month before, when the rate was the highest in more than three years. 'The fuel is here to support the housing market for a long time,' said Lorenzo Codogno, co-head of European economics at Bank of American in London. 'The excess liquidity floating around can push asset prices' higher than they otherwise would be."

March 28 - AFX: "Pay settlements in the UK continue to edge higher and are rising at their fastest rate in six years, a survey found today. Pay analysts Industrial Relations Services, part of the LexisNexis Butterworths online information group, found its headline measure of pay awards across the whole economy standing at 3.3 pct for the three months to February..."

March 30 - Market News: "Home construction in France remained buoyant in February, with the launch of nearly 33,000 units -- a rise of more than 13% from February 2004, according to non-seasonally adjusted data released Wednesday by the Construction Ministry. The three-month annual comparison highlighted by the ministry showed a gain of 13.4% for December-February over the previous-year period."

March 28 - Bloomberg (Jeffrey T. Lewis): "Prices of goods leaving Spanish factories, farms and mines rose 0.7 percent in February from the previous month, as an increase in the cost of oil boosted the price of gasoline and other energy products. Producer prices rose 4.9 percent from a year earlier..."

April 1 - Bloomberg (Bradley Cook): "Russia's manufacturing activity in March accelerated at the fastest pace in seven months as factories increased output to meet swelling demand, an index of purchasing managers showed... The survey of 300 purchasing managers 'signals further improvements in Russia's industrial dynamics, with the headline index reaching a seven-month high...'"

Dollar Consternation Watch:

March 30 - AFX: "The US dollar is facing an imminent collapse and a standard gold currency is the best alternative for international trade, the Star quoted former prime minister Mahathir Mohamad as saying. The dollar is retaining some value because of fears of a global economic catastrophe if it is rejected, Mahathir told a conference of some 650 chief executives from 30 countries at a conference in Kota Kinabalu on Borneo island yesterday, the report said. 'But the catastrophe will come one day because even the most powerful country in the world cannot repay loans amounting to seven trillion dollars,' Mahathir said."

Bubble Economy Watch:

March 31 - Bloomberg (Martin Z. Braun): "New York state lawmakers approved a $106.6 billion spending plan, the first on-time budget in 21 years. The plan leaves open to negotiation $1.6 billion in additional spending for welfare, the state's voting system and construction projects for public and private colleges. In the past five years, New York State's budget has grown 37 percent from $77.5 billion in fiscal 2001."

March 29 - The Wall Street Journal (Paul Glader): "Keith Busse added three Corvettes this year to his stash of 51. They're housed in his Corvette Classics Museum, an 18,000-square-foot showroom open to the public. The 61-year-old Mr. Busse lives in a 7,000-square-foot mansion when he's not spending time at one of his two lakefront retreats or shooting 18 holes at a golf course he spent $1.2 million to help build. Last year his compensation totaled $9.4 million and his net worth rose 30% to about $50 million. A boom in steel, coal and iron ore is bringing wealth commonly associated with Wall Street and Silicon Valley to an unlikely place: America's industrial heartland."

Financial Bubble Watch:

April 1 - Bloomberg (Kathleen M. Howley): "Manhattan apartment prices surged 23 percent to a record $1.21 million during the first three months of the year as the city's economy expanded and Wall Street bonuses fueled purchases in New York's priciest borough. The average price rose from $987,257 in the fourth quarter of 2004, according to a report published today by Miller Samuel Inc., the borough's largest appraiser, and real estate brokerage Prudential Douglas Elliman. It was the second-biggest price gain ever, following a 23.5 percent jump in 2001's first quarter... New Yorkers flush with bonuses bid up prices, rushing to beat rising mortgage rates, after the city's economy expanded at the fastest pace in four years. Wall Street firms such as JPMorgan Chase & Co. and Merrill Lynch & Co. awarded $15.9 billion at the end of the year, an average of $100,400 per employee, New York state Comptroller Alan Hevesi has said. 'There's a lot of Wall Street bonus money in these numbers,' Miller, 44, said. 'New Yorkers had money to spend, and they wanted to get their mortgages before interest rates went up.' Compared with the first quarter of 2004, the average price for an apartment gained 26 percent from $966,292, the report said."

That Kind-hearted Kate Welling:

I was traveling at the end of the week and had limited time to put together this week's Bulletin. I am indebted to that Kind-hearted Kate Welling for graciously allowing me to use one of her recent interviews from her outstanding Welling@Weeden publication. The interviewee seemed a little odd to me, but he may have made a couple of ok points. My take is that the interviewer makes him come across smarter than he is.

This following is a reprint of an interview with Doug by Kate Welling recently published in welling@weeden. Copyright, welling@weeden, 2005, All Rights Reserved. Reprinted with permission. For further information, call 203 861-7643.

"Gimme Credit - Not!" was the headline I put over my last full scale interview with my old friend Doug Noland, in these pages, back in December of 1999. If Doug, who writes The Credit Bubble Bulletin every week for David Tice & Associates at www.PrudentBear.com, was extremely worried by the economic climate back then, he's beside himself now. And he's still very much worth listening to. I called him last week, after he took the Fed's latest Z.1 apart in print, piece by piece.

KMW

Kate Welling: You're like a kid in a candy store, Doug, every time the Fed releases a fresh Z.1 - a macabre kid in Harry Potter's candy store, that is.

Doug Noland: Oh geez, you're not going to harp about all that gloom and doom stuff, are you?

That's your role. I really try to avoid it; it's just too darn depressing. But I have to admit, the dimensions of the credit expansion are mind-boggling. Even though the Fannie and Freddie, which you were so fixated on a few years back, have been largely taken out of the picture.

That's the power of the bubble. Once you create a bubble, it will sustain itself one way or the other. Once you get it revved up, everybody is waiting for an opportunity. So someone dropping out just becomes an opportunity for the others. That's why you can't let the bubbles get this heated.

You wrote that banks have been only too eager to pick up the slack from the GSEs?

Yes, banks can can grow their balance sheets as much as they would like today. And they are. For 2004, the pace of domestic financial sector debt growth actually declined to 7.2% from 10.4% - chiefly because of the abrupt slowdown in GSE asset growth and their attendant credit market borrowings. That slowdown, however, was more than compensated for by the ballooning in bank deposits and other financial sector claims. Total GSE assets increased only $109 billion last year, or 3.9%, to $2.9 trillion, and were essentially flat in the fourth quarter. Quite a comedown from their double-digit growth rates from 1998-2002, and even from 2003's 9%. Meanwhile GSE mortgage-backs grew by only $54 billion last year, to $3.54 trillion. The action in structured finance has switched into asset-backed securities, where outstandings surged a record $331 billion, or more than 13%, to $2.82 trillion. In fact, ABS is up $600 billion, or 27% in just two years. Yet even if structured finance provided the financial genesis of the credit bubble, its the banks and brokers and their clients who are keeping it aloft today. Banks are extending a lot of mortgage credit, generating lots of fee income that flows into earnings.

Surely you don't have a problem with that? Mortgage lending is as American as apple pie.

Apparently. Let me put it this way: The Z.1 is this beautiful document because it shows clearly where the credit excesses are - and those excesses explain so much of the strange behavior of the economy. This one quarterly statistical release provides lots of answers.

Only if you can navigate a mind-numbing avalanche of numbers.

It is packed with a lot of them that are worth noting. Like the fact that bank credit expanded 9.2% last year, or by a record $569 billion, while bank loans grew by 9.1% or $403 billion, also a record. Or that bank mortgage exploded to $2.6 trillion last year, a gain of 15% or $339 billion - and at better than twice the pace it had grown, on average, during the preceding 8 years. On the banks' liability side, total deposits last year climbed a record $510 billion, or 11.3%, to $5.03 trillion. And anyone who takes some time to study the statistics in the Z.1 can also see, for example, that these dopes running around talking about a "shortage of bonds" because "corporations are so flush" are just that - dopes.

I don't know about "anyone" but the preternaturally perceptive Andrew Smithers did a neat job in a recent report (published by his Smithers & Co.) of using the Z.1 to show that U.S. companies are anything but flush with cash. His contention, in fact, is that they're currently paying out more, in (paltry) dividends and share buybacks, than they're earning in profits - a situation that clearly can't go on forever, and has obvious negative implications for the stock market.

I haven't seen that research. But I was thinking in even more macro terms. Greenspan was recently asked about all those projections a few years ago of federal surpluses "as far as the eye could see." His response was basically, "Well, we were all wrong. Everybody thought there would be surpluses." That's just so outrageous. I mean, it was just so clear, if you looked at the Z.1 and if you really understood the flow of finance back in the late '90s, you had to see the huge capital gains tax bonus pouring into the federal government. And you had to know it was unsustainable. Today's situation is very similar. We have huge federal borrowings and mortgage credit that have created just a huge tailwind of finance blowing across corporate America. But it's not sustainable. You can't continue to create almost $1.2 trillion in mortgage credit every year - because then you'd continue to have these massive current account deficits and all of the distortions that go with them. Everyone wants to extrapolate the "positive" bubble effects. We don't learn.

Come on, Doug. Housing values aren't going to pop like the internuts back in 2000.

Unfortunately - the key right now is that the trillion dollars plus of total mortgage credit created last year is directly linked to the current account deficit.

What? There can't possibly be that many hedgies buying houses in the Cayman Islands -

No. The linkage I see is that when people borrow against their homes and when you have this inflation of asset values, it leads to over-consumption. I think you can draw that link clearly. The issue is global now. How long will the world continue to buy these dollar balances? Obviously, recently, we've been hearing from the South Koreans, the Japanese. Everybody is saying, "Oh, my gosh, no mas, please!"

Already, the only foreign interests actually buying our paper are the central banks. Private investors aren't interested.

The official flows are just amazing. What's called Rest of World (ROW) holdings of U.S. assets last year increased by better than 13% to $9.29 trillion. Official holdings, soared by $290 billion, or 25.3%, to $1.44 trillion last year, making the two-year increase in official holdings an unprecedented $537 billion, or 60%. In fact, official holdings lately have been rising more in one quarter than they did in each year, on average, between 1998 and 2002. But a clear preference, among foreign investors, for holdings of U.S. credit market instruments, as opposed to direct investments of any kind is also visible in the numbers. Thus, foreign direct investments climbed only 10.5% last year, to $1.72 trillion, while ROW holdings of U.S. credit market instruments surged 21% to $4.7 trillion.

You're saying foreign investors would rather buy Treasuries and ABS than make direct investments in this country. Okay, but so what?

What that points to is that the "love affair" you hear some people talking about between foreign investors and U.S. assets is really more a case of foreign central bankers doing what they have to support their currencies by recycling dollars. And if they do the same thing for the next year, do we have $80 oil? Today you can clearly see the price effects on global commodities prices. The CRB Index has just been on the fly. So if the central banks want to continue this recycling, we'll see what happens with global commodities, with the Asian boom and the emerging market boom. We're finally at the point where the inflationary bias globally is pretty intense. If we continue to feed that animal, there are going to be consequences.

Isn't that precisely what you see Greenspan and company trying to do? Asset inflation is surely more palatable than deflation.

Oh, sure. But I'm not certain that they appreciate the dynamics of mortgage credit - how it will continue to expand. I have never really sensed that there is an appreciation of that.

What's wrong with mortgage credit growing?

Well, take California, where home prices climbed 20% over the past year. That means that this year, mortgage credit there has an inflationary bias: More credit will be created simply because of the prices of the homes have gone up. Even if the number of transactions is flat this year with last, 15%-20% more credit will be created. And home prices have risen across the whole nation, which will feed more speculative excess, more transactions and more credit creation. Even Freddie Mac, which has been moaning about falling originations and fewer refinancings, estimates total mortgage credit growth of 11.9% this year (vs. a record $1.19 trillion, or 12.8% increase, in 2004). That is the dynamic that I'm not sure the Fed fully appreciates. Yet it is a key dynamic because all of this new mortgage credit is creating distorted spending patterns, and, especially, over-consumption. Yet the Fed doesn't seem to have a problem with it. From what I'm reading, they seem to be expecting a natural slowdown in the growth of mortgage credit this year. But that's just not the way that bubbles work. It won't gently slow just because rates have risen a little bit. Inching rates up in baby steps isn't going to curb mortgage borrowing, no way. Speculative psychology is so strong in housing, they're really going to have to ratchet rates up.

And deliberately pop another bubble? No way.

Look, whether you do macro credit analysis, or just old school inflationary analysis, if you look at the Z.1, you can see why my thesis is that this thing is a runaway train heading for a financial accident.

There you go with the gloom and doom again.

I know, but when I do the analysis, that's where I come out. I just don't see anything to slow down this impending train wreck. What I mean is, it would take exorbitantly higher rates to slow this down, but those sorts of rates, in and of themselves, would probably produce the accident. So to me, this is a runaway train at this point. Everyone can get all bullish because they see liquidity everywhere, but that is kind of textbook, too; that's the way credit bubbles suck everyone in at the end.

You don't agree, as a great lady once said, that too much of a good thing is just about right?

Absolutely not. Too much liquidity is a sign of the problem. Why did NASDAQ spike up like it did? Because of wild liquidity excesses. You always have wild liquidity excesses when you have this kind of monetary disorder. So why did NASDAQ collapse? NASDAQ collapsed because it went into a melt-up mode. When you create all this liquidity and prices spike up, eventually they reach a tipping point and reverse - and then liquidity collapses. Right now, wherever you look, you see liquidity. But you are also seeing global asset inflation and speculation. Which means that this thing is going to require continuous injections of liquidity now, to keep this thing levitated. But that's the danger. Right now, the system can, and does, create enough liquidity to keep everything up. But how long can this go on? It's already at the point now, where huge amounts of liquidity have to be created, because asset inflation has gone global; market bubbles have gone global.

As long as the governments of the world keep running their printing presses, what's wrong with a using a little inflation to keep things moving along?

There are consequences - and they are not all benign. Look at the price of oil, look at copper. These are distortions. What are the consequences, if this liquidity continues for another year? And what are the consequences if all of a sudden something impedes the flow? Either case is troubling.

Which would be worse is the question. Clearly, the Fed is working to insure that there's no end to the flood of liquidity. Your friend at the German central bank is about the only one who wants to take away the punch bowl.

Otmar Issing? He's chief economist of the ECB now. But what he's saying is nothing more than any other traditional central banker should be saying. When I went to Australia to study, I spent a lot of time in the library reading the history of central banking. The sort of language Otmar uses - that's traditionally the way central bankers are supposed to talk. The sort of talk we've heard recently from Alan Greenspan and Ben Bernanke is unbelievable to me. This is New Age central banking; there has never been anything like it. They've both effectively thrown up their hands and said they can't deal with these excesses.

Traditional central bankers didn't have a wonderful track record in dealing with bubbles, either.

It's not perfect.

I'll say. History is full of booms and busts - and their painful consequences.

No argument. But I have been reading the biography of one of Greenspan's illustrious predecessors, William McChesney Martin. Even 3% inflation drove him crazy in the 1950s and 1960s. He didn't want to see any speculation. He had been president of the New York Stock Exchange when he was younger. He just understood the markets. He didn't want to see a market get all revved up, because once one gets revved up, it's very hard to control the excesses. Today, no one will even address all this speculation. And we've come to the point where the Fed uses the speculating community as a "tool" of reflationary monetary policy.

He must be spinning in his grave. Speculation is what passes for investment these days.

It dominates the financial markets.

Fundamentals are irrelevant when long-term is this afternoon. And especially when the majority of transactions are in derivatives. There's a huge disconnect today between traditional business economics and the machinations of today's financial markets.

That's very well said. That is my point when I talk about "financial arbitrage capitalism." I mean, you are what you eat. The economy is how the financial sector lends. So if everything is a spread trade and no one cares about the underlying credit or the underlying economic return, how could you expect that to work well for the structure of the economy? It can't, yet that's what we see today. The system just wants to buy mortgage backs, or some derivative or some mortgage credit. So that's what the system lends to. What are the consequences? We have asset inflation and over-consumption and huge trade deficits.

That's very well said, too. But the "beauty" of the whole thing is that nobody is responsible. Everyone is just doing what he has to do to earn a return.

Absolutely. Hats off to them. That's why this all boils down to the Fed. Only the Fed can possibly control the direction in which the financial sector evolves. But they've just thrown up their hands and said, "We trust the markets to do what is best."

The ascendancy of unfettered market capitalism has been evolving for over 20 years.

The mid-1980s is a great starting point for it. Henry Kaufman had it right there in his 1984 book: "Securitizations are the future. Forget bank loan officers. Now we can just package up loans and sell them. Finance is changing."

It was incredibly liberating to shake off the shackles of Regulation Q; to march to the beat of the market, instead of fusty old regulators. But somewhere along the line, the rewards got separated from the risk-tasking.

What frustrates me is that no one ever asks, what's the end game? There is this whole Keynesian idea that the Fed will allow 3% inflation every year to keep the wheels moving. That's fine, but only for a while. It reminds me of telling a child he can grow 5% every year. That's fine until he reaches 18 or 19, but then you have to change the rules. If he continues to grow at that rate, he'll kill himself. The nature of the system changes. At some time, you have to make the difficult decision to recognize that. Today, we just ignore the way the system has changed. But we can't just sit back and let the markets do whatever they want, accept a 3% CPI and ignore asset inflation, as contemporary economics would have us do. It's just not sensible to ignore the tremendous changes in the financial sector and the economy that have occurred in the last 20 years, much less since Keynes was around.

Clearly, there's no rolling back the clock. Just as clearly, the financial system has grown like topsy. You're implying that there'll be some kind of day of reckoning, but that assumes an assumption of responsibility. And that just doesn't happen these days, at least unless Eliot Spitzer gets involved. To otherwise adopt old-time fiduciary religion is career suicide.

Exactly, It's so clear in my mind - in the category of often wrong, never in doubt - that in the whole focus on the market pricing mechanism, you have to separate the sphere of the real economy from the financial sphere. It's popular to quote Adam Smith these days. But even Adam Smith said the whole basis of free-market capitalism is sound finance, though that is not what he called it. Back then, it was gold-backed money. But the point is, if the financial sphere is out of control, there is no way the market pricing mechanism can function properly in the economic sphere. They are not all one. The financial sphere - credit - has to be restrained. Financial excesses have to be restrained. If they are not, you lose control of the pricing mechanism and so the whole system breaks down. That is what you are observing right now. Nobody has any incentive to slow down this runaway train. Everybody has every incentive to play this game as hard as they can, and it is a self-reinforcing mechanism. I repeat: If the central bank doesn't have the financial sphere under control one way or the other, it will lose control in a big way, and the system will not self-correct. The market pricing mechanism cannot self-correct in an era of uncontrolled finance.

A much older and wiser market pro put it to me somewhat differently, the other day, observing that the ultimate irony is that Karl Marx, in some sense, was right: Capitalism is destroying itself because it has succeeded in utterly divorcing financial markets from their basic economic raison d'etre.

Finance has got to be restrained, I can't over-emphasize this point, by the real economy. If it is, over-investment in the real economy causes returns to drop, and the market pricing mechanism tends to restrain the amount of new finance going into that area.

And if it's not, there's virtually no limit to how much can be poured into a rat hole like the internuts or credit default swaps.

Yet even a Bill Gross has been quoted saying something as nonsensical as we have more savings than we do investment opportunities, or something to that effect.

He's a pretty smart cookie.

Yes, but that is not it at all. I mean, if you are going to pour all this finance into asset prices, real estate or securities, the system will create huge excess liquidity, above what can be used in the real economy - by definition. That is part of the whole distortion of market pricing mechanism. You don't want all this speculative finance going into the asset markets because it starts to overwhelm the amount of finance needed for real investment. That is how you create bubbles. So sure, now we have a huge surplus of dollar IOUs arising from borrowings against homes and securities. But don't call that "savings." Bernanke saying that our current account deficit arises from not having enough savings for the amount of investment we do - What kind of craziness is that?

End of Part One --> Part Two