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Major Uncertainties


Financial instability is dizzying. For the week, the Dow and S&P roller coastered to a 1% gain. Economically sensitive issues outperformed. The Transports and Morgan Stanley Cyclical index gained 2%. The Utilities rose 2.6%. The broader market rallied as well. The small cap Russell 2000 added 1.5%, and the S&P400 Mid-cap index gained 1%. Technology stocks were strong. While the NASDAQ100 added only 1%, the Morgan Stanley High Tech index jumped 3%. The Semiconductors rose 2% and The Street.com Index gained 3%. The NASDAQ Telecom index increased 1%. The Biotechs gained only fractionally. Financial stocks were unimpressive, with the Broker/Dealers down 2%, while the Banks added less than 1%. With bullion up $9.70, the HUI index recovered 4.5%.

Treasuries were back on the defensive. Two-year Treasury yields ended the week up 13 basis points to 3.63%. Five-year government yields rose 5 basis points to 3.92%, and 10-year Treasury yields added one basis point to 4.25%. Long-bond yields declined one basis point to 4.58%. The spread between 2 and 30-year government yields dropped to 95. Benchmark Fannie Mae MBS yields added one basis point. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note widened one basis point to 37, while the spread on Freddie's 5% 2014 note was unchanged at 35. The 10-year dollar swap spread declined one to 44.5. The corporate bond market remains highly unsettled, with junk spreads widening sharply again this week. Auto and auto-related bond spreads generally ended the week at their widest levels. The implied yield on 3-month December Eurodollars increased 4.5 basis points to 3.935%.

April 20 - Bloomberg (Hamish Risk): "Trading in contracts that insure against companies defaulting on their debt surged to a record in the past week as investors sought protection from the biggest decline in corporate debt in more than two years. Deutsche Bank AG, JPMorgan Chase & Co. and Morgan Stanley, among the top five traders of credit-default swaps according to Fitch, said in the past two days they handled record volume of debt-insurance contracts.... 'Volumes have been astronomical,' Lisa Watkinson, a member of Morgan Stanley's structured credit product management team...said... 'People who in the past haven't traded credit derivatives have become active.'"

Corporate debt issuance dropped to $4.3 billion, in what Bloomberg news described as the slowest week of issuance this year. Investment grade issuers included Citigroup $2.0 billion, Lennar $300 million, Ryder System $175 million, and Washington REIT $100 million.

April 20 - Bloomberg (David Russell): "Hughes Network Systems, the satellite business being partially acquired by Apollo Management LP, postponed a planned $325 million junk-bond sale... Hughes proposed a yield of 9.75 percent to 10 percent, while investors wanted at it to be at least 1 percentage point higher... It was at least the third high-yield debt offering postponed this week."

Junk bond funds outflows rose to $679 million. Issuers included Newpage $775 million, Ziff David Media $205 million, Geophysique $165 million, Nationsrent $150 million, and Brown Shoe $150 million.

Japanese 10-year JGB yields declined one basis point to 1.29%. Emerging debt spreads generally narrowed sharply. For the week, Brazilian benchmark dollar bond yields dropped 41 basis points to 8.30%. Mexican govt. yields ended the week down 32 basis points to 5.77%. Russian 10-year dollar Eurobond yields dropped 10 basis points to 6.14%.

Freddie Mac posted 30-year fixed mortgage rates dropped 11 basis points to 5.80%, the lowest level in 7 weeks and down 14 basis points from one year ago. Fifteen-year fixed mortgage rates dropped 10 basis points to 5.36%. One-year adjustable rates declined 4 basis points to 4.26. The Mortgage Bankers Association Purchase Applications Index dipped 1.6% this past week. Purchase applications were up better than 7% from one year ago, with dollar volume up almost 18%. Refi applications also declined 1.6%. The average new Purchase mortgage rose to $240,700. The average ARM dipped to $328,500. The percentage of ARMs dipped slightly to 35.4% of total applications.

Broad money supply (M3) dipped $1.3 billion to $9.544 Trillion (week of April 11). Year-to-date, M3 has expanded at a 2.7% rate, with M3-less Money Funds growing at a 5.0% pace. For the week, Currency declined $2.0 billion. Demand & Checkable Deposits sank $27.2 billion. Savings Deposits jumped $16.5 billion. Small Denominated Deposits gained $4.7 billion. Retail Money Fund deposits dipped $0.6 billion, and Institutional Money Fund deposits declined $3.3 billion. Large Denominated Deposits surged $27.3 billion (up $48.7bn in 3 wks). Repurchase Agreements sank $22.6 billion, while Eurodollar deposits added $5.5 billion.

I have read recent commentary suggesting that the slow growth of "money supply" is a testament to Fed tightening. I'm not yet convinced. I believe it is more likely a case of Credit expansion being financed by the expansion of non-monetary (not in the M's) financial sector liabilities. A case in point is found with the examination of Bank America's first quarter liability expansion. Liabilities actually increased a blistering $103 billion during the quarter (financing rapid asset growth), although Deposits gained only $11.4 billion. The Fed Funds & "repo" liability line surged $67.9 billion, Trading Liabilities $16.8 billion, and CP & Other $14.8 billion. And at JPMorgan, Deposits increased $9.9 billion, less than half of the $21.1 billion Total Asset Growth. This compares to Deposit growth of $25 billion during the fourth quarter, while Assets expanded $18.8 billion. My hunch is that a rapid expansion of financial sector "trading" liabilities has been weighing on the monetary aggregates.

Bank Credit dipped $8.5 billion, reducing the year-to-date expansion to $283.4 billion, or 14.6% annualized. Securities Credit is up $80.8 billion, or 14.6% annualized, year-to-date. Loans & Leases have expanded at a 14.3% pace so far during 2005. For the week, Commercial & Industrial (C&I) loans expanded $5.3 billion. Real Estate loans declined $3.4 billion. Real Estate loans have expanded at a 16.3% rate during the first 15 weeks of 2005 to $2.66 Trillion. Real Estate loans are up $309 billion, or 13.1%, over the past 52 weeks. For the week, consumer loans declined $2.0 billion, and Securities loans fell $7.0 billion. Other loans jumped $11.8 billion.

Total Commercial Paper rose $8.7 billion last week ($48.5bn in 3 wks) to $1.478 Trillion. Total CP has expanded at a 14.7% rate y-t-d (up 11.9% over the past 52 weeks). Financial CP jumped $8.2 billion last week to $1.328 Trillion (up 11.1% ann. y-t-d). Non-financial CP increased $0.5 billion to $149.7 billion (up 27% in 52 wks).

Fed Foreign Holdings of Treasury, Agency Debt declined $0.3 billion to $1.389 Trillion for the week ended April 20. "Custody" holdings are up $53.2 billion, or 13.0% annualized, year-to-date (up $203bn, or 17.1%, over 52 weeks). Federal Reserve Credit jumped $4.2 billion for the week to $785.6 billion. Fed Credit has declined at a 2.1% annualized y-t-d (up $46.6bn, or 6.3%, over 52 weeks).

ABS issuance was a strong $18 billion (from JPMorgan). Year-to-date issuance of $193 billion is now 8% ahead of comparable 2004. At $122 billion, y-t-d home equity ABS issuance is 10% above the year ago level.

Currency Watch:

The dollar index fell better than 1%. The "commodity" currencies enjoyed a solid week. The South African rand jumped 3.5%, the Brazilian real 2.7%, the New Zealand dollar 2%, and the Australian dollar 1.7%. The Japanese yen and South Korean won rose 1.4%. On the downside, the Indonesian rupiah lost 1% and the Kenyan shilling 0.7%.

Commodities Watch:

April 21 - Bloomberg (Koh Chin Ling and Loretta Ng): "China, the world's second-largest oil user, boosted crude-oil imports 23 percent in March, damping traders' expectations that a slowdown in the nation's demand would help lower global prices from records."

April 21 - Bloomberg (Koh Chin Ling): "China, the world's biggest grower and consumer of wheat, may miss its winter crop forecast for the grain to be gathered in May and June as drought spreads in the country's biggest wheat producing regions. Drought is spreading in Hebei, Shandong, Shanxi, Henan and Shaanxi, China National Grains and Oils Information Center said..."

June crude oil surged $3.33 to $55.39. For the week, the CRB index rose 2.8%, increasing y-t-d gains to 8.2%. The Goldman Sachs Commodities index jumped 5%, with 2005 gains up to 22.1%.

China Watch:

April 20 - MarketNews: "House Small Business Committee Chairman Don Manzullo told Market News International this week that Treasury Secretary John Snow has made a 'serious effort' to persuade China to float its currency, but has achieved very little. Manzullo said congressional anger with China is mounting and that some kind of retaliation is increasingly likely unless there are 'concrete changes in China's economic policy very soon.' 'The status quo is unacceptable,' he said. 'There is a collision coming,' Manzullo added."

April 21 - Financial Times (Andrew Yeh and Mure Dickie): "China's economy expanded by an unexpectedly strong 9.5 per cent in the first quarter, driven by a soaring trade surplus and powerful consumer demand. Official statistics released yesterday will bolster hopes that retail sales and exports are reducing China's reliance on investment as an engine of growth, a dependency seen as a key structural weakness."

April 20 - UPI: "China's economic boom is causing an acute labor shortage, threatening the country's reliance on cheap labor that has largely fueled its growth. Managers of factories in major export zones like Guangzhou in southern China, near Hong Kong, say skilled workers and technicians are taking advantage of the situation by demanding double-digit salary increases. Employers are forced to offer a host of perks to retain people..."

April 20 - Bloomberg (Wing-Gar Cheng): "China's electricity output rose 13 percent in the first quarter from a year earlier as the economy expanded 9.5 percent, more than expected, sustaining demand for energy resources and raw materials. Coal production rose 9.1 percent as the country invested 86.1 percent more in coal mines. Investment in electricity, water and gas supply rose 44 percent"

April 20 - AFX: "China's urban citizens' disposable income per capita rose 11.3 pct year-on-year to 2,938 yuan in the first three months of the year, the National Bureau of Statistics said..."

April 20 - Bloomberg (Nerys Avery): "China's retail sales rose 13.9 percent in March from a year earlier, the National Bureau of Statistics said... The increase compares with a 13.6 percent gain in the first two months of the year."

April 21 - Bloomberg (Yanping Li): "China's restaurant sales rose 17 percent in the first quarter as surging incomes in the world's fastest-growing major economy encouraged more people to eat out. Restaurant sales reached 206.3 billion yuan ($24.9 billion)..."

April 20 - Bloomberg (Rob Delaney): "China's government said it will introduce fees to curb real estate-speculation and prevent property prices from rising too fast... The government wants to restrict construction of luxury housing, which has attracted wealthy speculators and driven up prices..."

April 22 - Bloomberg (Yanping Li): "China's capital account surplus doubled to $111 billion last year and its current account surplus rose 50 percent to $69 billion as foreign investment increased, the foreign exchange regulator said..."

Asia Boom Watch:

April 21 - Bloomberg (Theresa Tang): "Taiwan's export orders rose to a record in March as demand surged in China, which yesterday reported economic growth of 9.5 percent for the first quarter. Orders -- indicative of shipments in one to three months -- rose 21 percent from a year earlier to a record $20.9 billion..."

April 19 - Bloomberg (Stephanie Phang): "Malaysia's economic growth this year may exceed the official forecast as the government accelerates the award of 2.4 billion ringgit ($632 million) of construction projects, Prime Minister Abdullah Ahmad Badawi said. The government will speed up the construction of schools, hospitals and other infrastructure projects that were originally planned for a five-year development plan starting in 2006..."

April 19 - Bloomberg (Kate Mayberry): "Malaysian vehicle sales rose for a 14th straight month in March, surging 22 percent to a monthly record as new models and concern about higher prices lured Malaysians into car showrooms."

April 20 - Bloomberg (Stephanie Phang): "Malaysian inflation accelerated in March at the fastest pace in almost six years after transport costs rose and higher taxes pushed up tobacco and alcohol prices. The consumer price index rose 2.6 percent last month from a year earlier..."

April 19 - Bloomberg (Laurent Malespine): "Thailand's new car sales rose to a three-month high in March, boosted by a surge in sales of pickup trucks and promotion campaigns, according to Toyota Motor Corp.'s local unit. Sales in Southeast Asia's biggest auto market rose 24 percent..."

Global Reflation Watch:

April 20 - Bloomberg (Gonzalo Vina): "U.K. gross mortgage lending rose 13 percent in March from the previous month, reinforcing evidence of a recovery in the property market, said the Council for Mortgage Lenders..."

April 19 - Bloomberg (Laura Humble): "Consumer prices in the U.K. rose at the fastest annual pace in almost seven years in March, reviving speculation about another increase in interest rates... The inflation rate rose to 1.9 percent, the highest since May 1998, from 1.6 percent in February..."

April 21 - Bloomberg (Jonas Bergman): "Danish mortgage lender rose to a record in the first quarter as falling interest rates spurred refinancing and banks introduced new types of loans, the Association of Danish Mortgage Banks said. Danish banks made 187 billion kroner ($33 billion) in loans in the first quarter, up from 111 billion kroner in the year-earlier period and 125.1 billion kroner in the fourth quarter..."

April 20 - Bloomberg (Fergal O'Brien): "Irish homebuilders may complete a record number of houses for the 11th straight year in 2005 as population growth and rising employment boosts demand for property, according to a report."

April 21 - Bloomberg (Halia Pavliva): "Russian retail sales soared 8.6 percent in March from the previous month as a seventh year of economic growth and rising wages prompted consumers to boost spending."

Latin America Watch:

April 20 - Bloomberg (Heather Walsh): "Latin American and Caribbean economies will grow more slowly in 2005 than last year as expansion slackens in Argentina and among the region's trade partners, the United Nations said. The region's economy will grow 4.4 percent, compared with a revised 5.8 percent expansion in 2004, the fastest since 1980..."

Dollar Consternation Watch:

April 22 - MarketNews: "South Korea is moving ahead with a plan first announced last year to set up a new investment entity to diversify its reserves, starting with more than $20 bln to establish the agency in July. In an advertisement seeking senior staff for the new agency in the Economist magazine published Friday, the government said the Korea Investment Corporation (KIC) will 'gradually diversify investment strategies and enlarge scale.'"

Bubble Economy Watch:

April 18 - Bloomberg (David M. Levitt): "Construction spending in New York City is expected to grow to a record $19.5 billion this year as office construction responds to rising employment, an industry group said. Work might be so plentiful it could lead to labor and supply shortage, said Richard Anderson, president of the New York Building Congress... Office, residential and public construction will grow 17 percent from it previous high of $16.7 billion in 2003... The report doesn't include the proposed $2.2 billion New York Jets stadium on Manhattan's far west side or the $2.5 billion Brooklyn basketball arena and commercial complex where the New Jersey Nets would move..."

April 21 - Bloomberg (Josh P. Hamilton): "New York City's jobless rate adjusted for seasonal variations fell to a four-year low of 5.2 percent in March from 6.1 percent in February, helped by gains in leisure and hospitality industries as well as financial services employment, the state's labor department said. Statewide, unemployment dropped to 4.6 percent in March from 5.1 percent in February, on an adjusted basis. The city's jobless rate was the lowest since January 2001."

April 21 - Los Angeles Times (Annette Haddad): "Southern California remained the West's hottest apartment market as rents continued to climb well above the inflation rate... The pace of rent increases accelerated in recent months, according to the survey, as the supply of rental units barely budged while rising home prices continued to make homes less affordable. Apartment rents rose 5.2% year-over-year in the first quarter, compared to 4.5% in 2004, said RealFacts... In Los Angeles and Orange counties, the average monthly rental rate was $1,397 in the quarter, compared with $1,138 a year earlier, the survey said. RealFacts found that rents rose in 24 of the 29 markets it surveys... Demand is high and the supply is tight throughout the Southland, making it easier for landlords to hike rents."

April 21 - American Banker: "A Federal Reserve Board report issued Wednesday said business loan demand increased from the beginning of March through mid-April and did not show signs of waning... The upbeat reports in Wednesday's Beige Book reinforce recent earnings reports from financial services companies such as Sun Trust Banks Inc. and KeyCorp, which I the last week reported higher first-quarter commercial loan demand."

April 19 - The Wall Street Journal (Avery Johnson): "Tourists from abroad are flocking back to the U.S. -- and the influx is helping push up prices in some popular destinations. According to yearly statistics released by the Commerce Department, about 46.1 million international visitors came to the U.S. last year, up 12% from 2003. Those visitors spent $93.7 billion, an increase of 17% from $80 billion the year before."

Mortgage Finance Bubble Watch:

April 21 - Washington Post (Barbara Ruben): "Competition is so fierce for houses in Arlington neighborhoods near Metro stops that getting 10 to 30 offers on a property is common, according to Walt Babic, a real estate agent who has sold houses in the area for 33 years. 'This year looks like we'll get just as many multiple offers in the lower price ranges -- that is, anything under $800,000,' said Babic... Last year, Arlington home buyers paid the highest median price for single-family houses and townhouses of anyone in the Washington metropolitan area... At $550,000, the median price in Arlington has more than doubled from $259,000 five years earlier. Over the same period, the median condominium price climbed from $131,125 to $317,000."

Earnings Watch:

Bank America reported first quarter Net Income of $4.7 billion. Total Assets were up 37% annualized during the quarter to $1.212 Trillion. The asset Federal Funds Sold and Securities Purchased Under Agreements to Resell increased $48 billion during the quarter to $139.4 billion, and Trading Account Assets rose $31.4 billion to $125 billion. Securities Holdings jumped almost $24 billion to $219 billion. Loans & Leases gained $7.9 billion to $521.2 billion. Total Commercial Loans increased a notable 7% annualized to $195 billion. "[Global Capital Markets] recorded its best quarter (trading profits up 74% from the 4th quarter) ever in earnings and revenue. This was primarily due to increases in trading profits, led by increased sales of interest rate products, equities and strong portfolio management in fixed income. Also contributing to the increase in trading-related revenue were gains on credit portfolio hedges." The company repurchased 43.2 million shares during the first quarter.

JPMorgan earned a better than expected $2.3 billion during the quarter, although comparisons are challenging (July merger with Bank One). Total Assets expanded 7% annualized to $1.178 Trillion. Loans increased about $1 billion to $396 billion, while Federal Funds Sold and Securities Purchased Under Resale Agreements surged $31 billion to $132.8 billion. "Revenues of $4.2 billion were down $27 million, or 1%, compared to the prior year. Investment banking fees of $985 million increased $242 million, or 33%, compared to the prior year, reflecting continued strength in advisory fees, up 79%; debt underwriting fees, up 16%; and equity underwriting fees, up 34%... Fixed Income Markets revenues of $2.3 billion were down marginally from the very strong level of the prior year. Results were driven by strong client activity and portfolio management trading performance across most major asset classes. Compared to the prior quarter, revenues of $2.3 billion were up 50% due to strength in the trading revenues in credit and interest rate markets." The company repurchased 33 million shares of stock during the quarter.

Wells Fargo's First Quarter Net Income rose 5% from the year earlier period to $1.86 billion. Average loans expanded at a 9% rate during the quarter and were up 12% from the prior year. "Total commercial loan growth accelerated to 15 percent (annualized), up $3.7 billion... Commercial loans grew across virtually all customer segments, including double-digit increased...in small business direct, middle market, large corporate, commercial real estate and asset-based lending." "Home Mortgage saw a strong pick-up in application activity in the quarter, as applications of $91 billion increased 14 percent over fourth quarter 2004, and the March 31, 2005 pipeline of $59 billion was up 18 percent from year end." Home equity loans (were) up 34 percent year-over-year." Credit Card loans were up 21%. On the liability side, Total Liabilities increased $7.2 billion, while Total Deposits declined $1.7 billion.

ARM behemoth Golden West Financial reported Net Earnings up 16% to $348 million. Total Assets expanded at a 21% rate during the quarter to $112.6 billion and were up 30% from one year ago (up 61% over two years!). "The company also posted all-time first quarter mortgage originations and retail savings growth. New loan volume totaled $11.2 billion, up 19% from...one year earlier." "In the first quarter of 2005, Golden West's spread averaged 2.46%, down from 2.90% one year earlier." On the liability side, Deposits expanded $2.6 billion (a 20% rate) to $55.6 billion.

Washington Mutual reported Net Income of a better-than expected $902 million. Total Assets expanded at a 15% rate during the quarter to $320 billion (up 14% y-o-y). "While first quarter fixed-rate home loan volume declined 26 percent compared with the first quarter of 2004, adjustable-rate home loan volume was up 13 percent, while home equity loan and line of credit and multi-family volumes rose 6 percent and 39 percent, respectively." On the liability side, Deposits expanded at a 23% rate during the quarter to $183.6 billion. The company repurchased 2.54 million shares during the quarter. Advances from the Federal Home Loan Banks were up 43% for the year to $35.5 billion.

Merrill Lynch reported first quarter Net Income of $1.21 billion, down 3% from the year ago period. Total Revenues were up 2.6% from a year earlier, with Interest & Dividend Revenues up 81.3% to $5.541 billion. Commissions were about flat, Investment Banking Revenues down 3%, and Principal Transaction Revenues were down almost 15%. "As part of its active management of equity capital, Merrill Lynch repurchased 17.3 million shares of its common stock during the first quarter..."

ARM Mortgage REIT Thornburg Mortgage expanded assets at a 23% rate to $30.9 billion during the quarter. Total Assets were up 38% compared to one year ago. On the liability side, Reverse Repurchase Agreements jumped $2.83 billion to $17.08 billion. Shareholder's Equity increased $244 million during the quarter to $2.033 billion.

Credit insurer Ambac reported much higher Credit losses and worse-than-expected earnings. It is one more indication that Things are Turning Sour in the Risk Business.

Major Uncertainties:

I have never experienced an environment with so many Major Uncertainties. Is the U.S. Bubble Economy slumping or in the midst of an intransigent inflationary boom? Are general inflationary pressures gaining critical mass, or is "deflation" waiting patiently to make its appearance? Will heightened financial stress keep the Fed at bay, or are short-term rates on a methodical march to the much higher levels required to rein in destabilizing mortgage Credit excess? Are historically low long-term U.S. (and global) rates a secular phenomenon, or is the bond market a Bubble of historic proportions? Is the resolute marketplace conviction that the Greenspan Fed would never allow a bond bust precisely the psychology that ensures its inevitability? Are emerging economies - and the global financial system, generally - vulnerable to pneumonia when U.S. markets cough; or have three years of dollar weakness and global reflation buttressed individual Credit systems? Is the dollar poised for the much anticipated rally, or have we witnessed yet another pathetic Dead Cat Bounce? The "reflation trade" and the global pricing environment hang in the balance. Is tumult in Credit default swaps (and auto bonds) the initial manifestation of Acute Financial Fragility, or is it and attendant equity market weakness just what the system needs to keep the Fed cautious and the mortgage finance liquidity spigot wide open? Have the mushrooming derivatives markets actually dispersed risk and strengthened financial underpinnings, or are they a case of Speculative Bubbles Run Precariously Amok and ready to bust? Is a Chinese currency revaluation - breaking the dollar peg - a step toward rectifying massive global imbalances, or perhaps a blind leap forward with respect to global currency market dislocation and a U.S. inflationary shock?

It may be worthwhile noting that the weekly ABC/Washington Post Consumer Comfort index actually jumped two points last week despite stock market woes. And there are other indications that things have brightened in April. Do today's consumers look more to mortgage rates for an indication of their financial wellbeing than the stock market? There should be little disagreement that the U.S. Bubble economy is today extraordinarily sensitive to interest rates. Sharply rising rates would surely have a significant negative impact on the Mortgage Finance Bubble, home prices, and spending. Today's lower rates, on the other hand, can be expected to stimulate home equity borrowings and extend the life of the Housing Mania. There is, after all, no indication that the banks or mortgage lenders are tightening lending standards, so the strong inflationary bias throughout mortgage finance is today given the benefit of the doubt.

Globally, a Chinese hard-landing is not on the near horizon. The unfolding story in China - and perhaps Asia more generally - could be of stronger domestic consumption and less reliance on growth from investment and U.S. exports. It is also worth noting that the Brazilian real traded today at a 34 month high. I cannot think of a more striking indication that the "emerging" markets and economies are significantly less vulnerable to the vagaries of U.S. finance than in years past.

Recent tumult in corporate bond and Credit insurance (CDS) land is more analytically complex than meets the eye. While developments are important with respect to speculative market dynamics and risk intermediation, they are not at this point a major factor when assessing system-wide Credit expansion. The initial stress and unfolding bust that commenced in the junk and leveraged loan markets in 1999 was a critical inflection point with respect to financing the tech/telecom Bubble - a Bubble that was a major facet of the unsound stock market and economic booms. The Financial Sphere is today dominated by the Mortgage Finance Bubble and government debt issuance boom - spewing cashflow at corporate America. The corporate bond market has become more of a playland for risk speculation than a source of system Credit expansion.

There are myriad factors that continue to make Bubble analysis challenging, at best. The unprecedented dimensions of both leveraged speculation the derivative markets - as well as the system's dependency on massive unending Credit creation - create fragility to recent market losses in CDS (Credit default swaps), corporate bonds, and equities. For a system as leveraged and commanded by speculative finance, there is little room for error. And there is little doubt at this point that GM, Ford, and the airlines, among others, are today in serious financial trouble; Bubble markets in their debt have dislocated. Two years of zealous "reflation" have done more bad than good for some key companies (throw in Fannie, Freddie and the FHLB). Importantly, key risk market Bubbles have burst, heightened risk aversion is the order of the day, and the Credit Cycle has turned.

But I also believe a strong case can be made that the consequent decline in rates (and reduced fear of a yield spike) becomes a major development with respect to continued mortgage Credit excess - the key source driving both the Financial Sphere and the Economic Sphere. Heightened Risk Aversion initially may incite lower market rates and even stimulate demand for mortgage loans and MBS. And perhaps the banking system's desire to build commercial loan portfolios will for now largely counter flagging corporate Credit Availability in the securities markets. Perhaps, or perhaps bankers get rattled by financial market instability - Major Uncertainties.

Federal Reserve Governor Donald Kohn is an exceptional economist and would be an able replacement for Mr. Greenspan. He spoke this afternoon - "Imbalances in the U.S. Economy" - at the annual Hyman Minsky conference at The Levy Economics Institute of Bard College. In stark contrast to Dr. Bernake, he accurately identifies the Current Account Deficit as "the important imbalance (that) is the large and growing discrepancy between what the United States spends and what it produces." No nonsense about excess investment and global savings here, thankfully. Yet I was most stuck by the following paragraph from his speech:

"To the extent that current spending behavior is built on realistic expectations--in particular, for future short-term interest rates, the exchange rate, rates of return on capital investments in the United States relative to those abroad, and housing price appreciation--the transition should be relatively orderly: Asset prices should adjust gradually to changing developments, as should the spending patterns of households and firms. But if current expectations are badly distorted, then the way forward may not be so smooth. Eventually, reality always asserts itself over wishful thinking, and such realignments are sometimes abrupt, as illustrated by the collapse of the high-tech bubble a few years ago. In such circumstances, asset prices can adjust sharply, and private spending may also respond quickly, making it difficult for monetary and fiscal policy actions to provide a timely enough counterweight to keep the economy continuously on track. Are expectations substantially distorted?"

While I would articulate the analysis somewhat differently, the gist of what Mr. Kohn is discussing lies at the very heart of current Major Uncertainties and consequent increasingly wild financial market volatility. Is behavior built on "realistic expectations" in relation to sustainable fundamentals, or have excesses and tainted pricing ("Monetary Disorder") over time completely manhandled expectations and market forces?

I argue that "current expectations are badly distorted." And that is the inescapable dilemma of asset inflation, leveraged speculation, and resulting asset price Bubbles. The longer they are accommodated, the greater the distortions to market pricing mechanisms and the more confidently price gains are extrapolated. And it is the final extrapolation by the frenzied crowd of unsustainable "blow-off" excesses that fosters the greatest financial and economic distortions. Pricing, investing, speculating and spending patterns are distorted, creating vulnerability to abrupt changes in perceptions, speculative positions, and spending behavior. Much less apparent - but of vital importance - are distortions to both marketplace liquidity and the perception of ongoing liquidity abundance. It is during the "terminal phase" of excess when speculation and leveraging wildly distort marketplace liquidity and perceptions. Furthermore, the longer this problematic "blow-off" period continues the greater the gap between current conditions/perceptions of over-liquidity and the unavoidable collapse of liquidity associated with the reversal of speculative bets and the unwind of leveraged positions.

Being in the depths of Credit Bubble "blow-off" excess has been for sometime a delirious, if tenuous, situation. Until quite recently, the massive liquidity effects were inflating prices throughout virtually all asset classes - Treasuries, stocks, corporate bonds, junk, MBS, CDOs, emerging bonds & equities, houses, property, commodities, art, sport franchises, and so on and so forth (including CDS premiums). Some argue that all these prices adjusted higher due to declining "real interest rates." I will instead profess that they have risen because buyers had access to too much cheap Credit/liquidity/finance, and the more asset prices inflated the greater the intensity of demand to acquire more. Synchronized Bubbles were inflating in various markets which tended to create a false sense of reinforcing stability. To be sure, it has not been the conspicuous (but largely isolated) technology-style Bubble. Instead, we have witnessed a systemic inflation where a confluence of many marketplace Bubbles created unprecedented system-wide liquidity excess and distortions. Such systemic asset and liquidity Bubbles are as uncommon as they are dangerous.

And this returns us to Fed Governor Kohn's question: Are expectations substantially distorted? Well, not only are they highly distorted, these distortions have become dangerously systemic. And this is the fundamental source of Major Uncertainties. The CDS, corporate bond and equity speculative Bubbles have been pierced, with major negative ramifications. At the same time, the Treasury, agency and MBS Bubbles are more than holding together; the Great Mortgage Finance Bubble runs unabated. As such, there are extraordinary crosscurrents. However, the prospect for the continued massive inflation of dollar claims bolsters non-dollar asset classes, while weighing on the greenback.

It very well could be that the Treasury (agency, and MBS) market has the greatest affliction of distorted expectations. The marketplace is remarkable assured that heightened financial stress and instability are good; that the Fed is almost done; that the economy is slowing markedly; that inflationary pressures will abate; and that foreigners will provide unending demand. Well, each of these perceptions is today suspect, and as a whole they may be problematically unrealistic. There are today Major Uncertainties, including, I conjecture, the possibility for abrupt price adjustments in various markets including interest rates and currencies. If this week provided any indication, we have commenced a period of wild volatility that has in the past often proved a harbinger of financial accidents.

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