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Manic-depressive swung back to manic. For the week, the Dow jumped 3.3%, with the S&P500 up 3%. Economically sensitive issues shot higher, with the Transports up 6.4% and the Morgan Stanley High Tech index up 5%. The Utilities added 2%, and the Morgan Stanley Consumer index gained 3%. The broader market was very strong, with the small cap Russell 2000 rising 5% and the S&P400 Mid-cap index up 4%. The technology rally continued. For the week, the NASDAQ100, Morgan Stanley High Tech, and Semiconductor indices rose 4%. The Street.com Internet Index jumped 5%, and the NASDAQ Telecommunications index increased 4%. The Biotechs gained 3%. The financials were strong as well, with the Broker/Dealers up 5% and the Banks gaining 3%. Although bullion declined $2.75, the slumping HUI index mustered a 2% advance.

Normalcy has not returned to the Credit market. Two-year Treasury yields ended the week up 7 basis points to 3.66%. Five-year government yields rose 5 basis points, ending the week at 3.87%. The 10-year Treasury yield was unchanged at 4.12%. Long-bond yields declined 4 basis points to 4.44%. The spread between 2 and 30-year government yields sank to a miserly 78. Benchmark Fannie Mae MBS were again unimpressive, with yields rising 4 basis points. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note narrowed one basis point to 37, while the spread on Freddie's 5% 2014 note was unchanged at 36. The 10-year dollar swap spread declined 2 to 45. The corporate bond market remains unsettled, although the troubled auto (and CDS) sector somewhat stabilized at week's end. Junk bond spreads widened again this week. The implied yield on 3-month December Eurodollars jumped 8.5 basis points to 3.97%.

May 18 - Moody's: "U.S. collateralized debt obligations (CDO) continued their strong showing in the first quarter of 2005, as rated issuance volume was up 72% to $22.5 billion from $13.1 billion in the same period in 2004, says Moody's Investors Service... Moody's rated 53 CDOs in the U.S. during the first quarter of 2005, up 51% from the 35 rated during the same quarter a year earlier. 'The impressive growth in U.S. CDO issuance over the full year of 2004 continued through the first quarter of 2005 propelled by the continuing demand for synthetic arbitrage CDOs,' says Richard Michalek, Moody's analyst..."

Corporate issuance slowed from last week's $12 billion. Investment grade issuers included Bear Stearns $1.55 billion, Donnelley & Sons $1.0 billion, First Data $1.0 billion, CIT Group $800 million, Harrahs $750 million, Suntrust Bank $600 million, National City $500 million, Capital One $500 million, International Lease Finance $400 million, Nelnet $275 million, San Diego Gas $250 million, Entergy Gulf States $200 million, Yellow Roadway $150 million, and Entergy Arkansas $100 million.

May 17 - Dow Jones (Simona Covel): "El Paso Corp. postponed its pending high-yield bond offering on Monday, the latest victim in a string of casualties that come as the result of increasingly risk averse credit markets. Natural gas company El Paso was trying to remarket $272 million of senior notes due 2007, but delayed the offering due to 'unfavorable market conditions.' In recent weeks, those commonly-cited unfavorable conditions have triggered a wave of postponed deals and re-jiggered terms as increasing concerns over credit quality caused investors to shy away from risky debt deals."

Junk bond fund outflows increased to $452 million, the 15th consecutive week of negative flows (from AMG). Junk issuers included Seneca Gaming $190 million and BCI Finance $150 million.

Foreign dollar debt issuers included Quebec $1.0 billion, Korea Highway $500 million, and Panama Toll Road $150 million, million.

Japanese 10-year JGB yields dipped 1.5 basis points to 1.26%. Emerging debt markets posted another solid performance. For the week, Brazilian benchmark dollar bond yields declined 7 basis points to 8.08%. Mexican govt. yields ended the week down 14 basis points to 5.64%. Russian 10-year dollar Eurobond yields dipped 3 basis points to 6.01%.

Freddie Mac posted 30-year fixed mortgage rates dropped 6 basis points to 5.71%, a 12-week low and down 61 basis points from one year ago. Fifteen-year fixed mortgage rates declined 6 basis points to 5.27%. One-year adjustable rates added 3 basis points to 4.26%. The Mortgage Bankers Association Purchase Applications Index fell 10.8%, reversing last week's big jump. Purchase applications were up 3.4% compared to one year ago, with dollar volume up 12%. Refi applications dropped 10%, also reversing the previous week's gain. The average new Purchase mortgage declined to $236,400. The average ARM declined to $332,200. The percentage of ARMs dipped to 33.9% of total applications.

Broad money supply (M3) declined $5.7 billion to $9.584Trillion (week of May 9). Year-to-date, M3 has expanded at a 3.3% rate, with M3-less Money Funds growing at 5.5% pace. For the week, Currency dipped $0.9 billion. Demand & Checkable Deposits added $2.6 billion. Savings Deposits fell $15.9 billion. Small Denominated Deposits gained $4.2 billion. Retail Money Fund deposits dipped $1.9 billion, and Institutional Money Fund deposits declined $8.0 billion. Large Denominated Deposits dropped $8.8 billion. For the week, Repurchase Agreements rose $13.8 billion, and Eurodollar deposits gained $9.3 billion.

Bank Credit rose $10.9 billion last week, increasing the year-to-date expansion to $305.8 billion, or 12.4% annualized. Securities Credit is up $123 billion, or 17.5% annualized, year-to-date. Loans & Leases have expanded at a 10.2% pace so far during 2005. For the week, Securities surged $15.2 billion. Commercial & Industrial (C&I) loans added $3.2 billion. Real Estate loans gained $2.6 billion. Real Estate loans have expanded at a 12.6% rate during the first 19 weeks of 2005 to $2.67 Trillion. Real Estate loans are up $290 billion, or 12.2%, over the past 52 weeks. For the week, consumer loans declined $3.5 billion, and Securities loans fell $5.2 billion. Other loans dipped $1.4 billion.

Total Commercial Paper surged $16.6 billion last week (up $29.7bn in 2 wks) to $1.51 Trillion. Total CP has expanded at an 18.5% rate y-t-d (up 12.5% over the past 52 weeks). Financial CP jumped $14.1 billion last week to $1.363 Trillion, with a y-t-d gain of $78.9 billion (16% ann.). Non-financial CP gained $2.5 billion to $151.2 billion (up 28% in 52 wks). The expansion of CP, especially financial sector borrowings, is one factor explaining the lagging monetary aggregates.

Fed Foreign Holdings of Treasury, Agency Debt rose $4.7 billion to $1.404 Trillion for the week ended May 18. "Custody" holdings are up $68.3 billion, or 13.3% annualized, year-to-date (up $204.3bn, or 17.0%, over 52 weeks). Federal Reserve Credit expanded $4.3 billion to $787.6 billion. Fed Credit has declined 1.0% annualized y-t-d (up $47.1bn, or 6.4%, over 52 weeks).

ABS issuance was a solid $13.4 billion (from JPMorgan). Year-to-date issuance of $246 billion is 13% ahead of comparable 2004. At $155 billion, y-t-d home equity ABS issuance is 24% above the year ago level.

Currency Watch:

The dollar index gained less than 1%. The Brazilian real rose 1% to a 3-year high. The Iceland krona rose 2.3%, recovering some of its recent steep decline. On the downside, the South African rand declined 3%, the Hungarian forint 1.6%, and the British pound 1.3%.

Commodities Watch:

May 16 - Bloomberg (Helen Yuan and Xiao Yu): "China's imports of steel products rose to a one-year high in April, indicating efforts by the government to cool economic expansion isn't dampening demand from makers of home appliances and cargo containers. China imported 2.56 million tons of steel products last month..."

July crude oil slumped $1.63 to $48.65. For the week, the CRB was about unchanged with a y-t-d gain of 3.3%. The Goldman Sachs Commodities index declined 2%, reducing 2005 to 9.9%.

China Watch:

May 19 - Bloomberg (Nerys Avery): "Investment in China's factories, roads and other fixed assets rose 25.7 percent in the first four months, increasing concern Premier Wen Jiabao will add to curbs on corporate spending in Asia's second-biggest economy. The gain in investment in urban areas from the year-earlier period was faster than the 25.3 percent rate in the first quarter and the government's full-year 16 percent target..."

May 18 - Bloomberg (Philip Lagerkranser and Nerys Avery): "China's industrial output rose 16 percent in April, faster than the highest forecast by economists, as companies including Quanta Computer Inc. and Royal Philips Electronics NV move production to the nation. The gain followed a 15.1 percent increase from a year earlier in March and exceeded the median 14.6 percent forecast..."

May 16 - Bloomberg (Nerys Avery): "China's exports rose faster than its imports for a sixth straight month in April as the country shipped more electronics and textiles abroad, and government investment curbs damped demand for foreign goods. Exports rose 32 percent from a year earlier to $62.2 billion, while imports increased 16 percent to $57.6 billion, the...customs bureau said... That left a trade surplus of $4.59 billion..."

May 17 - Bloomberg (Nerys Avery): "China's retail sales rose at a slower-than-expected 12.2 percent pace in April, as grain prices fell and increases in home purchase costs diverted spending."

May 19 - Bloomberg (Philip Lagerkranser): "Hong Kong's unemployment rate fell last month to its lowest in more than three years as booming tourism and rising consumer spending prompted retailers, hotels and restaurants to expand. The seasonally adjusted jobless rate fell to 5.9 percent from 6.1 percent in March..."

May 19 - Bloomberg (Philip Lagerkranser): "Hong Kong's consumer confidence rose in April to the highest level in 16 years as the economy expands and unemployment declines, according to a survey by ACNielsen."

May 17 - Bloomberg (Joshua Fellman): "Hong Kong's top-end office rents have risen about a third this year and will probably climb at least another 10 percent by year-end, property agents, analysts and owners in the city said. Office space in the Central district rents for about HK$42 ($5.39) per square foot a month on average, more than midtown Manhattan..."

Asia Boom Watch:

May 17 - Bloomberg (Cherian Thomas): "India's exports rose 17 percent in April boosted by shipments of textiles, gems and jewelry to the U.S., the country's biggest export market. Exports rose to $6.56 billion in April, the Commerce and Industry Ministry said in a statement in New Delhi. Imports rose 51 percent to $10.42 billion in April, widening the trade deficit to $3.8 billion from $1.2 billion a year earlier."

May 14 - Bloomberg (Subramaniam Sharma): "India's business confidence in April rose to the highest in at least two years as economic policy changes since 1991 helped generate demand for manufactured goods and made companies more efficient, a research institute said."

May 18 - Bloomberg (Stephanie Phang): "Malaysia's inflation rate accelerated in April to a six-year high after the government raised taxes on cigarettes and beer. The consumer price index rose 2.7 percent from a year earlier..."

May 16 - Bloomberg (Amit Prakash): "Singapore's retail sales rose 13.1 percent in March from a year earlier, more than double the expected pace, as consumers spent more on cars and furniture."

May 17 - Financial Times (Shawn Donnan): "Indonesia, south-east Asia's biggest economy, grew by a faster-than-expected 6.3 per cent in the first quarter of the year amid renewed signs of a long-awaited recovery in investment. The strong year-on-year rise, well above the 5.5 per cent forecast by economists, came as data showed a doubling of foreign direct investment approvals in the first four months of the year."

Global Reflation Watch:

May 17 - Financial Times (David Turner): "Japanese wholesale prices showed their biggest monthly rise in six years in April, raising hopes of another blow to the deflation that has bedeviled the country for many years."

May 19 - Bloomberg (Matthew Brockett): "Producer price inflation in Germany, Europe's largest economy, unexpectedly accelerated to the fastest pace in four years in April as record oil costs boosted prices for energy and oil products. Prices for goods ranging from plastics to newsprint rose 4.6 percent from a year ago..."

May 16 - Bloomberg (Halia Pavliva): "Russia's budget surplus rose to a preliminary 618.8 billion rubles ($22.1 billion) in the first four months of the year as the rising cost of oil, Russia's No. 1 export commodity, boosted government revenue. The surplus is equal to 10.6 percent of gross domestic product..."

Latin America Watch:

May 18 - Bloomberg (Peter Wilson): "Venezuela's banks and financial institutions increased lending in April for a second month as a rebounding economy stoked for demand credit, according to the Softline banking consultant. Lending by Venezuela's 49 banks and financial institutions rose 9.4 percent to 24.1 trillion bolivars ($11.2 billion)... 'In the last 12 months, the banks' credit portfolio has grown 83 percent,' Softline said."

Speculative Financial Bubble Watch:

May 16 - Financial Times (James Drummond): "Hedge funds are liquidating positions in the expectation that investors will be redeeming substantial sums in early July, according to prime brokers and fund managers. Many hedge funds offer only quarterly redemption and require 30 days notice that investors will be withdrawing funds. This means that fund managers are looking to find cash at the moment so as not to be caught short next month. The past two weeks have proved among the most testing times for hedge funds since the collapse of Long Term Capital Management in 1998. No well-known names have gone under since the debt of General Motors and Ford was downgraded to non-investment grade this month, but many hedge funds are on the defensive."

Dollar Consternation Watch:

May 19 - New York Times (Chris Buckley): "Chinese officials on Wednesday angrily rebuffed both Washington's blunt demand that China loosen its fixed exchange rate policy and Europe's threat of quotas on a tide of Chinese textiles. The United States should 'put its own house in order before blaming others' for its trade deficits, said Wei Benhua, deputy director of the State Administration of Foreign Exchange..."

Bubble Economy Watch:

May 19 - The New York Times (Stephanie Saul): "In late 2003, Susan Blech sold her office products business, left her home in Long Beach, N.Y., and came here (Durham, N.C.) with a plan to spend her life savings losing weight. So far, her plan has worked. Ms. Blech, 39, has dropped about $70,000 and 220 pounds in Durham. When her weight falls another 50 pounds, to 200, Ms. Blech plans to spend her remaining money for surgery to remove dangling skin from her midsection and fill out her sagging breasts. She has already picked her plastic surgeon - one right here in Durham at the Duke University Medical Center."

April Producer Prices were up 4.8% y-o-y, with the Consumer Price Index up 3.5% from April 2004. Housing Starts were at a robust and stronger-than-expected 2.038 million annualized rate, with Housing Starts a much stronger-than-expected and near record 2.129 million pace. The National Association of Homebuilders Housing Activity Index rose 3 points in May to 70, the highest level since January.

California Bubble Watch:

May 17 - Bloomberg (Heather Burke): "Home prices in Southern California and the San Francisco Bay Area hit record highs in April, although the pace of growth slowed in the southern part of the state... The median home price in the nine-county Bay Area rose 19 percent in April to $586,000 from $492,000 a year earlier, according to DataQuick... The median home price in the six-county Southern California region, which includes Los Angeles, increased 15 percent to $445,000 from $387,000... Home prices in the Bay Area are rising at the fastest rate in four years and the rate of appreciation in the region has surpassed Southern California's..."

Mortgage Finance Bubble Watch:

May 17 - The Wall Street Journal (Ruth Simon): "In the latest sign of how frothy the housing market has become, new data show the degree to which people are stretching to buy homes in a hot hosing market. The data, from the Mortgage Bankers Association, show that adjustable-rate and interest-only mortgages accounted for nearly two-thirds of mortgage originations in the second half of last year... 'The situation with interest-only loans ARMs is just one of several very scary things going on in the mortgage industry,' says Stu Feldstein, president of SMR Research Group... In California, where home-price growth has been sizzling, interest-only loans accounted for 61% of the mortgages taken out to buy homes in the first two months of this year... Many economists see the current popularity of ARMs and interest-0only loans as the latest sign of how borrowers are stretching to buy homes they couldn't other wise afford - and how lenders are more tan willing to accommodate them."

May 17 - The Wall Street Journal (James R. Hagerty): "Rapid home-price inflation spread to more cities in the first quarter, the National Association of Realtors said in a report released last week. The NAR found that median prices for previously occupied homes rose at double-digit rates from the year-earlier quarter in 66 of the 136 metropolitan statistical areas included in its quarterly survey. That was the highest number of double-digit gains recorded by the NAR since it began compiling such metropolitan tables more than 25 years ago... The biggest increase recorded in the latest quarter was 46% in Bradenton, Fla. Florida also had two of the other biggest increases -- 36% in both Sarasota and the West Palm Beach-Boca Raton area. Other large gainers included Riverside-San Bernardino, Calif. (33%), Las Vegas (29%), Sacramento, Calif. (27%), and Atlantic City, N.J. (23%)."

May 18 - Bloomberg (Andrew Ward): "Surging U.S. home prices aren't just for big cities and sunny coastal communities. From Jackson, Mississippi, and Wichita, Kansas, to Rockford, Illinois, and Green Bay, Wisconsin, housing prices are rising at more than three times the rate of inflation, worrying economists such as Dean Baker, co-director of the Center for Economic and Policy Research... The U.S. is in a housing bubble that can't last, he said. 'We may be seeing the bubble spreading' from the East and West coasts to inland areas, Baker said in an interview. 'People are buying homes every day and paying much more than they'll be able to sell them for.'"

May 17 - American Banker (Todd Davenport): "Federal banking regulators, prompted by the explosive growth of home equity loans in recent years and a potentially darkening credit picture, issued comprehensive standards to guide banks that underwrite and hold those loans. Banks and thrifts held $491 billion of home equity loans on their books at the end of 2004, up 91% from the end of 2002 and more than 40% in 2004 alone. Banks continued to report startling growth in the product when they announce first-quarter results..."

April Issue: Inside Mortgage Finance: "According to a new ranking and analysis by Inside Mortgage Finance, a total of $226.81 billion of mortgage securities were issued in the first quarter of 2005 by mortgage lenders, investment bankers and other non-agency secondary market conduits. That's not the most ever for the private conduit business - the record was $231.91 billion back in the third quarter of 2004 - but it's a huge 62.6 percent increase over the pace set in the first quarter of last year."

ARM behemoth Golden West Financial posted a strong April. Mortgage originations were up 11% from April '04 to $4.2 billion. The company's loan portfolio expanded at a 19% rate to $109.2 billion, with a 12-month gain of 31%. On the liability side, Deposits expanded at a 24% rate to $56.7 billion.

Highlights from The Bond Market Association's May 2005 Research Quarterly:

"Asset-backed issuance increased 25.3 percent to $241.3 billion, up from $192.5 billion issued during the same period a year ago... The HEL (home equity loan) sector accounted for nearly 40 percent of total issuance in the first quarter... Issuance in the auto loan sector increased to $21.4 billion in the first quarter, up 16.6 percent... The student loan sector, now the third largest, continues to show signs of strength as issuance increased 21.6 percent to $12.6 billion in the first quarter... New issue activity in the credit card sector totaled $5.9 billion in the first quarter of the year, down 55 percent..."

Issuance of mortgage-related securities, which include agency and nonagency pass-throughs and CMOs, remained stable in the first quarter of the year... Issuance totaled $406.7 billion in the first quarter, slightly above the $403.0 billion issued a year ago...Total issuance of agency MBS decreased to $198.9 billion in the first quarter of the year, down 21.6 percent... Issuance of agency collateralized mortgage obligations (CMO) increased to $93.2 billion in the first quarter, up 12.6%... New issuance of private-label MBS increased 72.1 percent in the first quarter, to $114.6 billion...

Daily outstanding repo agreements averaged $3.08 trillion during the first three months of 2005, an increase of 16.7 percent from $2.64 trillion through March 2004. The average daily outstanding reverse repo increased to $2.23 trillion...a gain of 20.5%... Through the first quarter of 2005, over $98.7 trillion in repo trades were submitted by Government Securities Division participants, with an average daily volume of approximately $1.6 trillion.

The outstanding volume of money market instruments, including commercial paper (CP), large time deposits and banker's acceptances, totaled just over $3.01 trillion at the end of the first quarter...a 3.8 percent increase from the previous quarter...


After reading Bill Gross's latest, I felt compelled to muster some type of response. I was even quick with a title - "The McCulleyzation of Mr. Gross." I struggled with whether I would use "The Disappointing McCulleyzation..." While disheartened, I reminded myself that in these uncertain times everything needs to be kept in perspective. He has his job to do. Understandably, his top priority is performing for his bond investors.

Nonetheless, I do take it as evidence of our upside-down financial world that the universe's largest bond manager buys into the notion of insufficient global demand and a Bernanke Fed chairmanship. Is the world's largest economy not in the midst of an ill-fated consumption boom, with the most populated countries on earth - China and India - embarked on an historic increase in domestic consumption (along with investment)? Then there is the issue of Dr. Bernanke as a dogmatic standard bearer for continued artificially low U.S. and global rates, an environment today deemed untouchable by the entrenched financial powers.

The status quo is the problem and offers no solution. The U.S. and global financial systems are dysfunctional, and continuing to accommodate financial excess will end in tears, acrimony and the inevitable fanatical hunt for scapegoats. I very much fear this outcome. Today, the critical issue is not "insufficient demand" or a lack of global consumers, but an extremely uneven (and unstable) flow of finance both at home and abroad. Global asset inflation/Bubbles and massive speculative flows/Bubbles are creating only more extreme divergences in relative performances in sectors and economies across the globe. Yet such outcomes are the very essence of inflationary Credit and speculative Bubbles, and it is important to recognize that a continued accommodation of current dynamics will only worsen imbalances, wealth transfers, and animosities. The current unjust distribution of wealth was underscored in today's New York Times article by Mark Landler - "Europe: The Unlevel Playing Field - A union of Straggling and Booming Economies and Frustrations."

"Like thousands of young Spaniards, Rafael Matito left his home village for Madrid 18 months ago, lured by one of Europe's most thriving capitals. After landing a job as a computer instructor, he and his girlfriend set about achieving the Spanish dream: buying their own home. 'We weren't looking for a villa or anything close to it,' Mr. Matito, 28, said. 'We just wanted one or two rooms.' Madrid was out of the question because of the sky-high prices, so they hunted in the suburbs. But even there, apartments were twice what they could afford. Disillusioned, they called off the search until the market cools - if it ever does. Spain is in the seventh year of a housing boom that with interest rates at historically low levels, shows no sign of cresting. Nearly two decades after joining the European Union, Spain is on the leading edge of an emerging, and troubling, dichotomy between dynamic European countries, with fast-rising asset prices, and lumbering countries, with moribund markets, most notably Germany. Far from converging into a more homogeneous bloc, the 12 countries that use the euro currency are dispersing into sprinters and laggards, with different levels of consumer confidence, industrial activity, and economic vigor. Bustling Ireland, with a growth rate of 5 percent, has little in common with becalmed Italy, where output may actually shrink this year. This has created a conundrum for the European Central Bank in Frankfurt, which sets interest rates for much of the Continent."

Inflation manifests and alters behavior differently depending on myriad financial, economic, social, political and cultural factors. Today in Europe, rising home and energy prices place a drag on consumption and investment. In the U.S., the equity extraction-crazed American consumer responds altogether differently; he borrows and spends more and blows additional hot air in the Bubble Economy. And while the strong inflationary bias that permeates the U.S. system, along with its Asian partners, continues to captivate the global pool of speculative finance, a restive Europe anxiously watches and waits.

The ECB's conundrum with respect to increasing economic divergences and Mr. Greenspan's conundrum with respect to U.S. low market rates are two faces of the same coin. And, in truth, there is no conundrum. Uneven financial flows, divergent economic performance, rising asset prices, and artificially low global bond yields are intrinsic byproducts of ongoing global Credit, liquidity, and speculative excess. The global currency regime is anchorless and without a moral compass. The U.S.-based global financial system is in the process of breaking down, the consequence of the Greenspan Federal Reserve accommodating protracted lending and speculating excess throughout "The Core" Credit system.

I have to this point disregarded "Bretton Woods Two" propaganda. The fanciful notion that the concomitant ballooning of U.S. current account deficits and Asian central bank dollar holdings is part of a stable and sustainable monetary regime reminded me too much of the convoluted New Paradigm metrics and "analysis" spawned during the late-'90s manic technology circus. I am again reminded that there is a high correlation between the length of blow off periods and the capacity to relish nonsense. The current global currency arrangement evolved out of the necessity of managing escalating U.S. profligacy and the attendant precarious global financial flows. My notion is that Global Wildcat Finance is no more a lasting currency regime than wildcat banking was an enduring banking system. It works miraculously only while it works.

Many readers are likely familiar with Nouriel Roubini's (of NYU) insightful work analyzing the U.S. Current Account. In his paper "The US as a Net Debtor: The Sustainability of the US External Imbalance" he points to "the scale of financial flows required to sustain the new "Bretton Woods Two" as the "Achilles heel." According to Mr. Roubini's cogent analysis, "...there are five reasons why this new regime will not prove to be stable. 1) Internal dislocation in the United States... Bretton Woods Two keeps U.S. interest rates below what they otherwise would be, helping interest rate sensitive sectors of the U.S. economy. However, the financing comes at the expense of import-competing sectors... 2) The strains placed on Europe... 3) The strains placed on China's domestic financial system... 4) The financial risks associated with continuing to provide low-cost dollar denominated financing to the United States. Asian central banks are already taking an enormous financing risk by holding most of their reserves in dollar denominated assets... 5) Incentives to free ride and opt out of the cheap dollar financing cartel..."

I tend to lean toward the view that this strange global currency arrangement was fashioned more out of ad hoc urgency to manage destabilizing financial flows than an organized "cartel" to manipulate Asian currencies lower. What began with good intentions spiraled out-of-control right along with U.S. trade deficits. I thought the Financial Times' Wednesday interview with Bank of Korea governor Park Seung was especially telling.

"Financial Times: Korea has very large foreign exchange reserves. What is the best way for Korea to manage those reserves? You've said you'd like to manage them more profitably. I know about the Korean Investment Corporation but what are the other options? And what about diversification?

Park: As we experienced in the 1997 currency crisis, we think that we have a stronger need for enough amount of foreign reserves. So in our management of our foreign reserves we of course consider profitability but we are also focusing on safety and liquidity. I believe that we now have sufficient reserves to secure our sovereign credibility, so I do not think we will increase the amount of foreign reserves further. Since we have sufficient foreign reserves at $200bn, which is the fourth largest in the world, I think we now need to take more consideration of profitability, and I think we're at a stage where we need to manage our reserves in a more useful way...

Financial Times: Can I just clarify something. You said that you have sufficient reserves now and that you will not need to increase them further. Does that mean you will not be intervening in the foreign exchange markets?

Park: No, no, we will not be intervening. (Later in the interview, Park Seung clarified: "I said we will not increase our foreign reserves but actually we do not anticipate increasing our foreign reserves. We are trying to manage our reserves more usefully and the current account surplus is decreasing so we do not expect foreign reserves to increase.") In fact the Bank of Korea is not doing any intervenion in the foreign exchange markets to defend the exchange rate, we are just doing smoothing operations."

"Bretton Woods Two" proponents are content to extrapolate the enormous growth in Asian central bank balance sheets over the past few years. But bankers such as Mr. Park are undoubtedly today cognizant of the risks associated with continued monetization of U.S. Current Account deficits. There are internal domestic economic and financial issues, as well as the risk of loss on dollar assets. And one should expect the enterprising Chinese to join the Korean bankers in the pursuit of "profitability" with respect to their reserve position. Would they play against the hedge funds?

There are various estimates of the interest-rate "subsidy" that Asian central bankers are providing the U.S. bond market. Mr. Gross conjectured about 100 basis points. And while there is certainly a "subsidy," lower market yields are only one facet of what has become evolved into major marketplace distortions. The bottom line is that Asian central banks are acquiring a very significant portion of new Treasury issuance. This unusual dynamic takes on particular significance with Treasury bonds holding down the status of global yield anchor. It becomes of even greater relevance when Treasury bonds are the key vehicle used (shorted) for the enormous speculative "spread trade," as well as the predominant security traded for interest-rate hedging purposes. I argue that Credit market speculating and trading dynamics have been profoundly distorted by central bank purchases, and this is a key aspect of today's general Monetary Disorder.

This is my 16th year managing money on the "short-side." I have, more times than I care to recall, witnessed first hand the dynamics of "short squeezes." And it is those unusual episodes where the bears have shorted a high percentage of the outstanding "float," while a "cartel" of longs has "locked away" most of the tradable stock, when the stage has been set for wild trading, manipulation, and spectacular speculative gains - only to be followed by inevitable collapse. And it is a fascinating aspect of speculative dynamics that these "squeezes" too often develop right as negative fundamentals begin to manifest, although it is the rapidly rising stock price that proves the powerful impetus for hype and duplicitous promotion. In certain environments (1999/early 2000 comes to mind), the general backdrop becomes so conducive to systemic squeezes that fundamental analysis is cast aside en masse for the fun and easy profits afforded "squeezing the shorts."

Squeezes, manipulation and propaganda are facts of life for highly speculative markets. They are also an important, yet disregarded, aspect of Monetary Disorder and the breakdown of the market pricing mechanism. There is colored history of stock market Bubble antics and their consequences, certainly including the late-twenties debacle, Japan in the last-eighties and NASDAQ from not many years ago. That similar dynamics have taken such prominent hold of our Credit market/system is an extraordinary and very troubling development that cannot be measures in subsidies or basis points. And I can't stress this enough: Bubble dynamics in stock markets are very dangerous; Major Bubbles in the U.S. and global Credit systems are an unmitigated disaster for many reasons, certainly including no one will be willing to stand up and make the difficult decision to rein in excesses.

It is both reasonable and tempting to look to the imbalanced U.S. economy, stagnant Europe, heightened risk to Asian Central Banks, and a fragile Chinese financial system for the "Achilles heel" of the so-called "Bretton Woods Two regime." It is my view, however, that U.S. financial markets may very well be the first to buckle under. The weak link in this mechanism is that it today fully accommodates ongoing U.S. lending, leveraging and speculating excess. Resulting Current Account Deficits are then recycled right back to U.S. markets, exacerbating excess throughout.

It is my view that the resulting over-liquefication has already severely distorted market dynamics, including overly rewarding aggressive leveraged speculation ("carry" and "spread" trades, for example). And rewarding speculation - in this global environment of rampant liquidity excess - only enlarges the global pool of speculative finance. Importantly, the distorted marketplace is over-financing the Mortgage Finance Bubble - the greatest danger to financial and economic stability. Here, a confluence of massive speculative leveraging, derivative hedging, and artificially low Treasury yields has fostered a breakdown in the pricing mechanism for mortgage finance. The demand for mortgage Credit has today become irrelevant to the cost of borrowing, in what has developed into the most powerful mechanism for lending, speculative excess, and liquidity creation in history.

There is today false-confidence that we are enjoying a free lunch - that we can both import cheap imported goods and offload financial risk to Asian central banks. Overwhelming, financial risk mounts right here at home with our inflated securities market prices, increased speculative leveraging, and escalating late-cycle mortgage risk creation. In all cases, risk will compound every day that U.S. Current Account Deficits are recycled back into Dysfunctional U.S. Market Processes. And the greatest risk - the worst-case scenario - at this Mortgage Finance Bubble blow off stage is the current surge in liquidity and decline in mortgage yields.

There is today complacency that financial fragility and economic vulnerability ensure low yields - say 3 to 4% - as far as the eye can see. And even Alan Greenspan this afternoon implied that, since mortgage borrowers are increasingly stretched, the housing market can be expected to soon cool. This is wishful thinking quite detached from Bubble analysis and realities. The U.S. financial system is the vulnerable "weak link" specifically because of the confluence of unusual marketplace dynamics and the Mortgage Finance Bubble. A spike in yields would be immediately problematic, while the nature of market dynamics (unprecedented leveraging, speculation, and derivative hedging) engenders major self-reinforcing directional market moves (higher or lower). At the same time, the "Bretton Woods Two" recycling of finance into the Treasury market and recent heightened financial stress (GM, hedge funds) has created a powerful inflationary bias for the Treasury Bubble (proclivity for higher prices), pulling market yields sharply lower. This ensures only more destabilizing mortgage Credit excess and escalating late-cycle systemic risk.

The ongoing rampant flow of finance into already inflated markets is a serious dilemma for the U.S. financial system. Credit market prices are unattractive. The risk-reward profile of the stock market is anything but enticing. The sure thing of investing in the hedge fund community isn't looking so sure. At the same time, the reliable reflation trade is demonstrating the innate risk characteristics of over-liquefied speculative finance. And, importantly, the deteriorating quality of mortgage Credit is ongoing, with this year's estimated $2.4 Trillion of originations much riskier than last year's. There Credit and speculative dynamics at work very similar to those that distorted corporate risk market dynamics and prices, leading to the GM debt fiasco. Indeed, it is this precarious mix of the inherent instabilities of leveraged speculation and mortgage Credit excess that ensure the early demise of "Bretton Woods Two."

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