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Is The Bull Market On Its Last Legs?

Is The Bull Market On Its Last Legs?

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The Problem With Modern Monetary Theory

The Problem With Modern Monetary Theory

Modern monetary theory has been…

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The Diamond Anniversary of Monetary Disorder

Total Repurchase Agreements
Total Money Market Fund Assets
Financial Assets Held by GSE's
Housing Starts

It was a less than impressive performance for U.S. financial markets. For the week, the Dow dropped 2% and the S&P500 declined 1%. Economically sensitive issues cooled, with the Transports dropping 2% and the Morgan Stanley Cyclical index dipping 3%. The Morgan Stanley Consumer index was unchanged, while the Utilities added 3%. The broader market remains resilient, with the small cap Russell 2000 gaining 1% and the S&P400 Mid-Cap index largely unchanged. Technology stocks remain wildly volatile, with selling overpowering buying. For the week, the NASDAQ100 and Morgan Stanley High Tech indices gained 2%, and the Semiconductors declined 1%. The Street.com Internet index was unchanged, while the NASDAQ telecommunications index sank 3%. The Amex Securities Broker/Dealer and the S&P Bank indices declined 1%. With gold making a decisive $7.50 move higher this week, the HUI Gold index jumped 13%. The bullish case for gold seems to grow more compelling by the week.

Global bond markets took another battering this week. Two-year Treasury yields jumped 12 basis points to 3.70%, an increase of 64 basis points this month. It is worth pondering that two-year yields increased from about 3.80% in October 1993 to 7.70% by December 1994. This week, 5-year yields increased 11 basis points to 4.81%, while 10-year yields added 7 basis points to 5.40%. Long-bond yields ended the week up 6 basis points to 5.81%, while off-the-run bonds traded with 6 handle this week for the first time in awhile. Benchmark mortgage-back yields jumped 9 basis points, while the implied yield on agency futures increased 2 basis points. The spread to Treasuries on Fannie Mae's 5 3/8% 2011 note narrowed 3 to 67. The benchmark 10-year dollar swap spread narrowed 2 to 67. Global currency markets remain unsettled, with the dollar gaining about one-half percent this week. U.K. 10-year yields rose 6 basis points this week to 5.30%, a six-month high. Ten-year yields in Germany rose 2 basis points to 5.25%, the highest level since October 2000. Two-year German yields have surged 42 basis points so far this month to 4.29%. Australian 10-year bond yields actually declined 7 basis points this week to 6.37%, although yields remain up 42 basis points for the month. New Zealand's 10-year government bond yields rose 4 basis points to 6.99%, up 41 basis points for the month.

Bloomberg quoted South Korean commerce minister Shin Kook Hwan: "Based on the outcome of restructuring efforts so far, and the settlement of global economic standards, I see the possibility of the Korean economy growing by some 5 percent this year." Closer to home, Canadian retail sales grew at a better-than-expected 1.1% rate during January, led by a 4% jump in department store sales. February U.K retail sales surged at a much stronger than expected rate. Sales were up 5.9% y-o-y, the strongest pace in two years. Donald Brash, governor of The Reserve Bank of New Zealand, surprised the markets by moving to increase interest rates. Since Dr. Brash is our favorite central banker, and with his comments quite pertinent to economic and central banking issues generally, I have chosen to highlight extensively from his policy announcement.

"As you are seeing, the Reserve Bank has decided to increase the official cash rates from 4.75% to 5.0%. In the last few months of last year, we reduced the official cash rate by 100 basis points despite a domestic economy which was weathering the international downturn well. We did this partly because we expected the negative confidence effects of the events 11th of September to damage both the global and the New Zealand economies, and partly because it had become clearer that even before the events of 11 September the world economy was weaker than previously expected. Both led us to expect downward pressure on inflation. Indeed, in November we reduced interest rates by more than our projections suggested might be necessary on the grounds that the risks in the international economy seemed clearly biased to the downside. But we also noted in November that it was, and here I quote, 'conceivable that the combination of a stronger underlying performance of the New Zealand economy and a global slowdown that blows over rather more quickly than now expected, will require a reversal of recent interest rate cuts in the not too distant future.' In the event, the performance of the New Zealand economy has indeed been stronger than we expected and the risks to the global economy also look less threatening. Economic activity in the United States has picked up more quickly than most observers expected late last year and the Australian economy looks robust. Not that the global economy as a whole looks particularly strong. On the contrary, it seems likely that on average our trading partners will grow only moderately this year and significant risks remain. The Japanese economy continues to have major difficulties, the U.S. recovery could stumble over the high level of debt already accumulated, and global equity markets remain vulnerable to further weakness. But on balance, these risks appear less than they did four months ago.

Locally, the domestic economy has been surprisingly buoyant. After a brief pause in October, retail spending has been strong. Visitor arrivals have also recovered quickly. Turnover in the housing market has been high and residential investment has surged. Employment growth has been strong, and unemployment is close to its lowest level in 13 years. Although we are still expecting relatively slow growth in investment spending this year, a delayed response to the sharp fall in business confidence which followed 11th September, it now seems likely that investment too will be stronger than we expected in November. Imports have recently been very strong, confirming that domestic demand is relatively robust.

The reasons for the economy holding up well are fairly clear. Both consumer and business confidence have bounced back to pre-eleventh September levels. Interest rates have been at low levels for several months. While the exchange rate has strengthened a little recently, it has been well below most estimates of long-run equilibrium value for about two years… Looking forward, it seems clear that if things evolve as now seems likely, there will be a need for higher interest rates if inflationary pressures are to be contained. The economy is already operating at close to full capacity and indications are that pressures will grow further in the absence of some increase in interest rates. Headline inflation has been at or above the top of the inflation target for much of the past 18 months. And for a number of reasons that seems likely to continue to be true for most of this year…the risk is that this prolonged period of inflation near the top of the inflation target may lead people to adjust their inflation expectations upwards, making the task of controlling future inflation more difficult. Even after today's decision, monetary conditions remain stimulatory. Today's increase in the official cash rate simply represents some withdrawal of monetary stimulus, much of which was put in place as insurance against risks which have now receded. At the moment it seems likely that there needs to be some further reduction in monetary stimulus over the months ahead."

And in response to a question, Dr. Brash made cogent comments that we would suggest also be pondered carefully by members of the Greenspan Fed:

"I think it's always true that a stitch in time saves nine, if you like - that it is better to tighten early and moderately than leave it too late and tighten either much more aggressively in terms of the total quantum of increase, or to have to maintain interest rates at a much higher level for longer."

Spoken like a thoughtful, prudent and disciplined central banker. How refreshing! The resilient New Zealand economy may also provide a valuable example of the non-technology sectors in many Western economies. New Zealand largely avoided the tech Bubble, and thus has escaped its bust.

Speaking of Bubbles, February data is in from Freddie Mac. "Total mortgage portfolio purchases were $51 billion, the third highest volume ever..." Freddie's retained mortgage portfolio jumped $14.7 billion, a 35% growth rate. The retained portfolio has now increased $31.1 billion in two months, a 38% annual pace. Over this period, its total book of business (retained mortgages and guaranteed securities sold) has increased $44.5 billion, a better than 23% pace ($267 billion annualized). Freddie's total mortgage portfolio has surged $203 billion over the past twelve months. This week from the Los Angeles Times: "Home sales surged last month across much of the Southland, lifting prices for almost every type of housing and putting the market on a scorching pace through the early part of the year that is ahead of last year's robust levels." LA home sales were up 21% from last February, "marking the best February since the previous boom in 1989." The median price was a record $237,000, a gain of 15% over the past year. Quoting the chief economist from the California Real Estate Association: "The market is on fire. I don't know how else to say it." The Orange Country market has been hot for some time, "reminiscent of the late-1980s price bubble, some analysts say." With inventories low and construction not keeping up with demand, a Southern California real estate agent stated it was the strongest sellers market he had ever seen. "To be a buyer under $350,000 is very tough." "When a condo priced at $175,000 hit the market last week, he said, the unit elicited two offers at $195,000 and one that ultimately was accepted by the sellers at $200,000."

Wednesday the Commerce Department reported that February housing starts increased to the highest level since December 1998. At a seasonally annualized rate of 1.77 million (expectations were for 1.635 million), total starts (single and multi-family) have jumped 17% from October lows, and are now running up 11% y-o-y. For comparison, during the early-nineties recession starts bottomed at a level of 798,000. Single-family construction was the big eye-opener, with starts surging to the strongest level since 1978. Single-family starts of 1.457 million are up 19% since October and 13% above very strong year ago levels. For comparison, single family starts bottomed in January 1991 at 604,000 units. In a sign of things to come, building permits jumped to the strongest pace in a year. While the Mortgage Bankers Association's weekly index of purchase applications is off highs from earlier in the month, it remains about 3% above last year's brisk pace.

Wal-Mart is now expecting March same store sales growth of between 8 and 10%, with first quarter gains at the "upper end" of the forecast of 5 to 7% growth. The Bank of Tokyo-Mitsubishi weekly retail sales index had same-store sales up 5.1% y-o-y, with a forecast for March same-stores sales gains of between 6 and 7%. The Instinet Research Redbook weekly retail index had same-store sales up 5.9% y-o-y. With January's 3.5% increase in goods imports behind a worse than expect $28.5 billion trade deficit, our dismal trade position appears poised to only deteriorate throughout the year. With February revenues down 11% and spending up 9.7%, the Treasury reported a monthly federal deficit of $76 billion compared to last year's $48 billion. For the first five months of the fiscal year, revenues are running down 3% with spending up 9.3%. By major spending category, social security expenditures are up 5.8%, national defense 14%, income security 16.1%, Medicare 7.7%, and health 18%.

Most attention is directed to recent data indicating that the economy is emerging briskly from what is referred to as recession. As Credit Bubble analysts, we'll take special note of the 10-year Diamond Anniversary of the Greenspan Fed's frantic monetary easing back in 1992. It seems like such a different world today, but from an historical perspective ten years is not really that much time. After Fed tightening saw rates increase from 6.50% in February 1988 to 9.75% just 12 months later (difficult to believe it's the same Alan Greenspan), an historic monetary easing then saw rates collapse to 3% by September 1992. The Fed has since fallen in love with "easy money" and the kindness of quick rate cuts, while along the way having acquired a phobia marked by cold sweats and intense panic attacks at even the thought of "tight money." It has been an amazing (r)evolution in central banking, the structure of the U.S. Credit system, and the dynamics of financial markets. Even as Goldman Sachs this week doubled its estimate of first-quarter U.S. growth to 5% they, nonetheless, stated their expectations that the Fed will wait until the end of June to move and then only 25 basis points. Rates will supposedly [baby step] increase to 2.50% by year-end. The Fed is receiving its marching orders.

To appreciate today's environment and current acute financial fragility it is necessary to go back and retrace the footsteps that led to the Fed's 1992 panic and the consequences that followed. The banking system had found itself severely impaired after the late eighties real estate boom turned bust. There was, as well, the issue of the long neglected costs of the S&L collapse that were growing exponentially into the hundreds of billions. It is no coincidence that these types of costs always hit governments when they can least afford them - during recessionary periods as revenues sink and expenses escalate. Throw in the junk bond fiasco and all the corporate over leveraging coming home to roost, and it is not difficult to explain how the banking system found itself in the direst straights since the Great Depression. As we have detailed in the past, the real estate collapse had arrived at California's door, with potential to push the U.S. financial system over the cliff. Globally, there was the specter of the enormous Japanese Bubble collapse and deflationary pressures from the disintegration of communist block economies. The Fed responded aggressively, and not inappropriately.

From then on, however, there is much in dispute. To hear conventional wisdom tell it, somehow the U.S. financial system was over the next decade morphed into the best capitalized, ablest, and most "efficient" in history. While impressive, the financial sector's accomplishments were surpassed by the "real" economy that developed miraculously from a mature, slow growth, competitively challenged economy, into the most vibrant and "productive" the world has even know. This radical transformation created an economy that could now easily grow at previously unimaginable rates without risk of negative consequences, quite a boon to investors and central bankers alike. It is, admittedly, a seductive story.

I just can't shake comments made by Milton Friedman last month in the Wall Street Journal. That he endorsed Greenspan's policies and the unprecedented expansion of money supply as evidence of positive lessons learned from the Great Depression says a great deal. Dr. Friedman and the economic consensus see a fundamentally healthy economy that just needed a bit of extra, Fed-induced monetary cushion to get over a rough patch. This view has the financial sector as an afterthought, if that, while issues such as endemic speculation and systemic over-leveraging are not even variables in the equation (let alone the most important). We, on the other hand, will construct our analysis around financial institutions and arrangements, debt structures, money and Credit growth, and the financial sphere generally. We see a financial system completely out of control that even makes that which fueled the "Roaring Twenties" look tame and certainly rudimentary by comparison. It seems rather obvious that we today operate within a monetary economy like none previous. We are in the midst of an historic Monetary Disorder that runs unabated after being unleashed by the Greenspan Fed a decade ago.

I find it interesting that I am reading bearish analysis dismissing the possibility of economic recovery, very similar to that common 10 years ago. With good reason, some very adept economists and analysts are proselytizing that the U.S. economy is today incapable of returning to a period of strong demand. The litany of structural impediments includes poor profits, excessive corporate and household debt loads, a dearth of savings and investment opportunities, global uncompetitiveness, and so on. There are as well the major issues of the U.S.'s structural trade deficits and massive accumulation of foreign liabilities.

I am reminded of some painful memories but good lessons learned over the years shorting stocks. Occasionally, a truly worthless stock would come to our attention. With careful analysis and diligent fundamental research, it would become clear that earnings were being overstated, assets were being overvalued, management was poor and likely dishonest, and that there was little possibility that this enterprise would ever amount to a business of any merit or value. The excitement of finding such a short prospect, however, dissipated over time as the stock would disregard all the sound bearish analysis and rise to a level that made no sense whatsoever. Then, often after a bit of a respite, such stocks would proceed into a parabolic rise (before eventually collapsing and disappearing). There would come a point in the process - usually when true underlying fundamental became absolutely conspicuous yet the stock rose anyway - that our disappointment turned to frustrated dismay. While the fundamental analysis was correct, it did not change the harsh reality that we had failed to appreciate what the game was really all about. The game was to entice short positions and then incite a panic short-squeeze. Stock operators knew all too well that there were few opportunities for spectacular profits than those available during such market disorders. Negative fundamentals were a key variable, but just not in the way us fundamental analysts presupposed. We could have ranted and raved all we wanted and the response in the marketplace would have been the same: "Go ahead, make our day and short some more. We couldn't care less about fundamentals; we care that you are short and need to cover." The game was about playing market dynamics.

I am not claiming that similar dynamics are at work at a macro level for the U.S. financial system, but I am saying that there are meaningful parallels in the perverse role played by negative economic fundamentals that are not generally appreciated by bearish analysis. Importantly, I do believe that the underlying structural weaknesses and impediments in the U.S. economy and financial system have for some time played key roles in fostering the Credit and economic Bubbles. A fundamentally sound system would not have incessantly produced the Internet, telecom, technology, equity and real estate Bubbles. Endemic asset inflation is not a residual of the real economy's health but rather the financial sector's ills. Moreover, I do not believe that the U.S. boom would have been possible without severe financial and economic distortions throughout the global economy. Global factors were critical in accommodating U.S. Monetary Disorder over the past decade, just as similar factors nurtured monetary excess during the "Roaring Twenties." Without the deflationary forces emanating from Japan and the collapse of the communist block over the past decade U.S. consumer prices would surely not have been so immune to rampant domestic Credit excess. A more balanced and fundamentally sound global economy would not have been so accommodative to the unprecedented U.S. trade deficits. And if it weren't for the post-Bubble impaired Japanese financial systems, structural issues throughout Europe and then the domino Bubble collapses throughout SE Asia and emerging markets, there would have certainly been some market discipline imposed on the out of control U.S. financial sector and its multiplying dollars.

It was the "headwinds" of an impaired U.S. banking sector from the early nineties that played the key role in fostering the explosion of non-bank Credit creation that transformed the U.S. financial system to the point of being almost unrecognizable from a decade ago. Certainly, the Fed-orchestrated steep yield curve required to recapitalize the impaired banking system (as well as various global currency collapses) was the overriding catalyst for the leveraged speculating monster's rise to prominence as the master of the U.S. Credit system. I also remember the early 1990s Wall Street mantra, "harvest assets, harvest assets," as the Street was more than happy to provide a home of marketable securities to U.S. savers running from the shock of 3% CD yields. If Wall Street and the hedge fund community saw opportunities to profit from the banking system's maladies, the government-sponsored enterprises had visions of the pot of financial and political gold.

Hyman Minsky wrote in 1957 (Central Banking and Money Market Changes, The Quarterly Journal of Economics, May 1957, p. 171), "Evolutionary changes occur typically in response to some profit possibilities which exist in the money market." Indeed, and never had this been truer than with the revolutionary changes in the 1990s. Not only did the Greenspan Fed provide very low short-term borrowing rates for impaired bankers, an enterprising Wall Street, and opportunistic speculating community, it conveniently looked the other way to momentous developments in the structure and composition of the money market. Total money market assets began 1992 at about $460 billion only to grow to last week's $2.35 trillion. Continuing from the brilliantly prescient Minsky, "as the evolved changes often center around some technical detail of money-market behavior and as they usually start of a small scale, their significance for monetary policy is generally ignored at the time they first occur." Absolutely!

But more than mere "technical detail," what was really afoot in the early nineties was an acceleration of truly momentous developments in institutions, debt structures and financing arrangements, with the money market at the epicenter - the liquidity lifeline.

Money market funds had been around since the 1970s, but their growth was constrained by the limited quantity of top-quality short-term corporate borrowings (the temporary working capital requirements of the very top-tier firms). But this constraint was being subtly dissolved by financial evolution the likes not seen since the twenties. It is no coincidence that Minsky's insights are so relevant today. His analysis emanated from his keen understanding of and appreciation for the fateful financial evolution/innovation and resulting Monetary Disorder of the 1920s.

It takes abnormal monetary and Credit expansion to fuel Bubbles, and the proliferation of financial intermediaries and the explosion of non-bank finance during the 1920s provided plenty. Revisionist analysis (pushing aside the superior analysis of Minsky and others to dominate the consensus view starting back in the early 1960s) drew conclusions based on a fixation on the expansion of narrow money supply (bank deposits). This view was completely oblivious to the critical issue of Monetary Disorder, its causes and consequences, as is conventional analysis today that focuses specifically on GDP, "productivity," CPI, bank reserves, and bank Credit.

A key facet of the "Roaring Twenties" era was the great popularity of the automobile and a variety of new home appliances. Importantly, this was significant both to the real economy and the financial sphere. Bankers were actually leery to aggressively move into consumer lending, opening the door to financial innovation - the explosion of sales finance companies. During the first half of the decade the number of finance companies is said to have surged from a few to as many as 1,700. The major automobile manufactures and other durable producers jumped aggressively into the captive finance business. The urbanization and increasing wealth of the American worker was a boon to financial evolution. Concurrently, the liquidity emanating from the consumer Credit boom (economic and monetary) helped stoke the investment company Bubble. Ending 1923 at $15 million, investment company assets finished 1929 at $7 billion. With the stock market on the rise, margin loans, broker call loans, leveraged equity trusts and so forth then fueled a spectacular stock market Bubble. The stock market reciprocated and financial Credit stoked a Bubble economy, becoming the key transmission mechanism of spectacular Credit excess imparting the most damaging structural distortions at the end of what had been a very long boom cycle. Credit from the real economy fostered financial Credit excess that then only reinforced general financial excess

There are clearly great complexities in analyzing the 1920s Bubble and the subsequent Great Depression. But for our purposes it is critical to appreciate that momentous changes in the nature of the financial system and the character of demand, hence the structure of the real economy, fed and was fed by acute Monetary Disorder. Furthermore, for our purposes, the issue is not the depth of the Great Depression or the role played by post-crash policy decisions, but rather that once set in motion this period of destabilizing Monetary Disorder would inevitably come to an end with unavoidable economic and financial adjustments. The issue was not if, but when and after how much damage was imparted on the system.

The notion that somehow a cure could have been provided by throwing additional money at acute Monetary Disorder is as flawed as it is regrettable. But this only points out the analytical importance of recognizing systemic Monetary Disorder as the key variable. Is the drug the cure or the problem? Evolution and innovation in the monetary sphere were at the same time dictating profound changes to the structure of the economy, as well as creating indelible monetary processes directing self-reinforcing Bubble excess to and from the securities markets. The longer these processes and speculative impulses were accommodated by the central bank, the greater the maladjustments to the real economy and the more fragile the debt structures in the financial sphere. I work to refine this analysis, first, because there are very important issues from the 1920s that were never resolved and, more importantly, because these issues are keenly pertinent to the current Credit Bubble. Whether it was the "Roaring Twenties," late-eighties Japan, mid-nineties SE Asia, or the protracted and unrelenting U.S. Internet/technology/stock market/real estate/Credit market Bubbles, behind each of these booms there was stimulus emanating from some type of serious Monetary Disorder.

As a contemporary analyst, I will admit my biased view that economic and financial "evolution" over the past decade has been even more profound than during the 1920s. While bullish analysts would today claim a technology-induced, ultra-productive New Paradigm U.S. economy, this belies the fact that corresponding technological developments have not produced similar results in Japan and elsewhere. Instead, the key "real" economy developments in the U.S. economy have been de-industrialization and explosive growth in the service sector.

While enormous, it is our sense that economic developments pale in comparison to revolutionary changes in the financial sphere. This view becomes even more critical in combination with the belief that a de-industrialized economy, by its very nature, becomes increasingly monetary in character. Additional financial claims - not goods - become the residual of the preponderance of enterprise. Where Credit excess would traditionally result in inflationary affects on goods (output) prices in an industrialized economy, the consequence of similar excess may in fact be inflation of financial claims (output) in a monetary "services" economy. These inflating financial claims (the economy's "output") then become locked in a symbiotic relationship with various asset markets, feeding a maladjusted economic Bubble and crystallizing the monetary nature of the general economy. Returning to the importance Minsky placed on the money market, it is worth noting that financial sector commercial paper borrowings increased from about $400 billion to begin 1992 to last week's $1.2 trillion. Outstanding repurchase agreements ended 1991 at $497 billion and have since expanded to $1.96 trillion. Total GSE assets ended 1991 (also) at $497 billion, only to balloon to $2.3 trillion by the conclusion of 2001. These three related areas of extraordinary expansion are historic - "output" from the New Paradigm economy and the residual of an unprecedented expansion of financial Credit.

The prominent role of financial Credit during the past decade has been truly revolutionary. The financing of rapidly growing GSE balance sheets, with their implied government guarantee, provided the money market with something it had always lacked, an asset class (GSE short-term borrowings) that could be expanded in infinitum while maintaining pristine Credit status. At the same time, the financing (repurchase agreements and financial sector commercial paper) of both Treasuries and the explosion of top-rated agency bonds provided another asset-class with effectively no natural limits. Now, with these two asset classes combining with money market funds' unusual structure exempt from traditional banking reserve and capital requirements, the most powerful financing mechanism in history was in place. It was revolutionary yet so subtle it remains generally unappreciated to this day. Yet, any analysis of the past decade that does not begin with these historical financial developments - the money market, financial Credit, repurchase agreements, the GSEs, and leveraged speculation - is simply flawed. Clearly, the financial sphere does not explain everything and it does not, in itself, deny the possibility of a miracle, productivity-enhanced, New Age Economy. But the New Paradigm crowd cannot ignore these momentous financial developments, the critical role they play in (over) financing the real economy and asset markets, or the ramifications if they prove to have created a fragile and unsustainable debt structure.

So the early 1990s witnessed an extraordinary confluence of real and financial variables. With the banking system impaired, corporate profits in structural decline, and the Fed, accordingly, eagerly accommodative, the whole game changed. It may have been subtle, and it may have been completely off the radar screen for the "real economy-centric" economic community, but it was nonetheless monumental. As dismal as things were for the real economy (sub-par growth, business investment opportunities, and economic profits), financial evolution and monetary policy combined to supply virtual free money in the financial sphere. And exactly as one should expect from a Capitalistic economy, it did not take long for these financial profits to thoroughly incite animal spirits and captivate intense entrepreneur zeal.

It is a weakness of Capitalistic systems that the spirited entrepreneur cares not to differentiate between true economic profits and gains derived from aggressive lending, speculating, and deal making. It is furthermore a critical vulnerability that such gains in the financial sphere are powerfully self-reinforcing. Lending excess begets additional excess, as Credit-induced economic expansion stokes additional demand for borrowings. Speculative asset Bubbles, with resulting asset inflation providing enticing gains and additional collateral, are especially dangerous, as we have explained repeatedly. And with a contemporary money market now providing unfettered liquidity, systemic vulnerability rose to previously unknown dimensions. In hindsight, it is clear that only aggressive action by the Fed to quash these fledgling dysfunctional monetary processes could have protected the stability of the system. But the Fed nurtured them and the ensuing Credit Bubble. The confluence of extraordinary financial and economic forces could not have been more powerful and, at the same time, apparently less appreciated. That as early as 1994 Greenspan discussed the stock and bond market Bubbles that already existed supports the view that he recognized these developments but shunned his responsibility to protect the stability of the system.

It is the nature of successful innovation that it induces further innovation. It is as well the essence of speculative finance that if a central bank gives in inch, they will be expected in the future to give a mile. It is the character of uncontrolled Monetary Disorder to feed greater disorder. That the GSEs rose to prominence as "Buyers of First Resort" for the leveraged speculating community during the Fed's 1994 operations - bestowing the invaluable assurance of a liquidity backstop even during financial tumult - provided the final inducement ensuring the unprecedented growth and power of the leveraged speculators. Meanwhile, there was the growing realization that the money market now provided the financial equivalent of The Fountain of Youth, a bottomless pit of liquidity for the expansion of speculative holdings of GSE and Treasury debt. If there was a problem, it was that there weren't enough securities to go around (some resorted to cheating at Treasury auctions, which only makes the allocation process for agency bonds more intriguing). It did not take long for an enterprising Wall Street to see the enormous possibilities for, on the one hand, financing securities speculations, and on the other, utilizing securitizations as a financing vehicle for its borrowing clients and as fodder for speculation.

Financial "engineers" then rose rapidly to prominence. In one circumstance, she developed structures and derivatives to transform risky loans into easily financed top-rated securities. In the room next door, a colleague created sophisticated derivative strategies incorporating these new securities with leverage for their speculating clients. The transformation of the boring business of insuring general obligation municipal bonds into an exciting growth conglomerate writing various types of financial insurance and guarantees was seen as a great profit opportunity, as well as a critical development for the evolution of financial engineering. With techniques being mastered and the infrastructure in place, what were lacking were more aggressive lenders and their high-yielding loans. With financial "profits" booming, the Street easily brought a deluge of non-bank lenders public. These companies were aggressively financed myriad of high-risk loans from subprime auto and Credit cards, to Taxi medallions, to facelifts, happy to claim riches from the explosive combination of insatiable demand for these loans for securitization and gain on sale accounting. It was a veritable "profit" bonanza for the Street, with IPO fees followed by the "annuities" available from structuring client loans and selling the securitizations.

Nothing, however, could compare to the evolution that structured finance brought to the mortgage arena, where literally no stone was left unturned. This played well with real economy developments, where to be seen as successful increasingly required the large new home with a three car garage out in suburbia. Looking back, the surprise is that it took a few years for the U.S. economy to accelerate to a state of conspicuous boom. Many of these aggressive mortgage lenders collapsed along the way, but the GSEs were happy to take up the business. The economy didn't miss a beat.

There were a few scares along the way. There was the very close call in 1998, with the Asian Bubble having burst and global deflationary forces seemingly gaining momentum. The game nearly came to an ugly end with the collapse of Russia and LTCM. Yet, any doubt that the leveraged speculating community had by then achieved sacrosanct status was quickly put to rest. The Fed eased aggressively and the GSEs proved that truly no amount of Credit creation was beyond the realm of possibility. The Street then used the fear of Y2K to extort further Fed stimulus. The consequences were an outrageous escalation in Credit and speculative excess, with a spectacular Bubble in Internet and technology stocks, as well as telecommunications debt. Quietly, the real estate Bubble gathered steam. By this point, however, there was no doubt as to how the Fed and GSEs would respond to any crisis. Crises were thus no longer to fear, but were recognized as providing virtually guaranteed speculative profits in the U.S. Credit market. The speed and degree to which the U.S. economy responded to stimulation was also evidence of how far the transformation to a monetary/asset-based/"service sector" economy had proceeded. It was, as well, now obvious to the global leveraged speculating community that the Fed and GSEs had created such favorable rules that there was now really only one game worth playing. I have said written, "Liquidity loves inflation." Well, the nature of U.S. financial Credit inflation was truly irresistible to the speculators. The money machine was playing spreads and placing leveraged bets in the U.S. Credit market, and one only needed to get their hands on dollars to make dollars.

Back in 1998/99 I was a bit perplexed by the apparent demise of the "bond market vigilantes." Why was the bond market not in an uproar with the explosion of money and Credit? At the time I suspected that leveraged speculators had simply supplanted true long-term bond investors as the commanders of the market pricing mechanism, and I still ponder this critical issue. The leverage players love easy money and have little direct concern for future inflation rates. Their game is playing the Fed's pegged interest rates and liquidity assurances. They are not concerned with fundamentals per se, but are keenly focused on that which might cause the Fed to adjust the peg. But looking back it is clear that the technology sector (both in the real economy and financial sphere) proved such a magnet for the inflationary Credit deluge that, outside of housing, pricing pressures remained relatively tame. There was, as well, the kicker that note and bondholders could relish the conspicuous technology Bubble with pleasant thoughts of its inevitable collapse and an even greater Fed and GSE-induced bonanza in financial profits.

But this all seems rather like ancient history today. A critical issue nowadays is attempting to grasp the inflationary ramifications that will arise from the monetary fiasco experienced over the past twelve-months, and what type of response it may elicit from the Fed. Our sense is that there is considerable uncertainly developing on both counts, something not seen in quite some time. We have argued that finance will not flood into the technology sector, so a replay of such a contained inflation seems out of the question. Despite recent inflows into junk bond funds, the corporate bond market does not appear in a position to extend significant inflationary impulses to the business investment arena. With this in mind, it looks to us as if a major change in the inflationary environment may be in the offing.

We are beginning to see a few signs that perhaps the surprise on the inflation front could come this time around with heightened GENERAL price pressures. We see oil and petroleum product prices again on the move. Commodity prices look solid for a change. Core inflation was notably resilient over the slowdown, with services prices looking darn right intimidating. And let's not forget that goods prices have been tempered by the strength of the dollar, a benefit that we believe has largely run its course. On the margin, the dollar could now provide a stimulus for domestic goods inflation instead of a drag.

We also wouldn't be surprised that only a moderate general increase in demand will be necessary to resurrect some of the serious economic bottlenecks that had surfaced pre-slowdown. We also think there could be a real story developing at the "lower end." While the focus has been on price gains moderating for upper-end real estate, the more significant development may be that lower-end housing markets in California and elsewhere are increasingly "on fire." Then we have analysts that may have been too quick to explain the impressive sales at Wal-Mart, Target and the discount stores as indicative of economic weakness. Here again, there may be more at work, and it could be an early indication of major developments. Perhaps a better explanation would consider the possibility that the vast majority of the "working class" has never had it so good. Could it be that the shallow economic slowdown left most workers unscathed, with their jobs intact, wages growing smartly, and their homes a treasure trove of available purchasing power? How many see themselves moving up the ladder to "middle class" status with the purchase of a larger home and more expensive vehicle? And let's not forget that easy loan money is there for the taking. We sense an inflationary bias at the "lower end" as long as Credit remains so freely available.

It is certainly worth noting that wages and personal income remained buoyant throughout the slowdown, with workers in short supply in many sectors. And perhaps this boom in government spending and tax cuts, along with continued extreme mortgage Credit excess and a veritable consumer-lending free-for-all (terminal stage of consumer Credit excess?), is now transmitting problematic monetary excess in a more (traditional) general manner. After all, with corporate debt in the doghouse, investors and speculators are more than content to play the game with consumer debt instruments. This is key. For some time Wall Street could rejoice with the knowledge that the Credit Bubble was feeding the securities/assets markets and the more "well-to-do," while leaving "Joe Six-Pack" and his capacity to move the Fed's gauge of inflation, CPI, well under wraps. Looks to me like "Joe" could be doing pretty well - almost enough to make bond investors edgy…

So, if we are now set up for a potential surprise in the traditional measures of inflation, do we see a re-emergence of the Vigilantes? We will watch carefully, but for now things sure seem to be getting testy between some of the major Credit Bubble operators. It is quite a spectacle to behold when GE and Fannie Mae take shots at each other's financial disclosures. Then we have Bill Gross taking a shot at GE. Hard to know what to make of it all, but it sure is interesting. We just can't convince ourselves why those who might lose their affections for GE commercial paper can remain in love with short-term borrowings from GSEs, unless of course one places great faith in the implicit government guarantee. But the point is that these are all very key players and such public spats only encourage closer examination of financial institutions, underlying debt structures, and the strange U.S. Credit system.

Importantly, GE being forced to pay down commercial paper (CP) is a significant escalation in what we view as an unfolding (if slowly) systemic liquidity crisis. If GE convinces its commercial paper holders to trade their CP for GE bonds, there is little problem ("money" is replace with risky GE bonds). If, however - as is apparently the case with PIMCO and others - the holders have no interest accepting bond risk, GE must go into the marketplace and compete for limited liquidity out the risk spectrum (with other companies, liquidating speculators and derivative dynamic hedgers). Since "money" basically has insatiable demand, aggressive lenders with the capacity for issuing monetary liabilities are especially powerful players in the Credit creation process. On the other hand, demand for risky securities is both tenuous and quite satiable. Over the past four years, as GE borrowed aggressively in the money market to help finance its 60% balance sheet growth (to $500 billion!), GE was an acquirer of risk and creator of safe "money." GE, along with the GSEs and the leveraged speculators, has for some time used the powerful money market intermediation mechanism to its extreme, transforming risky loans into money fund deposits. This intermediation process has been at the very core of Monetary Disorder and the Great Credit Bubble. These players were risk gluttons and there was absolutely no protest or discipline from the marketplace, until recently. But, then again, ten years is quite a run in terms of the typical lifespan of historic financial schemes…

There are today very significant changes afoot. Post Enron, the marketplace is no longer looking the other way from conspicuous financial excess. But since no one seems to be running from GSE debt, liquidating asset-backed commercial paper, questioning the soundness of the securitization marketplace, asking questions about the repo market, or pondering the true value of all the Credit insurance, financial guarantees and derivatives, we are not going to get too carried away. All the same, seeing GE forced to reduce its commercial paper borrowings is as close as we've come yet to the heart of the matter. Perhaps it now makes sense for regulators to insist that GSE "risk models" incorporate the possibility that they may also at some point lose favor with money market investors. For now, the market is faced with the problematic issue of rising rates and a Fed content to sleep on the sidelines as the global move to more appropriate interest rates commences. Are the Vigilantes merely the creature of myth and legend? With all the happenings and revelations, one of these days the marketplace may not be so forgiving of Fed timidity. For now, we'll stick with our sense that the system will function sufficiently with either rates moving higher, spreads widening, or the dollar declining. But if they begin to occur concurrently, all bets are off. Only a little nudge could put us in the middle of a mad scramble for liquidity and dislocation.

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