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It's Going to be a Fascinating Second Half

My apologies for this unedited Bulletin!

The shortened three-and-a-half day trading week saw both the Dow and the S&P 500 rise about 1%. Notably strong Dow components included Disney, Microsoft, and SBC. The Transports were flat on the week while the Utilities lost half a percent. The Morgan Stanley Cyclicals were about unchanged, while the Morgan Stanley Consumer index gained 0.8%. The broader market used the holiday week to sport some nice gains. The Small-cap Russell gained 1.7% (up 23.4% for the second quarter!), and the S&P 400 Midcap added 1.1%. The tech-heavy Nasdaq 100 posted a decent 2.2% this past week, increasing year-to-date gains to 25%. The speculative technology sector continued to lead the way as the Morgan Stanley High Tech index gained 2.8% (up 31% y-t-d) and the Semiconductors added 2.6% (up 28% y-t-d). The Street.com Internet Index added a tidy 2.0% percent, increasing 2003 gains to 46%. The Nasdaq Telecom Index returned 2.4% on the week (up 38% y-t-d). The volatile Biotechs gained 0.8% on the week. Judge Milton Pollack helped lead the Broker/Dealers higher by 4.3% on the week. The judge called investors "high risk speculators" who effectively went to the casino and lost. Rounding out the week, the Banks added 0.8%. With bullion up $5.80, the HUI Gold Index gained almost 6 percent.

The Treasury market struggled along with global bond markets, with the yield curve steepening gain this week. The spread between the 2 and 10-year Treasury notes widening to 235 basis points, the widest in almost two months. Two-year Treasury yields declined 5 basis points to 1.31%, while five-year yields rose 6 basis points to 2.51%. The ten-year Treasury note saw its yields close the week at 3.66%, up 11 basis points, while long bond yield jumped 10 basis points to 4.68%. The spread on Fannie's 4 3/8% 2013 note narrowed two to 33, and the spread on Freddie's 4 1/2 % 2013 note narrowed three to 32. The 10-year dollar swap spread widened 0.5 to 35. Corporate spreads widened moderately, with investment-grade spreads up on average one basis point and junk spreads up 5-7 basis points.

Fannie benchmark mortgage-back yields rose 9 basis points, while the implied yield on agency futures jumped 12.5 basis points. Freddie Mac posted 30-year mortgage rates increased only 3 basis points this week to 5.24%. Municipal bond yields rose for the third straight week to the highest level since May 1. The Bond Buyer Muni index yield ended the week at 4.51%, up 30 basis points from June 12th.

UK 10-year yields rose 5 basis points this week to 4.28%, having increased about 40 basis points in three weeks. Yields throughout Europe have risen about 40 basis points in three weeks to approach 4%. Australian bond yields rose 8 basis points to 5.11%, and are now up 50 basis points in about three weeks.

Bond issuance slowed during this holiday-shortened week. Prudential Financial raised $1 billion, Southern Power $575 million, Western & Southern $350 million, and International Transmission $185 million. The junk market moves full-speed ahead: Vivendi Universal raised $975 million, Cincinnati Bell $500 million, Jacuzzi $380 million, Mohegan Tribal Gaming $330 million, Orbital Sciences $135 million, Cascades Inc. $100 million and Wackenhut Corrections $150 million. American Airlines this week issued $254 million of 7-year debt at a yield of 3.857%, 140 over Treasuries. Record convertible issuance continues. This week Fisher Scientific raised $250 million, Anixter International $328 million, Wynn Resorts $200 million, Level 3 $325 (up from $250 million), New Century Financial $175 million, Powerchip Semiconductor $112 million, Cable Design $110 million, Proassurance $100 million, and Sina $80 million.

July 2 - Income Securities Advisors: "Green Tree Investment Holdings, having shed its troubled past as Conseco Finance Corp, is now talking about growing its existing business as well as expanding through acquisitions."

July 2 - Dow Jones (Johanna Bennett): "If employers hope that their health plans' medical costs will grow at a slower rate next year, they may be disappointed, according to a recent study by Aon Consulting. In its semiannual cost trend study, Aon, a New York human resources consulting firm, not only predicted double-digit increases in claims costs in 2004, but also found no signs that medical costs are rising at a slower pace. The findings run counter to industry analysts and other studies… But as Bill Sharon, the author of Aon's study and senior vice president of the health and welfare group, sees it, companies with employee health coverage will impose some of the biggest changes to health plan designs, increases in employee contributions and benefit reductions that have been seen in recent years to help manage rising premiums... Among HMO plans providing prescription drug coverage, costs will rise an average of 16.4% in 2004… Medical costs among indemnity plans that pay for prescription drugs should rise an average of 17.2% in 2004… The estimates are taken from a survey of 20 insurers, pharmacy benefit managers and pharmacies and represent claims costs, which drive about 90% of premiums. The estimates do not take into account changes in benefit plans aimed at cutting costs."

Broad money supply (M3) jumped $21.1 billion, with a 10-week gain of $190.1 billion (11.6% annualized). Demand and Checkable Deposits declined $4.6 billion, while Savings Deposits expanded $9.6 billion ($47.9 billion over four weeks). Small Denominated Deposits declined $1.9 billion, as Retail Money Fund deposits added $1.5 billion. Institutional Money Fund deposits jumped $16.9 billion, the strongest gain since early March. Large Denominated Deposits increased $8.7 billion. Repurchase Agreements were about unchanged and Eurodollar dipped $1.3 billion. Elsewhere, Total Bank Credit declined $7.2 billion (while Total Bank Assets increased $47.7 billion). Securities holdings dipped $2.7 billion, with 3-week declines of $24.4 billion. Loans and Leases declined $4.5 billion. Commercial and Industrial loans decreased $3.8 billion, Real Estate loans dropped $13.5 billion, and Consumer loans declined $5.5 billion. Security loans jumped $14.5 billion. Total Commercial Paper increased $21.1 billion last week, with Financial CP borrowings up $21.4 billion.

Foreign ("custody") Official Holdings of U.S. and Agency Debt jumped $10.1 billion (Treasuries up $7.3 billion and agencies up $2.8 billion) to a record $943.3 billion. "Custody" holdings have surged $56.3 billion over the past nine weeks, and are up $136.5 billion since the first of November (25% annualized growth). Year-over-year, "custody" foreign central bank holdings of U.S. securities are up 19%.

July 3 - Bloomberg: "Morgan Stanley…said Asian investors in the past three years have more than doubled their buying of debt sold by U.S. agencies such as Fannie Mae and Freddie Mac as nations in the region boost foreign-exchange reserves. Central banks and other institutions in Asia buy between 40 percent and 50 percent of debt sales by U.S. agencies from about 25 percent three years ago, said Jialin Liu, Morgan Stanley's head of fixed income for Asia and the Pacific… That portion may increase as Asian countries' trade surpluses add to their approximately $1 trillion of reserves and the proceeds are invested in U.S.-dollar debt, he said. 'Many of these new issues are being driven by Asian demand,' Liu said. 'A large proportion of the current-account surpluses Asian countries are starting to amass are being parked in U.S. Treasuries or agencies.'"

July 2 - Financial Times (James Kynge): "China is looking at ways to relieve pressure for the revaluation of the renminbi, as a prelude to adjusting the 10-year-old system that effectively pegs the currency to the US dollar, according to officials and academics. Such considerations have become more urgent recently as a rapid inflow of 'hot money' has strained the central bank's ability to dictate monetary policy. Officials said the central bank had recently been forced to buy an average of $600m dollars a day to steady the exchange rate. The intervention helped to drive China's foreign currency reserves above $340bn by the end of June, up from $316bn at the end of March."

There were 31,703 bankruptcy filings last week, with y-t-d filings up 9.2% from comparable 2002. The June ISM Manufacturing Index was reported at a weaker-than-expected 49.8. It was not, however, a weak report. The key categories all increased and remain above 50. The Prices Paid component jumped 5 points to 56.5. Production added 1.4 points to 52.9, and New Orders increased 0.3 to 52.2. New Export Orders added 3.6 to 54.4 and Imports increased 4.2 to 56.4.

May Construction Spending was reported at a weaker-than-expected down 1.7%. Spending was up 1.1% y-o-y. The devil is in the detail. Year-over-year, single-unit residential construction was up 9.2%, with total residential up 6.8%. At the same time, Nonresidential spending was down 8.1%, with Industrial construction down 24.0% (Office down 14.6%, Hotels, Motels down 5.7%, and Educational down 6.6% y-o-y). Private spending on Hospitals was up 9.7% y-o-y. There are additional indications that the Public sector Construction spending booms has ended. Public spending dipped 1.8% during the month, with declines in three of the past four months. Year-over-year Public sector construction spending is down 2.5% y-o-y, despite a 7.1% increase in Housing. Year-over-year spending on Roads was down 4% and Education slipped almost 5%. Public spending on Hospitals was up 18.8% y-o-y, while Military was up 7.0%.

Mortgage finance Bubble blow-off week 50 saw the Mortgage Bankers Association application index jump almost 10%. Refi applications were up about 8% for the week and were 227% higher than one year ago. Purchase applications jumped almost 15% for the week to the second highest on record. It is worth noting that the all-time record set four weeks ago was affected by the holiday shortened week: applications from the four-day week were multiplied by 125%. Last week's Purchase applications were up almost 17% y-o-y, with dollar volume up almost 26%. The average Purchase application was for $199,100, with the average adjustable-rate mortgage at $311,100.

Freddie's back. Freddie Mac's total Book of Business expanded at a 9.2% annualized rate during May to $1.304 Trillion, the strongest growth since December. The company's Retained Portfolio expanded at an 8.1% rate, with y-t-d growth at a 2.0% pace. In further evidence that Freddie has recently ramped up its business, Retained Commitments to purchase mortgages surged to a record $48.8 billion from April's $25.2 billion.

During a CNBC panel discussion following yesterday's disappointing Jobs Report, the point was made that "this is the first recovery since the productivity revolution." Supposedly, productivity enhancements are to blame for the lack of job creation in the face of continued moderate GDP expansion. I would argue that the mythical "productivity miracle" has little to do with anything. During the same CNBC discussion, Morgan Stanley's ace senior economist Bill Sullivan hit the nail on the head when he averred that "structural issues" were likely restraining job growth.

The confluence of global manufacturing over-capacity and resulting pricing pressures, in conjunction with an inflating U.S. cost structure, makes it only increasingly difficult to produce goods profitably here at home. Further monetary accommodation, as we have been witnessing, will not ameliorate this critical structural distortion. And as I have highlighted ad nausea, inciting greater liquidity and Credit availability will work to stimulate those sectors that already demonstrate an inflationary bias. We see further evidence of this dynamic in yesterday's employment report.

June saw another 56,000 manufacturing jobs lost, with a five-month decline of 287,000. At the same time, Construction added 16,000 jobs during the month (101,000 over 4 months). Health, Social Assistance employment jumped 35,000 (107,000 over 4 months) and Financial Activities gained 9,000 (65,000 over four months). Temporary Help jobs increased 38,000, with two-month gains of 82,000. After dropping 100,000 jobs over three months, the Government sector added 1,000.

Structural changes to the real economy are more clearly illuminated when examining year-over-year job changes. Total Non-farm Payrolls have declined 421,000, or 0.3%, to 130 million over the past 12 months. Manufacturing jobs have decreased 4.2% (639,000) to 14.695 million (to 11.3% of total non-farm payroll). The economy's inflationary bias is found elsewhere. Service-producing employment is up 155,000 y-o-y to 107.9 million, despite Trade, Transport, and Utility employment having shrunk 270,000. Financial Activities have added 151,000 jobs in twelve months to 7.98 million, with Credit Intermediation up 122,000. Real Estate employment was up 23,000 y-o-y. Health, Social Assistance added 306,000 jobs to 13.8 million, with Ambulatory Health Care up 168,000, Hospitals 78,000, and Nursing, Residential Care up 55,000. Leisure and Hospitality employment increased 144,000 to 12 million, with Food Services, Drinking up 139,000. Local Government employment is up 119,000 over twelve months to 13.8 million. Total Government jobs are now almost 50% larger than Manufacturing. Is it reasonable to trumpet a "productivity revolution" when the vast majority of new jobs and attendant "output" emanate from Credit intermediation, healthcare, leisure and government?

Returning to the markets, the weak jobs report pulled the bond market all the way back to positive, after suffering significant losses overnight following Japan and Europe. But about ninety minutes later the market was slammed right back down by a much stronger-than-expected report from the non-manufacturing sector.

The June ISM Non-manufacturing Business Activity index jumped 6.1 points to 60.6, the highest reading since September 2000 up 12.7 points in three months). New Orders increased 2.8 points to 57.5, the strongest reading since November 2000. Prices Paid rose 1.8 to 51.4. The Employment component also jumped back over 50 (indicative of expansion), rising to the highest level since January's 50.3.

That the ISM Non-manufacturing report had such a significant market impact - it completely trumped the jobs report - is fascinating and perhaps even a watershed development. To this point, the Credit market has curiously stuck with its traditional focus on the performance of the manufacturing sector, despite the reality of its shrinking role in the contemporary services-driven U.S. economy. But, then again, it has been a most pleasing environment for bond players, recognizing clearly that the Greenspan Fed is fixated on the struggling goods sector. Yet, according to the ISM chair Ralph Kauffman, "(The ISM non-manufacturing) report represents 80% of gross domestic product…" (From Market News International's Mark Pender) Moreover, "Kauffman admitted he was surprised by the month's gains, with 15 industry sectors reporting improvement, 2 reporting no change and none reporting contraction. "I didn't look for that to happen that quickly.'"

This report provided the strongest evidence yet that "reflation" is "working." Although consistent with seemingly everything else in this extraordinary environment, "reflation" is not unfolding in typical fashion. Credit and speculative excess are imparting their greatest impact on housing and service sectors (arenas demonstrating inflationary biases), while the goods sector's deep-rooted atrophy is largely immune to even gross financial excess. And while rampant financial excess is having little impact on job creation - due to deep structural distortions - do not confuse this phenomenon with the inability of reflation to stoke demand (albeit unevenly and atypically). One can, as the bond market has been content to do, look at many traditional economic indicators and make a good case that reflation is fruitless. Yet sound analysis recognizes the reality that Credit inflation is bearing a most unsafe variety of fruit.

While business spending and capital investment remain restrained, U.S. consumer spending is improving. But goods demand will by necessity be largely satisfied by foreign producers. So between the even larger prospective U.S. trade deficits and continued strong liquidity flows to higher-yielding non-dollar assets, there certainly appears to be more than sufficient liquidity to stoke the unbalanced global economy. Japanese government bonds are taking notice. Kicking and screaming, the U.S. Credit market is now forced to pay attention as well.

While global equity market gains captured the headlines, it was quite a banner second quarter (and first half) for global Credit markets. JPMorgan Emerging Bond index was up 10.7% for the quarter. Solid gains were enjoyed in virtually every market, with the riskier the asset class the better the performance.

Some high yield indices have y-t-d gains approaching 20%. And, according to Merrill Lynch, US convertible securities posted their strongest quarterly gain since 1999's fourth quarter. Merrill's All US Convertible index gained 10.6% during the quarter, with year-to-date gains of 14.0%. Speculative Grade converts continue to outperform, with y-t-d gains of 21.6%. Small Cap converts gained 17.2% for the quarter and Utilities surged 27.5% (led by Calpine, AES, and Duke). June saw a record 52 new covert deals price, with $17.2 billion of proceeds (second-highest). Year-to-date issuance of $54.3 billion (a record 148 deals) has nearly reached 2002's total issuance of $55.4 billion (Thomson Financial has tallied $59.18 billion y-t-d).

June 30 - Bloomberg: "U.S. municipal bond sales surged to a 17-year high this month as state and local governments refinanced debt and borrowed to cover deficits at the lowest interest rates since the late 1960s. Sales of municipal bonds in June totaled $44.6 billion, the second highest ever, based on figures from the Bond Buyer newspaper. Only in December 1985, the month before the U.S. government tightened limits on tax-exempt bonds, were sales higher, at $54.7 billion. June's municipal debt sales, which include $10 billion of Illinois pension bonds and $2.3 billion of New York State tobacco securities, are an increase of 16 percent over June 2002. 'We're still in that hangover of paying for programs that we don't have revenue to pay for, and so it's being done through the debt markets,' said Tom Doe, president of Municipal Market Advisors…"

With first-half muni issuance of $192 billion, 2003 is on pace to possibly reach $400 billion for the first time. Last year's $359 billion was an all-time record.

June 30 - Dow Jones (David Feldheim): "Asset securitizations ended the first half of 2003 with record new issue volume, according to data compiled by Thomson Financial Securities Data. New issue volume surged almost 20% for the period to over $275 billion from $231 billion in the 2002 first half. Propelling issuance to record heights was a surge in the home equity sector, which Ivan Gjaja, head of ABS research at CitiGroup, described as a 64% leap to about $112 billion."

It was an historic first half for the Great Credit Bubble. According to Thomson Financial, total first half Global Debt issuance jumped 20.6% to $2.594 Trillion. Citigroup was the leading underwriter, with its $271.6 billion up almost 20% from 2002's comparable period. U.S. Mortgage-Backed Security issuance of $488 billion was up 41% y-o-y. Goldman Sachs led first-half MBS issuance at $63.9 billion, up 62% y-o-y. JPMorgan led the convertible marketplace, doubling first-half 2002 issuance. Lagging the more speculative, Investment Grade issuance was up only slightly y-o-y to $351.3 billion.

The global financial system has been awash with liquidity. Yet the European and Japanese economies have been stuck in the mud. And despite the U.S. financial system operating in four-wheel drive, the spinning wheels of the American economy have to this point gained only minimum traction. But when we examine the economies in China, Russia, India, Brazil, and throughout Asia, especially in the context of an over-liquefied global financial system, we see a potential new locomotive for (unbalanced) growth. Could surging exports finally pull Japan out of the muck?

Global financial traders are now contemplating the distinct possibility that Japan's reflation may be taking hold. The Nikkei index was up 8% over five sessions and almost 27% since April 28th lows. And, importantly, rising equity prices this time appear to be instilling some confidence on business managers. The Tankan survey of large manufactures improved significantly (up 5 points to negative 5) during June to the highest reading since March 2001. Furthermore, there was a notable increase in plans for future investment. This provides additional confirmation of anecdotal evidence that cautious managers are increasingly of the mindset that to better compete globally will require more aggressive investment.

It is also worth noting that the Japanese monetary base expanded strongly last month, with y-o-y growth of 20.3% (up from May's y-o-y up 16.7% and April's up 11.5%). Industrial production has strengthened, exports are rising, and a post-SARS Asian growth spurt is increasingly a strong possibility. Now, if the household sector comes around, the Japanese reflation story could really come together (just when everyone had given up hope!). Economists have begun to raise Japanese GDP forecasts, with growth approaching the one percent range expected over the next several quarters.

Meanwhile, Japanese Government Bonds (JGB) are in freefall. Yields surged 22 basis points the day before yesterday, the biggest one-day move since 1998. This after "a debt sale drew the least bids since a failed auction in September." JGB yields surged 68.5 basis points to 1.12% since June 12th. From Bloomberg: "Japan has the largest government bond market in the world with 562 trillion yen in marketable securities, or $4.7 trillion outstanding at the end of March, compared with the U.S. government's $3.3 trillion. Banks are heavily exposed, but stock market gains are helping to offset bond losses. To what extent the "Japanese carry trade" - borrowing funds at near zero interest rates to finance holdings of higher yielding securities in the U.S., Europe (especially with the currency rising!) or elsewhere - has fueled global liquidity will be on traders minds over the coming weeks.

From yesterday's Financial Times: "Investors shunned British and German government bond market auctions on Wednesday, fuelling fears that the three-year old bond 'bubble' has passed its peak… Demand for bonds is being hit by concern about deteriorating public finances in most large economies and by renewed interest in equities as hopes of economic recovery rise and fears of deflation fade… In Britain, Wednesday's£2.25bn ($3.8bn) gilt auction was covered only one and a half times, lower than would typically be expected. In Germany, the sale of less than €6bn ($7bn) of new 10-year government bonds - known as Bunds - was only 1.4 times subscribed, the second-lowest level of interest in a bond auction this year. Ciaran O'Hagan, fixed-income strategist at Lehman Brothers, said the German government bond auction was 'the worst I have ever seen in my 12 years of following the market'."

The past six months has been a period of unparalleled irrational exuberance throughout global Credit markets. It has had the look and feel of an historic speculative blow-off market top. Interestingly, the environment has been governed by an extraordinary confluence of severe global economic imbalances and structural distortions, along with runaway Credit and speculative excess. One must be a devoted optimist to not see how this has been sowing the seeds of its own destruction. Those of our analytical persuasion have looked aghast at precisely the prescription for things running unchecked and to most dangerous extremes. Yet global bond players correctly recognized that severe structural distortions, especially in the U.S., had created a despondent global economy. There was no fear that even extreme excesses would foster the type of economic recovery (or traditional inflationary pressures) that would jeopardize ultra-easy central bank accommodation. Excesses did in fact go to incredible extremes.

Here at home, imbalances have created an especially dangerous environment where Bubbles are sustained only by enormous unrelenting Credit excess and unprecedented leveraging and speculation. This some time back created a fragile Credit system acutely vulnerable to a problematic spike in long-term yields (unwind of speculative trades) at the first sign of recovery. I would argue that the Fed (too) cleverly moved to mitigate this risk with is Beat Deflation Now campaign. The end result, not surprisingly, was that this risky maneuver was the catalyst for the final terminal stage of blow-off excess. A case can be made that we have now passed a key inflection point in global interest rate markets.

Blow-off tops always create a perilous gap between perceptions and reality. Some marketplace dynamic/dislocation (cultivated over years) stokes an extraordinary buying frenzy, with news, "analysis" and market perceptions following the exciting price gains. Excess liquidity, as opposed to underlying fundamentals, drives price gains, while the breach between reality and perceptions widens exponentially.

Over the past months, the notion of intractable global deflationary forces infecting U.S. central bankers and global bond players has created what I believe is a dangerous chasm. It is worth noting that energy prices, after declining significantly with the official conclusion of the Iraq war, have bounced right back. Gold prices are above $350, up better than 10% y-o-y. The CRB commodity index is around 235, up considerably from the 185 or so back in October 2001. Both the ISM Manufacturing and Non-manufacturing Prices Paid components have bounced back above 50. I mention these items as I believe things will likely resolve themselves over the second half. Is there, as players have bet, a legitimate deflation problem? Did the post-Iraq decline in pricing pressures mark a key turning point in the global pricing environment, or have the past few months been merely "a pause that refreshes." Surly, on the heels of the first half's global Credit excesses there is now increasing risk that perceptions of global deflation (and Credit market speculative profits as far as the eye can see) are unusually poised for disappointment. Keep your eye on Asia, the emerging markets and commodity prices. Everyone knows the Fed will not tighten, but that's precisely why such enormous leveraged bets were placed. It's Going to be a Fascinating Second Half.

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