So far, I don’t really see many surprising developments pertaining to reflation dynamics. Thing seem largely on track in Asia, while the struggling U.S. Credit system is regaining some fire power. At this point I see little justification for revising my expectation for lagging U.S. asset markets and economic performance.

At the same time, one can see the makings of future bouts of acute fragility. I see great risk in the system’s increasing reliance on capital markets as the primary source for Credit expansion and liquidity creation. It is unfortunate – but not unexpected – that reflation requires a further concentration of financial power. Moreover, it is dangerous that Washington policymakers now completely hold sway over the Credit markets. “Federal” Credit – Treasury, agency, and GSE MBS – remains the vast majority of system Credit creation. It is worth noting that May and June GSE MBS issuance totaled almost $450 billion (from Bloomberg). There is an enormous amount of mortgage Credit and interest-rate risk being bundled and transferred to Washington – to a government that already has too much of it.

The problem only seems to get clearer. The maladjusted US Bubble economy is sustained by $2.0 to $2.5 Trillion of new Credit – Credit that must largely be issued or guaranteed in Washington. This reflation (a.k.a. Credit inflation/currency devaluation) drives massive flows to China, Asia and the emerging markets that have few takers other than the central banks. And as economies recover and inflationary distortions reemerge, these enormous dollar flows can be expected to foment increasing policymaker angst. Asian reflation is poised to take on a wild life of its own, forcing policymakers at some point to confront today’s reality that dollar flows are destabilizing and unmanageable. China, in particular, faces tough choices when it comes both to managing its Bubble and the massive accumulation of IOUs of deteriorating quality.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com