The current environment increasingly reminds me of the long, scorching summer of 2007.  The subprime crisis turned serious in early June.  And not to pick on Ben Stein, but this week I went back and reread his August 12, 2007 New York Times article, “Chicken Little’s Brethren, on the Trading Floor.”  Mr. Stein’s perspective at the time was in tune with the majority of analysts and pundits: subprime was just not that big of a deal; markets had way overreacted. 

From his article:  “The total mortgage market in the United States is roughly $10.4 trillion. Of that, a little over 13%, or about $1.35 trillion, is subprime… Of this, nearly 14% is delinquent… Of this amount, about 5% is actually in foreclosure… Of this amount… at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion… But by the metrics of a large economy, it is nothing. The total wealth of the United States is about $70 trillion. The value of the stocks listed in the United States is very roughly $15 trillion to $20 trillion. The bond market is even larger. . .”

The dollar is in trouble.  Our currency has now dropped for nine straight weeks, sinking to a near 15-year low against the yen.  Crude oil traded above $82 this week.  Wheat prices are up about 50% over the past month.  The last thing our struggling economy needs right now (in common with 2007/08) is surging energy and food prices. . .

It is worth noting that Treasurys held in reserve by foreign central banks at the New York Federal Reserve Bank have surged $74bn in just seven weeks.  Dollar weakness appears, once again, to be forcing foreign central banks back into the role as “backstop bid” for the dollar in global currency markets.  These dollar balances are then “recycled” back into our Treasury market, a dynamic that does not go unrecognized by the speculator community.  This presses market yields only lower, increasing the risk of prepayment on mortgage securities and forcing additional interest rate hedging (further exacerbating the decline in market yields).  And once a market dislocates, many will pile on in search of easy speculative profits.

With Treasury, Agency and MBS prices melting up (yields in melt down), key markets enjoy extraordinary, albeit destabilizing, liquidity abundance.  Understandably, market participants dismiss talk of U.S. structural debt issues.  Many will justify the move on fundamental grounds – “It’s deflation, stupid!” Ironically, collapsing yields, the sinking dollar, surging commodities, recovering global risk markets and the onslaught of global liquidity create a backdrop conducive to future inflation surprises.