BEST OF DOUG NOLAND

May 24, 2005

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 measured 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 that 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 Bubble 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 and exacerbates imbalances. 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. Overwhelmingly, however, 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. Monetary Processes. And the current surge in liquidity and decline in mortgage yields - at this Mortgage Finance Bubble blow off stage - is the worst-case scenario.

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 and squeezes), pulling market yields sharply lower. This ensures only more destabilizing mortgage Credit excess and escalating late-cycle systemic risk.