BEST OF DOUG NOLAND

August 10, 2005

For sometime now the bulls have enjoyed having a copy of the Fed’s playbook. This unusual luxury allowed them to create a fanciful world comprised of a productivity miracle, downward wage pressures, general dis-inflationary pricing pressures, a global savings glut, world-wide manufacturing overcapacity, a stable new "Bretton Woods II" global monetary regime and perpetually low global interest-rates. And, Thinking Soros, market perceptions do have a fascinating way of engendering their own reality – for awhile. The great bond bull market was granted an extended life, right along with an Extraordinarily Dangerous Credit Cycle.

As one would expect, this imaginary nirvana has incited speculation, along with the unwinding of hedges. In the process, we have witnessed the type of wholesale capitulation by bond bears (investors, traders, derivative players, and pundits alike) consistent with a major market top. As such, it would appear that the markets are today unusually susceptible to speculative de-leveraging and derivative-related dynamic trading strategies. And, in regard to "Bretton Woods II," I will assume that the Chinese today feel Washington has changed the rules mid-game. After accumulating $700 billion of reserves, it’s ok for the Chinese to buy Treasuries and MBS. But we won’t look kindly at our trading "partner" if they use some of those dollars to buy things we really want and need.

Over the past year we have watched (1999-like) end-of-cycle excesses throughout all aspects of mortgage finance – certainly including systemic risky lending and securitizing, leveraged speculation in various mortgage instruments, and the ridiculous mortgage REIT Bubble. The consumer has capitalized on inflated home equity and spent with reckless abandon. The combination of elevated consumption and surplus market liquidity has fostered a huge (end-of-cycle extrapolation) boom in consumer-related investment spending (certainly including housing, retail, and restaurants). Bubble Economy distortions went to unimaginable extremes, only to have maladjustments "double…."

Age-Old Credit Inflation Dynamics dictate that the longer boom-time psychology becomes ingrained in the financial and asset markets; throughout financial institutions; in businesses, governments and households, the greater the monetary tightening inevitably required to goad the system back on a more sustainable course. It is the case that the longer and more robust the inflationary boom, the more spectacular and problematic the unavoidable bust. The dilemma today is that we are long past the point of any possibility for an orderly return to stability. The interest-rate markets are now faced with the prospect of guessing if the Fed will actually attempt a true tightening and, if so, how high will rates have to go?