BEST OF DOUG NOLAND

October 19, 2005

In some respects, the market environment has returned to where I thought it was earlier in the year. I believed that "risk markets" had reached a critical juncture in the early spring. Market rates were moving higher, stocks were in retreat and then near debacle struck in auto Credit default swaps. I expected the leveraged players would be forced to shed risk, ushering in the end of the Credit boom cycle. Well, I was wrong. I today believe I was wrong because of the liquidity-creating power of a final unanticipated (for me, at least) bond market rally and decline in mortgage rates. What transpired was a classic final melee, replete with negligent mortgage lending, wild Wall Street excesses, a Credit default swap boom, an emerging market boom, and a Global Liquidity Glut sufficient for $70 crude. Those having hedged against higher rates were forced to unwind and dreams of a 3% 10-year yield filled giddy traders’ imaginations. For good reason, events have unnerved the Fed, and I suspect it will be some time before they are again so eager to pander to an imperious Wall Street.

If I am correct, pieces are falling into place for the unavoidable adjustment to highly leveraged and speculative U.S. asset markets. I would expect stress in auto-related risk markets to be contagious. Higher market yields from this point are also problematic. The highly leveraged MBS marketplace is vulnerable to rising rates, wider Credit spreads and self-reinforcing hedging-related selling. The entire financial sector is vulnerable to the unfolding environment, and this reality should begin to manifest in widening sector Credit spreads. Further negative Refco revelations would likely push this process forward. Because of the complex nature of the expansive speculative Bubble, we are forced to analyze subtleties in various markets for indications of heightened risk aversion, de-leveraging and waning liquidity.