BEST OF DOUG NOLAND

November 9, 2005

In stark contrast to the past decade, domestic Credit systems are almost universally robust. Not only has the global pool of speculative finance experienced massive ballooning over the past several years, an overabundance of liquidity now flows throughout the "periphery" (emerging markets) instead of being quickly "recycled" right back to the "core" before it can impart inflationary effects outside of U.S. asset markets. Instead of checking into the infirmary when the U.S. gets the sniffles, the emerging markets now shrug.

The major analytical error made of late is to confuse this newfound glut of liquidity for "savings." This Splurge of Global Financial Sphere Inflationary Excess will not forever lower global market yields - quite the opposite. It is bound for awhile to press global central bankers to raise rates much higher than anyone had anticipated. As the Fed apparently has begun to recognize, the global liquidity glut significantly mollifies the impact of central bank (baby-step) rate increases. This is a similar dynamic to the muting influence global liquidity over-abundance is having on the capacity for rising prices of oil, natural gas, unleaded gas, copper, aluminum, platinum, and other commodities to temper demand. Marketplace liquidity and speculative dynamics have changed profoundly in the 17 months since the Fed was compelled to commence its timid policy reversal.

To actually tighten global financial conditions today will entail concerted aggressive central bank rate increases, a scenario thought virtually impossible until recently - and still widely dismissed. While European and Japanese central bankers have domestic issues to contend with, the longer they delay the rate normalization process, the more of a headache created for themselves and the Fed. In advanced contemporary financial markets, liquidity is instantly created and rapidly flows from the lowest cost "producer" to higher yielding targets ("carry trade"), and it is today flowing in destabilizing excess from both Europe and Japan. The Fed and U.S. interest-rate markets are now faced with the (previously unanticipated) dilemma associated with widening rate differentials to these energized Credit systems, both inciting a reversal of speculative positions and enticing "hot money" flows. This liquidity will continue to mitigate the tightening influence from rising U.S. mortgage rates, in the process prolonging the inflationary boom and delaying the desperately needed adjustment process.

The Mighty Global Financial Sphere expansion ensures that inflation is no longer a domestic issue. The Fed, or individual central banks for that matter, has lost control of the process. Talk today that the Fed has about reached "neutrality" is nonsense. The massive U.S. Current Account Deficit remains that greatest imbalance exacerbating the destabilizing global liquidity glut. Inflationary pressures are poised to broaden and become only more destabilizing until the Current Account is brought under control. To be sure, $800 billion Current Account Deficits are not indicative of rate neutrality.

The highly leveraged U.S. Credit system is today a real wildcard. Huge bets were placed on a scenario altogether different than the one I have described. Never has a rate scenario seemed as pre-ordained, and never have leverage and derivatives been as easily incorporated into trading strategies. The speculators were banking on a fragile backdrop conducive to the Fed wrapping up their operations early and easy. It hasn’t been early and it’s not going to be easy. The speculating community also expected the U.S. consumer to buckle under higher energy prices and rising mortgage rates, not anticipating the mitigating influence the unprecedented global liquidity backstop would impose. The Mortgage Finance Bubble soldiered on and fueled ongoing asset price inflation and income gains, with global Credit systems playing aggressive catch up. As such, the U.S. Current Account was this year accommodated by rampant global Credit excesses and widening interest-rate differentials. This put the dollar bear trade in harm’s way, with the status of the myriad currency/interest-rate differential derivative plays now very much in question.