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Tuesday May 29, 2007 - 10:26:22 GMT
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Anatomy of a typical boom and bust

Key News
• Japan's jobless rate unexpectedly fell to a nine-year low in April and households increased spending for a fourth month, suggesting consumers will help extend the economy's longest postwar expansion. (Bloomberg)
• ECB Governing Council member Axel Weber said in an interview with the Financial Times that euro zone interest rates are not yet appropriate and the ECB was prepared to shift to a restrictive monetary policy if needed to keep inflation in check. (Reuters)
• Short sellers are betting against U.S. stocks like never before as the Standard & Poor's 500 Index approaches an all-time high. (Bloomberg)
• The Hong Kong Monetary Authority, the Chinese territory's de facto central bank, added its voice to the growing chorus of concern about the risk of an asset bubble in China. (WSJ)

• Key Reports Due (WSJ):
10:00a.m. May Conference Board Consumer Confidence. Previous: 104.0.
10:30a.m. May Dallas Fed Mfg Production Index. Previous: 24.3.
12:00p.m. Apr Chicago Fed Midwest Mfg Index. Previous: +0.8%.
5:00p.m. ABC/Wash Post Consumer Confidence. Previous: -9.


“More worrisome than the backup in bond yields over the past few weeks is that it has put the 10-year Treasury up to its downward trendline stretching all the way back to the historic peak of 15% in 1981. That's the ‘most important trendline in the world,’ writes Natexis Bleichroeder technical guru John Roque, who sees a little resistance at 4.90% and then more at 5.25%. From there, he likens the T-note yield to gold prices in 2001, which the consensus then said couldn't rise.”

Randall Forsyth, Barron’s

FX Trading – Anatomy of a typical boom and bust…

The world is awash in liquidity—no doubt. But something doesn’t seem to wash.

Market rates are creeping higher in most places. And central banks in all places are worrying about the impact of inflation on this excess money, as they witness the stampede by funds and punters alike to “get money invested.”

Many smart people continue to say “don’t worry.” Their view being that until there is a sign of a palpable fall in liquidity—asset markets will continue to be well bid. But we can’t help wondering if it’s the chicken or the egg? I.E. does liquidity dry up when markets break or do markets break when liquidity dries up?

If one believes that leverage (read liquidity manufacturing) is a function of underlying collateral (granted the definition of underlying collateral today is suspect itself) and said collateral is often a function of asset price inflation (driven by liquidity), doesn’t it then lead to the conclusion that liquidity is a direct function of asset prices and asset prices are a function of liquidity i.e. a symbiotic or “reflexive” relationship?

Maybe this helps, from Soros:

“For purposes of this discussion it may be helpful to distinguish between a ‘real’ economy and a ‘financial’ economy. Economic activity takes place in the ‘real’ economy, while the extension and repayment of credit occur in the financial economy. The reflexive interaction between the act of lending and the value of collateral may then connect the ‘real’ and the ‘financial’ economy or it may be confined to the ‘financial’ economy. Here we shall focus on the first case.

“A strong economy tends to enhance the asset values and income streams that serve to determine creditworthiness. In the early stages of a reflexive process of credit expansion the amount of credit involved is negligible. That is why the expansionary phase is slow to start with and credit remains soundly based at first. But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values. The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy. By that time, collateral values have become greatly dependent on the simulative effect of new lending and, as new lending fails to accelerate, collateral values being to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values. Since the collateral has bee pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous. That is the anatomy of a typical boom bust.

“Booms and busts are not symmetrical because, at the inception of a boom, both the volume of credit and the values of the collateral are at a minimum; at the time of a bust, both are at a maximum…In a bust, the reflexive interaction between loans and collateral becomes compressed within a very short time frame and the consequences can be catastrophic. It is the sudden liquidation of accumulated positions that gives a bust such a different shape from the proceeding boom.”

Whew! Enough said I think. So the next time you hear someone tell you that everything is fine because liquidity is abundant, think chicken or the egg…LOL…

Jack Crooks


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