"Down On The Levee..."

As pundits and analysts were engaged in trying to figure on
the direction of crude and natural gas prices yesterday, Katrina
swirled past New Orleans. The backwash from the storm deluged
Lake Pontchartrain with rain. Waters rose overnight, several
levees were breached, and now the City has been inundated
with a toxic swill replete with petrochem, sewage and tumblin'
gators and water moccasins. Since The Big Easy is set in a bowl
below sea level, 80% of it is now under water with no natural
run-off. Although it may be true that the flashy Red Rhino
Dance Club near Bourbon St. may have survived, the City has
effectively been destroyed.

Katrina, for her part, is cruising north toward eventual
extinction in Quebec, but not before damaging the economies
of several other states. All told, probably upwards of 15%
of the US economy will have been damaged, with said damage
ranging from total devastation to the loss of power for a few
hours.

Them's that know me have seen an icy cool money manager
deal with tough issues over the years. I am no alarmist, but
it appears to me we have a national emergency on our hands.
President Bush will be in CA today to give a speech or two.
This curiously defective man is handling this blow to the US
with his customary nonchalance. Why he is not down south
where he is needed escapes my understanding. At the least,
they could have swept Cheney from his iron lung and deposited
him there.

Folks are only beginning to get an inkling of damage done and
the fully national effort that will be required to restore the
central Gulf and areas north. The effective loss of New Orleans,
a wonderful and unique American City is a national calamity, and
the sight of our President whistlestopping up in CA is a national
embarassment.

Katrina Damage To Be Widespread

Markets focus has been on the damage the storm may have done
to the LA petrol/gas complex. However, this storm could easily
wreak havoc in up to seven or eight states before it settles
down and begins to dissipate. Flooding, structural damage and
power outages will do severe damage to small and local businesses
from the tip of LA right up the midsection of the country through
TN. Homelessness will surge temporarily and job and business
losses and downtime could last many weeks. The breadth of the
storm and rainfall amounts are alarming. The losses sustained
here will have quite an impact on the economy.

Greenspan's Valedictory Part 1 -- Inside Scoop

Fed Chairman Alan Greenspan is winding up his tenure at the
Fed. He is using the Fed conference at Jackson Hole, WY to
discuss the history of the Fed, his tenure, and unresolved
issues that will carry forward. It will provoke quite a bit
of discussion among the pundits and will have the hard dollar
analysts in a tizzy of sardonic snickering.

Folks will work hard to unlock its many meanings and their
implications for policy, the economy and the capital markets.
As a semi retired senior investment executive with 40 years
of experience with the Fed, mostly at arm's length distance,
but occasionally up front and personal, I can tell you
clearly the meaning of what he said today in Part 1 of his
valedictory.

The speech was quintessential Fedspeak, but it can be
quickly boiled down to: "Whatever bad may happen to the
economy and or the markets after I leave ain't my fault."
There you have it, plain and unvarnished. Thanks Al.

Bond Market Profile

The long term bull market in bonds remains in place.

The most recent downtrend in yields, which began around
mid-2004, also remains in place, although the market is
overbought for the very short run.

At 4.40%, the long Treasury is discounting a return of
inflation to 1.5-2.0%. Moreover, there has been some
slight shrinkage in the longer term volatility premium
as well.

With the CPI now at 3.1% yr/yr, the market is running
entirely on forecast and expectation. Viewed historically,
this is very unusual behavoir for this market.

The forecast/expectation is that the combination of rising
short rates and fuel prices coupled with a tightening of
basic monetary liqidity will be sufficient to produce
enough economic slack to return inflation to 1.5-2.0%.

The market is likely also forecasting that oil and gas prices
will ultimately retreat markedly from levels seen as well
above reasonable. This seems a fair assumption since
continued significant strength in fuels will eventually
infect popular "core" inflation readings as producers and
service providers move to raise prices as they can to
protect operating margins.

Market players are also clearly chasing yield. Even though
the expectation is of a slow economy ahead, Medium grade
corporate credits have also rallied from the 7.0% level
seen in Q2 '04 to 6.45% recently. So, there has been but
a minor widening of spreads between Treasuries and lesser
quality investment grade corporates.

Advisory sentiment as measured by Market Vane is too bullish
but not at the extreme levels seen in the past quarter,
when the measure registered 77% bulls.

This is all heady stuff, particularly the willingness of
bond players to forecast the future with such confidence.

The market leaves me edgy. I am not used to seeing the bond
market look so far out in time with such confidence, and as
discussed in the prior post, it appears to me that the Fed
does not have as full control of the situation as the market
may think.

Business Expansion -- New Wrinkle

Historically, business expansions have been fueled by three
factors: monetary liquidity, internal cash flows and credit.
The key driver has been monetary liquidity. Expand it and the
economy follows suit. Contract it and a recession will
eventually occur.

Economic expansion over 1995-2000 was different. The basic
money supply M-1 was flat over this period, yet the economy
flourished, funded by cash flow and short term credit. Note
though that it took only a mild liquidity squeeze in 2000
to tip it over.

I bring this up because M-1 is not growing fast enough to
sustain economic expansion. This means that business must
rely on cash flow and credit to keep it going, as must the
consumer.

In my view, it is riskier when an economic expansion is
reliant on cash flow and borrowing alone. It does not
have the sure footedness it has when money is flowing
in and through the system adequately. My problem is that
I cannot quantify it. I can only say the resiliency of
the expansion is now being undermined to some degree.

How did this new wrinkle come about? It results from
the Fed's decision in 1992 to eliminate or minimize
reserve requirements on a host of large and "jumbo"
deposits to liquify a financial system stressed out by
the S&L and commercial real estate debacles. Regrettably,
I think, the Fed never re-imposed those requirements,
giving the banks a much freer hand to fund loan demand.

In giving talks to investment managers over 1995-2000,
I introduced these thoughts and issues. What I thought
was an interesting insight was met by shrugs. And it
paid not to worry for the longest time, right up to
the moment when the Fed tapped ever so lightly on the
brakes.

Now one piece of good news is that the adjusted monetary
base which leads the direction of M-1, has finally
started to creep up a little after a dead flat six
month period. We'll see.

Oil And Natural Gas -- Caution: Flammable

Sep. crude is printing $64.25 - 64.50 bl and gas is printing
over $9.00 mcf. On longer term charts these are spike breakouts
that signify an erosion of market discipline. There should be a
ton of overhead in each of these markets, and if demand can
continue to chew through it, the ball game will change to the
rankest of speculation and dramatically increased volatility.

From my perspective, we have moved beyond the pale of reason
and are watching these two markets move into fantasyland on a
speculative binge. As my Irish mom used to say, "The devil shall
take the hindmost."

Step Up To 50 BP Al.....

The Fed is widely expected to raise the Fed Funds Rate
by 25 BP to 3.5% today. I think it would be better if they
stepped up the FFR by 50 BP to 3.75% and then add another
50 BP at the September meeting to bring the FFR up to 4.25%.

I measure the domestic purchasing power of the dollar by
whether dollars left in money market and sweep accounts
provide a positive return after adjusting for inflation
and for taxes. In my view, monetary policy should only
act to depreciate the dollar internally when the economy
is in peril. The economy seems to be doing ok, and I see
no compelling reason to drag out the restoration of
internal dollar integrity. Presently, there is no
incentive for people to save, and this is a bad thing
to allow to drag on.

Brass Band Bear Parade Could Be Ahead

Well, it's that time again. After August comes September
and October, two of the diciest months of the year for
stocks. But wait, it gets worse, for next year is 2006
and time perhaps for the quadrennial low. As both the
big money and the smart money know, the market tends
to have a sell-off period every four years or so, and
2006 is it. I's well documented enough through time
that most market pros have respect for it.

As we move through the remainder of this year, do not
be surprised to see market punditry and forecasts start
to get tweaked to the downside. And, expect a number of
bears to proclaim that leg two of the long term bear
market is fast approaching. The spectre of 2006 will
change a fair bit of thinking across the grid.

The low volatility of this cyclical bull and the absence
of a good 10% correction so far does make one wonder. Still,
my strategy here is to stay with my disciplines and let others
do the tweaking.

In that regard, my advance monetary liquidity indicators
have started to perk up in recent weeks and the negative
divergence with the stock market has lessened. But it is
still early in the game to posit that the Fed
has made a directional change toward letting its foot
up on the liquidity brake especially since short rates
remain too low.

Tim Woods of Cyclesman hag good charts on the four year
cycle. Go to www.cyclesman.com/4-year_cycle.htm to see.

One Hand Takes; The Other Giveth In Abundance

For a little over a year, the Federal Reserve has been
"removing accomodation" by raising short term interest
rates and squeezing monetary liquidity. That would be
the Hand That Taketh.

But friendly bankers have swooped in on the scene. And
Giveth they have. Measured yr/yr, bank credit growth
has rapidly accelerated by 12% to nearly $5.2 trillion.
Loans to individuals -- mortgages, home equity and
personal have jumped 15% to $3.9 trillion. So not only
are folks not saving, they are happily leveraging up
to buy homes, cars and all of life's other necessities.
Sound money types and assorted other bears are seething
at what they see as wanton profligacy.

Now, after a couple of quarters of inventory rebalancing,
order rates for business have turned up, promising
higher production and more jobs. Earnings estimates will
inch up, and this has supported and extended the rally
in the market.

The Fed will likely press on with its accomodation removal
program and the banks will likely be glad handing both
consumers and business, at least for a while.

The issue here is that money left on deposit or in money
market accounts is still a loser.It depreciates in value
and in an expanding economy, it is going to be spent until
short term rates rise enough to protect its value and/or
economic developments occur which give consumers pause.

Inflation stimulus has originated with commodities in
this cycle, a typical development. And looked at seasonally,
the push to higher inflation is still in place, although
it has narrowed primarily to oil, gas and fuels. So, the
Fed has another reason to remain cautionary.

In the long run, the Fed will win out. That is why economic
and financial risks in the system are continuing to rise,
even if corporate earnings do better than many expected
in the short run.

The 0.0% Savings Rate

Consumer spending surged at a nearly 10% annual rate in
June reflecting strong auto price promotion and sales.
The savings rate fell to 0.0%. With money funds in the
2.8 -3.5% area, there is no incentive to save when the
real return on these funds is negative after adjusting
for taxes and inflation of 3.0%.

This is another reminder that short rates need to rise
significantly further to start to regain a better
balance between consumption and savings.