POMO, the new four letter word

POMO, or Permanent Open Market Operations, see this, is one of the newest acronyms to hit the streets.  The caption below is taken from the FOMC website:

The purchase or sale of Treasury securities on an outright basis adds or drains reserves available in the banking system. Such transactions are arranged on a routine basis to offset other changes in the Federal Reserve’s balance sheet in conjunction with efforts to maintain conditions in the market for reserves consistent with the federal funds target rate set by the Federal Open Market Committee (FOMC).

We ask our readers to focus on the bold text above.  It appears as if the FED is using POMOs as a means to keep interest rates low in keeping with their target Fed Funds rate.  But what is actually going on? It sure seems like market manipulation, but I guess no one really cares as long as the end result is higher stocks and a well bid treasury market.

The problem here is not simply in the POMO activities, but the combination of POMO along side of other stimuli present in today’s markets.  What we present here is a simplified explanation though we are confident in having highlighted the major principles of the strategy.  Primary Dealers (PDs) are the large banks that buy up US Treasuries and then sell them off to individual investors.  What the PDs are able to do is borrow funds at super low rates through the FED’s discount window.  What appears to be happening is that these PDs are borrowing FED money, and using it to buy US treasuries ahead of POMO days.  Since these POMOs have become an almost daily occurrence, this has become a large part of the stealth monetization taking place right in front of our eyes.

On the POMO days, the FED is buying back previously issued treasuries to the tune of a couple billion/day.  The PDs have been able to benefit from these actions as buying a US treasury ahead of the POMO almost guarantees them the ability to sell it back to the FED a few weeks later at a higher price.  No one is better than this than PIMCO’s Bill Gross, who hinted in a recent interview that he may have access to information weeks ahead of the rest of us.  See this. 

Anyway, the PD’s buy USTs with borrowed money from the FED, then turn around and sell them to the FED for a profit.  What does the FED get out of this aside from an increasing balance sheet?  It gets to keep interest rates low, though a strong bid for Treasuries, and the resulting profits given to the PD’s through the POMO days often rotate right into the stock market.  This is truly an ingenious idea on the FED’s part if it were not for the seemingly limitless amount of debt incurred though said transactions.  The bottom line for most is that interest rates remain low while the stock market stays elevated.  This is precisely what the FED wants.  They also want you to be ignorant of the fact that these debts will eventually have to be paid.

The only way to effectively pay this debt off is by devaluing the dollar, which of course is happening right now.  The end result is that the price of gold and commodities continue to rise.  I am sure that we will hear at some point soon that inflation in the price of goods is a healthy sign of growth to come, but this sure seems like the beginning of the end to me.  All that is really going on is that the FED is sacrificing our future to make things look better for the time being.  Volume has been absolutely abysmal in the recent stock rally, indicating that no real buying is occurring.  Tie in the POMO days with the positive feedback algorithms know as the HFTs, and you get a stock market that continues to run higher on light volume.  Any analyst will tell you that bull markets are not formed with weak buying.  Should the switch be turned off on the POMOs, what will happen to the stocks and treasuries?  The FED has backed themselves into a corner on this one, and the only outcome I see is an eventual collapse of epic proportions.  Of course, the FED could keep on printing money to run these POMOs, giving the banks even more underserved profits but it will eventually lead to a global shunning of the US dollar.  The only saving grace at the moment is that everyone else in the world is in the same shitstorm as the US.  Hopefully this will be enough to keep the relative weakness of the US dollar from turning into an outright collapse but I fear it will not.

These are complicated times, filled with corruption and shell games going on right in front of us.  It is worth noting one key point here.  Market manipulation was blamed when Crude Oil prices rose above $140/barrel in the summer of 2008.  This led to higher prices at the pump and the world was screaming for a stop to all the market manipulation and speculation running rampant.  Yet today we are witnessing an event of substantially larger proportions but no one seems to care.  I guess if the end result is a higher stock market and low interest rates it doesn’t bother anyone.  Forget the long term results, like a weaker dollar and continued anemic growth, today’s positive close in the stock market is all that matters.

Here is what I think a best case scenario will be through such intervention.  The dollar will continue to weaken, but given that whole world faces a similar problem, the next few years will be consumed with wild swings in the FX markets as each central bank tries to kill its own currency for the sake of paying off future debts.  A global devaluation of currency will keep the US dollar from falling all by itself, but it will have further ramifications.  The price of hard goods like food, energy, and metals will begin to skyrocket.  Something has to maintain value as investors seek a store of value, money will flood into the commodities markets.  This is happening right now, as grains and metals continue their parabolic move higher.

So the price of goods will increase, but without the coinciding increase in wages.  In fact, the increasing debt load and low rate schedule will only make it harder for the banks to remain competitive and profitable.  This in a sense will take away their desire to lend to individuals or small businesses.  In fact why lend to anyone when the POMO scam is such a great way to make short term, guaranteed profits?  This will precede a period of stagnant wage growth combined with an increase in the cost of goods.  Sadly it will probably not mean an increase in home values as debt based investments will take the heap of deflation that everyone is talking about while inflation runs rampant in the hard goods sector.

What we need now is for the FED to stop all intervention in the markets.  True, it would probably lead to a collapse in the stock market and soaring interest rates.  But shouldn’t the “free markets” be allowed to find their own bottom.  Only then will true buyers re-emerge and start to right our swinging ship back towards the correct course.  It will mean more pain in the short term but less in the long run.  The actions taken by the Central Banks today will likely only prolong the duration of the current depression we face.  In the end the markets will make their way to a bottom at some point, but how much debt will we as tax payers be on the hook for when all is said and done?  The only way the US can pay these debts without taxpayer money is to print money which only dilutes the value of the US dollar.  The only way to not dilute the value of the dollar is to charge higher taxes from those that actually need stimulus, the individuals.  Markets don’t go up forever, nor should they be forced to do so.  At some point they will fall and no amount of printed money will stop it. 

If you have read this and thought well I’ll just keep my money in stocks because the FED keeps rolling money into the stock market, think of this fun fact.  Even though the DOW is now back to where it once was in the early part of this decade, the value invested is down about 30% due to a severely weakened dollar.  The only real store of value though this time frame has been gold. 

For a great interview check out this one from the European side of CNBC which still maintains a modicum of credibility.  

The Race to the Bottom is in Full Force

Basic game theory will tell you that the first to defect will often see the greatest reward.  This is, of course, a very glib interpretation of the science but in the case of currency debasement it will likely hold water.

The race to the bottom has begun!  Brazil and Peru are outright buying dollars now in an attempt devalue their currencies and keep exports competitive.  See this and this.  Japan has now tried to do the same for the second time in a week and failed.  That's okay, intervention only costs a few trillion yen each time.  See this.  The Swiss franc has hit all time highs vs the dollar this morning as well!  See this.  The currency game is getting downright horrifying.  It is no wonder that gold has breached the illustrious 1300 level in the early morning trade.

The world is waking up to the fact that US dollar is becoming more and more worthless by the day.  No wonder the FED is monetizing debt (printing money to buy US treasuries).  No one in their right mind is going to hold US dollars with actions like these taking place every day.  I said it before and I will say it again.  No one can debase the good old US of A.  And think about it, how else will we pay of the mountain of debt accumulated every day without a severely depressed dollar down the road.

Weak dollar leads  to lack of demand for US treasuries which leads to higher interest rates to attract more buyers which makes it harder to get a loan which leads to another downswing in housing which will lead to more loss of capital which will lead to further debt accumulated to support a defunct financial system which leads to a weaker dollar.  And so the circle-jerk continues...

Wanna see another cool chart?

The following is a monthly chart of the S&P priced in Gold.  You can't see prices, but you can see the path our illustrious stock market has taken.  When people ask me what I would recommend doing with their money the old line keeps coming back, "Buy gold."  I am not a gold bug and I have learned some hard lessons on the buy side of the precious metals in my day.  But really, does it get much clearer than this?  Buying gold, be it though physical purchases, ETFs, or futures is your way of saying screw you to the US government, I am not going to sit back and wait while you trash the value of my hard earned money.  Incidentally, if you are going to buy gold futures, don't do it without a professional helping you out.  The risks are too high for someone not watching every minute of the day.

Stealth Monetization

The following is a regurgitated post found on Zero Hedge.  Therein lays a step by step process of how the Federal Reserve is indirectly buying US Treasuries.  This ongoing process is what has led interest rates to remain at such low levels. It is also why small business is not getting a piece of the pie.  The banks are swallowing all the public bailout money we all work so hard to earn.  If you are not outraged by this you just aren't paying enough attention.

Let me say it again in case you skimmed the previous paragraph.  The bailout money that has come from our tax dollars has gone directly to the Too Big to Fail Banks.  The banks have taken that money, and now are borrowing from the FED at super low interest rates.  What do they do with this super cheap money?  They buy US treasuries.  This is the new normal for monetization.  Why come out publicly when a thinly veiled shell game will suffice?  Throw in a few wars in the middle east, ramp up some protectionist hatred against China (see this) and voila. The smoke mirror machines are working at full force.  Don't hesitate to weed through the BS.  It's no easy task when there is so much of it out there!

Let me put it one more way.  This monetization is essentially like taking money out of your right pocket and putting in your left pocket and thinking you just made a cool 20 spot.  Except your left pocket now owes your right pocket $21.  See where this is going?  Read on for details.

Stealth Monetization

The Cusp of a New World Order

I want to begin by going back to claim I made that we would see hyperinflation in the coming decade.  In all honesty, this is a highly unlikely outcome.  What led the Weimar republic to hyperinflation was set of unique circumstances that will not be duplicated this time around.  The age of information allows for instantaneous dissemination of data and were that the case in post WWI Germany, I doubt the same outcome would have come to pass. 

Yet at the time of the great depression Keynesianism was in its infancy.  One could argue that Keynesian policies led the US out of the great depression but is those same misguided principles that have put us in our currently dire economic situation.  John Maynard Keynes’ theory is based on the idea that governments can control the economy my through tightening a loosening of monetary policy.  This means raising or lowering short term lending rates and adding or removing money supply.  Tight policy implies higher rates and less money while loose policy means more money and lower interest rates.  The idea is that in times of duress, the government can lower rates and add money into the financial system.  The goal is to stimulate lending and by extension further growth.

Right now, the FED has lowered rates to virtually zero and in theory we should be witnessing increased lending and a return to higher growth.  The last time we witnessed such a shift in policy was right after the tech bubble burst.  At the time, FED chairman Alan Greenspan began lowering rates and even came out and recommended individuals refinance loans into Adjustable Rate Mortgages.  This led to the last part of the housing boom.  Interest rates were low, and home values could only go up.  It only made sense to do exactly as he suggested.  This boom in housing led the mortgage industry to begin selling and reselling these loans in packages called Mortgage Backed Securities (MBS).  In effect a bank could lend money to an individual then repackage the loan with a bunch of others and sell the group as interest bearing security.  Of course the success of an MBS is based off everyone’s ability to pay off those loans.  As long as the loans performed, the money kept flooding in.  Yet when the teaser rates on the ARM loans reset higher, many homeowners were left unable to meet their monthly payments.  Since the MBS’ had been repackaged and resold so many times over, it was difficult for even industry professional to know how to handle these new securities, many of which ended up in pension and retirement funds.  A lot of them ended up in money market accounts.  You know the accounts that give you higher return on your savings?  Well the money markets collapsed when Lehman Brothers was allowed to fail.  It seems the money market accounts had been buying the MBS’ that we now know to be toxic.  What happened was that money market accounts started posting negative returns.  The means that a guaranteed return on deposits was not actually guaranteed.  What was once seen as the safest type of investment was now giving you 80 cents on the dollar.  Not the outcome most were looking for. 

The Day the World Almost Fell Apart

What happened next was possibly the scariest thing ever to happen to the financial system.  On September 18^th, 2008, the world almost fell apart!  See this.  Investors, institutions, mom and pop, began withdrawing funds from the money markets.  Around $550 billion over the course of an hour or two.  The link above is for a commentary on the topic that was never covered in the mainstream media.  In fact it wasn’t until almost three months later that even the most astute blog sites were able to report on the event.  This was run on the banks ala 2010.  Don’t be surprised if you never heard of this.  In fact, I would be surprised if you did.  This is not the kind of thing that gets talked about.  Ever.  If this kind of event were to have been made public the entire system would have collapsed.  In the end, the FED stepped in, threw about $105 billion dollars at the problem and halted redemptions in the money markets.  They put a guarantee on $250k per account and that seemed to stem the tide.  But the FED was not done, and was essentially forced to become the de facto short term lender as banks were now too scared to lend to each other.  And with good reason.  Who would be the next to fail and who would they take down with them?  Well we have not seen another major bank fail since.  Nor will we.  The systemic risks to the entire financial system are too high for another Lehman Brothers type episode.  This means the FED has now eaten mountains of bad debt.  The powers that be have also let the banks pretend that any of these toxic securities they may still hold are worth more than they are.  Bank balance sheets have now become a total sham and are being used to perpetuate the biggest Ponzi scheme in history.  Thus was the end of the housing boom.  But the cycle of deleveraging is not over.

Recovery Reshmovery

The recovery that our government hopes you believe in lays in the faith of investors the world across.  Our own government has taken in so much debt to bail out the banks, states, and everything else that there is no way it will be able to pay off those loans.  Except by issuing new debt.  As interest accrues, even at today’s low rates, the government will be forced to borrow more and more just to pay off current liabilities.  The only way out this mess is through a substantially lowered US dollar.  This means hard assets like gold, silver, and agricultural products will be some of the only sectors to retain value.  Today we watch in awe and horror as Gold sets another record high.  Silver is at a 30 year highs as well.  You know what isn’t at new highs?  The US Treasury market.  If this isn’t the clearest sign that the world is now starting to shun US dollars I don’t know what is. 

The next decade will bring about a radical shift in the way the world sees the US.  No longer will we be the bastion of health and prosperity we once were.  The US dollar will lose its reserve currency status and foreign central banks will no longer hold US Dollars in their coffers.  As we continue down this dark road I urge you to take a look at your investments and life goals.  If you were planning on starting a new career in a few years, maybe do it now.  If your money is in a stock fund, don’t just let it be, start to put some of it into the hard assets that may actually hold value over time.  Whatever you do, don’t lock up your money in long term treasuries.  I fear inflation could get to such an extreme that even a high yield on your money may not provide enough return to offset a loss in purchasing power.  Sadly, this probably won’t mean that the price of your home will go up.  In times like these it is the demand of necessary goods and inflation tracking investments that will appreciate.  Food, metals and energies.  People don’t need to own a home, but everyone needs to eat.  

Bust to Bust

To tie everything together we go back to the boom and bust cycles which are at the core of Keynesian theory.  After the tech bubble burst the housing boom ensued.  So where does the next boom come from?  Some argue that bond bubble is the next one to burst and I will not argue that fact.  If the FED can pull off another boom cycle into the bond market in this current environment I will very shocked.  This would mean that the US will need to show signs of stabilization for the world to feel safe in US dollars again.  The opposite is happening right now and I very concerned for our future.  We may be on the cusp of a new world order.  The underlying problems in the financial sector have been swept under the rug in the hopes that the storm will pass.  My fear is that we are now sitting in the eye of the storm and the worst is yet to come.

Where is your money Invested?

I am a visual person.  I need to see charts to understand what is going on the markets, it's juts my nature.  For those not following the markets I have displayed a few charts below which should provide some clear insight into what is actually going on these days.  These are all monthly charts showing the past decade of price action.  Take a look:

Gold

Copper

Crude Oil

Sugar

Corn

S&P 500 futures

S&P 500 adjusted for US Dollar

The charts above show that commodity prices have been rising over the past decade while the stocks have gone virtually nowhere.  The last chart below is one of my favorites because it shows that when weighted against the US dollar, the S&P 500 has actually been losing money for 10 years despite a what main stream media would have you believe.

I post this so that those who do not have exposure to natural resources can see how they have missed tremendous opportunities for positive returns.  True, simply because gold has gone up for the past decade doesn't mean it will continue to go up.  Yet I beg people to think of where their retirement money is invested.  Are you really diversified?  If you don't have any exposure to precious metals these days, then you are not truly diversified.  Diversified into mutual funds and diversified into natural resources are often two entirely different beasts.  I urge you not to be complacent about your investments but to start to take an active role.  These are the days when we will plan our future and sadly a new course of action must be taken.  Apathy will be your worst enemy going forward.

With Friends like these...

Who needs enemies?  And for that matter, who needs realistic data for that matter?  Why report actual numbers when totally fudged reports just look so much better?!  The NBER has just told us the longest recession seen since WWII ended in June 09.  I'm sure the 17% of underemployed workers in the US are just too lazy to find real work and in fact it was probably their life goal to work part time at McDonald's.  See this.  This surely explains why gold is breaking to new highs this morning and is continuing to do so as we speak.  Wait, gold goes up when everything is good right?

HFT 2

This is getting ridiculous.  Yet another mini flash crash thanks to the electronic HFT systems that are here to enhance fair price discovery and provide the much needed liquidity absent in stocks!  I'm not even going to try to go into detail on this one because the guys at Zero Hedge will do a far better job than I.  See this.

Morning Musings

Looks like the stocks are in for another good run higher today.  Ignoring traditional fundamentals seems to be the prescribed logic these days and despite the housing report tying the worst sentiment numbers since March 09 it looks like the POMO day will take precedent.  See this.  Moreover, we contend that with the recent ruling against JPM, wherein the court found that JPM fraudulently foreclosed on homes while not in possession of the actual mortgages (see this), may actually benefit some new reports as it has led GMAC to halt foreclosures in 23 States.

We expect future housing reports to be even more based in alternative realities where up is down and blatantly corrupt practices now lead to ridiculous profits for the banks that have put us in this mess.  Though one could argue that it helps those in need stay in their homes a little longer, the larger implication still stands that those with enough money and power to lobby will pretty much keep getting whatever they want.  Pay no attention to the man behind the curtain, just buy stocks…  All is well.

HFT Rant

For those of you that don’t know what HFT means, it is High Frequency Trading.  I used to write a little code way back in the day, but I am by no means a proficient programmer.  An HFT is an algorithmic trading program designed to take advantage of extremely short term price discrepancies in a given stock or future.  My real contention is against stock based systems and I’ll tell you why.  It takes a pretty in depth understanding of how markets truly work and I will try to get into that below.  Let start with the basics.

Stocks, like futures, are bought and sold on an exchange.  Futures have one exchange, yet stocks can have multiple exchanges and Supplemental Liquidity Providers (SLPs) which are nonexistent in the futures market.  But more on that later.  When you go to buy a stock, the market finds a seller so you can buy it from them.  This is called the bid and ask.  You buy at the ask price and sell at the bid price.  It’s a little counter intuitive at first but it all comes back to the fact that if you buy, you buy it from a seller of the same security.  What HFT systems do is “make a market” for a security.  This means they are in the middle of a millions of transactions every day.  It has been suggested that HFT systems comprise almost 80% of stock market transactions these days.  When you go to buy a stock, through your broker, trading site, whatever, you buy it from a seller.  That seller might be an HFT system, who’s aim is to sell the stock to you then buy it back at a lower price, creating a profit on the trade.  Except these systems run virtually at the speed of light, buying and selling more shares than most of us could dream of affording every second of the day.  Because of the predominance of these systems in the market place, when you buy a stock you invariably buy it a higher price and sell it at a lower price.  I guess it’s your fault for not having a low-latency system co-located at the exchange so you too can take advantage of bids and offers coming in every microsecond.

What these systems are actually doing, though, is not simply exploiting existing discrepancies, but creating them.  These systems run predatory trade techniques where in fact they will send out orders to the market to gauge buying and/or selling interest only to cancel the vast majority of those orders instantly.  When you place your order, the HFT systems sees it, along with millions of others, and finds the best way to buy and sell shares to turn a profit.  Sometimes this means bidding up a price microseconds before your trade hits the system so you but the stock at a higher price then shutting off the buy orders and letting the market fall back down.  To most people it will go unnoticed, but when this type of trading becomes so widespread as it is now, it can make it almost impossible for a normal investor to survive.  It is no wonder everyone is leaving the stock market, yet every day I see job opening for programmers looking to get into the financial markets.  Normal people are leaving and are being quickly replaced by computer systems that could care less about housing data or inflation numbers.  It has led to a completely broken and irrational market.

Quote Stuffing

This is probably the ugliest part of the whole HFT dilemma and sadly the hardest to understand.  It all comes down to off exchange quote systems and the SLPs I mentioned above.  Stock markets run electronically on bids and offers coming from many different locations across the world.  In order to promote better pricing exchanges have opened up trading to these SLPs.  Yet the HFT algo’s have found a way to exploit this system.  When a one of the exchanges get inundated with requests for information it creates a lag in price discovery, sometimes even shutting off the system temporarily.  I think the number is like 20,000 request for quotes (RFQ) per millisecond is the cutoff to give you an idea of how fast  this shit is moving.  Say a system, or better put 1000s of systems slam the main exchange with RFQs and halt true pricing from being displayed.  In the seconds that follow these systems will then go to the SLP systems and slam the price a stock with sell orders running prices lower.  They can then buy shares at a cheaper price than anyone else knowing that once the main exchange server comes back online, prices will be instantly higher.  This in effect create the opportunity for mini flash crashes in stocks.

Algo's Gone Wild

Sometimes, a system or two, or millions, go off either due to bad coding or some unforeseen event like no more orders to buy at lower prices.  This has happened many times and is in fact what happened to the stock market on May 6^th but on a smaller scale.  The last one I saw reported was in Nucor Stock on September 14^th.  The algos took out the entire bid side order book running share prices from $39.58 to $0.01 in a second.  Now the SEC stepped in a cancelled the vast majority of the trades in that stock and reopened trading at $39.90 about 5 minutes later but you can see what kind of effects this has on a normal stock trader/investor.  These wild swings are occurring more and more often and have led to an entirely broker stock market.  It’s the same reason that a major report can have seriously negative implications while the market soars higher.  The HFT systems see exactly what will cause the most amount of pain for investors and run the market to turn a profit.

In this recent stock market upswing volume has been abysmal.  Meaning there are now real investors in the stocks, only systems designed steal money from retail traders.  It is making it harder for traditional investments like mutual funds or seasoned traders to survive.  It is no wonder we are seeing all investors leave the market.  Everyone is deleveraging exposure right now, yet the only one increasing exposure is the US gov’t.  I leave it to you to figure out what the end result will be.

The Age of Biflation

I will start with the fact that I am not the coiner of the term Biflation.  According to wikipedia, credit must be given to Dr. F Osbourne Brown though I doubt he was the first to think of the idea either.  I belive we are in an economic environment where we are witnessing both inflation and deflation across separate asset classes.  If my expectations are correct, we will see rise in commodity prices along side of a collapse debt based assets.  Ensentially, sell your house and buy gold, energy and ags.

The bottom line is that everything we know about housing, the stock market and the economy as a whole is, for all intents and purposes, dead wrong.  Mainstream media, or MSM as we will refer to it, has been cheering on the stock market and everything else done by the FED, central banks and other powers that be.  MSM does not want the individual investor/homebuyer/employed person to realize this.  Why?

Were the average Joe to wake up and think: what the hell am I doing loaded up to gills on mutual funds and/or stock index tracking funds and begin to sell, it could have devastating effects on the stock market.  Note I use the term stock market not economy here.  The stock market carries a very interesting role.  It is perhaps the worst, most lagging, indicator of economic performance or solvency, but it is the one thing that the average person uses as a gauge of the health of the US economy.  I hear this all the time: I saw the DOW was up 80 pts today, things must be good.  Let’s take for example the September 3^rd market rally as an example.  We saw a big move higher in US stocks.  Underscoring the run up in prices was the stronger than expected monthly Non Farm Payrolls number.  Possibly the biggest report we see on a monthly basis.  Now the report showed a loss of 54,000 jobs yet it was perceived as a positive report.  Why?  Because the market analyst were expecting the report to disclose near 100,000 jobs lost.  So yes, it is relatively better, and yes, employment is a very lagging indicator and slow to shift trend, but the point I am trying to make is that we have now reached a time where bad news is expected, horrible news is shrugged off and slightly less bad news is fucking amazing and we have to buy everything…right now.  That’s what happens on an almost daily basis.  Here, in the trading world, we call it the risk on risk off trade.  Some days you want to be a buyer, some days a seller.  It often doesn’t matter much what stock or commodity you buy or sell.  Stock correlation is at astounding highs so it almost makes more sense to trade and index the SPY over trying to pick the right stock to invest in. (if you don’t follow me on that one, I mean to say that most stocks are moving in tandem with no discernable sector outperforming another.) 

We have now seen the 19^th consecutive week of equity fund outflows with the last inflow not seen since back in May.  This means that everyone is heading for the hills, or perhaps more appropriately the US treasury markets.  Talk to your average financial advisor and ask him for a safe investment and he will probably tell you to buy bonds and notes.  Traditionally speaking, he is right, but we are at a crossroads where the decisions we make today may have enourmous implications for all of us down the road.  In buying a US 2 yr note, you are agreeing to lock up your money for a rate of return.  Right now, the prime concern is deflation or the increase of value in money, which actually makes buying notes and bills ( or a CD) and attractive idea.  Think of it this way, if the value of your money increases, not only will you benefit from the increase in purchasing power, but also the interest paid on your investment.  Yet interest rates are virtually at all time lows.  By buying a 2yr note, you are agreeing to lock up your money at one of the lowest rates of return in history.  Though it may seem like a good idea now, will it still be a good idea in 1 year?  What if you bought a 10yr note?  Would you still be ok in 5 years?  These are the questions you have to ask yourself. 

Better yet, let’s look at things from the other side.  Now instead of lending money, or buying a tbill/note/bond, you are borrowing money to say…buy a house.  Interest rates are low now so it’s time to buy right?  Well of course we need to delve deaper.  Why are interest rate low?  In the wake of the first downswing in the stock market, the FED has lowered overnight lending rate to near zero. This means credit is easier to come by.  But for whom?  The banks.  The FED only controls the overnight lending rate.  All other rates are more or less and extension of this level.  So now the banks can borrow from the FED at low rates and are supposed to be turning around and lending back to the consumers so they can go out and buy a house, car, xbox, iPad…whatever.  We are a debt driven consumer economy.  If this was actually happening we would be out the so called recession and not heading in the worst part of the biggest depression the US has ever seen.  What has been going on is that the banks are using the discount window to borrow from the FED and buy short term US treasury notes.  In effect using tax payer money for risk free returns.  Thanks guys!  Where’s my cut?  The velocity of money, or speed with which it circulates through the economy is dismal at the moment.  Meaning that the bailout money given to the banks is taking a lot longer than expected to trickle down to the individual.  Much like Reagan’s plan, this one is also a sham.  Money is sitting in the banks not going anywhere and if you were a bank, would you do anything different?  I know I wouldn’t. 

What is also going on in the inerest rate markets makes this whole predicament very very interesting.  Basically, fewer and fewer people are stepping up to buy US treasuries at these low rates.  Just too much uncertainty to want to lock up your money for that long.  But what appears to be happening is a shell game of debt.  The FED is basically monetizing US debt.  Or in simpler terms printing money to buy treasuries.  If you don’t know the dynamics of the rate market maybe this little part will help clear things up.  Interest rates are inversely correlated to treasury prices.  Prices and rates are determined by how many people actually want to buy said treasury security.  The more willing buyers, the lower the interest rates have to be for the US to keep selling debt.  What has been going on behind the scenes is possibly the biggest ponzi scheme ever passed off in the world.  I have this from trusted though unproved sources the FED has been printing money, using that money to buy all the toxic MBS crap off foreign central banks, with expleicit agreement that the banks then take the money and buy US treasuries with it.  This seems to be a good idea for all.  The US treasuries stay well bid keeping interest rates low, which by extention helps the housing market, and foreign central banks get to trade in their shitty Mortgage Backed Secuties (MBS) for higher quality US Treasuries.  This is all well and good except for the Himilayan sized moutain of debt being incurred by the US.  This debt will have to be paid off some time, but for now, it is causing massive fear for the value of the US dollar.  Therein lies the rub.

Biflation

Fear is a powerful motivator, and in my opinion, the fear over the US’ increasing debt load will cause a move from deflation to hyperinflation within the next decade.  Right now, we see some signs of Biflation.  Home prices have been falling, while it seems to cost more to buy a loaf of bread has increased or at least stayed the same.  It all stems from demand for goods.  Right now there isn’t a whole lot of demand for homes, but the demand our demand for food hasn’t changed.  Is the recession/depression continues, these problems will only multiply.  Continued low demand for home prices will feul lower home values which will eat away at lines of credit which means less money to spend on day to day activities.  Less spending leads to lower company profits which leads to more layoff/higher unemployment which leads to higher defaults on home loans which leads to higher interest rates which lead to a less active housing market which leads to lower home prices.  And the cycle starts anew!  Such the deflationary spiral we are in.  Lower home prices will prompt the FED, with their ingenious Keynsian economic ideals, to continue to print money to prop up the treasury market to keep rates low to stabalize houseing market.  This will incur more debt which will lead to further fear of the value of the US dollar.  When this fear over the US Dollar turns to scorn, we will shift to hyperinflation.  You will not be able to sell your dollars fast enough.  No one will want them and neither will the US.  Hyperinflation comes from a total collapse in confidence of the paper money sysetm.  Even though all the other central banks around the world are doing virtually the same thing, no one does it quite as big and as bad as the US.  We’re fucking America for Christ’s sake.  No one can beat us at our own game.

The Race to the Bottom

It sure seems that the world is in a race to devalue its respective currencies.  The lower the value of your currency, the less debt you need to pay off.  Think of it this way, if you borrow $100 at 3% interest, but the value of that money falls by 2% in that year (2%inflation).  The value of your $100 is now $98 because of inflation but you owe 3% on that $100 or $3.  Inflation helps the debtor out in this case as the net result is owing $1 on the $100 your borrowed.  This is a very simplified view of inflation and in fact you still owe $3 on the loan, just that the value of the $100 you borrowed is now $98.  This is the place the that US is in now.  With trillions in debt held by the US, how will we pay it off?  Higher taxes? That would probably kill any semblance of a recovery let alone cause even more bypartisan bickering on capitol hill.  Lower future interest rates?  Wrong again as the FED has taken the rate market about as low as it can go.  The option currently being used is the brush it under the rug for the next generation to deal with strategy.  Buy issuing every increasing amounts of debt, the US is able to pay off its current liabilities in exchange for larger future liablities.  This only make sense if we expect to see rampant inflation down the road. 

True, the US is left liitle choice in this matter now, but it should be clear that the US does not have the US Dollar’s best interest in mind.  The problem I see this time around is that we will not see the type of inflation that lead to the housing run up in 07.  Things are far too complicated this time around. What I suspect we will see is another furious collapse in home values coupled with an explosion in the cost of food, energy and other tangible goods.  Such an event could trigger a restructuring of the entire financial system, and almost certainly would remove the the US Dollar as the reserve currency of the world.  Without reserve currency status, there is little reason for world players to buy and hold dollars and those that still are will sell dollars in favor of other currencies or goods. 

What makes this so complicated is the fact that all developed contries are essentially in the same quandary.  The bank of Japan recently interevened in the Currency markets because their currency is far too strong.  As Japan is an export nation a higher YEN reduces their competitive edge.  In Europe we are currently wacthing the next shoe dropping for Greece’s debt problems.  Now it seem Portugal will be next in line to take IMF funds.  One could argue that Greece and Portugal are small parts of the EU, but one needs to understand that if one country defaults on its debt obligations, it will seriously impair other countries from paying off theirs.  Things are far too intertwined these days for problems to be isolated to individual countries let along individual companies. 

As the developed countries start the currency debasement race, we are left wondering what end result will be.  Who will have the last laugh?  In the end, I think the end result will be a debasement of all currencies as all central banks ramp up the fiat priniting presses.  When the world wakes up to vast amount of money now losing purchasing power it will cause a flight inflation tracking markets.  Gold and Silver are making impressively higher highs while the agricultural markets are going parabolic.

One of the most interesting phenoma we have seen as of late is the recent divergence between Gold and Treasury prices.  The Treasury market has recently begun a minor slide lower, indicating higher a lack of desire for locking money up in US.  Gold and Silver on the hand have starting running substantially higher as have safety currencies like the Aussie and Canadian dollar.  Investors are fleeing the dollar right now.  Whether or not this continues unabated is yet to be seen, but it is rare to see this kind of divergence which has such dire implications.  In future posts I will try to cover this in more detail.