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I feel we are facing significant headwinds moving forward because of the loose monetary policy of the Federal Reserve, the refusal to address the core problems in our financial system and the incredibly opaque derivatives market that has yet to be regulated or even cleared on open exchanges.

The root of the problem

To expand on the first point of loose monetary policy, from my own research I have gathered that the government has put at least $12T, possibly up to $30T worth of guarantees, backstops and other forms of insurance against the prospect of another meltdown. In addition the Federal Reserve has, in my opinion, illegally taken control of AIG through programs they are not authorized to participate in. These actions and other measures have transferred the risk of collapse from the private sector to the US government and to the Federal Reserve.

Interest rates remain below 1% in a range of 0.00% to 0.25%. Combine that with the infusion of US dollars the Federal Reserve has given to other central banks around the world and we have literally created a carry trade scenario. Not only are we repeating the mistakes of Japan, but we are going down a path where should a geopolitical event or other significant negative catalyst occur the repatriation of dollars could create a collapse across nearly every asset class.

Risk grows as stability wanes

This environment that has been created to engender a recovery is not only unsustainable, but it has created more risks than had existed beforehand:

#1 Should another market panic occur where AIG’s credit default swaps are due, the US Treasury and Federal Reserve must cough up the difference. This would lead to another series of bailouts and funneling cash to foreign and domestic banks at the tax payer’s expense on bets that never should have been made and were downright idiotic.

#2 Big banks are BIGGER now than before: JPM, BAC, WFC, USB and others are now larger and present a much more significant risk to the system should, say for example, one of their mark to make believe off balance sheet assets implode — potentially bringing down the entire world financial system, again.

#3 The stress tests were fraudulent and did not expose the off balance sheet asset liquidity vacuum these banks are suffering from. Papering over fraud never leads to a sustainable rebound.

#4 Tax receipts are down across the board – how can counties, cities, states and the Federal government hope to control deficit spending if they are not collecting as much in taxes? They can’t sell bonds forever, bringing me to my next point.

#5 Commercial real estate and corporate bonds are headed towards a potential implosion in the next few years, with major mall holders filing bankruptcy and many occupants of office and retail space vacating as they downsize. Corporations also must refinance their debtload which is ever growing while the global appetite for these bonds is diminishing.

#6 We in the United States are very seriously facing the risk of a sovereign debt default in the future. This prospect is made even more serious by continued bail outs, war spending, entitlements and other programs that are completely unsustainable with our country’s $14T debt burden.

#7 Such a sovereign debt default would lead to a currency collapse and that could engender either an environment of hyperinflation or heavy deflation — all depending on where the chips fall at the end of the day.

Inflation or deflation?

While speculators are now hedging for inflation and shorting the dollar in any way possible, there is another market we must pay close attention to. A market that significantly dwarfs the size of the commodities markets as a whole. That is the US Treasury Bond Market. Last I checked it was $33.5 trillion dollars. I find it interesting that gold is touching $1111.00 an ounce while 10 year bonds are at only 3.625% — who is wrong in this gigantic game of chicken?

Either the folks buying gold are insane to believe inflation is the bogeyman to fear or the much larger, much more influential and liquid bond market is crazy because they obviously fear deflation. Why else would a rational human being buy a bond at 3.625% that they must hold for 10 years? Such an instrument would be less than worthless in an inflationary environment.

First the principle value of the bond erodes as interest rates rise, and secondly the yield would not make up for the rate of inflation. So we are experiencing a financial conundrum right now. Either we are on the verge of a deflationary collapse or a hyperinflationary currency crisis. Which way we’re going to go has not yet been made clear to me because I feel the markets are being propped up, even manipulated.

The most dangerous bubble

Why would I pose such an idea? Let’s start with the P/E of the S&P 500 which is now well over 25 (and was at one point over 100). How can anyone feel that these stocks are reasonably valued with such an absurd P/E? Most of the decrease in P/E from over 100 to over 25 has been from companies downsizing, firing employees, hiding bad assets and not organic growth. In the current global macroeconomic environment there’s no feasible way earnings can catch up, so in my opinion we’re already in a bubble.

Bubbles of the past were not as dangerous because the US government never had such a large stake in the market. Now we’re talking about a situation where if the credit, bond, currency and/or stock markets implode, so does our sovereign debt and currency potentially.

Investing is now speculation

Investing in this environment is difficult at best. During the March panic I was a buyer in the high S&P 600s of just about any material, technology, financial and energy stock I could find, but once we got to the 900s and I saw P/Es jump beyond levels I felt were fair valuations I became a seller of my holdings. I also invested some in to silver, foreign currencies and other commodities during the March lows, but also have since taken a lot of those profits off the table.

We are in a very risky area for people to be entering the market. I don’t feel these lofty levels are sustainable nor do I think the valuations are rational. I don’t know when the rally will end, but I do know that any parabolic move usually ends very badly and any time there has been a carry trade in the history of money it has ended painfully for all the speculators who did not exit in time.

Another collapse coming?

In closing I will say that before Rome’s collapse the government was shaving gold and silver coins down to create more currency. They also had a severe debt crisis. The shaving and continued spending led to awful inflation that eventually catalyzed the empire’s downfall.

History is being made every day and the decisions are going to shape the face of America’s future. It is imperative that we start to take our medicine (meaning we must face the financial problems instead of ignoring them) and deal with the overwhelming burden of debt before it swallows up everything left.

There are no shortage of credit problems to navigate through with mortgages (both subprime and now prime), credit cards and commercial lending, potentially indicative of a deflationary credit squeeze for the everyday person who will no longer be able to borrow to buy everything based off their future earnings or assets.  This contraction could also have very negative effects on small business growth and hiring, too.

It’s because consumers and small businesses account for the majority of the US economy that I think we are wise maintain a defensive posture as most of the multi-month rally’s asset allocation haven’t taken this matter in to focus yet.  I believe we are well out of bounds of realistic equity valuations and the dollar is being sacrificed by the printing press of the Federal Reserve, Treasury and Congress to temporarily support financial markets.

Once this liquidity flood induced euphoria wears off there will be severe consequences to the US currency, bond and equity markets that most investors don’t seem to be aware of or have not positioned themselves for.

Sources:

http://market-ticker.denninger.net/uploads/KeyCharts/Credit-y-o-y-large.png

http://www.federalreserve.gov/releases/g19/Current/

http://econompicdata.blogspot.com/2009/09/consumer-credit-freefall.html

http://www.marketwatch.com/story/troubles-shift-to-prime-borrowers-wsj-2009-09-04

http://www.boston.com/realestate/news/blogs/renow/2009/09/mortgage_market.html

http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSN0829660420090909

http://www.reuters.com/article/newsOne/idUSTRE58752720090908

It looks like safe haven assets like bonds, yen and dollars are becoming more attractive vs. risky assets like commodity currencies, commodities, equities and emerging markets in general.

I think we may be entering the next leg down as Mohamed El-Erian and others have expressed the same sentiment I have. The rally is running on fumes.

We probably will retest the lows in the market and bring some fear back in to the trading. VIX is up 6%+ today and we’re seeing a lot more put buying as institutions either bet against or insure profits in stocks.

Consumer sentiment was terrible and there is now some question as to whether the FDIC is solvent after taking over Colonial Bank. All the Maes are probably completely toxic now, too. I hope foreign central banks continue their generosity or the falloff here could become a disaster.

The flight from US treasuries, equities and the dollar is a category five hurricane against the once safe haven.  Is it fear of hyperinflation or just a ripple of the recession?

Speculation is increasing that the US will not be able to pay off its mounting debt and it is showing in the markets.  Most currencies, especially commodity driven ones like the Australian and Canadian dollar, are rallying.  The US treasury bonds are selling off at an alarming rate.  The stock market is starting to either consolidate or make a larger move down.

If the hyperinflation hits and creates a panic, this type of activity will increase markedly.  If instead this is a ripple from the recession tarnishing the confidence of other markets it is still a negative because it shows that central banks around the world are not supporting US debt to the degree that they did in the past during a time when the US is creating more debt than ever before.

The implications are vast and will have an effect on purchasing power, employment, wages and the types of jobs available moving forward.

I’m afraid that there’s no easy way to stop the debt avalanche now that it has begun.  Trillions have been committed, tens of trillions more of entitlements and other debts stand to hit us during the years to come.  We’re entering a deep, protracted global recession and deficit spending on pork barrel legislation will not have any tangible stimulative effect.  Instead it creates the potential for a depression when US Treasury bonds suffer from a lack of confidence and the government is no longer able to borrow to pay the interest on its ever growing debt.

I’ve done everything I can, writing the media, my elected representatives and trying to stir the minds of those I know with economic discipline.  There is no quick fix for this crisis, it will be difficult for every single hard working American.  Mortgaging the next generation’s future to prop up the corrupt edifice of insolvent banks and bail out home buyers who never should have gambled is a terrible approach to the underlying problem.

Capitalism is not dead, but any company, individual or even government that cannot sustain itself must be allowed to fail.  That is one of the most important and fundamental underpinnings of American capitalism.  Socialism will not be an effective stick save.  It engenders an environment where the most innovative are allowed to fail in favor of those who cannot compete.

America is still a great country and our dollar is still the reserve currency of the world.  In order to keep our economy the global leader we cannot spiral out of control with debt, but instead must reign in spending on all fronts and embrace an era of thrift while we recover our bearings and wealth.

According to CNBC, the White House has claimed Obama will give more details on the mortgage rescue plan in a speech on Wednesday.  This has provided a confidence boost and provided a bid to stocks.  Treasury bonds, however, continue to sell off in a significant way.

The stock market cheered the US central bank’s historic interest rate cut today, surging nearly 5% on the S&P 500 back above 900 to 911.82. The rate cut, combined with continued quantitative easing in Treasury bonds was evident in today’s trading, with a flood out of US dollars in to commodities and other currencies as well as bond yields dropping sharply.

The implications are clear. Inflation will begin in some measure of time, whether it is days, weeks or months. We can see traders already preparing by taking long positions in anything that stands to benefit from the dollar’s fall. Near term we could see the US dollar index fall as low as 72, retesting its prior lows and further confirming the head and shoulders pattern. Commodities and currencies remain attractive buys.

The US Federal Reserve, a private bank, is mulling issuing its own debt.  There are several problems with this, one of which is that if the debt is backed by nothing, no one will buy it. If it is backed by the full faith and credit of the US Government it needs Congressional approval.  Either way, the fundamental story is clear.  The Federal Reserve has overextended itself and finds its balance sheet loaded with worthless assets that it can not sell.  Karl Denninger has a nice rant about this on his blog that I recommend for your morning reading.

We’ve seen bonds outperform nearly every other asset class, as the flight to safety has been fast and furious.  The short end of the yield curve is yielding 0.335%, which is actually up from the lows of the year.  The TED Spread is at record high levels, showing the stress in the credit markets is exacerbated by the uncertainty surrounding the corporate welfare bill for financial companies.  The current trend in equity indexes is lower with no sign of abatement.  Most emerging markets have been deeply affected, with China down 60% from the peak of last year to the trough of this year’s lows.  Russia’s financial crisis worsened to the point where the markets were shut down for days and in India and Brazil we’re seeing inflation continue to plague the central bank policy, causing an abrupt departure away from steady growth.

The world is in limbo right now.  Are we going to let institutions fail as capitalism would demand or will we socialize the entire free market in favor of stablizing a fearful world in the aftermath of the biggest asset inflation bubble in world history?  While the US Congress debates these issues the markets are deteriorating, as they should, given the uncertainty that forward-looking traders and investors have to factor in every day.

Right now we are on the precipice of the greatest global financial crisis the world has ever seen.  Most people are beginning to wake up to that.  We’ve seen some liquidation of mutual funds in retirement accounts, money markets become unstable because of Lehman’s collapse and AIG, the world’s largest insurer, have to be taken over by the US Federal Reserve Bank, because of balance sheet insolvency from “mark to make believe” accounting practices.  While legislators debate what implications this bill may have and how to oversee it prudently, I fear that this is by far the worst approach to solving a problem that stemmed from bad risk management and greed.  You cannot bail out the biggest banks with debt that is created out of borrowing at interest from the Federal Reserve and expect the problem to be eased.

Every government and Fed bail out so far and in the foreseeable future relies off of using public funds to bail out private sector mismanagement of capital.  Suddenly the entire financial sector’s balance sheets are reminiscent of Enron and we’re celebrating this by rewarding their worthless paper with billions of dollars from an already heavily debt-burdened Treasury balance sheet. We can’t expect this one to be any different.  Sure it may address short term credit market confidence issues for just enough to get us through another quarter, and to a new elected government in 2008, but it is not a solution.  It is a bandage on a gaping axe wound.  Eventually limbs will have to be lopped off because the infection wasn’t handled by Dr. Ben.  This is what I fear is next.

Instead of stemming the risk taking, the policies suggested and enacted thus far have actually created the opposite effect.  We give banks easy access to cheap capital as the Fed cuts rates, the dollar weakens and all of these banks target commodities as an investment, instead of putting the money to work back in the US economy.  Of course their argument is that they have a fiduciary responsibility to generate capital for their investors, and that allows them to operate in a completely apathetic manner towards the overall wealth of America.  Instead, they invest in metals, energy, grains, etc and the rally is the biggest and boldest in decades.  It was no coincidence that when credit became harder to access, hedge funds started imploding and the banks that benefited from the rally on the way up started taking profit or reversing positions while the economy slowed down, that the rally completely ceased and reversed.  The correction, like the rally, was the unprecedented in its scale and veracity.

In the midst of incredibly expensive short term capital, market participants that relied off leverage to create profits are imploding left and right.  Many models, like the ones employed by Bear Stearns, Lehman Brothers, AIG, Washington Mutual, Wachovia, etc. will not function in a world where confidence has eroded because of excessive greed and terrible risk management.  Many smaller boutique firms that receive less media coverage have also been facing redemptions, funds have been closing down at an alarming rate.   At the end of the day, there are less market participants and those remaining have less capital to employ strategies.

Many elements of the market system are changing very fast.  Be careful trading.  The risk hasn’t been higher for a long time.  Short term strategies seem to be the most feasible, but keep your eyes glued to your terminal!  I’m keeping my portfolio in cash with occasional conservative short term trades when the opportunity presents itself.  Good luck!

The world’s biggest insurer, AIG, is going under… if they can’t get some big loans they will surely implode.

This will continue to feed the downward spiral of financial markets and put pressure on every other institution, raise interest rate spreads and continue to force the market in to a state of illiquid volatility.

If you or anyone you know has policies with AIG, you may want to cancel them and move them elsewhere.
Again, I’m afraid this is only the beginning.  Washington Mutual will fail and Wachovia will fail or be bought out by a bigger bank by end of the month.

Merrill Lynch’s deal to be purchased by Bank of America is in FLUX.  It may not happen.  Anyone doing business with Merrill should closely examine how this may impact their accounts.  Especially if the deal falls through and Merrill fails.

What happens next is systemic credit risk spreads throughout the system, forcing debt to be much more expensive.  All these financials count on cheap money to leverage their operations.  This will cause the remaining independent brokers (Goldman Sachs and Morgan Stanley) to have to partner or merge with money center banks.  It will consolidate money and power to a few hands. There are about 2000 banks now.  At the end of this, there may be less than 1000.

This morning, with tremendous support from the US futures, European markets and gold, the world optimistically awaits the Federal Reserve’s speech during the conference on housing and monetary policy in Jackson Hole, Wyo. at 10 a.m. EDT.

Currently S&P futures are up about 1%, gold is up about 1.5% and the German DAX is up 1% all in anticipation of good news.

Why is the world optimistic about this? Let me present a few views:

1) President Bush has stated he will expand the government’s role to deal with the subprime mortgage credit crisis.

2) Ben Bernanke is expected to at least give traders and investors clarity about his views on the economy. There is also (somewhat irrational) speculation that Dr. Bernanke will give indications on his Federal funds rate policy decision at this speech.

3) Bond rates indicate traders expect a rate cut in the short term.

4) A lack of volume because of the upcoming holiday makes the US market very volatile.

5) The weakness of the Yen has lent strength to US markets as the carry trade may be winding up again.

All of this is important to consider today. What does it mean?

If the Fed speech gives no clear indication of policy or interest rates we may see market weakness. That market weakness may be exaggerated to the downside because of the low volume. This weakness may be temporary, as President Bush will be speaking around 11AM EDT regarding the subprime mortgage credit crisis. It will be very important to watch bond yields and the Yen today for signals.

Alternatively, if Mr. Bernanke gives the market a high degree of transparency in his speech, and it gives markets the indications it wants to hear about a rate cut, we will absolutely see an unprecedented rally.

My advice? Watch and wait. If you are an experienced trader you may want to trade the speech.