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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.

I would like to pose an important societal question to any banker that is willing to answer it:

Why are bankers increasingly hesitant to lend, even drawing back lines of credit, yet at the same time allocating a lot of funds in to commodities, especially oil?

Isn’t it true that oil and consumer consumption are closely correlated?

Are they seeing something that I am not or is this a bit of a logical paradox?  How can the banks create the growth they need for their trade (or investment) to be profitable if they refuse to lend to those that would spend it on consumables?

There has to be more than just dollar weakness factored in to this equation.

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

The Chinese sell-off seems to be spreading as US markets are experiencing profit taking bringing them below 1000 on the S&P 500 and leaving them oversold by many short term technical indicators.

What’s next?

My forecast isn’t too optimistic given the convergence of many different economic complications. I think that the risk remains very high that the market faces a significant correction given the irrationally optimistic rally we’ve experienced since the March apocalyptic head-fake.

Real world valuations simply don’t match stock prices and future profits are not going to come from anything more than further cost cutting. The picture being painted is anything but rosy.

Add to that a looming commercial real estate crisis, a bankrupt government and an FDIC that’s running out of insurance for depositors as banks continue to fail.

What happens when the next shoe drops?

Consider this: We’ve had a jobless recovery and everyone is optimistic. People feel like the worst is behind us, yet unemployment remains remarkably high. Then, the unexpected. Another economic meltdown.

If we were to go in to a downward economic cycle and reenter recession here after this artificially orchestrated ‘recovery’ the devastation would be deep and pronounced. Unemployment could rise exponentially as commercial real estate implodes, forcing malls to shutter and tens of millions of Americans out of work.

The materialism capital of the world

The United States has 600% more malls than any other country on Earth. Our economy is very consumer driven, yet right now the consumer is so leveraged in to debt they can’t afford to spend much. This is a broken and unsustainable model that will continue to eat away at our economic core until we see a more sustainable (and modest) implementation of capitalism.

Because the economy is consumer driven and because consumers can not spend we have a conundrum that bank bail outs can not solve. How do you engender an era of confident spending by selling off the average consumer’s future with gigantic amounts of debt that in no way benefits the debt holder? Certainly there has to be a better way.

The real crisis is coming

It is my opinion that we have yet to experience the true crisis that will manifest out of the past few decades of reckless unimaginable greed. No amount of reflationary policy can adequately combat the implosion of credit capital that has drained liquidity and forcibly deleveraged the global financial system.

The only success the government can claim here is that they have temporarily staved off this crisis by sacrificing the fiscal solvency of the Treasury. Ultimately the United States is the most indebted country across its respective private citizens, corporations and governments. This national debt costs the country $500,000,000 per day in interest.

The national debt is largely owned by foreign countries like China, Japan, UK, Russia, Saudi Arabia and others. Does this sound like a sustainable plan for the future of our country? Can we truly continue to borrow our way out of crises we’ve created by ignoring our looming debt and anything resembling fiscal responsibility?

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.

Every day more light is shed in the dark corners of our banking system.  Today I thought I’d share this tid bit.  While Americans lose their jobs, houses and ability to sustain themselves the Federal Reserve was busy handing out $500B in “currency swaps” to 14 foreign central banks all over the world. Watch the following clip and judge for yourself the kind of message that’s being conveyed:

Everyone is welcome to correct me if I’m wrong here, but I was under the impression that the Federal Reserve had a mandate to maintain stable employment and fight inflation. It seems to me that these kind of actions actually ensure the polar opposite end result. Ben is deliberately printing tons of dollars, shipping them overseas and taking foreign currency in exchange in order to supposedly facilitate a more liquid, lower interest lending facility for US dollar-based loans. This is not part of the Federal Reserve’s mandate nor does it seem as though it could be a constitutionally sound policy.

When Ben was asked about the Federal Reserve’s opposition to an audit of their programs and balance sheet, he responded by alluding that interest rates would rise if there was any attempt to oversee the actions of the Fed. This is a veiled threat and can not be taken as anything less. Our economy is now being held hostage.

The crisis in the United States is reaching a silent boiling point in the struggle between the citizenry and the largest banks.  Revealed today in a story breaking across various news agencies, the United States has potentially indebted itself by nearly $24 trillion dollars through various bail out programs since 2007.  This is effectively bankrupting our entire country and if allowed to continue will ruin any chance of a sustainable recovery.  We are already on the heels of a major change in how we live, work and save money.

Debtor nation

If this amount of debt is incurred on a federal level it is twice our GDP.  That is completely out of bounds with any kind of spending plan that is sensible.  It puts the creditors of our nation in to a very difficult position, because they understand we’re debasing the world’s reserve currency to buy our way out of a financial catastrophe instead of facing the pain and making constructive changes.  These $24T in financial commitments could literally strangle our nation’s economy for decades.

Some things never change

Wall Street is back to its old tricks.  Goldman is making “record profits” amid a crisis where its competition conveniently perished under the watch of former CEO Hank Paulson as Treasury Secretary.  Now Morgan Stanley is repackaging subprime mortgage debt as AAA while JP Morgan, Barclays and others are leasing supertankers full of crude oil.  All of these actions are benefiting the banks at the expense of tax payer dollars that provided the cushion so that these companies could continue to sustain their existence.

Time to wake up

Most of the time people turn off the TV, put down the newspaper or close their browser when they encounter the intentionally dull financial news.  They want to focus on the here and now, not projections of profit or bailout recapitalization.  It’s understandable that in a functional society people would have the luxury of ignoring the banking system because they have some implicit trust, a notion of safety, about where their money sleeps.  This relationship should no longer be taken for granted and the institutions holding the dollars we cherish as our future savings may be participating in the largest, most sophisticated power and money grab the world has ever seen.

With the last legs of this rally really more of a sideways trade on very light volume, we’re starting to see some signs that a rolling over process has begun.  While there is plenty of reasons to be a bear, the most compelling reason to be a bull was the notion that things were getting worse at a slower pace.  The idea was that we overcorrected to the downside in March, facing what appeared to be a depression, and having (at least temporarily) taken that off the table, we see very attractive valuations.

We’ve had a nice run already

After about 40% off the bottom, I think we can say the valuations have gotten ahead of themselves.  In addition, there are no signs of an earnings-led recovery or any real green shoots that indicate we’ll be seeing a pronounced rebound in the economy.  Most of the optimism is coming from China, which seems to be hoarding commodities for its own hedging game against the falling US dollar.  While hunger for raw materials is good for the markets, if it is not a genuine appetite that stems from growth, but rather a desire to build a materials portfolio for the Chinese government, then much of the optimism in energy, materials and other related sectors is overdone.

The biggest driver is not behind the wheel

The consumer is facing more foreclosures, credit card defaults and an increasingly tight employment picture.  This is not the atmosphere that is condusive towards a consumer-led recovery.  Consumers probably have 5-10 years before they can start to lever up again on their credit.  Other emerging markets are attempting to build consumer economies, and facing tremendous headwinds from populations who treasure thrift rather than spending.  The appetite for material possessions is not nearly as strong nor are earnings per capita elsewhere enough to sustain the vacuum left behind by the American and European economic implosion.

Greenflation not back, yet

Green energy is a promising sector when crude oil is above $100.  Right now the motivation is just not as strong with consumers or companies to make big moves in to more environmentally sustainable energy.  I believe that once inflation makes energy less affordable the appetite for green energy will increase.  This may be a while off depending on how fast the global economy can pick up the slack left behind from the last bubble.

Climb a plateau once its peaked…

So where is the catalyst for the next rally?  What could drive equities higher?  The only way we’re going to see a tremendous rally from here is if we see much more currency debasement and intentional inflation.  That kind of manipulation could continue to lead markets higher, but at the cost of the currency that equities are priced in therefore nullifying much of the gains.

Or fall right off?

I think the market is setting up to fall.  I’m not so sure we’ll retest the lows or not, but I do think we’ll see some more selling as fundamentals begin to play a center role in the stock market again.  On a technical note, we may be building a pretty significant head and shoulders pattern on the S&P 500.  Today’s action seems to confirm the right shoulder.  We could see a retest of 875 or lower if it continues to play out.

Global systemic risk is back in fashion, as Blackrock buys Barclays Global Investors, creating a combined $2.8T balance sheet, much larger than the US Federal Reserve.  If this newly formed titan ever had large its own liquidity problem it could threaten to once again bring down the world financial system.

Of course Blackrock has a number of curious aspects to it as well.  Merrill Lynch had a 50% stake which Bank of America gobbled up along with Merrill in a backroom deal with Uncle Sam.  Now Bank of America has a large (supposedly non-voting and non-influential) stake in this behemoth.  I believe this is cause for concern, because among other duties, Blackrock helps the Federal Reserve manage some of its assets and performs consulting as well.

How does Bank of America have a stake in a company that has some influence on the value of its assets in the eyes of what is supposed to be an independent central bank?  This question has come up in congressional hearings and been asked by pundits as well as traders.

Apparently there’s absolutely no rules to the game as long as the biggest banks survive.. at least for now.

What do silver, the Australian and Canadian dollars all have in common? They should all be considered good inflation hedges for US dollar-based portfolios.  The Australian and Canadian dollar are commodity-based currencies, because their underlying economies are very much driven by the production of commodities such as gold, silver, oil, industrial metals, etc.  Silver itself is very undervalued against ever increasing real world demand for coinage, jewelry, electrical and chemical applications.  The combination of all three assets, in two different asset classes (foreign currencies and commodities) provide strong upside as the dollar weakens and world growth comes more from emerging economies than industrial economies.

The Australian dollar ETF can be bought through symbol FXA, the Canadian dollar ETF through FXC and silver through SLV.  I currently have holdings in all three assets and advise those concerned about inflation to consider what their long term investment goals are and how these assets may or may not fit in to their strategy.

As the rally appears to be running on fumes at this point, I’d like to say that I was a little early saying to sell it before, but one never can trust a bear market rally.  That’s what it still seems like we’re dealing with, too.  The technicals were powerful during the 8 week surge, but we do not yet have a Dow theory buy signal (need a close above 9125) or a break above the 200 day moving average on the S&P 500.  Now the charts are beginning to look more exhausted as the overbought conditions are worked out.  Longer term the trend remains down as we seem to continue with the 10+ year double top formation playing out on the S&P 500.

Banks led the rally up and now they are beginning to give way as fundamentals point to a more pessimistic picture than the prior trading action of their equities might suggest.  While I do feel that the substantive cash injections, ZIRP cheap liquidity and stimulus have filled part of the vacuum left by the implosion of Lehman and the deleveraging process, there is simply too much enthusiasm around when this alleged recovery is due to transpire.

We are quite literally in the midst of a complete reinvention of how the world does business and in that process there likely will be further dislocations and market abberations before settling in to a U or L-shaped recovery — either economic destiny will be determined by the shape of fiscal policy and whether insolvent institutions are infact allowed to fail or continue indefinitely as “zombies”.  Unregulated derivatives markets must be brought in to the light and fully regulated in order to prevent credit default swaps and other leveraged contracts from contributing to widespread system disruptions.

This turning point has been marked by the downfall of the US as the financial capital of the world.  A slow unwinding process that in the decades to come will be much more apparent than it is now.  This is the unfortunate consequence of being the largest debt bearing nation in the world whose currency is quickly losing popularity as reserves for central bankers around the world.  The unraveling is going to degrade the quality of life for Americans and boost domestic inflation considerably.

If nothing can be done to restore confidence by regulating the shadow markets and unraveling the insolvent institutions, then this trying period shall last quite a while.  At this point I don’t feel the actions of the US government or the Federal Reserve have been constructive to that end.  That is why I feel the rally is largely unsustainable and right now we are in a frothy period where short positions in equities and long positions in foreign currencies may be appropriate to consider putting back on the table.

Disclosure: Short US equities, long foreign currencies

Washington is losing sight of the real crisis.  Incompetence, loose money and impulsive decision making are what brought us to near collapse.  Why are we repeating these same mistakes again?

Bonuses of the bailout

The $2B in Merril bonuses and the $187M in AIG bonuses when the government effectively saved these institutions from their own incompetence is far from acceptable.   There is no reason that people who created the systemic risk should be rewarded by the bail out money which is ultimately funded by tax payers facing higher taxation and a reduction in government services.

Having said that, the anger that swept the US House of Representatives to pass an unconstitutional bill that singles out individuals and retroactively taxes them at a 90% rate is equally an unacceptable reaction.  The bail out bill contained the provisions to allow these retention plans and bonuses.  How was this overlooked?  Because most lawmakers don’t read bills before signing them in to law.

Global righteous indignation grows

It’s an unbelievable situation we, as global citizens, find ourselves in.  The international banking conglomerates have failed us.  Our respective governments have failed us.  Yet they now want to claim to be the heroes and the saviours that will restore prosperity to the world.  Cutting interest rates, funding defunct institutions, floating trillions of dollars out to prop up bad debt all to relieve the liquidity vacuum the last bubble bursting left in its wake.

In the last two weeks there was a positive change of character, albeit short-lived, that boosted markets worldwide.  It was the prospect that the rules of the game had been set in the United States to favor a partnership between private capital and government loans that would allow an eventual transition away from the US Treasury and Federal Reserve propping up the every marketplace they can.

In an attempt to quell popular angst over the AIG bonuses, which were 90% less than the Merrill bonuses and 99.9% less than the total bail out AIG dished out to other banks, including non-US banks, the House of Representatives set out to destroy all the good faith that had been built.  Completely ignoring the bigger picture that AIG was simply a proxy for money that was siphoned all over the world, in the billions, not millions.

Who’s really in charge?

Let’s not forget the US Government is a majority stakeholder in AIG.  They own 80% of the shares and easily control any issue put to vote.  They can also demand the board and even CEO are replaced.  These types of extreme actions wouldn’t be positive, but they certainly seem more logical than passing a retroactive 90% tax.

The problem is the government keeps changing the rules in the middle of the game.   It’s very difficult to restore confidence when no one knows what the law will be tomorrow, let alone next week.  Every time there’s some level of complacency that the rules have been set, the rug gets pulled out again from under everyone.

Laws and lawmakers

The rule of law is a fundamental element of successful capitalism.  There is no confidence if laws  can be arbitrarily and retroactively changed or contracts can be freely broken without consequence.  I fear that more of this knee jerk legislation will completely reverse progress we’ve made toward restoring some level of confidence.

It’s unfortunate that we’ve propped up any of these institutions and in my prior entries I’ve always spoken out against bail outs and the corporate welfare environment it engenders.  No business that is unable to continue to sell products or services should be allowed to be given second, third or forth chances funded from the public trust.  Innovate entrepreneurs will create better, more profitable and functional replacements in time.

The problem is, Washington only realized this after the fact.  Only in retrospect do lawmakers seem to understand that most if not all of the effort was a waste of money.  Now, in order to not look foolish before the 2010 elections, lawmakers are putting on a big media circus to scapegoat everyone but themselves, who share in the blame just as much as the banks.  Let’s not forget as citizens that any lawmaker who voted for the TARP or the stimulus was complicit with bonuses and retention plans.

Even back when Fannie and Freddie were taken in to conservatorship, part of the contract with the US government was to guarantee the bonuses and retention plans remained.    The US Congress would have us believe that they were swindled and the bonuses flew under the radar.  Seriously?  Did you guys even bother to read the bill you signed?

Recently there’s been some discussion about regulation and improving oversight of our global markets.  Of course bankers and would be capitalists scoff at the notion.  Why would we want to regulate a free market?

In what seems to be a massive legal loophole being exploited for the gains of insiders with privileged information at publically traded companies, the existence of the JP Morgan PrISM program provides compelling reasons to closely examine the way banks and brokers handle securities and favor their biggest clients at the expense of everyone else.

The creation of a legally rigged market alienates and burns most average market participants, whether they are traders or long term investors.  If insiders are allowed to freely trade their company’s stock with privileged information, where is the incentive for any other person to participate?

Anyone who would knowingly lie, cheat and steal in this manner undermines the very system that allowed them to accumulate wealth and operate a business.   These individuals deserve to be held accountable for their actions, especially now that the world knows how disruptive this level of fraud can be.   What we’ve seen with AIG, Citigroup, Bernie Madoff and the rest of the firms and individuals is nothing short of a cataclysmic blow to free market capitalism.  To restore some level of trust we need to see a lot more folks than just Mr. Madoff going to prison, not passing go and paying BACK the $200 (or however much bailout/bonus/fraud money they received).

Just how many banks have a PrISM-like insider trading system much like JP Morgan?  With cockroaches you know that there’s always more than one.  I feel this scenario plays out much in the same manner.  More banks will have whistleblowers reveal that they also have insider trading and other very unethical programs.

Just how many money managers try to avoid doing their homework and try to cheat the system by getting insider information?  How many will be investigated by the SEC and actually be arrested?  Will the SEC reinvigorate itself to return as the sheriff of Wall Street or will this administration create a new, larger and more overbearing regulatory apparatus?  More importantly, will the crooks go to jail?

Or will we keep the status quo?   A revolving door between the SEC and Wall Street where former officials are given cushy jobs as legal counselors or advisors.  This massive conflict of interest includes members of the Madoff family working for the SEC and Bernie himself being a paid advisor for several years, helping to shape policy for the agency that was supposed to watch out for people like him!

I say we close all the loopholes and start prosecuting the crooks post haste.  No one deserves another breath of fresh air or moment of freedom if they are directly responsible for lying, cheating and stealing our system in to near collapse.

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 Obama administration’s wide-ranging plan to stabilize the financial system no longer includes creating a “bad bank” but will still contain measures to encourage private firms to buy up toxic assets from financial institutions, according to a source familiar with the plan.

In addition, funding for the bank-rescue plan is unlikely to exceed the $350 billion currently available under the TARP, this source said.”

News has been circulating that the US government / FDIC / Treasury wants to create a bad bank to absorb the toxic assets of US institutions that are on the verge of insolvency.

I have two questions for the new administration:

1) Wasn’t this the very idea that inspired the “Troubled Asset Relief Program” or TARP? The last implementation of a “TARP” did anything but buy troubled assets. It seems as though $350B+ of Treasury funds were thrown to the wayside for a temporary relief in the credit chaos that was building.

2) Hasn’t the Federal Reserve become the de facto “bad bank” with its massive balance sheet of troubled assets? Is there a reason to create a second, US government-backed version of the same concept? If so, how does this quell the problem of bad risk management by the failing institutions?

There comes a time when the path least explored may be the most logical. We are reaching a threshold whereby future generations are having their potential prosperity sacrificed to save a financial infrastructure that is paved with greed and selfish intentions. Banks should not be given limitless liquidity in the name of short term stability.

A bad bank facility is by no means a solution and I feel that there is little chance of success. Hopefully I’m wrong and the US economy can be stimulated, but from what I’ve researched central planning is rarely successful. The worst part is those in most need of help have largely been ignored, which is both immoral and absurd. How can we regain the confidence of the consumer if they are being left out in the cold during the worst financial storm since WW2 if not the Great Depression?

Meanwhile, traders are liquidating US government treasuries and buying gold and silver. Clearly the “smart money” has an idea that inflation should be feared looking forward.

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.

Today’s non-farm employment change was nearly twice as bad as consensus expectations and the worst in 34 years, slamming futures on all major US indexes sharply lower.  This economic data confirms that the US economy is in a deep recession and puts in jeopardy the consensus GDP estimate of -4%.  We may see a number as bad as -8% on the next quarterly GDP report because of the massive contraction in employment and ISM data.

Should the negative sentiment continue, this sell off could push markets much lower.  Futures are hovering at support levels and could be pushed significantly lower at open.  Watch this market closely today.  The price action will be extremely important in determining the next likely move.

Much of yesterday’s rally was predicated on a rumor being circulated about the US Treasury planning to price fix new home mortgage interest rates at 4.5% and other whispers.  Many who selectively watch the news or ignore it may fail to fully realize how this short term optimism can impact markets.

We had a sleu of negative economic data yesterday, but it was trumped by the aforementioned rumor and speculation that the TARP be brought back to fund more bailouts.  Today we see terrible same store sales from every chain but Wal-Mart.  We also have unemployment claims at over 500k and factory orders at 10am that promise to be nothing short of terrible.

There will be plenty of Fed speak today.  I can’t for the life of me imagine any optimism they could install after yesterday’s gloomy beige book.  Most of the chatter will probably be about how the Fed wants to avoid cutting to 0% by using quantitative easing strategies, such as buying long bonds and forcing prime interest rates lower.

The futures are weaker by about 2% this morning, giving back much of yesterday’s gains.  Market gains made Tuesday and yesterday are still part of a bear market rally.   Markets are facing the upper resistance line of a falling six month wedge pattern on all major indexes.  Don’t get BULLied!  Remember the trend is your friend.

He plans to potentially cut rates to 0%, creating a liquidity trap, much like our friends in Japan did in the late 90s.    This is an absurd solution to a problem that originated with too much cheap credit availability.  It is also naive to speculate with trillions of dollars, mortgaging our next generation’s future for the mistakes of bankers and regulators.

What if it doesn’t work?

There is a strong likelihood that this “fix” will create stability (not necessarily growth) in other asset classes by sacrificing the dollar.  If it doesn’t work, however, we could see a protracted global depression with many central banks already having expended their monetary policy ammunition prematurely.  Japan’s crisis never technically ended.  Their stock markets never regained their 1990 highs.  Since then they have been in a deflationary environment for 18 years.

Won’t the bail outs help the country?

Probably not.  Capitalism was built on the philosophy of letting the strong prosper and the weak fail.  If a company can not make a profit or has made terrible investment decisions, the tax payer should never be held accountable.  Bailing out the weak also stifles real growth and innovation.   Other companies are usually poised to fill the gaps left behind by the weak companies failing with better products or services.

If it won’t help, why try?

Central planning rarely works, but is often utilized in times of crisis to provide moral support.  We are going down a dangerous road that could end in the socialization of corporate America while leaving the middle class to decay.  The favoritism employed by Treasury and Federal Reserve officials to arbitrarily choose what lives and what dies is the polar opposite of free market capitalism.  It undermines the very framework that could have been the solution to our credit woes.

How do you make money in this environment?

So far short term trading, while risky, seems to be more reliable than any buy and hold approach.  Some folks are playing the double and triple leveraged ETFs based entirely off of technical indicators and having good success.  Others are accumulating positions in commodities for what they expect to be an extremely inflationary environment.  My take is that both strategies are applicable, depending on your risk tolerance, time horizon and availability to watch this volatile market.