Welcome to a Weekly Report special, incorporating further discussion of last weeks Occasional Letter.

This week we look at an example of Eggertsson Theory in practise, what really worries the Fed and what is their favourite import,  how expectations can be managed, why General Electric are going to struggle and I announce something a little different.   A lot to cover and I am pressed for time so let's get on with it.

The Bank of England Applies Eggertsson Theory - An Example

For background please read this article The Future Actions of The Federal Reserve And US Govt Are Known in which I assert that the Federal Reserve is applying a monetarist/Friedman solution, formalized in a theory put forward by G B Eggertsson in The Deflation Bias and Committing to Being Irresponsible.

I have been watching for signs that other Central Banks may also be applying similar methods in an attempt to offset deflationary tendencies and the Bank of England (BofE) duly obliged:

• 11:00 am 8th APRIL LONG-TERM REPO OMO

  
  In its scheduled long-term repo OMO on 15 April, the Bank will offer Stg 15bn at the 3-month maturity. In this operation, there will be a minimum bid rate at the 3-month maturity. This will be determined by the Bank based on the 3-month overnight index swap (OIS) rate, and will be announced shortly before the operation. The maximum total size of a counterparty's bids, across all maturities offered in the long-term repo OMO, may not be greater than 20% of the total size, across all maturities, of the long-term repo OMO. The wider range of high quality collateral will be the same as that accepted in the December, January and March operations.

  
  Reserves will also be offered as usual at the 6, 9 and 12 month maturities, in the standard size and against the Bank's standard published list of eligible collateral. The total size of the April operation will therefore be Stg 16.35 billion.

  
  The Bank is committed to providing the liquidity assistance that the system as a whole needs to function normally.

So we see stage one of an Eggertsson Theory based currency infusion into the Banking system. However as Eggertsson pointed out we need to see an increase in Government debt to raise expectations that a credible attempt is being made to inflate.

This is from the aptly named United Kingdom Debt Management Office:

• CREATION OF COLLATERAL FOR CASH MANAGEMENT OPERATIONS: APRIL 2008

  On Wednesday 16 April 2008, in accordance with paragraph 6.10 of the 2008-09 DMO Exchequer cash management remit, an additional £15,000 million (cash) of collateral will be created and issued to the DMO for use in the DMO's Exchequer cash management operations. The collateral to be created will comprise £11,650 million (nominal) of gilts (excluding gilts maturing within one year, double-dated, undated and rump gilts) plus £483 million (nominal) of the Treasury bill maturing on 7 July 2008.

  The additional collateral will be held on the Debt Management Account by the DMO and will not be available for outright sale. Specific gilts will not be available to the repo market for a period of three months, during which time these new issues will only be used in Delivery-by-Value (DBV) transactions. The additional Treasury bills being created will also only be used in DBV transactions.
  

• "DBV: Delivery by Value

  Mechanism whereby a CREST member who has borrowed money against overnight gilt collateral may have gilts on its account to the required value delivered automatically by the system to the CREST account of the money lender."
  
  

Now to ensure this is seen as an inflationary move, we need rhetoric from the BofE who are in charge of the attempts to meet the 2% inflation target rule.

As if by magic the BofE excels itself (I will underline the inflationary bias):

• The Bank of England's Monetary Policy Committee today voted to reduce the official Bank Rate paid on commercial bank reserves by 0.25 percentage points to 5.0%.
  CPI inflation rose to 2.5% in February. The Committee expects inflation to rise further this year, reflecting the continuing impact of higher energy and food prices, as well as the recent depreciation of sterling on import costs. Such pressures are already evident in producer input costs and pricing intentions.

  Even if commodity prices remain at their current high levels, inflation should fall back. But to ensure that inflation meets the 2% target in the medium term, the Committee needs to balance two risks. On the upside, above-target inflation this year could raise inflation expectations so that, in the absence of some margin of spare capacity, inflation would remain above the target. On the downside, the disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target.

  In the Committee's judgement, the balance of these risks to the inflation outlook in the medium term justifies a cut in Bank Rate this month. Credit conditions have tightened and the availability of credit appears to be worsening. While the recent depreciation in sterling will support net exports, the prospects for output growth abroad have deteriorated. In the United Kingdom, business surveys suggest that growth has begun to moderate and that a margin of spare capacity will emerge during this year. This should help to keep domestic inflationary pressures in check in the medium term.

  Against that background, the Committee judged that a reduction in Bank Rate of 0.25 percentage points to 5.0% was necessary to meet the 2% target for CPI inflation in the medium term.

• "CPI inflation rose to 2.5% in February."

  "The Committee expects inflation to rise further this year, reflecting the continuing impact of higher energy and food prices," 

  "depreciation of sterling"

   "pressures are already evident in producer input costs and pricing intentions"

  "to ensure that inflation meets the 2% target"

  "above-target inflation this year could raise inflation expectations"

   "inflation would remain above the target."

The reasoning for the rate cut is beautiful:

• "On the downside, the disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target.

  In the Committee's judgement, the balance of these risks to the inflation outlook in the medium term justifies a cut in Bank Rate this month. Credit conditions have tightened and the availability of credit appears to be worsening. While the recent depreciation in sterling will support net exports, the prospects for output growth abroad have deteriorated. In the United Kingdom, business surveys suggest that growth has begun to moderate and that a margin of spare capacity will emerge during this year. This should help to keep domestic inflationary pressures in check in the medium term."
  

Notice the committee expect inflation to rise further this year, yet their actions are dictated by the possible slowdown of the economy and a specific mention about the lack of available credit (which is the same as "disruption in the financial markets").  It is the expected slowdown in growth and an increase in spare capacity (unemployment up, capacity utilization down) that will keep inflationary pressures in check.

I'll put it this way. If you feel you need to cut rates, engendering an inflationary expectation and are then relying on a recession or slowdown to keep inflation in check at a lower level, you are not really expecting inflationary forces in the medium term.

• "Committee judged that a reduction in Bank Rate of 0.25 percentage points to 5.0% was necessary to meet the 2% target for CPI inflation in the medium term."
  

This is an attempt to front run deflation. The giveaway is this snippet:

• "Even if commodity prices remain at their current high levels, inflation should fall back."
  

Is this policy succeeding, do we have evidence that inflation expectations are being driven higher by "credible actions"?

Quite possibly we do and current actions by the BofE can only reinforce such expectations. The following is from Finfacts, reported on 13th March:

• "A survey by the Bank(of England) showed Britons' expectations of future inflation rose to a record 3.3% in February, more than a percentage point above the actual rate of inflation…..At 3.3%, inflation expectations are at their highest since the Bank began its survey in November 1999. Britons' expectations of future inflation have risen steadily higher over the past year as food prices, energy bills and petrol costs have all rocketed. In November, the median was 3%. A year ago it was 2.7%."
  

Is the Federal Reserve achieving the same result as it talks up inflation and appears to be credibly inflating along with the US Govt? Here is the latest University of Michigan Sentiment Index readings:

• Sentiment Index 63.2 mid-April vs 69.5 in March
  Current conditions 78.4 vs 84.2
  Future expectations 53.4 vs 60.1
  One-year inflation expectations 4.8%, 5-year 3.1%
  Economic outlook 78.4 vs 84.2
  

• RBC Consumer Attitude and Spending by Household index for April showing the overall index hit a new record low of 29.5

• Compared to 6 months ago, are you NOW more or less comfortable making a major purchase, like a home or car?

The Fed will need to intensify its inflationary campaign to change consumer sentiment.

Which brings us nicely to the Feds favourite import. Can you guess what it is yet?

• Import prices rose 2.8 percent in March, the largest monthly increase since November. Economists were predicting a 1.8 percent rise in import prices for March.
  

Within the report is this:

• U.S. export prices in March rose by a record 1.5 percent. Agricultural export prices rose 4.1 percent in March. Over the last year, agricultural export prices are up 33.4 percent, another new record. Excluding agriculture U.S. export prices were up 1.2 percent in March.
  

Exporters are able to pass on higher production costs, expected or real, because domestic monetary inflation in overseas markets allows dollar pricings to rise. This would point to a continued and concerted effort by many Central banks and Governments to allow inflation to devalue worldwide debt.

The loser in all of this is the consumer. Without price inflation matching increases in their cash assets they face a deflation in of actual cash asset amounts. In other words, whilst price inflation rises, actual cash held after liabilities is deflating. Consumers face being "upside down" not only in housing but also in cash assets.

Once consumers recognise this dilemma it will become acceptable for Government/Central Bank re-inflation polices to hand cash directly to consumers, bypassing the traditional pricing mechanisms.  The groundwork for such a policy is already firmly in place.

It is imperative for the successful application of Eggertsson Theory that expectations in consumer attitudes are managed, if the consumer remains entrenched and refuses to spend the policy could unravel.  

I highlighted my worries about General Electric (GE) in this article, identifying their exposure to real estate, credit cards and loans. Sure enough the damage was enough to offset those parts of the conglomerate that performed well. It was noticeable that other consumer reliant parts of the company were affected badly too:

• "Our primary shortfall was a decline in financial services earnings," said GE chairman and chief executive Jeff Immelt. "We knew the first quarter was going to be challenging, but the extraordinary disruption in the capital markets in March affected our ability to complete asset sales and resulted in higher mark-to-market losses and impairments."
  Results were also affected by double digit % falls in health care and the industrial divisions, which were hurt by a drop in consumer sales. The commercial division earnings were down 20% with GE Money down 19%.

  "On the finance side, GE isn't bound by the same rules that financial institutions are, which is why they've been able to outperform them in the past," said Jefferies' Schenosky. "But there is still exposure to the economy - they are not immune."
  

To finish, some links to charts (scroll down) I am currently monitoring. In the near future this list will expand.

Now, I'm not one to boast, really I'm not. No one enjoys the likes of me stuffing "I told you so" remarks down reader's throats. There comes a time when it does become slightly unavoidable. Is it ego, a demand of recognition? Is it a desire to be kingpin, the ultra guru? Frankly my dear, I don't give a damn, as long as my readers get something that helps make life as an investor /trader easier then my attitude is "so what?"

What a week that was, Dow up, then down, up again…..stop! Hindsight - blah! This is the Collection Agency, we pride ourselves on looking forward, not back. Where do I look, how far forward? The Occasional Letter looks 6-18 months ahead, soon it'll be looking for some buy opportunities. The Weekly Report is more short-termism, with the aim of looking for opportunities in the next few weeks.

Speaking of readers it is time for an update. Now most of you know I'm a blogger, no fund to sell, no angle to push, I really don't care what you buy and sell. I'm not bothered. I'm googlable but I don't really exist beyond those that read me at some rather classy sites. Yes that was me being a creep.

Here is my world coverage over the past 2 months, remember, I'm an unknown, a blogger:

If it's green, someone visited. I know, I'm amazed too, my grammar is awful! Around 16000 people have read my stuff in the past 2 months. Some may scoff at such figures, I don't. I would like to thank you all, I had no idea my "stuff" was that readable. As much as I can be, I feel slightly humbled.

"Enough" I here you cry and being one not to spit in the face of a crowd, lets get on with it.

There has been a war of words between Gary North and Steve Saville about whether the Fed is inflating or deflating. I have absolutely no connection with either writer and have no interest in badmouthing either of them. I am sure both have a loyal following and I do know both make interesting points.

Here is my roadmap, unchanged these past 5+ years:

• "A recap of the scenario: bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation."

If you read that 5 years ago, you would have pegged me as a survivalist or a gold-bug. Now you can pick your appropriate position. How did I know such tremors were coming? Simple, I studied the very same things Ben Bernanke studied, he became a bald academic, I became a bald blogger. I am better looking though. Back to the GN/SS spat. I looked on, an interested observer in all matters inflationary and deflationary and decided to strip the argument back to its core. From what I could see this was a difference between M1 and MZM as to which held the key to inflation/deflation signals. So I went to the Fed.

St Louis to be exact, mainly because I like Poole, his St L Fed site is excellent; I do hope his successor keeps the access to facts as open as Poole did. Its worth reading up on William Poole, he may well surprise you. I digress, again:

Charts:

This is a chart of MZM (green), M1(orange) and CPI(blue), using the base of 1982, as CPI was rebased in 1982/84 according to St L Fed statistics. Everything is based on the left side, pure figures. You know what's coming next:

Same chart with CPI based on the left axis and M1 and MZM on the right axis with the same baseline of 1982. Astute readers can know see why I stick my nose into uninvited areas. Is any measure of "M" a worthwhile measure of inflation trends?

Inflation is not purely a monetary phenomenon. We all know if you over-print cash notes you encourage a debasement and a monetary inflation. What isn't so understood (except by some and believe it or not, the Fed) is that in a fiat monetary system, reliance on growth using leverage for the expansion of credit, is the true driver of inflation/deflation.

It's simple and easily understood if you think of greed. It is also why a fractional GOLD backed currency won't work.

I have $10, I lend it to my bank as a "savings" deposit. The Bank uses the deposit as an asset, lending on that asset by a factor of 10 (leverage). The bank lends out $100 backed by the original asset. The Hedge Fund borrows (credit) $100 from the Bank and utilising margin (further leverage), raises positions in markets notionally worth $1000.

The economy is booming, thanks to my $10. I am a capitalist hero. One day I decide to take my $10 out of the Bank to spend on a battery powered radio, to alleviate my boredom whist mowing the lawn.

Does the Bank have to unwind the leveraged lending based on my $10? No, it can count upon other deposits, savings, to replace the capital base.

This is all well and good during the good times. What happens when all my neighbours decide they would rather own assets than leave cash on deposit? We know already, thanks to the 3 day collapse of Bear Stearns. Banks fear above all else a run, where depositors decide they would rather have their cash in hand than in the Bank. You can see why they fear such a run, mass withdrawals would force the unwinding of leverage, a call on the loans made. That means the Hedge Funds would have to unwind their positions, to enable repayment to the banks. You get the picture. Another angle would be to look at productive workers, paid for their labour and depositing wages into the Bank. If the Banks had a shortfall of received wages the same problem would occur, Banks would no longer have the fractional base to enable their lending. Less workers, less deposits.

What we are witnessing is not a shortfall in the ability of innovative structures to enable credit. What we are seeing is the beginning of the destruction of the fractional base of Banks. I could go on, mentioning the shortfall in expected corporate profits over the next quarter or 2 as judged by the S&P500. My astute and clever readers have already jumped ahead to that conclusion.

Back to the central question, is the Fed inflating or deflating? Amazingly, it is doing both, thanks to the newly introduced "Facilities":

Above is something I rustled up earlier in the week. To my eye, the Fed is inflating the amount of Treasuries available to both Banks and Primary Dealers and debasing their worth by swapping them for cheaper assets. On the other hand the Fed has been extremely active with the Permanent Open Market Operations, selling treasuries and absorbing cash from the markets. The Fed is walking along a very loose tightrope, where each step is producing vibrations that affect all market participants.

It would seem the Fed is set on a course to provide solvency to Banks and Primary Dealers, by lending assets that can be used to raise/roll borrowing from Banks who are only willing to lend on AAA assets. This is far beyond the ability of MZM and M1 to measure. Such slow moving indicators are unable to capture the true intentions of the Fed as it provides the replacement for the Commercial Paper markets.

Let us gaze upon the graphs for M1, M2 and MZM:

Where M1 has remained in a tight range for the past 11 Quarters, the sudden acceleration in M2 and MZM points to a reflation BEYOND cash.

• M1 is defined as all coins and currency held by the public including travellers cheques, checking account balances, NOW accounts, ATS accounts and balances in credit unions.

• M2 is defined as all of M1 plus savings and small time deposits, overnight repos at commercial banks, and non-institutional money market accounts.

• MZM is defined as all of M2 minus time deposits but including money market funds.

Yes, we are back to the Fed and its Facilities again. M2 and MZM include overnight repos at commercial banks. Since the credit crisis burst open in the summer of '07, the Fed has made ample use of repos. Indeed when the crisis intensified in October '07 and again in January '08 the Fed enlarged the amounts and frequency of repo arrangements. It is quite clear that M2 and MZM are reflecting this. M1 does not include such actions as those carried out by the Fed. Repos can only be viewed as credit, newly created by the exchange of assets. Cash itself is not printed, there is no need. All that happens is a bank can swap assets to increase the notional amount it holds in its reserve and meet reserve requirements. Only if the repo was made permanent, with assets remaining at the Fed, could the Bank issue currency.

It is at this point I agree with Gary North, consumers are not seeing a reflation in wages or income, actual cash in the economy has been remarkably stable over the past 3 years. If one considers the loss of spending power of each dollar, then without an increase in the amount of physical cash, consumers are already in a deflationary cycle as the amount of cash after liabilities is falling. An inflation of prices must never be confused with an inflation of monetary supply, consumers are suffering a deflationary lack of cash when compared to the requirements demanded by an increase in the PRICE of goods.

For the consumer this is clearly unsustainable. Eventually the consumer will hoard resources and only use cash to pay for essentials. Regardless of the Fed pumping assets into Banks and Primary Brokers who use the largesse to fund their own borrowings, the consumer will find it extremely difficult to access credit. Without credit consumers will be unable to expand spending as reliance on increasing wages is obviously misplaced.

Here we have the roots (and they run deep) of a major deflationary period. I have opined before that I saw a two track America, one where consumers where crushed by deflationary forces whilst "International USA" continued to offer acceptable returns in exchange for it debt. That moment may well be playing out in front of us now.

Here is a chart of 2 inter-related phenomenon; Consumer Prices (blue) and Total Retail Sales (red):

Here is a classic example of prices rising when goods are in demand. If you look closely, you can see that retail sales lead CPI, dips in sales slows and at times reverses CPI.

An adage I have for this is it doesn't matter how high prices go if there is no demand for goods. The goods will either be re-priced lower to stimulate demand or the production of the goods is stopped if the venture becomes unprofitable. It is the lack of cash that causes (spending and therefore) sales to drop. How the amount of cash consumers own is decreased is important. If more cash is required to pay taxes or service debt then the expenditure is onerous on the consumer balance sheet, no asset is exchanged. If the consumer chooses to spend more money buying assets, then at least there is an asset owned. If however the asset is depreciating in value, including assets bought using debt then the net worth of the consumer suffers a double blow.

Housing is suffering from the same effect. Now we see it in retail sales. You can see why tax rebates have been lined up, it is an attempt to stave off a deflation in sales. If it works it will have a lagging inflationary affect on CPI.

The problem though is whether consumers will spend tax rebates or save them. If rebate cash is used to pay down debt or placed on deposit there will be no stimulation to sales. CPI will drop. Here is a close up of the same chart:

The tax rebate effect can only be temporary even if it does stimulate spending. Without an expansion of credit or an increase in wages sales will continue to drop. What are the chances of credit conditions changing in the medium term or wages increasing during a recession?

The interesting part of all this is if consumers do save the tax rebate then M1 will not increase as savings and small time deposits are calculated in M2/MZM. Thus savings could cause a display of supposedly inflationary tendencies in M2/MZM. M1 would only increase if the savings ( or the tax rebate itself) were used to buy goods or services.

The actions taken by the Fed and the US Treasury will either distort CPI or cause a misreading of inflation if M2/MZM are used. The latter would be a grave mistake as the consumer would not have increased their spending power. The increase in M2/MZM would be a combination of increased use of credit by banks and an increase in savings by consumers.

The following chart shows the relationship between Sales and Industrial Production for Durable Consumer Goods:

Sales and Production are linked, it shows that the compensation given to workers for their labour is used to buy products, amongst other uses. The correlation is particularly noticeable prior to 1991. However since 1991 an inequity between spending power and production has appeared. It is my contention that increased productivity was a function of the slowdown of compensation in real terms and spending was boosted by an increase in the use of credit allowing sales to continue to rise.

This is a form of mal-investment, were credit has replaced true efficiencies in production. Purchases were not made from savings (workers earnings) but from earnings of yet unrealised worker compensation with a forward CPI and risk premium added.

With the standards for credit now at much tighter levels seen since 1991 this mal-investment is beginning to bite. Although this has consequences for consumer spending power, the real problem will lie within Corporate balance sheets. Reduced income will make the servicing of corporate debt much more difficult as we have seen in the Financial Sector. "Liquidity injections" from overseas investors have high rates of interest and with income streams falling, increased productivity and the ability to service debt can only be achieved by lowering costs.

If a production system is reliant on the use of credit to expand and that facility is removed then the results of previous bouts of debt fuelled expansion cannot be carried forward and offset against expected future income. Either the debt is repaid or defaulted.

Can increased productivity re-light consumer spending? It would appear not:

And it's a tactic that's already been tried. Notice the increase in productivity in 2007 did not re-ignite sales. It's most likely that the 2007 increase was a function of cost savings, rather than expansion.

On a more practical front, how can an investor use such information to aid their strategy?

Avoid debt on company balance sheets. An investor should get into the habit of checking the ratio of company debt to income and reserves. If you can find a company selling essential products that carries no debt on its books you are on the right lines. If you can find a company that also has saved its profits and is only willing to expand using its savings you may have found a good opportunity.

We finish off with a look at some charts and wonder why investors are buying financial sector stock. Is the recent rebound in financials worth buying into or watching? I leave that decision up to you, I don't do recommendations but as you have read, my filter for acceptable buys would discount the sector. You may well have a different take on the situation, my only advice would be to do your research with extra diligence. I have no positions in shares in the following charts and will not take a position on them for some time.

Firstly my Dow Daily Chart, used for long medium length trends:

We are near the top of the sideways trading range(down arrow) that has been in force since January. For the first time in 4+ months we have a neutral reading, with 3 days of support at the pink, median line (up arrow). Whilst calling direction from here would be a bit silly, at least with a neutral scenario we can take cues from breaks of support/resistance from here.

Citi, I have removed the down channel as we have broken out. Citi is trying to break above the MA but might be forming a rising wedge:

Goldman is at the upper end of its down trend channel and finding resistance at the MA. Strong support at $163:

Gold, an update from last week. The down arrow shows the attempt last Monday to regain the MA which failed. Gold found support in the $885 area on a closing basis. This level now becomes important support for future moves. I would need to see a higher high and support from the MA before looking for upside:

Welcome to the Weekly Report. Click on the link for my update on Moral Hazard written for Livecharts earlier this week. Stress continues to increase across all markets, a fact that should make all investors stop and think about the root cause.

First up, we dig into the Flow of Funds Accounts of the United States for Q4 '07. Specifically I want to look at the growth of Domestic Non-Financial Debt:

Remember this is a growth chart, the amounts are still rising. Without using a chart, you can see a bell curve in household debt, State and Local Govt debt and Federal Debt. Inverse to this is Business debt. There are some disturbing patterns here that bode ill for the future.

The growth in household debt is slowing rapidly, almost halving since Q1 '06 to Q4 '07. I somehow doubt Q1 '08 will show an improvement. It is clear that for consumers the debt crisis did not begin in the summer of '07 but in Q3 '06. Anyone who tries to label the MBS credit crunch as a Minsky event, an unforeseen happening that surprised the Markets, didn't look deep enough. This disinflation in the growth of consumer debt is different than the expansion we saw during the last recession. There is no support coming for the economy from a continued and increasing expansion of consumer debt. This is a consumer led recession that has ramifications for the whole system of funding used by local and national government. Without an increasing flow of taxes raised through spending, Municipal, State and National funding will be increasingly reliant on raising debt through bond issuance.

Indeed the process had already started, as can be seen by the rise in Local/State and Federal Debt to cover the shortfall in funding. As we all know the Municipal Bond (MB) Market looks like the Somme in 1916, cratered and deadly to all participants.

The figures for Q3 and 4 '07 show the sudden difficulty in raising debt experienced and the acceleration of the problem. This makes sense if viewed from MB buyer's point of view. If the MBs are issued using future tax/income flows as the underlying asset it is no wonder that, after a quick glance at slowing consumer debt, the underlying asset is no longer seen as such a secure basis for borrowing. It is exactly the same calculation used when buyers deserted the lower (and now top) rated MBS tranches, a lack of confidence in the underlying asset to perform at its historical level of return.

Business lending looks solid at first glance but if we take a longer term view, a pattern becomes evident:

Notice the pattern? Business debt grows until hard times arrive. It is likely that falling rates (yields) become attractive and business debt is increased or rolled over on better terms. As I have shown before it is this short-sighted view that often becomes the undoing of Business. Whilst falling yields are attractive to borrowers they are the precursor of a contraction in economic performance. The Fed allows rates to drop for a reason; it is to attempt to stimulate economic growth. That stimulation is required as conditions weaken:

We can see this in practise above, as conditions shown by the ISM readings for manufacturing (red) and non-manufacturing (black) business are interest rate sensitive (effective Fed Fund Rates- blue). Rates climbing above 5% are not conducive to a healthy business environment. Even periods of stable rates above 5% do little to help business; it demonstrates that business planning is not aided by "stability" but by low, accommodating rates. As we can see, the Fed did not pursue a new paradigm this time around. Business conditions had to show marked deterioration before the Fed cut.

Here is the conundrum for the Fed. Previous accommodating drops in rates helped to re-invigorate business after deterioration, helping employment, expansion of credit and consumerism. This time the Fed faces a problem not seen since the depression (except in Japan 1990 - present).

Lowering rates is ineffective if Banks do not lend. It is clear that Banks either are not willing or are unable to extend credit facilities to all sectors of the economy, including to each other. The Fed has attempted to address this with a series of new measures, designed to alleviate the pressures on Bank capital reserves. Banks are grateful for this but will not take new positions in credit markets. The Fed support is being used to repair and rebuild bank balance sheets by deleveraging, using cheap Fed assets and funds to roll their own positions, whilst keeping income streams high on current lending. If the Banks decide its time to clear the decks of liabilities, this process could take much longer than most expect.

Without access to lower commercial rates, businesses could find themselves unable to use credit to roll over existing debt or to use new credit for "expansion". This would be comparable to the conditions seen in Japan in the last 2 decades.

How tight are current Bank credit conditions? Put it this way, if the Fed has to enact '30s legislation to save a broker and then set up a discount window for other Primary Brokers it is clear that Banks are unwilling to help out.

Here we see the massive drop in borrowing, except for two sectors:

Apologies if it is a bit small, here is the link to the Fed Fed Z. 1. Credit market borrowing in the Financial Sector is down from $2339.1Bn in Q3 to $1300.5Bn in Q4 '07. That's some disinflationary rate, 55.5% quarter on quarter! No wonder Banks and Primary Brokers were happy to take "liquidity injections" from SWF's and Middle/ Far East investors.

The only expansions of note were in Agency and GSE backed mortgage pool securities and Funding Corporations.

Conditions will not improve until Banks allow credit to expand. Clearly from the data above that hasn't happened into the end of '07. With the continuing use of the Fed and its expanding list of lending programmes, the "Bank of Last Resort" demonstrates that conditions continue to worsen. Until Bank lending standards are relaxed the consumer and business will remain mired with long term debt that requires servicing at rates well above those Banks are being charged by the Fed.

In effect a dollar based carry trade is in operation, with low rate debt borrowed from the Fed lent out at higher rates to all sectors of the US Economy. As we have seen in the past year the carry trade mechanism is reliant on confidence that the high rate income stream continues to flow allowing the servicing and pay down of the low yield debt.

If confidence in the income stream becomes threatened then in normal conditions the carry trade is unwound or more collateral is required to secure the short term (in this case, Fed) debt. This though is not a trade under normal conditions. The Fed can allow collateral levels to remain the same or even be relaxed even if conditions worsen.

The method being used to bailout the financial system is now open to public scrutiny. Banks and other lenders that are "vital" to the stability of the US Economy will be allowed to set their own rates on their lending whilst assured of a low burden of payment on their own borrowings.

Conditions are ripe for Banks to begin to encourage issuance of Corporate Bond debt. The following chart shows the Moody rates for AAA (purple) BAA (green) corporate bond yields and the Primary Credit Rate. I have had to join up a couple of gaps in the data, it is still worth showing:

Primary Credit Rate at the Discount Window (left axis) is now 300pb below AAA corporate yield and 440bp below BAA.

Here is a plan that may well be put into place by the Fed, Banks and now the Primary Brokers. The Fed continues to lend at very low rates to the financial sector. The Banks and PD's begin to roll their leveraged assets into a mix of corporate bonds and higher yielding treasuries using the income stream to payback the Fed and repair the balance sheets. To further enhance the domestic dollar carry trade, the Fed raises the Fed Fund Rates, citing inflationary pressures but keeps rates at the discount windows artificially low. It might not happen in the near future but there maybe a hint that others are considering this as a possibility:

(Chart from CLP Structured Finance)

It's too early to say "trend change" but it maybe worth watching yields to see if markets start to price in rate hikes.

Finally, two charts which are both at a critical juncture. First up is Dollar/Yen, a monthly chart. With the month close on Monday, it looks increasingly like the Dollar is in need of help. Will anyone hear the call?

Lastly, Gold Daily chart. Gold needs to rally rapidly from here to stop a test of support at $845 area.

That's it for this week.

Welcome to the Weekly Report. Firstly a big thank you for the interest in this article. From the reaction I have seen, it looks like I put into print what many were thinking. Enough hindsight, let us see what opportunities and risks face us in the coming week, or longer. We take a look at the Financials, looking for weakness and strength, wonder what the Dow has to say and have a look at gold and a few other commodities. We finish with an example of current living standards in the US, thanks to an email sent to me a couple of weeks ago.

Regardless of whether we consider the Fed/US Gov't (Fannie and Freddie especially) intervention into "free" markets as right or wrong, we have to be realistic and face the fact that it is happening. One of the worst mistakes you can make as an investor or trader is to fight the Fed. Their pockets go much deeper than ours and as I have said previously intervention begets more intervention. Are we facing a dramatic drop in the stock markets, the big one? Or will the Fed/US Gov't instil enough confidence to let stocks rally?

It's the big question and it is one you do not want to ask. So rather than stand on the rail tracks hoping the train will switch rails, lets see if we can highlight some possible trends. Keep in mind the following, regardless of what the media and shills will tell you, the macro-economic fundamentals are under stress, meaning more shocks are likely. In the shorter term leverage is being unwound on some positions whilst new positions are being created elsewhere. Volatility abounds, it may give us new opportunities but it can also severely damage your wealth. Use protection to stop contamination.

First up an old favourite (that may not last….) Dollar/Yen/Euro/Dow. I use this chart to spot changes in Forex flows over the medium term. Some of my longer suffering readers know I use $/Y to help identify carry trade flows in stocks and bonds. Whilst the carry trade continues this chart will be helpful.

In this version, Yen is shown as a baseline (hence 0%) and the dollar (pink), DJIA (red) and Euro (green) show their respective moves from Yen.

It gets worse, much worse. This next chart holds a warning about why policies that allow dollar devaluation will continue to damage fundamentals, we may be seeing an acceleration of foreign funds abandoning support for dollar assets.

We are at a critical junction here, either direct Central Bank intervention stops Yen appreciation (remember Yen is up against just about everything) and restores stability or we could see a capitulation. With a lack of credit liquidity and therefore further leverage unavailable for Hedge Funds, Banks and Institutional Brokers, no wonder the Fed has spread its largesse this past week. If the carry trades in Financial Sector cannot add capital (margin calls) or double up, hoping for a reversal then they are stuffed, roasted alive.

So what will be the outcome? Let us look at this realistically, not at what should happen but at what the interventionist policy prone Central Banks are likely to do. We do not want to get caught on the wrong side of this.

As much as I would hate to see it on a macro-fundamental long term view because of the damage it will cause, I think Central Banks will intervene, they know of no other reaction. The only question open now, in my opinion, is the timing. Do the Central Bankers wait for the beginning of a capitulation move or do they move earlier to try and prevent it?

Looking at the timing the Fed took over Bear, they were deeply concerned about the Far East reaction (Greenspan was asked what would be the biggest change to his routine after he left the Fed, he replied "not having to check the Tokyo markets first thing in the morning") and ensured the plan was released before Far East markets sold off heavily (they bounced on the announcement). So we need to be prepared for an attempt to push the value of the Yen down, to re-invigorate the carry trade and stop Yen based losses. If such intervention does happen (I could be wrong, I have been before) the rally in stocks could be fast and large. As the Financials would benefit the most, I would expect them to rocket higher.

However, any such move may well be temporary. Remember, Banks, Institutions, Primary Dealers and through them Hedge Funds are surviving on the Feds willingness to lend. The Fed will want their money and assets back (with a profit, notice Fed lending is not free) and a rally could well be an opportune time to unwind positions, drawback leverage and withdraw credit facilities on repayment. Look for strong hands to sell into the weak hands who buy. Keep an eye on the financial media, if it starts telling investors that the good times are back, be wary.

Finally on the subject of Yen carry trades, I did a bit of digging, looking at $/Y and 3 month Treasury Bill yields. I went back to 1980 to encompass 4 recessions, mainly to see what effect recessions had on Fx rates and yields. I got more than I bargained for.

$/Y is in blue, 3 month T-Bill rate in red. Some important points show up here. Falling yields weaken the dollar, rising yields strengthen it. Since the double dip recession in the early '80s there is a strong correlation to this link and showing that yield moves lead FX changes. We can see the effects of Japanese Central Bank interventionist policies from 2001-05 as the dollar was propped by the Bank of Japan which mitigated but did not break the correlation.

Now we shouldn't map the future according to the past, we avoid it wherever possible but Central Banks tend to rely on the past to give them lessons for the future. Let there be no doubt, either the Fed has to raise rates to stop $/Y descending into the abyss or the Bank of Japan has to intervene and prop the dollar by selling Yen.

What are the chances of Ben "chopper" Bernanke raising rates in the next 6 months?

Intervention from the Bank of Japan becomes the last hope of the carry traders, without it all of the emergency actions taken by the Fed will come to naught. I may not like the Feds policies or direction but I do not think they are stupid. It seems to me that the Fed has laid the foundations for the Bank of Japan to build upon.

So how can we ensure that if/when intervention occurs we are not standing in front of the train?

You do not want to be caught in short positions on dollar based shares as a re-invigorated carry trade will home in on perceived Yen priced value. If the dollar climbs against the Euro be careful going long on speculator dominated commodity positions. Whilst in the big scheme of things such actions by Central Banks can only be temporary, remember timescales are relative. A temporary move by Central banks can last 1-2 years, sometimes longer. That is far too long to attempt to fight the trend as a trader.

Here is my long term trend chart of the Dow:

The trend is still down but we have an important attempt to hold the 2000 high as support. Note the retest of the moving average. It looks to me that over the next 2-3 weeks we may well get to find out if concerted, combined Central Bank intervention is to take place. You do not want to be on the wrong side of the move whichever way it goes from here.

Lets look at a few daily charts of financials both in the US and UK (The Bank of England, as reported by The Sunday Times, seems to have decided to use Fed style tactics to support Financial Institutions, although Merv King did say his remit did not stretch to "propping up the banks' profitability") remember, don't fight the trend.

Goldman Sachs:

Barclays:

Finally gold:

A couple of weeks ago a reader sent me his thoughts on the current economic climate along with his personal experience and situation in life. Normally I wouldn't do this but I think it may strike a chord with many readers.

M***, a US veteran living in Oregon, didn't rant or ask for anything, he just wanted to show his frustration at seeing old mistakes from the past repeated in the present. Notice that M*** is not a spendthrift, he is solvent and responsible:

"The day before yesterday I tanked my truck up to the tune of $79.50 (I already had a quarter tank) and used my debit card by mistake rather than my credit card, easy enough to do since both are WaMu MasterCards. So, realizing that, I had to go yesterday to the bank to make a cash advance on my credit card to deposit into checking to make sure I did not have an NSF fee of $32. Like so many other Americans today, this is just how fine a line I tread in daily living though my gross income is now over $51K and I am single with no dependants, and I do not work but am a disabled vet who also gets social security disability. Thank god I only have a total of $1*K in debt for my truck and credit card and nothing else.

Well, since banking today is more or less an exercise in futility, yesterday was no exception. The bank has new rules and I was not allowed to take a cash advance from credit for deposit into checking, I had to go to a payday loan shark for the money to avoid the NSF fee. So maddening when I get paid on Wednesday anyway.

Frankly, I wonder how much longer WaMu can stay in business, I doubt it will be allowed to fail entirely, but more like folded into another bank, or carved up and sold off piecemeal for pennies on the dollar. You know last year in the summer I went to them to ask about a veteran's home loan when I was thinking of buying a condo, they told me they no longer do those loans. Loans mind you that are backed by the VA. Also, when Wachovia took out two truck payments last summer in one month and messed me up, then refused to make a refund of the overpayment I went to WaMu to refinance my vehicle there, I was told that no longer do any form of auto financing, I went through State Farm instead.

I am a prisoner of this system though, as a recipient of two federal benefit payments per month, each requiring direct deposit, I may find one day that I cannot access my income at all. I already feel like I am on the border of what is referred to as working poor income levels, that is income adequate to stave off real poverty, but not enough to live well or even buy a house. I got by better two years ago on the VA income alone than I do now on combined VA and SSA incomes though both have had small COLA's since. I estimate that more than one third of my purchasing power has been lost to inflation in the last 35 months since I moved to ******.

It is my opinion that the rest of America will do what I am doing, cutting back all but the very most necessary spending, I eat little meat anymore, and never go to restaurants, I even get haircuts only about every three or four months and then I just have it buzzed off. I refuse to pay $25 for a haircut with tip, and if McDonalds wishes to grant themselves an 11% across the menu raise when I cannot do likewise then they will have just lost my business (I remember when a great steak dinner out was cheaper than a big mac meal is now, and it was not THAT long ago).

I think few Americans under the age of 40 can remember just how painful stagflation is, in my county on the ***** coast in the seventies the unemployment rate was 30%, I faced graduation in 1976 with no prospects for either work or college. I had no choice but the military. They never called it a depression, but for much of America that is just what it was.

So, I economize to the maximum extent I can and buy silver with what I can scrape up each month. It is not a lot of metal, but it is infinitely more than 90% of Americans who have laid nothing real aside for harder times. Mr. Bush and his NeoConmen have looted the nation and the piper is coming up the footpath to our collective doors, they may never call it a depression but no matter what name they offer it will come faster and crush more than any of your readers will ever understand.

Thanks for letting me vent and thanks for your great work, keep it coming.

M***"

Thank you M***.

Welcome to the Weekly Report. Events are moving at an accelerated pace requiring further Central Bank intervention as Hedge funds and Investment Banks are hit by ever tighter credit conditions and a run on deposits. I make no apology for using the past weeks events as the central theme for the coming week. Without doubt we have entered a new phase in both the financial and monetary spheres of the Global economy.

First up is US Tsy Sec Hank Paulson who had some rather strange advice for Financial Institutions. He warned that the largest US banks should raise extra capital beyond the $70Bn already accumulated in order to prevent the credit crisis from worsening. He went on:

• "We are encouraging financial institutions to continue to strengthen balance sheets by raising capital and revisiting dividend policies ,…… We need those institutions to continue to lend and facilitate economic growth."
  

I have some bad news for anyone relying on Mr Paulson to come up with a solution to the credit crisis. The statement shows a complete lack of understanding of what is currently happening. This is not a crisis, this is a full blown, unfolding before our eyes, collapse in confidence in the fiat monetary system.

The complete lack of innovation by Banks, Hedge Funds, Financial Institutions, Central Banks et al in response to the beginning and current situation is staggering. What have we seen so far?

Consumers will get some legislation (passed eventually) it will be too little, too late to save them.

Financial Institutions get instant, on demand, no books read bailouts from the Fed. If you are not a Primary Dealer and not entitled to access the Discount Windows, don't worry, the Federal Reserve will funnel the money through a PD, it saves a lot of regulatory hassle. It helps if your party and counterparty risks are huge, then you get classified as "too big to fail" as the domino effect would destroy the current credit system.

Within Paulson's comment we see the lack of understanding of what Financial Institutions (Large Banks and Primary Dealers) are already doing in an attempt to stave off the biggest financial disaster in 100 years. They are already raising capital by calling in loans, regardless of risk. It doesn't matter if you are a Hedge Fund using borrowed leverage to deal in AAA rated Municipal bonds, the FIs are calling in the loan, raising margin requirements or asking for more and higher rated collateral on any borrowings. This is no surprise, anyone who watched what happened with Asset Backed Commercial Paper (ABCP) last year could see this coming. The Financial Institutions are not recouping capital to re-invigorate lending, they are just hoarding cash to ensure they can meet their own capital requirements and hunker down to survive the approaching disaster.

Credit markets have not seized up due to a lack of capital per se, they seized up due to a lack of confidence in the ability of collateral to keep its worth and the rising risk that any Insurance used might not pay out. The "buck" didn't stop here, it stopped everywhere.

A fiat monetary system, built on the use of credit as a driver for economic growth, is utterly reliant on confidence. If action is taken that undermines that confidence then the system stops working.

This is not a new phenomena, the evidence is already on display. The rise in commodities, i.e "stuff" is not a function of inflation. It is a rise in the lack of confidence of fiat money. When the dollar, the current world trading benchmark, is debased you place your capital into assets that have a tangible worth. They cannot be eroded or re-valued by the actions of a Central Bank, they are worth something to someone. The dollar does not have the same worth. It functions only because of the confidence placed in the assets that underpin it.

Devalue the assets and you devalue the dollar. The Fed has decided to swap US Treasuries for so-called AAA rated debt backed bonds, not placed on "watch" by the credit rating agencies, currently on the books of Primary Dealers. The risk of default on the debt has not been reduced, it has been transferred from private Financial Institutions to the US Government and the tax payers. All of the Feds actions are just to allow the current credit lending mechanisms to continue.

Devalue the assets, devalue the dollar. The cure to all these ills that Paulson refers to is an illusion. The FIs have bought time, swapping their collateral to the highest standard, allowing them roll their own borrowings whilst calling in monies and assets owed to them. It helps when you have to go begging to Sovereign Wealth Funds (SWF) to raise more cash. Don't expect an increase in dividend payments on your banking shares either, in fact don't expect dividends from a number of Financial Institutions for some time. Hank said it is okay not to pay out. It's the patriotic thing to do.

How much capital do Financial Institutions need to reclaim?

We know the situation has deteriorated with TAF limits now pushed out to $100Bn. Doing a simple calculation, it would appear that the update to the chart above (if total reserves are to be maintained at around $43Bn) will show non borrowed reserves are now at or headed for net minus $57Bn (TAF minus total reserves). When we drop into The Slosh Report (highly recommended for Fed watchers) we see that the total amount lent out by the Fed is currently $60Bn of which $44.8Bn is collateralised by Mortgage Back Securities (MBS).

The Financial Institutions are in the hole to the Fed for between $101.8Bn up to a possible $117Bn. Obviously this does not include any borrowings made with other Central Banks, Institutions or SWFs.

Let us make an assumption that the "Fed capital" is required to shore up FI borrowing positions and that they will have to repay it some time in the future. We will use the lower figure of $101.8Bn and a leverage of 5, which is probably very generous. FIs have a minimum of $509Bn in positions reliant on continued Fed lending. If the FIs have (want?) to cover then they need to reclaim $509Bn from the financial system. To do that they stop lending, call in margin, make margin cover and leverage more onerous and close credit lines and facilities.

If the $509Bn is leveraged by a factor of 10 by the borrowers (Hedge Funds, Mutual Funds, Insts, Private Venture, Buy out vehicles, off balance sheet vehicles etc) then the drawdown on the financial economy to close out could amount to $5090Bn.

Any attempt to do this in a disorderly fashion would result in financial Armageddon. Thus we see the rationale behind the Feds actions. It is an attempt not to mitigate the pain but to drip feed it, a little at a time, so the markets only feel a series of pinches, not a right hook. The result however will be the same.

If I had any funds invested with Hedge Funds or leveraged accounts I would be looking for the door. It is more than feasible that the situation is worse than the current headlines.

I have been watching the actions and words coming from PIMCO, specifically Bill Gross and his call to reject the worries of moral hazard:

• " And if Washington gets off its high "moral hazard" horse and moves to support housing prices, investors will return in a rush. PIMCO wants to sit at this more attractive return table - to provide an attractive return on your money (no matter what the asset class) as well as a return of your money. No Old Maids. No silicone AAA ratings. And ladies - no crotchety old bachelors either. The game, as well as the name of the game, is changing. It's no country for Old Maids anymore."(his emphasis)
  

At first glance its strange to see a bond maven calling for such a move, his job is to oversee investment to make returns on capital based on his projections for the future economy. Then I noticed this line in his March 2008 Investment Outlook letter:
"Old Maid now has a second life mimicking our financial markets, and at PIMCO we've played it frequently in our Investment Committee over the past several months. "Who's got the 'Old Maid'?" we ask over and over again - not to make us feel good that we don't - but to make sure we won't draw it when its holder tries to pass it on."

Mr Gross is saying, quite rightly, that his job is to avoid any potentially toxic assets leaking into his pond. Unfortunately sometimes a previously healthy asset already in the pool begins to decay, leaking toxins into the pond. In a small pond its easy to fish out the decaying matter, in a large lake, filled with cumbersome assets it can be much more difficult.

Has PIMCO found an Old Maid hidden in its hand?

Consider this, from Bloomberg :

• "Ross, chairman of WL Ross & Co., and Gross, chief investment officer of Pacific Investment Management Co., said they jumped at the chance to buy $1 billion of municipals each. Their interest helped to drive last week's rally in fixed-rate debt. Investors remain concerned that a flood of new issues from borrowers refinancing auction-rate debt will overwhelm demand while hedge funds and banks pare their purchases, analysts at New York-based Citigroup Inc. said in a March 7 report."
  

Now this could be viewed as an attempt to capture some cheap assets with high yields. It could be viewed as an attempt to catch a falling knife. I don't think the reasoning behind such a move is either of these options. Mr Gross has no qualms about causing a moral hazard which in financial markets means intervention. I suspect the intervention, an attempt to restore confidence, has more to do with PIMCOs own position than it does with the Municipal Bond market.

A quick look at Allianz Global Investors site highlights PIMCO exposure to Municipal Bonds. The PIMCO California Intermediate Muni Bond Fund A (PCMBX) has total fund assets of $130.5m, PIMCO California Short Duration Municipal Income Fund A (PCDAX) $14.7m and PIMCO High Yield Municipal Bond Fund A (PYMAX) $167.5m.

However, the Fund that caught my attention was one that you might not expect to find, if your notion of PIMCO is as a safehaven:

• PIMCO All Asset All Authority Fund A (PAUAX), total fund assets $772.3m, here is a description of the fund:

  Portfolio Construction

  "PIMCO All Asset All Authority Fund's portfolio invests in an expanded group of PIMCO mutual funds, rather than in individual securities, providing access to a variety of investments across both traditional and alternative asset classes. These underlying funds cover the full spectrum of traditional sectors of the stock and bond markets, as well as other asset classes, such as Treasury Inflation Protected Securities (TIPS), commodities, and real estate. Using a dynamic asset allocation strategy, as well as the potential use of leverage to attempt to enhance returns, the Fund's manager seeks to identify those asset classes and sectors that offer the most value at a particular point in the economic/market cycle. In keeping with PIMCO's dedication to risk management, the Fund contains internal guidelines to optimize risk controls, including:

  
  
  • No more than 50% invested in any single underlying PIMCO Fund.
    
  
  
  • No more than 20% invested in PIMCO StocksPLUS Short Strategy Fund.
    
  
  
  • No more than 50% invested in PIMCO Funds that track U.S. equity indexes.
    
  
  
  • No more than 331/3 % invested in PIMCO Funds that track non-U.S. equity indexes.
    
  
  
  • No more than 662/3 % invested in U.S. and non-U.S. equity funds combined.
    
  
  
  • No more than 75% invested in PIMCO Real Return Strategy Funds."
    

I have no doubt that Rob Arnott, the fund manager, is a sharp cookie and may well be rotating successfully between asset allocation models. What we don't know is the current composition of PIMCO mutual funds used within PAUAX and the amount of leverage currently employed. Maybe I am worrying too much, maybe things are fine and dandy at PIMCO. Then again, I have preserved a lot of capital by worrying.

That's it for this week, I have to finish this early today. Keep an eye on financials and Insurance (all types) as a measure of further market distress or intervention.

Welcome to the Weekly Report. This week the Federal Reserve made its intentions clear and set a course into uncharted waters, taking the US citizen to the land of deflation. We look at the reaction in the fixed income markets, take a long term view of the Dow using 2 propriety indicators to help identify long term trends and wonder what Fitch has done to upset MBIA.

The Federal Reserve has decided to acknowledge that the Banking system is in total disarray and is now unable to meet its own obligations. Some of you may remember I referred to the banking cartel as being "sub-prime".  I also pointed out a couple of weeks ago that the Banks no longer have any capital reserves that are usable. In other words all capital is now employed in current leveraged positions. Losses in those positions that result in margin calls, requiring more capital, are now being met by the Federal Reserve through repos (repurchase) and the TAF (Term Auction Facility).  As the stock markets slid into further losses on Friday the Fed announced new measures to attempt to bolster the cash at hand for the banks.

Let me make one thing abundantly clear, this is NOT an attempt to save indebted US citizens, Funds, Hedge Funds or any other Capitalist Venture. This is a major bailout of the whole US fiat monetary system. It is designed to save the current banking structure of the USA and by indirect means support the world banking system. No country is immune (except Zimbabwe, whose currency might appreciate against the dollar) that uses a leveraged fiat monetary system.

Here is a prediction that might be seen as somewhat risky. By the end of 2009, I expect at least one trading currency in the world adopt a gold standard and regulate against leverage.

Back to the Federal Reserve and its new measures aimed at keeping leveraged trading in all markets possible and that all but officially announced it is now the Bank of Last Resort. There were 2 statements on Friday, the first concerns the TAF, the second related to the repo markets, covering both temporary and permanent operations. We had a warning that conditions are deteriorating as mentioned last week and now the Fed has been forced to take action.

The Fed announced that the TAF in March would be raised to $100Bn and continue to operate over at least the next 6 months. The Fed said that the action was to "address heightened liquidity pressures in term funding markets" and "to provide increased certainty to market participants" until market conditions improved sufficiently to allow the TAF to be discontinued. The Fed will accept Treasuries, Agency debt and Mortgage Backed Securities as they do in normal repo operations.

In conjunction with the increase in the TAF limit, normal  temporary open market operations would also be increased in size, totalling up to $100Bn  using 28 day repo agreements.

Both the TAF and the new 28 day repos could be increased in size "if conditions warrant". However the Fed then made it very clear, beyond the statements made above, that this increase of $140Bn (TAF was already at $60Bn) was to directly help bank balance sheets and not to increase monetary liquidity by also carrying out a permanent open market operation. The Fed trading desk announced it was selling $10Bn of US Treasury Bills to the markets "in order to   maintain a level of reserves consistent with trading at rates around the operating objective for the overnight federal funds rate." The Fed trading desk also announced this little snippet:

"The Desk will continue to evaluate the need for the use of other tools to add flexibility to its open market operations. These may include further Treasury bill sales, reverse repurchase agreements, Treasury bill redemptions and changes in the sizes of conventional RP transactions"

We have conclusive proof that Fed is attempting to drain cash from the economy to support rates (and indirectly the $) whilst pumping funds directly into the balance sheets of the banks. Therefore the whole series of measures are not to deal with a liquidity issue but are to combat a breakdown in the capital reserves of the banks and a freezing/tightening/collapse of the credit markets.

US banks are being nationalized, temporarily, whilst they attempt to take cash away from all sectors of the economy, by either de-leveraging positions or calling in all debt owed to them on the flimsiest of excuses. Any non-performance in debt servicing by either Corporations or private citizens, for whatever reason, will result in immediate and swift foreclosure and an asset grab. I expect most credit lines to be withdrawn and limits imposed on the size of cash transfers and withdrawals in the very near future. All of these actions are to bolster bank reserves and the Fed itself believes this will take a minimum of 6 months. Some believe that is not enough. Kansas City Fed Pres. Hoenig called for the TAF to be made permanent.

It should be noted that if you use leverage or margin to trade markets, be prepared for that facility to be curtailed or withdrawn completely, forcing you to close your positions. Why would this occur? To enable further deleveraging and reallocation of capital and it's a very effective way of removing private investors from the markets. The Financial Institutions (FI) are in pain, they wouldn't like to have to move cash in the direction of private investors.

Am I being hysterical in my reaction to recent events? No I am not. The Fed and the FI's have yet to surprise me in their response to this self imposed crash; as conditions worsen I expect further draconian measures to be visited upon us.

For some, this is already happening in their everyday lives:

The green line shows CPI for all urban consumers minus energy, the red line is CPI for all items (both right scale).  The argument that consumers are spending more on energy and less elsewhere is weak. What we do see is that rising CPI is not causing an increase in $ spending by consumers as seen by the blue line, showing retail and food services sales y.o.y (left scale). CPI is climbing higher but the amount spent is deflating year on year, as can be seen by the minus reading.

The price of goods may well be rising but the consumer isn't buying. I have said before, it doesn't matter how expensive an item is priced if no one buys it. Market forces will ensure that either prices fall to meet the reduced ability to spend or goods are no longer produced if that re-pricing makes it an unprofitable enterprise.

It should not be ignored that this deflationary effect is starting from a much lower base than the previous period covering the recession in the early 00's. The cushion of consumer spending power has been removed. Consumers are already suffering from a monetary deflation.  I believe the cause is due to higher costs for servicing all debt and yet again the financial system will rebalance the capital reserve ratios at the expense of the US consumer.

There are possible signs that the credit market turmoil has spread to the Corporate Bond market. Whilst rates in Treasuries have been falling and have been followed down by the Fed Fund Rate, Corporate Bonds have maintained their yield levels from the beginning of 2007. Although the Corporate Bond yields have moved within a range there was a slight downward bias that occurred as Tsy's and the FFR fell, as you would expect in such an environment. Indeed even lower rated Corporate Bonds followed this pattern as can be seen in this chart:

The message I believe we see here is that the Corporate Bond Markets thought corporations would not be affected by the credit turmoil and that the requirement for a risk premium was purely down to the specific credit market problems. That is, there would be no spillover to the economy and therefore no requirement to price in a specific company risk premium.

I think that message has changed. Since the beginning of '08, even though the basis point  gap to Tsy's (black line) and FFR (orange line) has grown, affording more risk premium, both top (blue) and junk (green) rated Corporate Bond yields have begun to rise.  This dislocation can only mean that some in the corporate bond market now see possible or actual spillover effects that will affect the economy and company's on a widespread scale. Indeed, Moody's Seasoned Baa rated corporate yield is at new highs and has possibly broken out of the old well established range.

It is early days but with Aaa rated yields also moving higher this is a situation that must remain under close scrutiny.

This week we look at 2 propriety indicators that help identify longer term trends in stocks, specifically the Dow Industrials.

First up is the daily Dow chart going back to September 07 using a trend system that works equally well in bull or bear markets:

The Dow has broken and closed below support at 11928 as part of the move lower from late February. Unless the Dow rallies on Monday and moves above the 11928 ex-support then it would target a move to the January lows, circa 11640 and possibly a move to 11465. Only a close above 12145 trend support would have me looking for upside. 

Here is the weekly Dow showing the long term trend. This chart is used to identify periods of weak and strong market performance. As of the close on Friday and for the first time in 5 years the Dow is now in a weak performance period. Only a move by the indicator above zero, combined with a recovery above the moving average would negate this.

This is my opinion only, I do not recommend any trading stance or investment decision is taken based upon this information. The information is purely supplied as a view to my thoughts and not to be taken as advice under any circumstances.

Finally we look at a rather strange decision taken by MBIA. It appears that MBIA has asked Fitch Rating Agency to stop rating its financial strength but to continue to rate the company's credit. It isn't known if it has made the same request to other Rating Agencies.  MBIA had this to say:

"Fitch's ratings process differs in many significant respects from those of the other rating agencies, which affects how investors assess value……Fitch's coverage of the underlying credit quality of the transactions that MBIA insures is limited, and in turbulent times, the impact of this difference becomes significant, raising the risk of misinterpretation."

Could it be that Fitch's rating processes are more accurate and demanding than those of other rating company's? Has MBIA decided that it is easier to avoid meeting Fitch's rating qualification by just walking away? I expect further developments to appear about this as the week progresses.

Have a good week.