Welcome to the last weekly report. I would like to thank everyone who wished us all the best over the past week, it is truly appreciated.

This week we are going around the world courtesy of the St Louis Fed to see if the economy is reflecting the mood of the markets.

We start with the US:

NOTE: The charts plot four main economic indicators tracked by the NBER dating committee; each series is indexed to 100 at the start of the recession. For industrial production, employment, and real retail sales, the average series includes the 10 recessions starting with the November 1948 business cycle peak. For real income, the average starts with the April 1960 peak.

NOTE: The charts plot Real Gross Domestic Product (SAAR, Chn. 2005$) and its major components; each series is indexed to 100 at the start of the recession. The current recession (red line) started in the fourth quarter of 2007. The solid blue line indicates the average over the past ten recessions. The two dashed lines report the highest and lowest values recorded across the past ten recessions.

As you can see the only glimmer of hope is the possible bottoming out of the contraction of Industrial Production. Just about every indicator, with the exception of Government spending, is tracking below the lowest levels of the previous 10 recessions.

Let us now move across the globe, starting with Australia, who recently raised their interest base rate:

NOTE: The charts plot four main economic indicators similar to those tracked by the NBER dating committee for the U.S.; each series is indexed to 100 at the business cycle peak. The red line indicates the current recession. The solid blue line indicates the average of the previous seven recessions, starting with the April 1977 peak. The two dashed lines report the highest and lowest values recorded across these previous recessions.

NOTE: The charts plot Real Gross Domestic Product (SA, Chained) and its major components; each series is indexed to 100 at the business cycle peak. The red line indicates the current recession. The solid blue line indicates the average of the previous seven recessions, starting with the April 1977 peak. The two dashed lines report the highest and lowest values recorded across these previous recessions.

No wonder the Australians see the need to begin tightening, the potential for a new bubble, especially with the reliance of commodity exports built into the economy, is rising.

Next up is Canada:

Same methodology as above covering the previous 8 recessions.

Again the averages are over the previous 8 recessions.

Canada is interesting, its biggest trading partner is the US, unlike Australia which has the Chinese and the Far East markets. Canada may well be dragged lower as the US recession continues.

We move across to Germany, the economic powerhouse of the EU:

Again, the averages are over the previous 8 recessions.

Again averages over the last 8 recessions.

The only indicators that have not dropped dramatically are those directly affected by fiscal stimulus measures. The EU is not out of the woods yet.

Now the UK:

Averages of the previous 7 recessions.

Averages over last 7 recessions.

The UK looks very similar to the US, which should not surprise readers.

Finally, Japan:

Averages over the previous 4 recessions.

Again over the previous 4 recessions.

Whilst there are some signs of improvement for Japan according to the economic indicators, the GDP data looks appalling.

Overall there are few signs globally that point to the recession ending soon. Australia looks attractive but it is reliant on continuing demand from the Chinese and the Far East. With the EU,UK and the US still contracting the Chinese and FE might find themselves without a market to export to. If you wish to keep an eye on these indicators in the future, visit The St Louis Fed

So, that's it. We reach the end of the Weekly Report and I would like to thank you all once again, it's been a pleasure writing for you all. Keep an eye on the website every so often to read my irregular Occasional Letter.

Until we meet again, goodbye.

This week we concentrate on the US Dollar but start the article with some personal news.

As you may remember I started the subscription service about 18 months ago to stop the unauthorised reproduction of articles on other sites and plagiarised versions appearing in and around the main stream media. It was the driving force behind starting the site and hence I ran it as economically as I could which helped keep subscription costs very low. Just after its inception I had taken on a consultancy role to help out a public body whose finances were somewhat struggling. This week I have been offered a permanent role which includes a wider portfolio of responsibilities and hence more work. I knew the offer was coming and have thought long and hard about whether it is possible to keep doing the proper research to produce weekly articles that have sufficient quality to justify a subscription service.

Sadly the answer is that I cannot devote the time to keep producing worthwhile articles on a weekly basis. So with immediate effect I will not take further subscriptions or renewals for An Occasional Letter and will wind the site down over the next few weeks. Many of you came across from the free blog and some have been regular readers of my econo-babble for years. We have walked down the first and second scenarios together and hopefully all that took place from 2007 onwards didn't come as a huge surprise for you. I shall keep the website going for the foreseeable future and I will re-organise the archives so that they can be accessed without a password. When I can I shall produce articles, it will be on an ad-hoc basis and available to the public at the website. So, its not goodbye, more like a good neighbour who has moved away.

Back to the matter at hand, the US Dollar and its conversion to the new carry trade of choice. For years the Yen was the carry trade of choice, it had a constant flow of liquidity and very low borrowing costs. It could be borrowed, sold and converted to higher yielding currencies to gain a higher return. The Yen carry was one of the main drivers of the asset bubbles we saw in the previous ten years or more.

Now that preference has switched to the US Dollar which has massive liquidity and extremely low borrowing costs for Banks and Institutions. Selling dollars to buy practically any other asset is the name of the game.

Lets look at some charts, courtesy of Stockcharts, that show what has happened this year, especially since March:

It's a bit busy but stay with me here. The red line is the dollar used as a baseline to measure the +/- % move of other assets, in this case gold, sterling, yen, 10 year US Treasury price and the Dow. Prior to the March QE / ZIRP announcement by the Fed, the dollar was the strongest asset to have, with only gold holding its own. Once the QE announcement became public the dollar immediately began to devalue against all assets, even US Bonds were stronger than the underlying currency. Here are 2 charts with gold as the baseline:

You wouldn't believe it from the press coverage in the UK but Sterling has devalued the least against gold when compared to the Yen, Dollar and the Euro. However all the currencies have been involved in increased liquidity by Central Banks.

With Gold again as the baseline, this time compared to the Nikkei, Dow, FTSE, DAX and US 10 Year Treasury price. Again the dollar priced assets suffer badly with the Dow down 17% and the 10 year note down 33%. Again the surprise is the FTSE (considering the UK QE policy) which has gained against Gold since March. The surprise is that the FTSE has done as well as the DAX considering the Germans have been reticent about increasing domestic liquidity through fiscal stimulus. The Nikkei compared to Gold has performed strongly from March until September when Gold saw the move toward the current high begin. So what does this chart tell us? Simply dollar assets are being sold with the proceeds going into other currencies, even Gold saw an erosion of its March premium when compared to non-dollar assets.

Finally I am going to add the US Dollar as the baseline and introduce the Australian Dollar:

With US Dollar as the baseline the picture becomes clearer. The asset to hold in this list was the Aussie Dollar, up 50% against the USD and outperforming Gold. Anything with a yield, even USD denominated assets, are more attractive that the USD. Interestingly the US 10 year note is outperforming its benchmark rate with a 7.5% return over the USD. No wonder we are seeing a re-flation period, the over-performance against the 10yr note yield can only be caused by higher demand.

However whilst the re-flation trade has boosted asset prices, with some equalling or exceeding Gold's rise, it is all based on one simple strategy and therefore all the risk is concentrated on one side of the trade. The trade is to sell borrowed US Dollars and buy anything with a yield that outperforms the interest payments and the % devaluation of the Dollar. Any guesses what the Australian stock market looks like?

From a low of circa 3050 the All Ords has reached 4800, a 1750 point increase, well over 50% from the March low. Is this just a one off or is it a wider happening? Without listing them all, here are a couple more examples:

Brazil:

Mexico:

This one way bet is fraught with danger. For me Gold, foreign stocks and other commodities are being used as a transfer medium, a way of selling US Dollars into an asset that can later be converted to other domestic currencies to recover the yield and currency appreciation. This is a typical carry trade pattern of behaviour.

We know that the Fed intend to slow and stop aspects of the liquidity schemes and QE starting this month which will have a tightening effect on money supply, causing a rise in the USD. This will crimp USD carry trades and cause some unwinding, adding to USD strength in the short term. Looking further ahead to when the Fed decide its time to reverse the liquidity schemes to recover the cash and cash like assets (in exchange for the assets they bought) the demand for the USD will rise substantially. That will cause a much more severe unwinding of the USD carry trade. If the Fed sticks to its timetable as shown in the FOMC 23 September minutes:

• To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt. The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010. As previously announced, the Federal Reserve's purchases of $300 billion of Treasury securities will be completed by the end of October 2009.
  

As if to show the correlation between the Fed actions that increase liquidity and the rise in non-US assets here is a chart of Fed purchases of Agency debt and MBS:

Roughly $550 Billion to go, this ongoing liquidity injection is why any post October correction will be minor.

However the following chart is the elephant in the room from Q2 '10 onwards:

The US Treasury purchases are almost complete. Whilst many are talking of a need to unwind $2.1 Trillion I suspect (like the Japanese did) we will see an unwinding of $1.2 Trillion to return the Fed to its pre-August '08 level of holdings.

Whilst the USD can be seen as weak and could be heading lower in the short term, the longer term bias toward non US investment is reliant on US easy money policies. As we have seen time and time again when everyone is betting in one direction any unwinding cannot be orderly. Many foreign Central Banks and commentators are calling for USD support, they may wish to ponder this request when they see where the money has come from that re-flated their own economies. Instead foreign Central Banks should be looking further out and readying themselves for the eventual reduction of US Dollar liquidity.
To give you some idea of what the Fed is thinking, here is a portion of a speech given by Ben Bernanke on the 8th October. I have headed straight for the piece titled "exit strategy":

Exit Strategy

My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. Looking at the Federal Reserve's balance sheet is useful, once again, in helping to understand key elements of the Federal Reserve's exit strategy from its current policies (slide 7).

As we just saw in slide 6, banks currently hold large amounts of excess reserves at the Federal Reserve.

As the economy recovers, banks could find it profitable to be more aggressive in lending out their reserves, which in turn would produce faster growth in broader money and credit measures and, ultimately, lead to inflation pressures. As such, when the time comes to tighten monetary policy, we must either substantially reduce excess reserve balances or, if they remain, neutralize their potential effects on broader measures of money and credit and thus on aggregate demand and inflation.

To some extent, excess reserves will automatically contract as improving financial conditions lead to reduced use of our special lending facilities and, ultimately, to their closure. Indeed, as I have already noted, the amount of credit outstanding in the first two categories of assets (short-term lending to financial institutions and targeted lending programs) has already declined substantially, from about $1.5 trillion at the beginning of the year to about $350 billion. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Federal Reserve mature or are prepaid.

However, even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time--paying interest on reserve balances and taking various actions that reduce the stock of reserves. In principle, we could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

The Congress granted us authority last fall to pay interest on banks' balances at the Federal Reserve. Currently, we pay banks an interest rate of 1/4 percent. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate. In general, banks will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk. Thus, the interest rate that the Federal Reserve pays should tend to put a floor under short-term market rates. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed. Considerable international experience suggests that paying interest on reserves is an effective means of managing short-term market rates. For example, the European Central Bank (ECB) allows banks to place excess reserves in an interest-paying deposit facility. Even as the ECB's liquidity operations have substantially increased its balance sheet, the overnight interbank rate has remained at or above the ECB's deposit rate. The Bank of Japan, the Bank of Canada, and several other foreign central banks have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

Although, in principle, the ability to pay interest on reserves should be sufficient to allow the Federal Reserve to raise interest rates and control money growth, this approach is likely to be more effective if combined with steps to reduce excess reserves. I will mention three options for achieving such an outcome.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements (reverse repos) with financial market participants, including banks, the GSEs, and other institutions. Reverse repos, which are a traditional and well-understood tool of monetary policy implementation, involve the sale by the Federal Reserve of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date. Reverse repos drain reserves as purchasers transfer cash from banks to the Fed. Second, using the authority the Congress gave us to pay interest on banks' balances at the Federal Reserve, we can offer term deposits to banks, roughly analogous to the certificates of deposit that banks offer to their customers. Bank funds held in term deposits at the Federal Reserve would not be available to be supplied to the federal funds market. Third, the Federal Reserve could reduce reserves by selling a portion of its holdings of long-term securities in the open market. Each of these policy options would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has a wide range of tools for tightening monetary policy when the economic outlook requires us to do so. We will calibrate the timing and pace of any future tightening, together with the mix of tools, to best foster our dual objectives of maximum employment and price stability.

Conclusion

By using our balance sheet, the Federal Reserve has been able to overcome, at least partially, the constraints on policy posed by dysfunctional credit markets and by the zero lower bound on the federal funds rate target. By improving credit market functioning and adding liquidity to the system, our programs have provided critical support to the financial system and the economy. Moreover, we have carried out these programs responsibly, with minimal credit risk and with close attention to the exit strategy. Our activities have resulted in substantial changes to the size and composition of our balance sheet. When the economic outlook has improved sufficiently, we will be prepared to tighten the stance of monetary policy and eventually return our balance sheet to a more normal configuration.

That's it for this week.

Welcome to the weekly report. Over the past few weeks a number of Federal Reserve Bank Presidents have put out warnings about the possibility of declining prices.

Charles Evans, President of the Chicago Fed recently took on the task of discussing the possibility of either inflation or deflation occurring in the future. The speech he gave on the 9th September shows the methodology behind Fed thinking about which threat is the more likely to occur. Evans succinctly sums up the current debate between the Deflationist and the Inflationist camps:

• "During normal times, inflation evolves gradually, and this debate rarely spills over into major disagreements about policy. But, today, we are not in normal times. The inflation debate on the determinants of inflation has broken out on the front pages of newspapers, with major disagreements among distinguished experts. For example, in recent New York Times op-eds Paul Krugman said that large resource gaps have made him worried about deflation, while Allan Meltzer said that massive growth in the monetary base has made him worried about inflation........

  ......So it is quite disconcerting when highly regarded analysts talk about the possibility of another debilitating deflation while others-just as highly regarded-suggest that even though we have avoided the Great Depression 2.0, the U.S. economy may be facing the Great Inflation 2.0.

• "In brief, I think neither a harmful deflationary episode nor a repetition of the Great Inflation is very likely. Stimulative policies combined with the economy's resilient market forces will, over time, reduce resource gaps. Deflation has been averted. And as the economy continues to improve, and when we see rising inflation pressures, Fed policy will respond aggressively. Having said this, the main threat to these outcomes would be if clear danger signals were ignored or if central bank independence were compromised."
  

Evans concludes his speech in the normal manner (the Fed is right and whilst deflation is dead, inflation is under control):

• "Policy conclusions

  
  I started today by describing two extreme views for the future of inflation. One view, motivated by the expanding Fed balance sheet, has inflation greatly increasing in the future, while the other view, motivated by a sluggish economy and large resource gaps, has strong disinflationary forces. My view is that large resource gaps have been met by a large growth in reserves: In an effort to prevent a repeat of the Great Depression, the Fed acted quickly and decisively over the past year to provide liquidity to markets and to prevent systemically important institutions from failing."
  

• "Will such operations have any effect on expectations about future policy? Open market operations in foreign exchange (or any other private asset) would lead to a corresponding increase in public debt defined as money plus government bonds. This gives the government an incentive to create inflation through exactly the same channel as I have explored in this paper and, therefore, leads to a corresponding depreciation in the nominal exchange rate hand-in-hand with the rise in inflation expectations. An advantage of buying private assets, as opposed to cutting taxes, is that it does not worsen the net fiscal position of the government. It only changes the inflation incentive of the government."

We look over to the FDIC to find out why the Banks are acting this way:

Look at the total exposure to tier 1 capital (credit equivalent amount = leverage), this is a % reading showing that banks have a long way to go before they balance the books. We can also see that the exposure to risk and losses is still concentrated with the big banks, those considered "too big to fail". Until the tier 1 coverage to total exposure goes below 100% (i.e. enough tier 1 capital to cover liabilities) Banks will continue to accumulate reserves and restrict credit lending activities. The longer term implications are that Banks will have to keep the ratio below 100%, so to expand credit lending in the future Banks will have to raise further reserves, something that will be extremely difficult to do if the Fed withdrew its liquidity.

This of course is deflationary as we have discussed many times before. A credit based fiat money system is utterly reliant on expanding credit flows to function, the offset being a system that always has an element of monetary inflation as the norm. This embeds the need to expand asset prices, our famed credible expectation of future inflation, which results in price inflation rising slightly higher than credit creation in an attempt to keep the net worth of the asset stable.

The removal of an expanding flow of credit, let alone a contraction, causes monetary inflation to fall and re-values assets lower in real terms as the need to inflate prices is negated. The Fed is currently trying to jawbone inflationary expectations higher with talk of quick action to reverse stimulus when the recovery becomes entrenched.

How does this jawboning match up to the current readings of the US economy? Let's finish off with some charts and figures that reflect what the Fed is watching:

This is from the Livingston Survey, sponsored by the Philly Fed:

Lowered inflation expectations and I'm not even smiling.

GDP from the NEA:

Still contracting but at a slower pace.

Both imports and exports still remain in contraction.

Unemployment, 1 month net change from the BLS:

The economy continues to lose jobs, though the rate has slowed. Christmas hiring, or the lack of it, will affect Q1 '10.

Industrial production looks anaemic, even after the lay offs.

Capacity utilisation remains very weak and the excess capacity will continue to keep price inflation low.

Finally M2 (money stock) from the St Louis Fed, the chart shows the % change from a year ago:

And this one the amount:

The rate of growth for M2 has halved as the Fed caps the injection of liquidity, I expect this chart to go negative, unless we have another bank crisis. To round off here is revolving and non-revolving outstanding credit, both deflating:

We are still in a deep recession with all the indicators showing downside, albeit they are falling at slower rates, the circumstances should see more stimuli from the Fed. However as shown above the Fed has restricted the flow of money since March and that combined with the continued reduction of credit now makes the intention to end QE somewhat hazardous. Without the continuing liquidity supply from the Fed, Banks will have no option but to tighten further, strangling off credit. Unless the Fed decides that QE will have to continue I am firmly in the double dip recession camp.

Dow update. Here is the weekly Dow chart, showing the wedge and now the negative divergence I mentioned could occur a few weeks ago. The indicator is still above zero so I expect any drop to be more of a correction than a new downtrend. If it does become a new downtrend I would expect to see indicator action similar to that in the 3rd quarter '08, a break below zero.

Have a good week.

Welcome to the Weekly Report, this week I want to look at some charts to see if those "green shoots" are still growing or showing signs of withering.

First up, manufacturer's new orders, excluding defence and aircraft:

This chart is not reflecting a sharp V shaped recovery, we could be in for an extended period of a sideways to down drop in new orders.

Unemployment may well remain elevated for some years, probably at higher levels that we see here.

The rate of initial claims has fallen but is still elevated. A poor Christmas season could see this climb to new highs.

It is unsurprising that M2 has levelled off and now trending down, unemployment and contraction sucks money out of the system. Unless The Fed pumps on a weekly basis in the hope a trickle through effect continues M2 will fall.

Savings continue to grow as excess income is hoarded.

The Fed is allowing bail out schemes to unwind if the Banks no longer come calling. With interest rates at zero, the reduction of bailout funds, the announced end of QE and the end of the MBS purchase scheme in Q1 '10 will ensure a tightening effect on market liquidity.

The amount of securities held by Federal Reserve Banks. This quantity is the cumulative result of permanent open market operations: outright purchases or sales of securities, conducted by the Federal Reserve. Notice that the Fed did something it hasn't done since WWII, it reduced securities held. To do that the Fed sold the securities into the market absorbing cash. Did the Fed cause the credit crunch by removing liquidity just when it was need the most?

The long term view of the imbalance in the US economy. The red line shows exports, the blue line imports. As can be seen during previous recessions the gap between imports and exports closes, however such corrections have not balanced since 1991. The current re-balancing appears to have stalled, with imports still exceeding exports:

Therefore one of the only "benefits" touted for dollar devaluation has yet to appear. I suspect the drop of 20% in global trade has more effect than any devaluation.

Is global trade recovering? The Baltic Dry Index has given up half of its recovery bounce and continues to trend down. Has Christmas been cancelled? The brown line is copper, the weather-vane of manufacturing, which has stalled and lost short term support. Neither of these indicators gives me a warm feeling for the year ahead.

Last chart for this week but it contains a strong warning. The chart shows the consumer discretionary sector, note the negative divergence on the MACD and the doji candles showing resistance earlier in the week. If support at 26 fails then it could be that Christmas retail is going to struggle, if 24.5 goes then Christmas retail is in serious trouble.

The Durable Goods Report for August makes bad reading, rather than me reproducing it here, click on the link. The second page shows the % change from last year (far right column). I'm beginning to think my 20% reduction in global trade might be optimistic.

That's all for this week.

Welcome to the Weekly Report. The UK is facing some serious headwinds in its efforts to avoid a deflationary outcome to the near collapse of the banking system and the recession that continues to affect the economy.

Whilst the FTSE continues to rise the outlook for the medium term UK economy looks shaky and could easily enter a long term deflationary cycle. This week the government eventually announced that cuts would have to happen in public spending to re-balance the books. The Chancellor has started a series of meetings with Ministers to identify areas of spending that can be cut completely, reduced or deferred.

On Friday figures released showed that the Public Sector Borrowing requirement had ballooned, rising £16.1 Billion in August as the continued fall in tax receipts widens the gap between income and expenditure. The government spent just under £46 Billion in August, showing that a third of liabilities are to be funded through borrowing. Government debt now stands at over £800 Billion, over 57% of GDP. Current year borrowing is expected to reach £175 Billion although that figure now looks to be optimistic and could easily exceed £200 Billion. The last budget set by the Chancellor had a reduction in spending of just under 10% built into the mid term outlook and while this makes PM Brown look rather stupid in his attempts to avoid using the word cut, it does show that the need to rein in public spending is understood. However there is still a failure to realise that 10% cuts are not enough to cover the interest payments due on the new debt issued since 2008 that was used to bail out banks and stimulate public spending. All political parties in the UK are talking of a combination of spending cuts and tax rises to solve the funding shortfall however there are real problems with the currently proposed solution.

The current government, in power now since 1997, have used a wide variety of "stealth taxes" to raise income to support spending. The ability to continue to raise taxation will have to targeted directly on income, rather than on goods and services used by businesses and consumers. However raising taxation on income has some inherent problems that could reduce the expected return from corporate taxation and add further pressure to further reduce government borrowing and thus force deeper cuts.

The government's own figures show that currently it needs spending cuts and tax rises of around 6.5% of national income, amounting to around £90 Billion over 8 years, to negate the increase in borrowing required to see the UK through to recovery. (Readers can already see that some assumptions by the UK Treasury are not exactly set in concrete, e.g. when does the recovery begin?) The long term outlook has austerity written all over it, this from Robert Chote of The Times:

• For now the Government plans to begin this tightening next year and for it to intensify steadily over eight years. Over the first four years 80 per cent of the squeeze is set to come from spending cuts (including sharp cuts in capital investment) and 20 per cent from the tax increases announced over the past year. But we do not yet know which departments would bear the brunt of the cuts. As for the second half of the tightening, the Government has not said whether it would come from tax increases or spending cuts, although it thinks that capital spending would have suffered enough.

  The figures will make grim reading for Labour loyalists. They imply that by 2013-14 three quarters of the increase in spending on public services as a share of potential national income that Labour achieved during the years of plenty would be reversed. If even half the remaining tightening were to take the form of spending cuts, that would reverse the rest.
  

There are signs that the demand for funds from the Public Sector are going to outstrip the ability of the economy to supply the required cash. In other words the fiscal requirement to raise income taxes is going to make it harder for businesses to increase turnover, let alone profits. This will affect the amount of taxation that the government can raise from business. We are going to see a spill over effect of fiscal policy that will have an effect on monetary policy.

We turn to the bank of England to see if there are any beneficial effects from its ZIRP and QE policies. The BofE has been injecting liquidity through the purchases of assets to enable banks to stabilise their capital reserves and build excess reserves to allow lending to increase. That should show an increase in M4 (notes and coins, deposits and short term paper and securities held by BofE, Banks and Building Societies) and M4 lending as the trickle down effect takes hold:

M4 is dropping on a 12 month view and the 3 month annualised figure shows the drop is accelerating. The amount of cash in the economy is barely growing and M4 lending (credit) on a 3 month view is approaching deflation. If current trends continue then a de facto tightening will occur and with base rates already at 0.5% a liquidity trap looks very likely.

This may be why Mervyn King, Governor of the BofE, had this to say last Tuesday:

• "Money spending fell by over 4% in the year to 2009 Q2 and real activity fell by 5 ½%. Most of our major trading partners have experienced similar falls in demand. But both at home and abroad, there are now signs that activity is picking up. The key question facing the Monetary Policy Committee is whether this recovery will prove to be sufficiently strong and sustained to keep inflation on track to meet our 2% target.

  At present, though, most financial institutions around the world are focused on recuperation, giving them a powerful incentive to be cautious about extending new credit to households and businesses. That is acting as a direct drag on demand. But the crisis has also caused households and companies around the world to want to strengthen their own financial positions and that has acted as a further brake on spending."
  

The expected reduction of public spending, the increase of taxes on income and the reluctance of Banks to lend are all major deflationary forces which may force the BofE to carry out such unconventional actions mentioned by Mr King.

Whether this approach would work is reliant on consumer and business willingness to borrow. This is no small barrier for the BofE to overcome and they refer to it in the Quarterly Bulletin 2009 Q2, in a paper called Quantitative easing:

• "The overall impact of asset purchases on spending will also depend on how households and companies respond to changes in their money holdings and asset prices. The impact of higher money holdings will depend, for example, on the extent to which households and companies choose to pay down debt or increase spending.

  Companies facing a lower cost of borrowing, as yields fall, are likely to spend more on investment projects, for example, but the impact will also depend on the expected demand for their products. The extent to which the policy stimulus contributes to an improvement in confidence is therefore likely to be important.

  The impact on household spending of an increase in asset prices will depend in part on whether it is perceived to be persistent. If households expect asset prices to remain higher, the impact on spending is likely to be stronger. Alternatively, additional wealth may be used to provide a precautionary buffer against future income shocks, and so have a more limited impact on current spending. Some wealth will be tied up in pension pots or other funds. Increases in the value of these assets may be less visible, or more difficult to access, so households may be slower to respond. Such examples illustrate the uncertainty surrounding the impact of asset purchases on aggregate spending. "

We are about to see what happens when Eggertsson Theory is not applied in full. The UK is fearful that continued fiscal spending enabled by increasing debt will increase interest rates. With markets dropping hints that the UK has to make progress toward cutting spending and slowing borrowing this fear is probably justified in normal circumstances. Further asset purchases beyond the £175Billion earmarked by the BofE would be viewed as monetisation of debt, causing markets to devalue Sterling and Sterling based assets.

Deflation is not dismissed by 12 months of fiscal and monetary expansion; especially if the mechanisms of recovery are constrained by the unavailability of cash and an environment that encourages savings (Remember our discussions about cash becoming an asset?). The withdrawal of fiscal stimulus alone would cause a return to a contracting economy; the cutting of public spending would embed such contraction for the long term. In such an environment banks would not be encouraged to lend if the interest rate on reserves went negative, the ability to hold cash as an appreciating asset would offer risk free returns and the possibility of better future investment returns as asset prices fall.

Remember Eggertsson Theory calls for the appearance of credible irresponsibility by government and central banks to engender future inflation expectations. Ceasing such actions before inflation expectations are realised by the appearance of sustained real inflation will guarantee that QE will not have the desired effect, both consumers and business will not adopt the spending and investment strategies that the BofE have based their model upon.

As the FTSE continues to rise and the shills and mainstream media talk of the end of recession (and point to the FTSE as proof!) there seems to be an unwillingness to recognise what is coming towards us. We should not be surprised that yet again the markets will be ramped right into the oncoming period of austerity, however the onus now lies with us to ensure we protect our investments. No one else is going to do it for you.

Welcome to the Weekly Report. Thank you all for your patience whilst I took my holiday break, I thoroughly enjoyed my time off and would recommend taking a cruise through the fjords of Norway, the scenery was wonderful. I realised something quite important over my break, especially during the cruise. Life is still going on, people are still spending and generally seemed relaxed. However, once the economy surfaces in a discussion people almost visibly draw themselves into a huddle and talk warily about the long term prospects. Nearly everyone is saving and being careful about discretionary spending, talking of only one cruise a year rather than 2 or dropping the ski trip in favour of next years summer holiday. The people I talked to are not poor, they are reasonably affluent, employed and not over-stretched (as much as one can tell). Across the board the rejection of large scale debt seems entrenched in the consumer mindset, with the exception of mortgages. No one mentioned expanding there spending plans, even if the recovery becomes embedded and the crisis is consigned to history. A true change in the thinking of these affluent consumers has occurred and is unlikely to change for some years.

Whilst such remarks as above are from a narrow consensus and not exactly scientific it is interesting to note that the public seems much more aware of the bigger picture now than they did in 2007 or 2008. I put that down to the lagging interest of the mainstream media who didn't really start to produce documentaries and in-depth programmes until late 2008. Does such a mind set change for the public denote a bottom of the market syndrome? A question we will revisit in the future, no doubt.

The talking point over the past 2 weeks seems to be the rise in gold, however for me the talk should be about the dollar. Here is a comparison chart, with the dollar as the baseline, showing the % moves in the Dow, gold, euro and yen:

The dollar is the pink line. This is the typical pattern of an inflation trade which started with the Fed's adoption of QE and ZIRP back in March as assets appreciate against a falling dollar. The problem with this theory however becomes evident on the following chart, were the price of 10 year US Treasuries is inserted (I have removed the Dow to make the chart less cluttered):

The dollar is still the baseline, now coloured green. The light blue line is the price of the US 10 Treasury. Like the other assets shown, UST bonds are rising in price, yet the underlying currency is depreciating. This is not how bonds should price themselves, if the currency is depreciating, bond prices should fall as a higher yield is demanded to compensate. This chart is saying that UST's are safer than the currency they are priced in!

Let's have a look at the 10yr chart, this is a weekly view with a simple moving average of 50 and a MACD:

If this was a share, the only worry about buying it would be possible resistance from the 50ma. We have a higher low that looks like a double bottom, a breakout from the year to date downtrend and a MACD that has crossed and is turning higher. Why is this chart of the 10yr so bullish when we consider that it is priced in US dollars? Unlike gold or oil where prices rise because the dollar's worth goes lower, the 10yr is effectively a bundle of dollars; it should track the move of its underlying currency if bond buyers are worried about the inflationary effects of a weakening currency. Let us not forget, the Fed told us they are slowing and stopping the purchase of UST's by the end of October. The biggest single buyer of Treasuries has announced its future withdrawal from the market, the dollar is threatening to drop further:

to around 72 and someone is buying. I doubt even Greenspan could label this a conundrum, it's a flat out contradiction of what you would expect to see.
I had a look at Bloomberg to see what they had to say:

• The almost 2 percent decline in the dollar this week against a basket of currencies of six trading partners has bolstered the attractiveness of U.S. assets to international investors.

  The Dollar Index, which measure the performance of the greenback against a basket of currencies that includes the euro, yen and pound, retreated for a sixth day in its longest losing streak since March.

  "All dollar denominated assets are getting cheaper, including Treasuries," said O'Donnell of RBS. "Treasuries don't look that bad even though rates are at the low end of the three month average."
  

Look over to the right hand side, around the time of the Bear Stearns Hedge Funds imploding. Now look at the centre of the chart around February '07 when the yen carry trade was partially unwound. Another example occurs in May '02, just before the Dow took at 20%+ drop.

Are we looking at a safe haven trade that was placed in the early summer that attempted to anticipate the July low? If so it looks as though the trade was wrong as the Dow happily bounced from that low to its current levels. Or more ominously is the event yet to happen?

The divergence I showed to you in August still exists, along with the rising wedge. I cannot say that we have a reversal of the current various asset markets close at hand but I shall be watching the current reflation trend closely from this point on.

My only other worry is that I am mis-reading the situation and the uptrend for stocks will continue as we saw from 2004 to 2007. Calling for an end to such a trend now would be a mistake. So my advice is to look closely at where the risk is to your positions and have a plan to protect profits if you are long the current up trends (or if you are short dollar).

Welcome to the Weekly Report. I am about to start my holidays so this weeks article is short and sweet. There will not be an article for the next 2 weekends.
This week I want to share some charts with you that I regularly review.

I use this chart to show longer term divergences between my proprietary indicator and the Dow on a weekly basis. As you can see the indicator reflects volatility, it also shows bull / bear conditions with bull conditions above zero and bear conditions below. The divergences help to identify turns in the market. Currently I am watching the rising wedge but more importantly the possible divergence (the rise in the Dow may not be over and the current divergence may well disappear.) that is forming from the previous high to the current level of the Dow.

I like the indicator; it has a proven track record. Here are the same chart parameters from 2001 to 2005:

The familiar feel of the 2002 Dow and the 2008/9 Dow does keep me on the cautious side, especially as I don't believe the current economic fundamentals are conducive to a "V" shaped rally.

The following chart shows the dollar (pink), euro (green), yen (blue) and Dow (red). Clearly not all the move higher in the Dow is because of dollar devaluation but the relationship is still intact:

The following are from the ISM July reports, firstly manufacturing then non manufacturing (with comparison to manufacturing):

Clearly the rate of contraction in manufacturing is slowing and in places showing signs of growth. However the non manufacturing sector, the larger part of the economy, is still depressed. Notably pricing power in the services sector is under pressure as new orders and business activity continue to contract at a faster pace.

Commercial paper, of all sorts, continues to show contraction with asset backed paper down by over 60% from the 2007 peak.

Conditions are relatively benign, as shown by the contracting of the spreads:

The availability to securitize debt and use it as collateral to raise funds in the CP markets has been crushed, in effect the Fed is the only lender willing to grow its loan book. The withdrawal of QE in October seems a strange and dangerous decision after viewing these 2 charts.

Is demand for residential and commercial mortgage loans seeing recovery?

Sub-prime lending no longer exists. Whilst non-traditional and prime lending saw a rebound in late 2008 that seems to have slowed, however prime demand is still showing a real increase. This is unsurprising as credit standards remain tight.

Finally for this week, commercial real estate loan demand:

Demand remains very weak, even as the level of tightening standards slows (not dropping, just slowing):

That's it for this week, I am about to start my holidays and will return with the next article the weekend of the 12 September.

Welcome to the Weekly Report, this week we look at what the Fed had to say and get the answer to last weeks Occasional Letter:

• "Now having carried out the Eggertsson plan, invoking QE and ZIRP, there is no choice but to follow the plan, withdrawing the stimulus now would result in 2 outcomes, namely credit would contract at a higher rate and everything that the bank/dealers had purchased since March would be dumped in a fire sale. Far too many econo-bloggers and all of the mainstream media are desperate for the public to believe that the current situation is a typical recession that will result in a typical recovery. Many are following an inflation based investment strategy and need investors to believe it's the right path to follow."
  "We return to our central question, how long will the reflation last for?

  Simply it will last as long as the bank/dealer fraternity see no risk to their access of funds. That risk will be measured by watching the Fed and the US Treasury's ability to raise cash in the bond market. So far the Fed remains firm in its intent, that the reversal of the stimulus remains a distant prospect."

• "To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October."
  

The Fed introduced QE and ZIRP to defend against the forces of deflation. The deflation was not the lack of cash in the economy; it was the destruction of the credit mechanism and the consequential loss of the ability to draw on what are effectively future earnings. Asset prices were driven higher by the availability of credit derived income, causing assets to be mis-priced higher due to the illusion that credit, especially leverage, would always be available and expanding. When credit deflated the purchasing ability of all sectors of the economy suffered a contraction and assets were re-priced lower.

The Fed has now decided to carry out an experiment (because it may well be that QE will have to return) slowing the pace of QE and withdrawing the facility by the end of October. Interestingly ZIRP will continue:

• "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."
  

However, along with other Fed schemes, the main by-product of Fed purchases has been an injection of cash into the Primary Dealers and those Banks allowed to deal directly with the Fed. The result of the Fed liquidity injection is plain to see, a historical look, comparing the last recession to the current:

The required reserves continue to climb and are obviously supplemented (or enabled) by the injection of Fed cash into Bank/Dealer coffers.

The intent to create a stimulus led bounce has worked, albeit muted compared to the previous asset bubbles:

The top chart shows reserve balances with the Federal Reserve which began to accumulate above historical norms in the autumn of 2008 as Banks started to hoard cash as an asset and place it with the Fed. Notice that this hoarding of cash began after the deleveraging events in assets had been triggered. The next 2 charts are (in order) the Dow and oil. Clearly cash transferred to bank reserves from other assets into the beginning of 2009. Thereafter stock and commodity performance correlates almost exactly to the increase or decrease in the level of reserves. Many are claiming that banks are refusing to use the excess reserves gifted by the Fed, as we can see that would appear not to be the case. Whilst the reserves are not being used to increase credit facilities for the wider economy they are being used to place a bottom under the markets. Further it would not be that surprising to find that occasional profit taking has added to the reserves pot.

It is at times like this that watching such comparisons helps us to plan ahead. The use of QE has enabled the banks to increase reserves and place a floor under asset prices. We know that QE is going to slow and eventually finish in October; the game is going to change.

We need to think of the effects of QE in the same light as inflation. An economy that is based on the use of credit needs inflation to work, banks charge interest to offset the effects of inflation as new "cash" is constantly created to meet the demand of further credit creation and the payment of interest. QE is used to replace the lost inflation when credit demand collapses and cash becomes an asset worth hoarding (saving). Thus even though the end of QE does not mean that the excess liquidity is called back by the Fed; it does have the same effect as a deflationary episode by reducing the further expansion of available cash. By now readers you should all be well aware of what happens when liquidity is restricted, credit tightens, cash becomes scarce and assets have to be sold to meet cash requirements.

The Fed is gambling that the levels of excess reserves will be sufficient by October to allow all markets to function correctly. It's not as if the Fed hasn't looked at the previous example of what happens when QE ends:

We see that during Japans QE episode excess reserves rose in synchronisation with the increase in liquidity pushed into the financial system. Each injection resulted in a floor being placed under the Nikkei. However it required further massive injections before the Nikkei found any form of rally. Not until 2005, 4 years after QE was introduced, did the Nikkei manage a rally of some magnitude and move above the 14,000 level. However the '05/'06 rally was part of the goldilocks scenario, were excess credit based liquidity was trying to find a home in any market or asset. In the current US episode, we are approaching the beginning of the plateau seen in the Japanese example in late '03. The Nikkei went into a narrow range of 10500 to 12000 until that final rally broke out of the range in mid '05.

The worry now is that the credit bubble that helped world wide markets in the mid 2000's no longer functions; there is no mechanism to replace the lost expansion of cash that will occur when QE liquidity injections stop.

Again we can look at Japan and examine what happened when the liquidity from QE was withdrawn. The initial reaction from the Nikkei was a sharp retrace of near 4000 points back to the 14,000 level. You have to look closely but you can see that liquidity was temporarily increased in mid 2006, coinciding with the obvious buying support (the long lower wicks on the candles) for the Nikkei, resulting in a final, weak rally into the 2007 high. Thereafter the Nikkei joined the rest of the worlds markets and suffered deleverage as credit markets imploded.

The point of this is to demonstrate the weak behaviour of the Nikkei when the amount of QE liquidity levelled off. Importantly we cannot ignore what happens when the reduction of QE was too rapid to allow it to be replaced by other sources of liquidity.

The best we should hope for when US QE halts its expansion in October is that the Dow goes into a sideways trading range, probably after a sharp fall. That fall will probably begin prior to the official end date as profits are taken in anticipation of a loss of the ability to support share prices. Again though we cannot ignore that the current economic environment is very different to that faced by the Japanese. Japanese QE levelled off when the world economy began to expand after the '01-'03 recession as other forms of investment took up the strain of constant liquidity expansion. Without hindsight the Japanese decision to withdraw QE in 2006 looked correct, domestic inflation had gone positive and global inflation pressures had banished memories of the deflation threat Bernanke discussed in '01/02. The Japanese economy looked reasonably healthy and exports were expanding.

The US has none of these advantages. Therefore trusting in the above scenario has large downside risks. If US QE has been the only supporting crutch enabling the ability to expand asset purchases then removing that expansion capability may well cause a much deeper fall in stock and commodity prices.

It may well be that Bernanke is painted into a corner, that the Chinese have told the US that it is unwilling to allow further dollar expansion or that the Fed itself has recognised that the lack of indirect bidders in recent auctions signals that the capacity to issue further debt has reached its ceiling. It doesn't really matter what has caused the announcement to end QE expansion, we have to get prepared for a sharp retrace in stocks and commodities and look for a safe haven bid in Treasuries.

Our timely question of last week has been answered; add this chart to your check list:

Welcome to the weekly report, this week sees the US holding up its begging bowl to the rest of the world and hopes that enough charity exists for it to remain a first world nation.

In the coming week the US will offer near a quarter of a trillion dollars to the debt markets as calculated by Karl Denninger at The Market Ticker

• "Let's see if I can count this up....

  70 day CMBs, $30 billion (tomorrow), 13 week Bills, $32 billion (July 27th), 26 week Bills, $31 billion (July 27th), 52 week Bills, $27 billion (July 28th), 2 year Notes, $42 billion (July 28th), 5 year Notes, $39 billion (July 29th), 7 year Notes, $28 billion (July 30th), 19 year, 6 month TIPS (reopened), $6 billion (July 27th).........That's two hundred thirty-five billion dollars over the next week!"
  

Courtesy of StockCharts.com

The 5, 10 and 30 year Treasury yields have broken up through their 20 and 50 day moving averages as the dollar falls below the same averages. The short end of the bond market is heavily influenced by the Fed and its various schemes; hence the flatline for the 1 month and 1 year yields. The middle and long end of the bond market has re-established the link to the dollar, yields are rising to compensate for a fall in the worth of the dollar. This coming week is extremely important; will the bond markets allow such debt issuance without exacting compensation in the form of higher yields? Will foreign Central Banks swap excess dollar holdings for Treasury debt? There is some doubt that this weeks auctions will happen in a smooth fashion.

It's possible that the Chinese have already begun to diversify away from debt purchases and are now focused on foreign asset purchases:

• "Beijing will use its foreign exchange reserves, the largest in the world, to support and accelerate overseas expansion and acquisitions by Chinese companies, Wen Jiabao, the country's premier, said in comments published on Tuesday.

  "We should hasten the implementation of our 'going out' strategy and combine the utilisation of foreign exchange reserves with the 'going out' of our enterprises," he told Chinese diplomats late on Monday...

  China Investment Corp, the $200bn sovereign wealth fund, has been buying stakes in overseas resources companies and has taken a 1.1 per cent stake in Diageo, the British distiller...

  "Everyone is saying we should go to the western markets to scoop up [underpriced assets]," said Chen Yuan. "I think we should not go to America's Wall Street, but should look more to places with natural and energy resources."" (Economist.com)
  

The ingredients are in place for the auctions to fail this week, the comments of the Chinese will not have gone unnoticed by other Central Banks and some might decide to pass this time around and wait to see what the bid ratios look like.

If the auctions fail the fallout will be extremely serious for the current reflation. Yields in the middle and long end of the market will jump higher, as serious panic selling kicks in. Even yields at the short end will attempt to pressure higher and will succeed unless the Fed intervenes and becomes the buyer of last resort. Whilst the demand for cash will initially move the dollar higher this will be a temporary condition as the dollars are later sold to purchase hard assets or perceived safer currencies.

A rout of the bond market will not be the most serious outcome, the inability of the US to make good on the promises to underwrite the current and future losses of the banking system will cause a mass panic and quite possibly a run on banks of all sizes.

The amount required is shown in this testimony to the House Financial Services Committee from Mark Zandi at Moody's:

About a third of what has been promised has been delivered. The financial system is currently functioning because the US has underwritten it; if the US is shown to be unable to deliver further funds then we will see a repeat of the 2007 and 2008 credit crisis events but on a larger scale. The risk lies where it always has resided, with the banks and the liquidity needed to make banks function, the Commercial Paper market.

The Fed has provided less than 10% of what it pledged to support the CP market, if the Fed were unable to fund further short term paper facilities then LIBOR spreads will rocket higher and inter-bank lending will cease. This will place enormous strain upon those banks already in a weakened position, notably Citi and Bank of America. Whilst the Fed has guaranteed the assets of Citi and BoA they have not actually provided any funds to offset the losses from toxic debt. Both of these banks are literally surviving because the Fed has underwritten them. Other banks will also suffer as the Fed safety net is withdrawn, especially if they are already on the tightrope and trying to remain balanced whilst taking losses. Here is the list, again from the testimony supplied by Moody's:

Is this a doom and gloom scenario that flies in the face of the reflation we see taking place in stocks and commodities? I honestly wish I could say yes, that I am being too pessimistic and my worries about a large scale auction failure are overblown. But you don't subscribe to read my hopes, you subscribe because you want someone to look at these possibilities and lay out the events that could follow.

I could well be wrong and this enormous slice of debt is happily devoured by the market. However as you can see from the earlier table showing the government response this will be the first offering of many more large scale debt auctions, how many will it take before the bond market rejects further issuance? Within the government response table are the seeds of further conflict, note that the Congressional donation is fully paid up. The further fiscal stimulus that some are asking for will either increase the debt burden or divert previously promised funds to other bailout schemes.

The Fed is now reaping the harvest sown by ignoring the moral hazard it caused by interfering in the bailout of banks and investment houses. By placing itself in the position of guaranteeing all "too big to fail" losses and allowing the reflation of stock and commodities bubbles it has introduced longer term risks to financial stability that it cannot control. When faced with the credit / debt implosion that climaxed in the autumn of 2008 the Fed should have removed risk from the market (by nationalisation, which as Moody's say would have cost taxpayers less than schemes such as PPIP) rather than shifting it to bond markets and the government's balance sheet.

Now the risk is concentrated within the Treasury and Agency bond markets and can only be mitigated by the willingness of others to buy such debt. The Fed dare not become the buyer of last resort; it would be seen as monetising the new debt issuance and cause market participants to demand much higher returns, undermining the Zero Interest Rate Policy and the ability to continue Quantitative Easing.

The Fed and Bernanke have failed to take into account the difference between the Japanese ZIRP and QE experience and the current US efforts. The Bank of Japan had excess reserves from a positive balance sheet (thanks to Japan's export orientated economy) to buy debt issued by the Japanese Ministry of Finance in an effort to increase monetary growth. The Fed does not have excess reserves to re-circulate, it is reliant on increasing debt in the form of cash to purchase other debt issued by the Treasury.

The Fed is on the cusp of discovering just how much debt it is allowed to create as it asks the bond market "please sir, can I have some more?"

Welcome to the Weekly Report where we continue our look at the BIS 79th Annual Report.

$1 Trillion and counting. However we can see that the announced losses are significantly lower in Q1 '09 than the preceding 18 months and possibly resulted in the talk of green shoots. The reduction also co-incides with the massive reflation attempts by the various Central Banks, allowing Banks to hold onto or swap (with the CB's) those assets that they consider under-priced. We can take little comfort in this, even if my reasoning is wrong about Banks withholding losses by using bail out funds to increase margin requirements, it still shows that funds are not flowing into the general economy.

Yet something is happening in the US compared to Euro-land and Japan:

The expectation of inflation amongst consumers in the US is showing signs that the Fed's campaign is gaining traction. This shows the difference in approach, we know the ECB and BoJ are not setting a deliberate inflation target, whilst the US has followed a plan to encourage inflationary thoughts across business and consumers. The US effort to maintain such expectations have been enormous with the commitment to increasing liabilities growing throughout '08 and into '09 on a scale never seen before.

Yet the US is not alone in believing inflation expectations are crucial to the stabilising and eventual recovery of the global economy.

(Remember, when I first postulated this approach not a single econo-blogger - including the big names - believed it would happen. Indeed some who invited me to publicly discuss the use of inflation expectations to initiate recovery backed off when I said it was an anti-deflationary measure and a credit deflation was a certainty.)

Here is what the BIS has to say:

• "Such uncertainties highlight the key role of expectations in inflation prospects. Short-term inflation expectations of households in the G3 economies have fallen markedly since mid-2008, but long-term expectations have remained relatively stable. One downside risk is that a further sharp reduction in short-term inflation expectations, combined with doubts about the capacity of policy to arrest the downturn, may lead households to postpone spending, resulting in a larger than projected fall in the inflation rate or even a sustained period of declining prices. But if agents base their spending decisions on steadier expectations about long-term inflation, the risk of deflation will be considerably reduced. Also, a danger exists that long-term inflation expectations will rise if private agents come to believe that public debt burdens will not be manageable without higher inflation to erode that debt."

We are back to credible expectations through the use of "irresponsible actions":

Two Central Banks have led the way introducing liquidity schemes, the Fed and the BofE. It is not surprising that both have either elevated credit lending levels and/or increasing expectations of inflation. Compare the actions (or inaction) of the ECB and the BoJ and it is not surprising that inflation expectations and indeed the level of inflation show no signs of recovery in either Europe or Japan. Whilst many have pointed to a Japan '90's style decade occurring in the US, I believe it is more likely to occur in Europe. That does not mean the US will be immune from the credit deflation but is more likely to suffer a situation more akin to the Japanese 2000-2006 period where the effects of QE and ZIRP had only minor, intermittent success.

The following chart clearly demonstrates the bloated nature of Central Bank assets and liabilities and interestingly shows that the Japanese see the current situation as an extension of their predicament, rather than the introduction of a new scenario. In effect we are all Japanese now:

The only difference now is the amount of QE each Central Bank wishes or is allowed to indulge in. The US has a disadvantage, it owns and produces the world's reserve currency but is a debtor. That means the pressure Bernanke et al have been subjected to recently from the Chinese, to ensure that the worth of Chinese $ holdings is not reduced through monetisation of debt will act as a strict cap to the amount of QE the Fed can carry out. Failure to obey the Chinese will result in increased political pressure to seek a new reserve currency and the abandonment of further Chinese purchases of US debt.

From the above and last weeks article we can see that limits have been imposed, either through currency devaluation, rising yield on debt issuance or outright threats to the amount creditors are willing to allow debtors to monetise their debt. The BIS is looking (along with most of the Central Banks) at the Nordic banking crisis in the '90's to find a way to nationalise debt, re-price assets and reflate the economy. The following charts compare the effects of the Nordic situation with the current situation, specifically with the 3 Central Banks most willing to adopt QE and ZIRP:

The chart was correct at the beginning of '09. Since then the US, UK and Swiss have carried out the actions required to fulfil the blue and green lines, debt guarantee and bank recapitalisation. As we have seen since March the current crisis has followed the Nordic recovery, in part. Equities have risen and the fall in commercial and real estate prices, whilst still continuing have moderated.

Here though we come to the central issue of why the current crisis is not just a simple matter of nationalising debt to remove the toxic assets from banks.

Note the dashed red line, it is the amount of credit as a % to GDP. The Nordic solution was to allow the amount of credit to fall in relation to GDP, rebalancing both the private and public level of debt to more sustainable levels. The current crisis is not, especially in the 3 countries identified above, allowing that re-alignment to take place. Instead of allowing credit use to fall the Central Banks have made the use of credit and its expansion a central priority to enable a successful recovery. Even as banks do the right thing, restricting lending when the output gap of the global economy widens (more risk of default due to failure) the governments and Central Banks have stepped in to keep credit flowing and encourage banks to lend regardless of the economic situation.

In effect the Nordic solution allowed the Scandinavian authorities to trade out the toxic debt using government run bad banks whilst tightening credit. This reduced credit to a sustainable level from which reflation could have a reasonable chance of succeeding. The newly available credit was used to support expansion when the prices of assets began to rise. (Typical mal-investment but that is the reality, rather than my Austrian based wish list)

The US, UK and Swiss seem determined not to allow credit levels to drop if they can possibly help it. Whilst some credit destruction has occurred and lending to consumers and, until recently, business (corporate bond issuance is rising) has been tightened, the amount of overall credit remains very high. It is here that the Keynesians have run into a problem. If the creditor nations are no longer willing to allow debt to be increased then under their system when recovery does occur and the prices of assets try to rise, credit will not be available for the expansion of business, or consumers to purchase.

All credit booms are followed by a bust and the length of time of the bust is how long it takes to allowed bad debt to be wiped out. By attempting to interfere in the bust under the guise of allowing an orderly step down of debt, governments and Central Banks are prolonging the event. So far the only sector that seems to be bearing the brunt of a reduction of credit and income is the consumer.

Yet clearly this is not enough. The amount of debt issued by governments to bail out the financial sector and others deemed "too big to fail" cannot be paid for just by the use of inflation (set at a level by the threats of the Chinese) and allowing the losses to be borne by consumers. Without doubt the next move will be an increase in taxation and a reduction of public spending and services.

However, the consumer is under pressure as unemployment rises and working hours and pay are cut, the ability of the consumer to absorb more losses to their income is becoming a serious question that no one wishes to address. The central tenet of increasing inflation expectations will fail if consumers find that their income is deflating, yet governments may well have no choice.

If creditors will not extend further funds and the pool of domestic credit to governments (taxation) fails to meet expectations then those countries seeking to maintain high levels of credit may be thwarted and forced into a realisation of the losses they have tried to avoid.

It would seem that the attempt to avoid doing what should have already occurred, to realise losses amongst the banks, will through market forces be thrust upon governments that have already hit their credit ceiling. Trying to cherry pick from the Nordic solution will not work, bad credit needs to be purged and until that happens the burden of financing the bailout will cripple any attempt at a sustained recovery.

The BIS has already spelled this out in its report and is now calling on those using fiscal and monetary stimulus to explain how they will remove the extra liquidity when the economy returns to normal.

An answer from a country that is not deemed credible could result in a withdrawal of support and a rejection of their sovereign debt. I suspect the deadline for an acceptable plan is no later than mid '10.

Take care and have a good week.

Welcome to the weekly report, part one of a two part article looking at the BIS report.

At least one bank is doing well in the current environment and paid a handsome dividend too, although net profit was down from last year.
Here is the general manager's covering note that accompanied the annual report:

• Ladies and Gentlemen,

  It is my pleasure to submit to you the 79th Annual Report of the Bank for International Settlements for the financial year which ended on 31 March 2009. The net profit for the year amounted to SDR 446.1 million, compared with SDR 544.7 million for the preceding year. Details of the results for the financial year 2008/09 may be found on pages 176-80 of this Report under "Financial results and profit distribution".

  The Board of Directors proposes, in application of Article 51 of the Bank's Statutes, that the present General Meeting apply the sum of SDR 144.7 million in payment of a dividend of SDR 265 per share, payable in any constituent currency of the SDR, or in Swiss francs. This year's proposed dividend per share is the same as paid out last year.

  The Board further recommends that SDR 30.1 million be transferred to the general reserve fund and the remainder - amounting to SDR 271.3 million - to the free reserve fund.

  If these proposals are approved, the Bank's dividend for the financial year 2008/09 will be payable to shareholders on 2 July 2009.

  Basel, 12 June 2009

• "The second set of macroeconomic causes of the brewing crisis stemmed from the protracted period of low real interest rates in the first half of this decade. The proximate cause of the low rates was the combination of policy choices in both the industrial and emerging market economies together with the capital flows from emerging market countries seeking low-risk investments.

  A fear of deflation in those years led policymakers to keep short-term real interest rates unusually low. The real federal funds rate in the United States was consistently below 1% from mid-2001 up to the end of 2005; indeed, for much of this period it was negative."

  "Low real interest rates had a variety of important effects, some more predictable than others. On the more predictable side, by making borrowing cheap they led to a credit boom in a number of industrial economies. For instance, credit in the United States and the United Kingdom rose annually by 7% and 10%, respectively, between 2003 and mid-2007. It is always difficult to establish clear causal links, but in this case it seems reasonable to conclude that cheap credit formed the basis for the increase in home purchases as well as for the dramatic rise in household revolving debt.

  A second predictable effect of low interest rates was to increase the present discounted value of the revenue streams arising from earning assets, driving up asset prices."

The BIS also recognised that the boom caused distortions in residential (and in my mind commercial) construction, consumer durables consumption and the financial sector. None of this comes as a surprise to us but the effect upon those who do not follow the macro economic picture must be bewildering.

The increase in the supply of money and credit at very low rates of interest enabled the bubble distortion in many sectors of the global economy. Worse by allowing some to participate who should have been excluded, that is the penalty cost of failure to repay was removed by constant expansion of debt (rolling it over, credit card rotation, equity withdrawal etc) meant that the system was allowing the entry of its own future failure.

We can relate this to a simpler outlook. When the shoeshine boys are offering trading tips, or magazines headline the greatness of an asset, or when Estate Agents talk of forever rising prices we know too many participants are in the game and the risk of failure if a parameter changes (such as interest rates rising) is certain. Some call this a contrarian view but that's a label applied to those issuing a warning, something the market participants do not want to hear and even more importantly do not want the next buyer to hear.

The only way to clear the system is to allow the toxic part of the investment to be unwound. When oil shot up in price in the '70's the old energy intensive methods of production had to change to leaner models or die. The failure of the financial system will require the same unwinding process. However because the financial system used credit to expand it will require either a leaner credit system (higher qualifying standards and realistic rates of return) or the destruction of bad credit that is stopping the issuance of further credit due to the requirement to raise capital to cover losses. Either (probably both) way the amount of available credit will be reduced substantially for consumers and businesses. This is our credit based deflation that we discussed over the past number of years.

The BIS then lists all the failures that allowed the financial system to become unstable:

• "Consumers failed to watch out for themselves"

  "Compensation schemes encouraged managers to forsake long-run prospects for short-run returns"

  Moral hazard "but the downside belonged to the creditors (or the government!)"

  " the skewed incentives of the rating agencies"

  "The difficulty of assessing the tails of the distribution of outcomes is even greater for new financial instruments"

  "there were governance problems in risk management practices"

  "financial institutions found it relatively easy to move activities outside the regulatory perimeter"

As can be seen in the table below, many of the responses will have to be unwound (hence why government intervention prolongs a crisis) before a smaller, more highly regulated and transparent financial system gains the confidence of market participants:

The chart above shows that for all the talk of green shoots, end of recession and signs of recovery we can see that risk measures are still elevated from July 2007 and wealth measures remain depressed.

The next chart expands on some previous articles, showing risk measures, losses and bailouts and a nice divergence:

The senior and subordinated debt CDS spread remains elevated with CDS cover for Investment Banks higher than that of other major banks. However, when we look to the right we see that Investment Bank equity prices have largely recovered to pre-crisis levels, whilst other banks remain depressed. This shows a mis-pricing of risk in the equity markets and something investors should be watching closely. The centre chart updates a chart we looked at sometime ago comparing the bank losses to the capital injections. As we can see the rate of losses outstrips the injection of capital. This means banks must still continue to hoard and add to capital from profits. That means that the funds available for lending to consumers and business remain heavily restricted both by capital rebuilding and the reduction in the amount of leverage that can be used.

Further evidence that the fragility of the financial sector is still acute (and adding to the evidence of the mis-pricing of Investment Bank equity prices) is the price of insurance:

Despite all the efforts of the Central Banks and governments, Banks are still viewed with suspicion and the suspension of mark to market has not decreased the perception of risk. Central Banks need to take notice of this and realise that until the losses are fully realised confidence will not return.

The next chart contains a warning that you have to be careful about what you are looking at:

The growth in credit is still positive but the trend is down and will continue in that direction until banks no longer need to grow and hoard capital, I would not be surprised to see US, Euro, Aussie and Canadian rates to go negative. The anomaly is the UK were credit availability remains high and is reflecting the concerns that the UK is not tackling indebtedness and attempting to let the good times roll into Gordon Brown's "election date".

The tricky chart is the changes in credit lending standards that appear to show a drop in the changes. However as we mentioned last year it is important not to confuse a stop to the level tightening standards and the actual loosening of standards. That loosening may be some time away.

Finally for this week we show the changes in real spending and capital goods orders:

Note the US consumer durables; are we seeing the expectations of future inflation bearing fruit? Too early to say but worth watching as part of the reflation phase of the scenario. Of more concern is the depth of the fall of capital goods orders which at first glance shows a slight recovery. However the "recovery" is not US-centric, the rises seem to be Japanese and European related. The US is still the world economic powerhouse and without recovery in the US, all else is temporary.

Next week we continue to examine the global economy and look at what is required to create true recovery.

Welcome to the Weekly Report. Here is a chart of real US GDP from Q1 '06 through to Q1 '09:

The chart above is slightly wrong, final GDP for Q1 '09 was revised higher to -5.5%. However, a little digging and I can produce a chart for GDP in billions of chained 2000 dollars, based on the final GDP figures released:

GDP is back at Q1 '07 levels and in dollar terms is still firmly in a downtrend. Anyone who is still talking about green shoots should be disregarded; there is nothing in the 2 charts above that point to an imminent recovery above '08 levels of GDP.

The following chart is initial claims, not seasonally adjusted from '06 to current:

Although the number of initial claims has fallen from the post '08 Christmas season (a pattern seen in previous years) they remain elevated, holding a level only previously seen at the peaks of preceding years. Claims remain at highly elevated levels and are not conducive to a recovery appearing in the near future. What of the famed Fed Printing Press?

It too looks elevated but we know that for inflation to gain traction the rate of growth in the monetary base must continue. Here is the St Louis Fed adjusted monetary base as a compounded annual rate of change:

In other words, the Fed boosted the monetary base in the autumn of 2008 and then turned the presses off. We go back to a central theme of the Eggertsson Plan when we discussed that because the Fed had swapped cash for assets and held the assets on account, no new money had been created. All that has happened was less liquid assets were swapped for more liquid assets, in this case dollars. As long as those assets held by the Fed are not marked to market then a zero sum game has been played. Many inflationists (and sellers of gold and gold funds) would have you believe the Fed is flooding cash into the system, as we can see above that is not happening.

Right now the Fed is not inflating, the inflation of the monetary base has already occurred. We zoom in and look at the Dollar index on the run up, at and through the increase in monetary base:

Fancy that, the dollar went up in anticipation of the monetary base increase and fell back only partially as the base compound rate of change went bananas! Note that the dollar effectively ignored one of the biggest debasements a developed world currency has seen since the '20's, even gaining a new recent high. Now as the base has stabilised since April, actually showing a small decrease in the rate of change, the dollar has devalued.
There is only one reason why an asset rises and falls in worth and that is demand. The run up in 2008 was a demand driven rise, a shortage of dollar availability as positions were closed, debt repaid, margins met and most importantly as credit dried up.

The Fed had to double the monetary base to cover demand. The Fed had to do this and watched the dollar to ensure that demand was met. Now as the dollar index drops and approaches 78 the Fed has announced that some of its special facilities designed to expand liquidity will be reduced and in some cases closed:

• "The Federal Reserve also announced changes to certain liquidity programs in light of the improvement in financial conditions and the associated reduction in usage of some facilities. Specifically, the Federal Reserve trimmed the size of upcoming TAF auctions, because the amount of credit extended under that facility has been well below the offered amount. In view of very weak demand at TSLF Schedule 1 auctions and TSLF Options Program auctions over recent months, auctions under these programs will be suspended. The frequency of Schedule 2 TSLF auctions will be reduced to one every four weeks and the offered amount will be reduced. The authorization for the Money Market Investor Funding Facility (MMIFF) was not extended, and an additional administrative criterion was established for use of the AMLF. If necessary in view of evolving market conditions, the Federal Reserve will increase the size of TAF auctions and resume TSLF operations that have been suspended.

  The Board and the FOMC will continue to monitor closely the condition of financial markets and the need for and effectiveness of the Federal Reserve's special liquidity facilities and arrangements. Should the recent improvements in market conditions continue, the Board and the FOMC currently anticipate that a number of these facilities may not need to be extended beyond February 1. However, if financial stresses do not moderate as expected, the Board and the FOMC are prepared to extend the terms of some or all of the facilities as needed to promote financial stability and economic growth. The public will receive timely notice of planned extensions, discontinuations, or modifications of Federal Reserve programs."
  

The Fed has reduced its actions by circa 40%. I have been looking for a range in Treasury yields to tell me what the Fed wanted to do. I should have taken a simpler view and watched the lowest common denominator, the level of the dollar. The Fed had already made noises about winding down the bail out schemes and now has made a statement that cannot be ignored.

I believe the Fed intend to ensure that deflation is not allowed to gain further traction but it knows that the dollar must be supported to ensure that those who have dollar holdings do not panic. Of course the results of manipulating the supply of currency to match demand, using the dollar as a weathervane is going to upset a lot of planned trades, especially carry trades and inflation based trades. If I am right we should see the dollar gain support and move within a band of roughly 78 to 88 on the dollar index. A Fed induced "goldilocks" scenario may well be our future for some time.

Welcome to the weekly report. A shorter article this week, I'm not feeling too well. As you can see, I am becoming worried about the current state of the global markets and macro-economic climate. As I mentioned some months ago, I believe we have seen a global contraction in trade (and commerce) of around 20%, now we are seeing evidence that supports this.

That makes me bearish, what makes me worried is that the current reflationary period is almost exclusively driven by Central Bank and Government largesse, using borrowed funds to supply banks and "brokers" to drive up asset prices. However public opinion seems to be hardening toward any further bail outs of the Financials or large multi-national businesses. This is a natural reaction in the current environment, unemployment is still high and rising, spare cash is at a premium, mortgage rates are not dropping and credit has become difficult to obtain. All this goes on whilst huge amounts of cash and asset swaps continues to be "fed" (pun intended) into the bankrupt banks and obsolete business models. The public see absolutely no benefit from Central Bank and Government actions and so now begin to question the policy. Paul Volker hit the nail on the head:

• 'Government bailouts should be limited and a clear policy set forth defining who would have access to the government's financial safety net.'

  'One unfortunate consequence of the massive public assistance provided both banks and nonbanks in dealing with the present crisis is that moral hazard may, I am afraid, become more deeply embedded.'

  'Financial institutions beyond the government 'safety net' should not count on government protection, said Volcker. But they may be subject to government oversight.' (WSJ)
  

We all know what happens if a market is artificially driven higher, eventually the funds stoking the reflationary fire are restricted or withdrawn and true buyers suddenly become scarce. From this we get 2 results, a fall in asset and stock markets and a seeking of a safe haven. We may well be seeing this occur, I can't say it's a 100% call, but I am alert to the possibility and the timing of such an event seems much closer than it did in March.

First up is the Dow:

This is a weekly chart and I use it to help spot divergences, you may well have seen it before. As you can see we have a negative divergence, the MACD is not confirming the price action. However, it is too early (for me) to call a down leg, the yellow areas identified areas of support and resistance and its holding support, so far.

Gold:

This a daily chart, from July 08 with simple support and resistance levels shown. Of all the markets I find gold the simplest to "see". In the short term Gold has to hold $929. The gold chart should tell us what inflation expectations are. Whilst it reflected the bail outs in Oct 08 onwards and again reacted in March/April 09, gold has, yet again, rejected the $1000 area. That doesn't mean $1000+ is not still possible, however it now relies on making a higher high that the $863 area low. Right now, what we can say is that gold isn't reflecting a large scale expectation of inflation.

Here is the $/Y, still an important indicator:

And here is the Euro/Y:

Both are daily charts, back to mid '08. Both charts show a tepid recovery in the dollar and euro. That tepid recovery isn't showing large scale hunger to place carry trades back into Europe or the US.

Oil:

I hope you are now beginning to see a pattern. When we look at the mid term daily charts we see a tepid recovery, in the shorter term we see a loss of up trend support. I can see a lack of Japanese influence, something that markets have relied on for many years. Its possible that markets are beginning to realise they are not going to benefit from that influence and we may be seeing the first participants moving slowly for the exits as a more realistic view of the global economy overcomes the "green shoots" baloney.

That's all for this week, I am now going to find a comfortable chair and sniffle as I herocially fight off my "man flu".

Welcome to the Weekly Report. For the first time in many a year there is talk of the return of bond vigilantes in the market.

• Bond Vigilantes Confront Obama as Housing Falters By Liz Capo McCormick and Daniel Kruger

  May 29 (Bloomberg) -- They're back.

  For the first time since another Democrat occupied the White House, investors from Beijing to Zurich are challenging a president's attempts to revive the economy with record deficit spending. Fifteen years after forcing Bill Clinton to abandon his own stimulus plans, the so-called bond vigilantes are punishing Barack Obama for quadrupling the budget shortfall to $1.85 trillion. By driving up yields on U.S. debt, they are also threatening to derail Federal Reserve Chairman Ben S. Bernanke's efforts to cut borrowing costs for businesses and consumers.

  The 1.4-percentage-point rise in 10-year Treasury yields this year pushed interest rates on 30-year fixed mortgages to above 5 percent for the first time since before Bernanke announced on March 18 that the central bank would start printing money to buy financial assets. Treasuries have lost 5.1 percent in their worst annual start since Merrill Lynch & Co. began its Treasury Master Index in 1977.

  "The bond-market vigilantes are up in arms over the outlook for the federal deficit," said Edward Yardeni, who coined the term in 1984 to describe investors who protest monetary or fiscal policies they consider inflationary by selling bonds. He now heads Yardeni Research Inc. in Great Neck, New York. "Ten trillion dollars over the next 10 years is just an indication that Washington is really out of control and that there is no fiscal discipline whatsoever."

  Investor Dread

  What bond investors dread is accelerating inflation after the government and Fed agreed to lend, spend or commit $12.8 trillion to thaw frozen credit markets and snap the longest U.S. economic slump since the 1930s. The central bank also pledged to buy as much as $300 billion of Treasuries and $1.25 trillion of bonds backed by home loans.

  For the moment, at least, inflation isn't a cause for concern. During the past 12 months, consumer prices fell 0.7 percent, the biggest decline since 1955. Excluding food and energy, prices climbed 1.9 percent from April 2008, according to the Labor Department.

  Bill Gross, the co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co. and manager of the world's largest bond fund, said all the cash flooding into the economy means inflation may accelerate to 3 percent to 4 percent in three years. The Fed's preferred range is 1.7 percent to 2 percent.

  "There's becoming an embedded inflationary premium in the bond market that wasn't there six months ago," Gross said yesterday in an interview at a conference in Chicago.

  .......the Congressional Budget Office projects Obama's spending plan will expand the deficit this year to about four times the previous record, and cause a $1.38 trillion shortfall in fiscal 2010. The U.S. will need to raise $3.25 trillion this year to finance its objectives, up from less than $1 trillion in 2008, according to Goldman Sachs Group Inc.
  

• Deflation, credit contraction, Conglomerate destruction, nationalisation, mis-placed rejection of sound shares, Bank asset hoarding, historically low base rates, wide spreads to commercial rates, low/no access to credit, sovereign default and bankruptcy, widespread poverty, increase in regional wars, Quantitative Easing in the US/UK, attempted reflations, savings growth, debt repudiation, FX re-pricing, non-governmental intervention from IMF and BIS, co-ordinated protectionism, a new form of capitalism leading to profit sharing through true ownership/part ownership and not based on risk transference...... eventual emergence of new trading and commercial environments.......Remember these events are not listed in a strict chronological order, they will overlap and in some cases occur more than once.
  

Although base rates have remained, and will remain at low levels it has not necessarily led to the desired outcome, a lowering of yields on longer term bonds. Right now, even with The US Fed actively purchasing US Treasuries, the market is supplying more bonds than demand is requiring, lowering the price and raising yields:

The chart shows the increase in yields using the 3 month Treasury yield as the baseline over the past 10 days. The following view shows a more accurate timescale for the change in market sentiment, again using the 3 month yield as a baseline to monitor other yield movements:

Quite clearly around the 21 May the demand for 2/5/7 and 10 year bonds dropped compared to what was supplied to the market and the following week saw prices fall. Was this a result of China (or other foreign investors) dumping Treasuries?

No, I think the fall in prices was down to a more urbane reason:

• Treasuries Fall After Fed's Purchase of Debt as Supply Looms By Susanne Walker

  May 21 (Bloomberg) -- Treasuries fell, pushing yields on 10-year notes up by the most in two weeks, after the Federal Reserve bought a smaller amount of debt than some investors expected and the U.S. said it will sell $162 billion of notes and bills next week to finance the budget deficit.

  The declines were led by longer-maturity notes and bonds, sending yields on 10-year securities to 2.5 percentage points above those on two-year notes, the most since November. Rising debt sales have contributed to a 3.3 percent loss for Treasury investors, the worst start to a year since 1994, according to Merrill Lynch & Co.'s U.S. Treasury Master Index.

  "The Fed buybacks are over and it's taken the market down," said Michael Franzese, head of government bond trading for Standard Chartered in New York. "We thought the Fed would have bought more. Supply is carrying a heavy amount of weight. Supply keeps coming and there's no end in sight."
  

Click here to see the clip.

Vigilantes maybe worried about capital loses but I suspect (as mentioned the other week) that the Fed is not happy to have a one way bet on Treasury markets and are making it difficult to be 100% confident about the direction of bond prices:

• Tony Crescenzi, chief bond-market strategist at Miller Tabak & Co. in New York, wrote in a note to clients today. "The Fed, in purchasing a smaller proportion than normal of what was offered by dealers, may have wanted to push back the dealer community after many concluded yesterday from the FOMC minutes that the Fed might either increase its Treasury purchases or be more aggressive with its purchases."

  The central bank bought $122.984 billion in U.S. debt through the purchase operations, which began March 25, as it seeks to lower borrowing costs. The next purchase will be on May 26, when the central bank will buy Treasury Inflation Protected Securities, or TIPS, maturing between January 2010 and April 2032.
  

Not helping is the dollar:

A failure to hold 79 opens up 72 and all the consequences that go with such a move. As we discussed a couple of weeks ago, the Fed is in a bind, caught between trying to hold yields down whilst the dollar threatens to fall further.

My worry is that the Fed will once again disturb the trends in an attempt to wrong foot the markets. I have no wish to get caught in the crossfire and remained hedged.