Welcome to the Weekly Report. I had a nice break over Christmas and the New Year, having spent a week in Norway skiing enjoying guaranteed snow and a good exchange rate to Sterling, thus avoiding the horrible reality of a less than 1:1 Sterling/Euro tourist rate. Sometimes all this macro-econobabble has its uses.

When it comes to skiing, I am no Franz Klammer. I started skiing in my mid 30's and after a knee injury and operation some 8 years ago I now use various knee support devices to combat weakness and arthritis in both knees. One day I will have to face reality and recognise that even with the knee supports I will be unable to ski. These days I do gentle red runs and look carefully at the piste map and terrain before sliding downhill. As I was riding a long T-bar lift (you hook the bar under your behind and ski uphill) I realised my knees and the global financial economy have a lot in common.

My knee worked fine until it didn't, I blew out the medial ligaments and ruptured the cartilage doing no more than gently gliding along, I didn't even have time to react to the fall. I knew the risks involved in skiing, especially for a beginner yet I took no added precautions against the risk, indeed I found it difficult after the fall to believe I had done serious damage to my knee. I continued to ski and skied off the mountain. However the swelling and pain warned that I had done some damage so I went to a local doctor who unsurprisingly had seen this type of injury before. I ended up on crutches and a month later had keyhole surgery to repair the cartilage. The ligaments managed to recover under their own steam.

The global financial system worked fine until it didn't, it blew out in 2007 as commercial paper markets withdrew liquidity, as signs that ABCP might not be AAA, even though the global economy seemed to be gliding along. It didn't even have time to react to the drawdown. Those involved knew the risks, especially as the derivatives markets had only expanded to their colossal size in the previous 5-6 years, yet they took no added precautions to the risk, indeed as the borrow short / lend long model unwound it was believed the damage was contained and the system continued to adhere to the financial models used prior to the damage. However as the default rates on overstretched mortgages began to show large scale losses in MBS/CDO packages, it was realised that the sellers of insurance, the CDS writers, couldn't cover the losses. Some local doctors tried to warn the patient that something was wrong but the patient decided to keep dancing until the music stopped. What could and should have been a period of convalescence aided by crutches and some surgery turned into a major disability and toxic infection, requiring the liberal use of life saving equipment. The Banks were unable to self heal and had to hoard cash to repair the overstretched conduits that allowed credit to be enabled. The patient remains in a critical condition.

My knees creak and groan and let me know when it's going to rain but they still function - as long as I recognise the risk and avoid overstretching their impaired ability. Banks feel nothing from the chest down.

Worse is the effect on those that relied on Banks. Without the support of continuous rolling credit those businesses reliant on credit to function suddenly realised that the game was over. From Hedge Funds to Automotive makers, from Retailers to Mortgage brokers the world stopped. Ponzi schemes fell apart (You think Madoff is a renegade one off?), Insurance companies collapsed and the spectre of mass unemployment in a deflationary environment reared its ugly head.

The Fed and the US treasury stepped into the Intensive Care Ward and cringed at the carnage facing them. After the initial shock they began to infuse the patients with cash and cash like assets in exchange for the toxins that kept the patient at deaths door, when this proved ineffective they nationalised those too far gone to rely on conventional medicine and dosed them with straight cash, right into their veins. The Fed stayed by the bedside, often giving emergency care after normal hours on a Friday or over the weekends in desperate moves to keep the heartbeat of finance beating.

However even all this intensive care was not enough, credit remained clotted, chocking the lungs of the economy, requiring non-conventional processes to be adopted just to keep the possibility of a heart attack at bay. Some patients didn't make it. When Lehman exhaled its last shuddering breath, the Fed stood back unwilling to prolong the agony.

Has all this emergency care and medicine helped the economy at large, especially those businesses with lower credit ratings?

No. Rates for A2/P2 are back at the highs seen when the 2007 and 2008 shocks took place but now are at a massively higher spread from all other CP, that is some risk premium.

Whilst the Fed pumps funds into the Banking sector the same is not happening for the economy. Banks are rebuilding reserves and setting aside cash to cover further losses, right now there is no spare capacity to pass on funding to anyone or any business that might have risk attached to it.

The Liquidity Trap

I keep referring back to the Eggertsson Theory articles, which laid out the approach the Fed and US Treasury would follow as we fell into a deflationary period caused by the collapse of credit mechanisms. Without doubt we are past the mid point of the experiment to see if Friedman was right and Keynes wrong. Keynes said that at zero bound rates (where we are) that monetary policy becomes ineffective, Friedman disagreed. Here is a quote from another paper, The Liquidity Trap, written by GB Eggertsson to expand on this:

• A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. In this case, many argue, increasing money in circulation has no effect on either output or prices. The liquidity trap is originally a Keynesian idea and was contrasted with the quantity theory of money, which maintains that prices and output are, roughly speaking, proportional to the money supply.

  According to the Keynesian theory, money supply has its effects on prices and output through the nominal interest rate. Increasing money supply reduces the interest rate through a money demand equation. Lower interest rates stimulate output and spending. The short-term nominal interest rate, however, cannot be less than zero, based on a basic arbitrage argument: no one will lend 100 dollars unless she gets at least 100 dollars back. This is often referred to as the 'zero bound' on the short-term nominal interest rate.

  Hence, the Keynesian argument goes, once the money supply has been increased to a level where the short-term interest rate is zero, there will be no further effect on either output or prices, no matter by how much money supply is increased.

Whilst we have seen short term rates dip below zero as the rush to seek safety overcomes any requirement for returns, this is an infrequent occurrence.

Right now we have a situation that reflects the '30's and the Japanese 90's - 2006 were nominal rates are at zero and money supply is being increased at a massive rate. Why are the Fed following such a policy if we know there are inherent difficulties in breaking out of such a situation? Bond bears need to pay attention. We are back to public expectations, as Eggertsson points out:

• In contrast to the static Keynesian framework, monetary policy can still be effective in this model even when the current short-term nominal interest rate is zero. In order to be effective, however, expansionary monetary policy must change the public's expectations about future interest rates at the point in time when the zero bound will no longer be binding.

  For example, this may be the period in which the deflationary shocks are expected to subside. Thus, successful monetary easing in a liquidity trap involves committing to maintaining lower future nominal interest rates for any given price level in the future once deflationary pressures have subsided.

We move our attention to the last FOMC announcement:

• Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

  The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

However, we are no longer in normal circumstances. We are in an environment that has changed radically.

The Fed are buying Treasuries along the curve as well as Agency debt. This keeps a bid in place, keeping prices high and lowering the yield:

This is part of the Quantitative Easing policy, reducing yields whilst allowing an increase in liquidity of the money supply. Inflationary? No, this is a swap of cash for cash like assets that will have a low or no nominal yield. The Fed will continue buying to suppress yields until the deflationary forces have passed and a credible expectation of inflation, including a positive series of inflation figures are apparent. However the Fed has ensured that Banks can continue to hoard the excess liquidity at a positive rate of return by paying interest on excess reserves held by the Fed:

• The Federal Reserve on Tuesday issued a technical note concerning the calculation of interest rates on required reserve balances and excess balances for reserve maintenance periods ending December 17.

  On Tuesday, the Federal Open Market Committee (FOMC) established a target range for the effective federal funds rate of 0 to 1/4 percent, and the Federal Reserve Board established the interest rates on required reserve balances and excess balances at 1/4 percent for reserve maintenance periods beginning December 18.

If a bank wants a safe haven for their reserves and get a positive return, they need look no further than the Fed. Even better Banks can sell Agency debt and hoard the cash they receive in return:

• Investment managers will employ a passive buy and hold investment strategy in accordance with investment guidelines prescribed by the Federal Reserve. Purchases will be guided by commonly referenced market indices. The agency MBS program will involve the outright purchase of up to $500 billion in agency MBS by the investment managers on behalf of the Federal Reserve by the end of the second quarter of 2009.

I see no incentive for Banks to do anything different than selling Agency and Treasury Debt to a determined buyer and hoard the cash at a positive return. It's a guaranteed, risk free profit. Why would Banks want to get back into the credit markets with such a deal on the table? I see nothing that will encourage a loosening of credit standards or an increase in the velocity of money. For the economy outside of the financial system which uses credit to maintain spending and investment this is highly deflationary. Until Banks decide that the risk of lending is outweighed by the rewards of profits then funds will not be made available for borrowing. Therefore unless the Fed can encourage lending from Banks to the wider economy then a liquidity trap is already in place.

The Bernanke Fed has placed all its eggs in one basket by using the Zero Interest Rate Policy and Quantitative Easing. The basket is one of credible expectations in which the Fed has to promise to keep interest rates at a suppressed level (for a considerable period) even if there are signs that positive monetary inflation is occurring and will continue to increase beyond a point in time when one would normally expect such policies to be curtailed.

We can see that such expectations will not occur in the short term, the Fed is explicit in its actions of buying assets for at least another 6 months and banks have a risk free profitable trade that removes the need to enter the non financial economy for business. Indeed it could be said that the Feds actions will ensure a prolonged period of tight credit conditions, low or no investment in productivity and continued deflationary trends in the availability of liquidity beyond the Banking system. This is of course the foundation for a deflationary spiral that has only one method available to combat it. Fiscal policy will have to concentrate on infusing the non financial economy with cash, through Government sponsored works, in an attempt to break the deflationary trend by increasing the supply of cash and its velocity. In an economy worth $14Trillion per annum and using the example from the FDR '30s answer which involved increasing spending by 70% of GDP, I estimate that fiscal spending will have to increase by around $9-10Trillion for each year that inflation refuses to move higher.

I shall be watching the S&P Construction Materials Index with interest:

Courtesy of Incredible Charts. (Free EOD)

Have a good week.

Welcome to the Weekly Report. This week some fool decided the US had been in recession for a year. I hope they don't get paid too much. What I find amusing is that straight away all sorts of bull side writers and shills started talking about the US stock market being a discounting system, looking 6 months ahead, look for signs of recovery etc blah.

Piffle.

The stock markets are heavily manipulated right now, bans on short selling alone distort the real conditions of the stocks, government bailouts allow dead businesses to keep walking and the expectation of centralist bail outs for conglomerates considered too big to fail keep prices higher on mis-placed optimism. Attempting to use stock markets as a leading indicator with so much interference in place is not a wise move. Maybe one day in the future it will be worth monitoring stocks but right now they are a sideshow.

Anyway, back to our 12 month recession, was there anything that we could have monitored over the past 12 months that would have indicated what was coming?

Here is the ISM report for manufacturing:

• WHAT RESPONDENTS ARE SAYING ...

  "The only positive thing of late is that the U.S. dollar has strengthened significantly against other currencies. We import the majority of our materials so this will have the effect of lowering our COGS." (Transportation Equipment)

  "Steel industry is our main customer, and they have had a real slowdown." (Computer & Electronic Products)

  "Criteria for projects is significantly higher with very short ROI periods." (Food, Beverage & Tobacco Products)

  "We have revised downward our top-line sales estimates for CY2009 by 8 percent due to the continued softness we see in the housing sector." (Machinery)

  "Suppliers are trying to hold onto pricing, but petrochemical and commodity prices are dropping like a rock." (Plastics & Rubber Products)

  
  

How about non-manufacturing ISM?

* Non-Manufacturing ISM Report On Business® data is seasonally adjusted for Business Activity, New Orders, Prices and Employment. Manufacturing ISM Report On Business® data is seasonally adjusted for New Orders, Production, Employment, Supplier Deliveries and Inventories.

** Number of months moving in current direction.

• WHAT RESPONDENTS ARE SAYING ...

  "General slowdown and cost-cutting actions." (Other Services)

  "Business remains strong despite the general economy." (Health Care & Social Assistance)

  "Although funding for our core goals has not changed, new programs will be curtailed." (Educational Services)

  "Store closures with associated employee layoffs, the continued downturn in the construction sector and the curtailment of local government spending have combined to hammer the local economy." (Public Administration)

  "One unusual aspect of the current environment is that suppliers are getting very selective about who they conduct business with. We are spending more and more time ensuring that our key [suppliers] continue to see us as a key customer." (Retail Trade)

  "General concerns about the economy continue to impact consumer confidence and our sales." (Accommodation & Food Services)

Here the trends are not as pronounced as manufacturing but as we can see the trend is one of falling activity that is accelerating. Interestingly employment, often accused of being a lagging indicator, was the first series to show slowdown and the November reading should have made Fridays unemployment figures unsurprising. I would recommend that you keep an eye on the ISM report over the next year, especially those series that gave an early warning of the current situation. Right now I see absolutely nothing that would want me to buy stocks based on a macro-economic viewpoint.

So if stock markets are not telling us the whole story, what is?

Courtesy of StockCharts.com

Yields have plunged across the board since July but a noticeable acceleration of the trend kicked in during late October. This follows on from last weeks report were subscribers read about the move of the US into a Quantitative Easing policy (QE) which involves Ben Bernanke's favoured method of controlling the yield curve across all bond asset classes:

• "A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well."
  

Quantitative Easing is another way of acknowledging moral hazard and increasing it exponentially. Once started, as Bernanke is beginning to discover, QE cannot be suddenly dropped from the game plan as its very existence becomes the only bulwark of confidence for all markets. The inevitable outcome of QE, on the scale envisaged by Bernanke, when taken to its conclusion is that no asset can be left outside of the guarantee, regardless of the solvency of the underlying corporation. This was the lesson Japan learned when it underwrote its banking sector. Bernanke has a much greater struggle to contend with, he has to underwrite practically the whole economy.

Many economic writers are currently looking at the rise of M1& M2 and shouting about the inflation that will occur in the near future, however they are looking at the new situation through the wrong lens:

Is the rise in M1&M2 unexpected? Clearly, those that have studied QE in Japan would say no:

The comparison to the M1/M2 Fed chart is no coincidence. The outcome of the US adopting a QE policy will have wide ranging consequences but today I want to flag up a comparison that can be used by investors.

With rates zero bound, that is when a level of interest is reached where conventional monetary polices fail to work, QE is designed to encourage rates to fall by swapping (i.e. buying in unlimited quantities) 0% bearing cash for near 0% yielding bonds and other assets. Therefore inflation is unable to take hold until the inflation expectations of all other market participants are raised to the extent that they believe that the unlimited buying will continue ad infinitum or until a pre-defined set of parameters are met. This expectation of high prices, supported by continued Fed/government purchases, allows risk premiums to be drastically reduced. In many respects it is the reverse of what many have been taught, that buying high is not a good idea.

Whether this happens is central to the success of the US QE experiment. QE also means that the fixation with the Fed Fund Rates will become a thing of the past. When the Japanese began QE they couldn't use interest rates as a tool as the rate was at or near zero. Instead they set the level of the current account as the operating target. The current account level moved from approximately $40Billion to $250-300Billion and was deployed to buy financial assets from across the spectrum. Effectively the current account was used to swap financial assets for cash with the aim of flooding the economy, via the financial system, with Yen. The Bank of Japan also set the conditions for how long QE would operate, therefore setting a credible expectation of continuing inflationary policy.

The Yen carry trade was a direct result from the QE policy of Japan. QE began in March 2001 and lasted until March 2006 when, as promised by the BoJ, the criterion was met to allow the policy to be set aside.

Both the start and the end of QE led to a noticeable change on stock charts but it did not lead to an immediate change in general trend:

However it could be argued that the lag between the announcement of the QE starting and finishing and the actual increase or decrease in the Japanese current account and therefore the amount available to put into the carry trade is what the chart above demonstrates.

What we can infer is the announcement of a QE policy is a precursor to a change in monetary policy designed to allow massive infusions of cash. Because the infusion is the result of a swap of cash for cash like assets the policy is non-inflationary at a domestic level. However the cash will need to find a home outside of the non-inflationary environment to garner returns. For US investors that means looking at foreign markets, for others (except the UK which will also follow a QE policy, albeit without the commitment of the US, it isn't in the mindset of British politicians to "go for it") it means watching for signs of US dollar inflows and the resulting increase in asset prices in markets outside the US.

We can also see that there is a lag between the announcement and the visible effects of a carry trade. What we have now is a warning signal, it is time to start looking for higher yielding, (than US$) stable countries with controllable sovereign debt. What we do not know is how long the lag will be between now, as we start the US QE policy and when its effects begin to show. We cannot use the time lag from the Japanese experience as a rule, macro-economic conditions today are very different from the Japanese situation. The current crisis is much larger and is not confined to non-performing Banks or Financial Institutions and although the Fed will enter into QE without restraint, the problem of corporate debt may take priority.

It will depend on the approach the Fed takes about the mechanism to buy corporate debt, the choice between buying the debt from holders or allowing corporations to roll the debt over with the Fed, rather than through the banking system. Having seen Fed policy in action so far, I suspect the debt will be purchased from holders (banks et al) , allowing a quicker release of the cash infusion into the financial system and then flowing to the domestic and global economy. This method also allows capital reserves to be expanded, replacing riskier assets for the safety of cash.

So if bonds are going to be controlled by the Fed using its now unlimited buying power (that is what QE is all about) what effect will this have on corporate bonds? Will Bernanke's assertion that private debt yields fall as well be proved correct? (As an aside you may want to read this short article written for Livecharts in February 2008)

Here is a recap of the chart used in the article mentioned above, comparing the ishares high yield corporate bond fund to SPY:

As I mentioned in the Livecharts article, there was not a decoupling of high yield corporate bond prices from the direction of stock prices, despite the "attractive prices" and the clarion calls of the shills. However if Bernanke wants to see his plan come to fruition then a decoupling event will have to happen, otherwise yields for corporate bonds will remain high.

Why? Because looking at the ISM report corporate bond yields are where they should be at this stage of a deep recession and if we do fall into a depression then yields will go higher on those still solvent. To drag yields down Bernanke will have to buy an asset and ignore what the market price is telling him about the state of the underlying guarantee of that asset, namely the corporation. I am not at all sure that buyers would appear for the shares of corporations in such circumstances.

That's it for this week, I suspect the subject of QE and a US$ carry trade will become a reoccurring theme over the next few years. I would be interested to hear from subscribers about where they think the US carry trade will flow to, I shall start a list that we can all share if I get some responses.

Welcome to the Weekly report. There is much talk these days about the inflationary bias of the US Federal Reserve, the rationale being all that money being pumped into banks, brokers (RIP), insurance, car makers and so on (monetary inflation) will eventually flood into the economy and cause prices to rise as too much cash seeks too little supply of goods and services (price inflation).

In normal circumstances, I would readily agree that lending on this scale would eventually lead to a hyper-inflationary period, however we live in interesting times, were we are at the mercy of a credit contraction, the likes of which has never been witnessed before. Right now I believe we are entering a period of deflation that must be traversed before we can expect an increase in inflation.

Below are 2 charts showing the total reserves of depository institutions as at the 19th November:

This one shows the recent action:

Total reserves as of the 19th November were $652831Million but total borrowing from the Fed was $725177Million. In other words the reserves do not meet the liabilities, what we would call insolvent. The borrowing is to offset losses, to re-capitalise the Bankers et al who have blown the lot on dodgy derivative purchases, debt liabilities and the default of borrowers. The following table from the Fed shows the massive increase in lending since October '07:

The Fed is replacing cash and cash like assets that have been eradicated either as a direct loss or through a devaluation as assets are savagely re-priced lower. The funds are not an addition to the amount that can be used to create credit, they are a replacement for the losses incurred by the re-pricing of risk and the closure of credit facilities. The Fed will continue to throw cash into the bottomless pit of debt destruction but this is not inflationary, it is not adding to the availability of funds, just replacing them.

We should remember, the Fed is lending out the funds, it will want the money back. Banks and the rest of the borrowers are being given time to sort out their positions and extract as much profit as possible to allow them to make up the shortfall. Those profits will go straight into the reserves, they will not be used for investment to expand business. As the profits will essentially come from the pockets of the consumers the amount of cash in circulation will fall unless the Fed replaces the shortfall by printing or the US Treasury directly parachutes cash into the accounts of the consumers. Again, these actions are not inflationary, the direct cash injections will be replacing the cash withdrawn from circulation as it sits in the reserves of banking and corporate America.

Yet the future inflationary expectations of many are not mis-placed. There is good reason to think that inflation may well be the deliberate, planned outcome of the US Fed and Treasury actions. We know that the Fed will just about accept anything as collateral to allow borrowing to take place. It is this willingness to expand lending, coupled with the increase in debt liabilities of the Government that make many think the only outcome can be a future increase in inflation. Indeed it is vital for the Fed/Treasury plan to work that such future expectations exist. As I wrote in An interpretation of The Deflation Bias and Committing to Being Irresponsible by G B Eggertsson:

• "If Bernanke and Co keep with the blueprint (it would be difficult to see how they could deviate now without destroying carefully implanted expectations) we can expect to see continuous and expanding intervention in what was previously thought to be off limit areas.

  Treasury bond issuance should rise and does not have to have a defining limit. Tax rebates will continue and grow, expanding beyond traditional areas. Use of current GSEs to expand government debt will be encouraged and may well lead to the formation of "Super GSE's" that could take on second lien loans on property, for example.

  The Fed will expand its facilities, including more market participants and widening the range of assets that can be used, including stocks. The facilities will become permanent but will be allowed to run down in use as circumstances dictate. It will be imperative to remove any stigma associated with the use of such facilities, possibly by converting the facilities to a type of GSE, or more likely, a Fed Sponsored Enterprise.

  Concerted and possibly international intervention in Forex markets should be given a high level of probability. This will allow a slow and orderly re-pricing lower of the dollar and a continued bias toward inflation.

  A campaign of "anti-inflationary" bias will continue and be ramped up if necessary. Rates could be raised without affecting the fight against deflationary forces because expectations would require such a move. A constant attempt will be made to anticipate a move higher in growth."

• "WASHINGTON (Reuters) - The U.S. economy is likely to shrink for at least half a year and the Fed should act aggressively against any risks that deflation could take hold, Federal Reserve Vice Chairman Donald Kohn said on Wednesday.

  "We have a very weak economy. The U.S. economy is declining right now," he said in response to questions after a speech at the Cato Institute.

  "My most likely outcome is for a couple of quarters of negative growth, and inflation coming down, but not getting to that deflationary state," he added.

  Kohn said that while risks of deflation are small, they had risen in recent months and that policy-makers should be vigilant to ensure the phenomenon does not become sustained.

  Kohn said the U.S. central bank should consider forms of "quantitative easing," the effective lowering of interest rates by flooding markets with funds.

  "We have already engaged in forms of quantitative easing and we should be looking carefully at the effects that they might have, what other forms of quantitative easing might happen as a contingency plan, should that still remote possibility -- but I think less remote than it was -- occur."

Where does this leave the Dollar and by implication all dollar based assets?

Weekly dollar chart, courtesy of Stockcharts.com

With the current rise of the Dollar attributed to a safe haven bid, the threat of QE may see a reversal of the trend. QE involves the Fed buying, in unlimited amounts, Treasury issued debt and any other asset it sees fit whilst keeping the nominal interest rate low and announcing such an intention as being "long term".

Whilst many know of Bernanke's infamous speech about helicopter drops it is this context that he was talking, the following is from the section titled "Curing Deflation":

• "What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

  Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation. "
  

Did Bernanke know something at the time of his speech "Deflation: Making Sure "It" Doesn't Happen Here" in November '02 that we did not? At the end of the speech, as it is reproduced at the FRB site, there is a list of references. I now reveal why I followed, interpreted and then formulated the Eggertsson theory:

Eggertson, Gauti, "How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible," unpublished paper, International Monetary Fund, October 2002.

How do I know that Bernanke at the helm of the Fed is following this theory? It is something that Bernanke mentioned as a preferred weapon against deflation:

• "So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.

  There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates.

  A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well."

• "Since money and bonds are equivalent in a liquidity trap dropping money from helicopters is exactly equivalent to issuing nominal bonds. If the treasury and the central bank coordinate policy the effect of dropping money from helicopters will have exactly the same effect as deficit spending. Thus this paper's model can be interpreted as establishing a "fiscal theory" of dropping money from helicopters. The model can also be extended to consider the effects of the government buying foreign exchange (or any other private assets)."

10 year treasury note yield, courtesy of Stockcharts.com

What can we expect from the implementation of such policies? It is clear than the dollar will fall in value but that bonds will not as the Fed keeps rates artificially low right across the curve. A new search for yield will start, financed by the money used by the Fed to purchase UST, corporate bonds and certain asset backed bonds. An attempt will be made to find and inflate a new bubble and if the Japanese experience is anything to go by, it will involve a dollar based carry trade.

Welcome to the Weekly Report. This week we look at new appointments, timings and why Obama is willing to start work early.

An hour before the stock markets closed on Friday we started to get some "breaking news" scrolling across the screens of the financial TV channels, pointing to new appointments in the Obama administration-in-waiting.

Seasoned and grizzled bear market traders recognised the announcements as the usual cover (any news will do) for an end of week rally and closed out, letting the markets rebound from important lows:

The drop on Thursday, the basing move and the sudden move up into Fridays close is also a familiar pattern for those that study options expiries, albeit on a smaller scale. Does this mean the bear market is over? I doubt it very much but remember bear markets love a rally, they are usually much greater in size and speed than in bull markets, so don't be surprised if we move higher, for awhile.

As an aside, I think there is a concerted effort to give the consumer anything to make them feel a little better as we enter the retailers make or break season, I refuse to call it Christmas anymore. Just when the public should be responsible and hoard cash and reduce debt, corporate America (and the rest of the Christian developed world) is spending a fortune on advertising. Don't fall for it people:

Keep the trend going folks, y-o-y retail sales have plummeted and now inflation, as shown by CPI, is starting to follow. Keep the cash in your pockets and Retailers prices will continue to fall as they seek a level where consumers eventually think goods are cheap and once again part with the asset that is so in demand - cash.

So, back to Friday's announcement, that Timothy Geithner will be the next Treasury Secretary.

Is this the change Obama has been so vocal about? Are we looking at the new wave of the future being appointed to clear out the old defunct thinking and relationships that caused us to wake up daily and stare into the abyss of financial destruction?

No, I am afraid not. Let's start with the timing of the announcement, an hour before the Friday close. It looks to me that Obama is happy to be used to help "boost" markets, a pattern seen with government during the last 2 bear events, how quickly change is dropped in the face of expediency. Already I can feel that hope I held on to ebbing away as the flush of expectation dwindles to the dullness of acceptance. Did it really only take 3 weeks for political realism to replace rhetoric wrapped promises?

What of the US Treasury Secretary nominee Mr Geithner? Currently serving as the 9th President of the New York Fed, has he come from a background that would bring change? After he finished an MA in Failed Keynesian based International Economics he went to work for Henry "King maker" Kissinger at Kissinger and Associates in Washington, followed by a stint at the US Treasury, culminating as Under Secretary of the Treasury for International Affairs until 2002.

He then moved onto the Council on Foreign Relations joining the International Economics department before being appointed to his current role in 2003, becoming the Vice Chairman of the Federal Open Market Committee as well as the President of the New York Fed. He is also the Chairman of the committee on Payment and Settlement Systems with the Bank for International Settlements. He was instrumental in the bailout of Bear Stearns and allowing Lehmann to disintegrate.

We have a life long staffer, a peddler of influence and failed economic theory, a man who has never worked in the financial system outside of Government circles. Not exactly the change Obama seemed to promise. Worse than that is who does Geithner rely on for his financial education? I can do no better than to direct you to an excellent article written by Gary Weiss for Conde Nast Portfolio.com titled The Man Who Saved (or Got Suckered by) Wall Street (June 2008). Here is an illuminating picture for you to digest that is connected to Gary's article:

I urge you read the article, its well worth the effort. We should not forget that it was Geithner who gathered officers from Wall Street as well as representatives from market supervising bodies in Europe at his office in 2005 to hold talks on how to instigate an automated and electronic trading and reporting system for the unregulated and massively inflated Credit Default Swap market. Even as the events of this year unfolded, especially the destruction of AIG, Geithner continued to have meetings that produced no outcome. This leaves me with 2 thoughts, Geithner either didn't see what could happen with CDS or some of his friends persuaded him that regulation wasn't needed or wanted.

Obama seems intent on moving forward well before his January house move and this could prove to be a political mistake. He will now be associated with the financial system crash and the current regime, rather than entering the fray riding on a wave of hope, delivering new solutions to rescue the American people (and the rest of the World). However, I believe Obama knows this and has taken the risk because he believes time is of the essence, that his influence is needed to ensure that the bailouts and stimulus plans are implemented now, rather than in 2 months down the road. This from Bloomberg:

• "Obama Targets 2.5 Million Jobs With Stimulus Plan (Update1)

  By Edwin Chen and Jason Gale

  Nov. 22 (Bloomberg) -- President-elect Barack Obama said he aims to save or create 2.5 million jobs in a two-year plan to stimulate an economy facing a "crisis of historic proportions."

  "It's likely to get worse before it gets better," Obama said today in his weekly radio address. He said that this week "financial markets faced more turmoil," potentially leading to a "deflationary spiral" that may plunge the nation further into debt and cost millions more jobs."

Later in the same article Obama unveils his methods for revitalising the US, I had to check the article twice, thinking FDR had made it back from the grave. You can view Obama's weekly address here.

Change? No I'm afraid not, just more of the mistakes of the past wrapped into the rhetoric of the present. At least we know one thing, the plan already being followed by the Fed and the US Government using the ideas and methods laid out in the Eggertsson Theory articles will continue uninterrupted. The shame is that the one premise required to make the idea work is now seriously undermined by Obama himself.

Remember to make the plan work there must be a constant expectation of future inflation in the actions of the Fed and the US Government. Obama warning that we face more turmoil that could lead to a deflationary spiral might well be true but it will not instil confidence in banks to lend, Business to invest or Consumers to spend.

Finally an announcement from An Occasional Letter. This will be the last Weekly Report that will be published in full at public sites. I will be reverting to part publishing with the rest reserved for subscribers. Publishing full articles was only ever temporary, I had to weigh up many different wants and needs, the wish to give subscribers fair value, the need to let readers know what was coming and the hope that some may take action and preserve their wealth. However the immediate need has now passed so I have to put the wishes of subscribers first and go back publishing incomplete articles.

Welcome to the weekly report. This week we look at some longer term indicators that will help identify when a turning point in the economy has arrived and why you should cancel Christmas, or at least go back to its traditional meaning, forgoing the pointless consumerism that surrounds it.

Before we start, you may have wondered (or not) why the weekly report wasn't around. I have spent the past 3 weeks laying out the groundwork for an attempt to peer into the longer term future. Subscribers have seen all 3 articles, culminating in the new scenario. I have released the first 2 articles to the public, the final part will also be released but not for awhile yet. Whilst this may be viewed as harsh I believe subscribers deserve some added value for their money. I must admit, it was hard to leave the original scenario behind, it had served me (and others) well over the past 5+ years but as events have finally played out, it became obvious it was time to look ahead.

As someone who looks at the larger picture it becomes apparent that certain events happen in recessions and expansions and these events can be monitored to signal a change in economic conditions. However most people ignore these signals or dismiss them as "lagging". Whilst that may be true for those conditions that result after a primary change has taken place, some indicators of economic conditions are more responsive. The trick is to find such indicators that are in the public domain and that show a repeating pattern when economic conditions repeat.

By keeping an eye on amongst other things changes in forex, yield curves, the ISM surveys, Senior Loan Officer Opinion Survey on Bank Lending Practices from the Fed and commercial paper rates then a "heads up" warning can be received about changes in macro-economic conditions. Some readers might well say (with some justification) why don't the Central Banks watch for the same signals? I believe they do but the staffs have an overly optimistic view on the ability of economies to avoid downturns or recessions. This over-optimism leads to decisions being delayed and actions not taken even when evidence of a change is apparent. It is a failure that is all too human but leads to greater risk taking in the hope of a change happening that would forestall having to make hard choices. Not unlike a trader that is unwilling to cut a losing position, hoping for a change in trend.

That makes the work of humble writers like me more difficult. Many of the so-called bear commentators have warned for some time that the imbalances in credit and derivative markets would end badly, the difficult bit has been to work out what the Central Banks and Governments would or would not do as the imbalances became too big to ignore. With hindsight it is now apparent that the response to the tightening of credit, the disappearance of asset backed commercial paper facilities and the increase in LIBOR back in the summer of 2007 were insufficient. Yet at the time the invention of the first US Fed "facilities" to enhance discount window and repo market operations took many by surprise and allowed markets to believe the problems were contained and a fix was in place. Whilst the initial drip feed of assets from the Fed balance sheet into the banks restored some confidence and allowed markets to rally all that really happened was the eventual melt down was delayed. Yet some indicators showed that such actions were indeed ineffectual.

So let's have a look at those indicators that warned conditions had changed and were not misled by any false confidence.

Chart courtesy of www.StockCharts.com

The Yen didn't lie, it gained strength as the carry trade unwound and when compared to the Dow it outdid any chart based indicator. Since August the Yen has established a clear and steepening uptrend and until that uptrend is broken I see no signs of a new carry trade being implemented. I am watching the triangle that has formed since October very closely. Interestingly the dollar/euro carry trade has also unwound since July, explaining how the dollar has remained resilient despite all the bad news. If Eurozone rates continue to fall then the carry will continue to unwind.

Banks always play the game the same way, tightening standards and increasing spreads when risk is high, loosening when risk is low, according to their models:

October 2008 Senior Loan Officer Opinion Survey on Bank Lending Practices.

Probably amongst the most revealing charts you will see. As banks tighten and increase spreads to offset risk of default economic conditions follow. Notice the extreme conditions we are currently living with and remember these charts show "tightening" and "increasing spreads". What that means is that these charts could fall from the current peaks because they had stopped tightening and increasing spreads, it would not necessarily mean that conditions are getting looser, any fall would probably reflect that banks had stabilised their positions. It is the move above and below the neutral line at zero that would reflect looser lending conditions. It is also clear that some banks were aware that trouble was brewing well before the summer of '07. I do not see a short or shallow recession in our future and neither do the banks, rather conditions are extreme and will remain so for some years.

Conditions for mortgages are no better as we see from the Loan Officer Opinion Survey:

Again we see the mortgage market at extremes across the board which makes the following chart even more important:

Do not be fooled by the lack of sub-prime green, it's still there hidden behind the Alt-A. Overall total resets are about to increase into '09, fall back in mid '09 and then move much higher into Q1 '12. Without a functioning mortgage market, what we have seen since the summer of '07 to present may seem mild in comparison. The following chart is a little old now (I originally saw it in early '07):

Anyone telling me that the worst is over is trying to sell something!

Finally we look at the yield curve:

Courtesy of www.stockcharts.com

Click on the link above and press animate. Any future economist, analyst or writer who says the yield curve doesn't work like it did in the past should be regarded with deep suspicion.

Should you cancel Christmas, is this the deluded ranting of an over-stimulated bear?

It truly depends on your circumstances. If you are in debt, struggling to pay a mortgage and decide that you are going to have one last splurge with your lower limit credit card, be ready for a knock on the door in the spring from a Collection Agency.

The situation now feels dire yet it may well be about to get much worse. Anyone calling for a shallow recession and a move back to the "good old days" is to my mind not looking at the new landscape we live in.

I would rather forego the pointless giving of presents if it means that more debt is incurred or a reduction in savings results. Your family would rather have a roof over their heads than a 42 inch plasma screen in '09.

Maybe it is time for a new fireside chat to be introduced into the homes of America. A chat that is not reliant on the word of the government but one where the family gathers around (turn the TV off!) and tells the truth to each other. Talk about the real meaning of giving and caring, not the display of swapping presents but through the protection of those you hold close. Agree to look after each other, cut spending, start saving and most importantly do not ignore what is coming. Prepare yourselves, have a realistic plan and ignore the consumerist brainwashing that will be directed at you.

This time next year those you hold close may be very grateful they didn't receive an expensive present this Christmas.

Welcome to the Weekly Report. It looks like Europe wants to re-invent the wheel and soundings are being made to introduce a "new Bretton Woods".

Bretton Woods was effectively an exchange rate mechanism, were gold backed the new kid on the world block, namely the post war US dollar and all other currencies floated around the dollar in a fixed range. If a currency moved too far either way of the range then the respective Central Bank stepped in and delivered the appropriate medicine.

However the US dollar was pegged to the price of gold which was fixed at an official rate of $35. All went well until one or two countries, well, mainly France decided that they wanted the gold that backed the dollar reserves they had accumulated by repatriating the dollars back to Uncle Sam.

Eventually President Nixon decided in 1971 to abandon the BW agreement, triggering other attempts to set other fixed currency systems which all failed. In the end FX became a free floating system that has resisted any attempts to regulate exchange rates other than "pegs". Have we all forgotten how the European Exchange Rate Mechanism collapsed? Even currencies pegged to the dollar, yen, euro or sterling can come under attack if the peg does not reflect the underlying economic fundamentals of the country involved. Here are the views of the Hindsight Brigade, first up Trichet :

• "European Central Bank President Jean- Claude Trichet said officials reshaping the world's financial system should try to return to the ``discipline'' that governed markets in the decades after World War II.

  ``Perhaps what we need is to go back to the first Bretton Woods, to go back to discipline,'' Trichet said after giving a speech at the Economic Club of New York yesterday. ``It's absolutely clear that financial markets need discipline: macroeconomic discipline, monetary discipline, market discipline.'' (Bloomberg)
  

And this from Brown, Sarkozy and Merkel:

• The Prime Minister on Wednesday called for a "new Bretton Woods", an overhaul of the world economic order that has stood since 1944.

  Mr Brown says the major summit is justified by the need to establish new rules to prevent a repeat of the recent world financial crisis.

  
  He made the call at a meeting of European leaders in Brussels, where he has been feted by some leaders in the wake of Britain's widely-emulated banking bail-out this week.

  However, Mr Sarkozy holds the presidency of the EU and with it the right to speak for the bloc on the world stage.

  The French President made his own call for a "new Bretton Woods" earlier this month, arguing that it was time to replace the "Anglo-Saxon" model of unrestrained markets has failed.

  Angela Merkel, the German Chancellor, backed Mr Brown's call, saying it was time to "rethink the world's financial system and prevent any repetition" of the current crisis. (Telegraph.co.uk)

So are we to believe that a return to Bretton Woods is on the cards, that the dollar, or more likely the Euro becomes backed by gold? Whilst I wouldn't rule it out, considering the ruling class are bereft of ideas other than adopting the historical methods (which all failed) of other post crash era's, I suspect we are facing some attempt to fix currencies using a supra-national, non-governmental institution.

Whilst the one being mentioned currently is the IMF, I would not be surprised to see the Bank of International Settlements given the leading role. Why do I prefer the idea that BIS is trying to put itself at the hub of the economic and financial matrix? From the BIS website:

• "The Bank for International Settlements (BIS) is an international organisation which fosters international monetary and financial cooperation and serves as a bank for central banks.

  The BIS fulfils this mandate by acting as:

  • a forum to promote discussion and policy analysis among central banks and within the international financial community

    a centre for economic and monetary research

    a prime counterparty for central banks in their financial transactions

    agent or trustee in connection with international financial operations

  The head office is in Basel, Switzerland and there are two representative offices: in the Hong Kong Special Administrative Region of the People's Republic of China and in Mexico City.

  The BIS

  • Aims at promoting monetary and financial stability

    Acts as a forum for discussion and cooperation among central banks and the financial community

    Acts as a bank to central banks and international organisations

, What we have is a de-facto Bank for Central Banks, a hub around which everything else revolves. It has 3 offices strategically placed in the world (have a look at the world clock) and most certainly has already incorporated many of the mechanisms required by the plutocrats and politicians around the world. For instance, membership of BIS means you are immune from prosecution. Its membership would make anyone who believed in conspiracy theories shudder but I'm not going to dwell upon that.

If like me you believe FX markets lead and all else follows, then those who would diminish the main inherent risk in capitalist markets (which is the differential in currency, tax and interest rates from one currency to the next) would want to make the FX system their focal point.

Think about it for a moment. Why does trade, in any form exist?

It is about making a profit by exploiting an advantage. The only thing you have to be wary of is risk, the risk that the situation will change to a disadvantage. The Euro is a typical example and exemplifies why Gordon Brown was against it for the UK.

The Euro should be worth the same in all its member countries, the ECB sets the Eurozone interest rate so no advantage can be gained from owning French Euros from German Euros. However there are 2 problems.

The first is the individual member states tax regimes. If you do the same work, say as a Hedge Fund, in the Euro-zone then the main advantage you have is to pick the country with the lowest tax regime. The UK didn't join the Euro because Brown knew taxes were going to rise in the UK which would have encouraged Hedge Funds to move to a lower tax regime that pays out in Euro's. He allowed light regulation to encourage Hedge Funds et al to remain domiciled in the UK.

Secondly is the differential that can be achieved by choosing which nationally issued Euro bonds you buy. This from the Telegraph in March 2008 (and politicians still say they didn't see this coming? They are either liars or incompetent):

• "A flight to safety has pushed the yield spread between 10-year Italian bonds and equivalent German Bunds to 55 basis points, the highest since the launch of the euro. A similar pattern has emerged across the southern belt of the eurozone, with spreads hitting post-EMU highs of 53 versus Greece, 44 for Portugal, 38 for Belgium and 36 for Spain."
  

Many commentators remarked on this at the time (the above is from Ambrose Evans-Pritchard) and indeed the risk was commentated on before March 2008. An unintentional internal market has occurred allowing trading in a single currency to exist. The differential in default risk that a Country is perceived to have is being traded.

The ramifications are deep especially if we are faced with an attempt to introduce Bretton Woods type currency controls. However, I doubt the new Bretton Woods will use gold as its anchor for valuing a reserve currency. More likely is an implicit pan-national guarantee of a non-sovereign, trade weighted measure. An expanded and strengthened version of the IMF Special Drawing Rights (SDR) springs to mind.

Unlike previous crisis when the risk (of default) tended to be concentrated in a particular area, such as Latin America, the current financial mess is worldwide and has a heavily interwoven, cross border risk that is much greater and the possibility of a break in the chain of obligations more likely. However the predicament is the same, when all is unwound the player holding the old maid is the Banks.

Banks are already in deep trouble, most are technically insolvent. So Central Banks and Treasury Departments have created enormous piles of "cash and cash equivalents" to allow Banks to rebuild their reserves by adding to their Tier 1 holdings, as Mr Brown let slip last week.

Who created the Tier ratio of debt? It was the Central banks through their nominated members who become part of the Directors Board at BIS. No wonder calls to eliminate or suspend the Tier ratios have fallen on deaf ears and have quietly died away.

Whilst the IMF has a mandate to use members money to help bailout bankrupt governments only the BIS has the ability to channel funding between Central Banks. The current US Fed lending of dollars to other Central Banks to ensure dollar liquidity is a typical example of the type of work the BIS does.

Many people ask what will happen next if the amount of debt default continues to climb. Do we face a situation in which the Central Banks become tapped out and are unable to provide further reserves? As we know Central Banks and Treasuries can continue to create reserves but even they reach a limit as we saw in the US with Congressional approval needed to deploy tax- payers money. This "revolt" by politicians, whilst it did not stop the Bail-out, will stand as a warning that the willingness of the public to continue to allow taxes to be used in this way has become exhausted. Even with the shock and awe, fear tactics deployed by the Fed and the Treasury the overwhelming majority of the public were against the idea.

So the next step is to remove further bail outs from the democratic process. By using the non-sovereign BIS to funnel funds to member Central Banks, raised by IMF member governments and re-distributed through IMF intervention to its member governments, the nationally based tax payer's wrath is circumvented.

What will be worth watching for is the implementation of other zones similar to the Euro, a particular favourite topic of the BIS in this working paper:

• "The recent introduction of the euro and projects for monetary union in other parts of the world make the replacement of national currencies (either by a foreign currency or by a new, multilateral currency issued by a regional central bank) a topical issue. Related regimes are the tight linkage of the national currency through a currency board and the official or unofficial use of foreign currency - often referred to as "dollarisation".

  While these various monetary regimes differ in a number of respects, they have the common feature that they virtually eliminate the possibility of an independent monetary policy. Issues arising include the preconditions required for making these arrangements work, the institutions that need to accompany them, and the extent to which they harm the smooth functioning of the economy (for instance, by eliminating monetary policy flexibility and lender of last resort facilities).

  Many of these issues were considered by a small group of senior central bankers at the BIS during a two-day meeting in September 2002. The first day focused on economic issues and the second on legal and practical issues. This volume contains edited versions of most of the papers prepared for the meeting."

However what of the problems I discussed earlier about the Eurozone? Did you doubt they had not thought of this?

• " In the European Union's case, monetary union was the culmination of these other economic initiatives. There was much debate about whether this model is the only one, with a rough consensus emerging that it need not be (for instance, the CFA franc zone has been in existence for more than 50 years, much of that period without other significant elements of integration), but that to be successful and permanent, those other elements (customs union, macroeconomic coordination, harmonisation of taxes, removal of barriers to factor mobility, etc) needed at least to be constructed in parallel." (Italics my emphasis)

Many are discussing the changes that will occur in the capitalist system as a result of the credit crash and the resultant spill-over into the World economy. Whilst such views as I have expressed here might be taken as "far-fetched" I would ask you to think back about 5 years ago and the treatment of those who warned about a property, stock and credit bubble implosion.

Still think I am being far-fetched?

To defend yourself in these times you need to be in cash with low or no debt. Just be careful where you put your money.

Subsequent bail outs will show you that you have no parachute, no protection. The long term plan appears to be to grab your assets through taxation and use the fruits of your labour to ensure the banking system survives and becomes centralised away from all government interference. Once the pain threshold for the populace has been reached then the next great plan to take the pain away will unfold before you.

Don't put yourself in a place where you beg for the pain-killers.

Welcome to the Weekly Report. As I write this on Saturday afternoon, I see nothing from the G7 statements that can be taken as co-ordinated action. Indeed all I see is a repeat of what is becoming a tired mantra:

• At the White House, Mr Bush pledged the G7 most industrialised nations would take robust action together.

  On Friday, G7 finance ministers agreed to take moves to free the flow of credit, back efforts by banks to raise money and revive the mortgage market.

  
  Announcing no new policies, Mr Bush said: "We must ensure the actions of one country do not contradict or undermine the actions of another.
  "In an interconnected world, no nation will gain by driving down the fortunes of another. We are in this together. We will come through it together." (BBC)

• Meanwhile, French President Nicolas Sarkozy and German Chancellor Angela Merkel said there would be no common financial rescue fund for Europe, like the US bail-out of Wall Street.

  The two spoke on Saturday in eastern France where they were commemorating the 50th anniversary of Franco-German reconciliation after World War II.
  Chancellor Merkel said "there is no question of a European fund", while Mr Sarkozy said such a move would pose "gigantic problems" in terms of co-ordination between European nations.

  The German leader said governments must "redirect the markets so they serve the people, and not ruin them."

  The two leaders said a common approach to the financial crisis would emerge from a Paris summit on Sunday of 15 eurozone leaders.

It also shows why Iceland was left to go bankrupt, the ECB has no authority to intervene or "help" those banks outside of the Euro system. Iceland is not alone, many countries in Europe do not belong to the Euro and will have to survive on their own abilities or, in a move reminiscent of earlier decades, become reliant on intervention from the International Monetary Fund (IMF). The only country I saw helping Iceland was Russia who lent them $8Bn. Iceland will be the first of quite a number of countries that will be unable to guarantee the obligations of domestic banks, a pointer is to look for low GNP countries with a high density of domestic banks operating across international borders.

• "The world financial system is teetering on the "brink of systemic meltdown", the head of the International Monetary Fund (IMF) has warned in Washington.
  Dominique Strauss-Kahn said rich nations had so far failed to restore confidence, but he endorsed a new action plan by the G7 group." (BBC)
  

• "Directors considered that there are large uncertainties surrounding the near-term outlook, with significant downside risks. At the same time, they noted that the long-term prospects for the economy remain promising-even enviable-given Iceland's sound governance and stable institutions, open and flexible markets, large and well-managed renewable natural resource base, and the authorities' long track record of resilience and adaptability to changing circumstances.

  Directors observed that the authorities face the challenge of facilitating an orderly rebalancing process, while mitigating risks. They welcomed the authorities' efforts to bolster confidence, including by entering into currency swap arrangements with other Nordic central banks, and by committing to maintain tight macroeconomic policies and boost international reserves. Effective coordination between monetary policy and fiscal policies, and actions to reduce financial sector vulnerabilities, will be key to achieving orderly adjustment."

  (IMF Executive Board Concludes 2008 Article IV Consultation with Iceland September 19th)

The fallout is stories like this:

• "....mints are struggling to keep up with demand, including the Austrian Mint, which produces the Vienna Philharmonic - one of the best-selling bullion coins worldwide. Sales of Vienna Philharmonic gold coins have gone up by more than 230% since last year.

  Kerry Tattersall, the director of marketing at the mint, says production has gone into overdrive.

  "We are running at present something like three shifts on all of the machines, on the presses, producing both gold and the silver bullion coins."(BBC)

Although the UK is not part of the Eurozone, PM Brown will be attending by invitation to showcase his latest "idea" of part nationalization of some UK banks. It seems that after repeating the mistakes of the past, he is about to try the cures of the past. As I have said before we are unlucky with the timing of this depression, there is a distinct lack of innovation and original thinking among those who rule.

It is also very clear that the global cure is directed at Banks to "strengthen the reserves". This innocuous looking phrase means a depression is guaranteed in economies reliant on credit for expansion. The banks will hoard cash and close down the lending desks. The unwinding of margin levels, margin calls and de-leveraging coupled with outright selling to raise cash is more than evident in world wide stock markets. The failure of Lehman cost $270Bn (so far) but it may not be the Broker/Banks that bring down the markets. I am extremely wary of the consequences if the likes of GE, Ford and GM go bankrupt. The CDS obligations on these 3 if a default event occurs would dwarf the cost of Lehman going under. Notice the concentration of risk in the Industrial/Financial sectors by using these 3 companies as examples.

Credit Default Swaps were meant to spread risk and avoid concentration of exposure. Clearly this has not happened, the CDS situation has played out the way I thought it would. If you sell insurance you need to ensure you are able to pay when an "event" occurs. If you ignore this rule or used "assets" to show you could pay up then when a day of reckoning arrives you have to either hold your hand up and go broke or sell assets. If the sellers of insurance are now facing the possibility of a widening of credit tightening to the industrial and service sectors of the economy the selling of assets will continue. Eventually we get a default on a default event. I suspect that day is not far off.

Consequently the Collection Agency is now positioning for an imminent systemic global meltdown of banking, credit and insurance liabilities and the destruction of the ability to carry out normal trade.

Why so dramatic? Because the World's Central Banks combined are no better off the Iceland. They do not have the reserves or "assets" to cover the total liabilities of the CDS market, let alone the total of outstanding OTC derivatives:

Bank of International Settlements

Remember these are liabilities that belong to the Banks; a failure of one market will automatically cause a collapse in all the others. The 2 currencies that dominate the world are the Yen and the Dollar:

Courtesy of Stockcharts.com

The chart above uses the Euro as a baseline and shows the +/- movement of the Dollar, Yen, Sterling and the Dow. I fully suspect the current moves are preparation for a currency crisis and shows demand for the 2 most liquid currencies in the world as the unwinding and de-leveraging of global trades intensifies. I expect this trend to continue until the "credit crisis" is resolved. Indeed as far as I am concerned the term credit crisis no longer accurately describes the current situation. We are facing the recentralization of wealth, away from the global economy and back to the Government/Banker complex.

Why do they need cash? To pay liabilities and ensure enough cash is at hand to avoid using credit in the future. In a deflationary depression those holding cash need not invest to get wealthier, the asset itself appreciates.

Finally for this week I continue to see calls for massive intervention to over-ride free market mechanisms. Such calls are justified because "its different this time" the events are so big, the fallout so enormous that Governments must act in a coordinated manner to overcome the threat. So just to remind readers, this is not different this time, we are seeing the same results from an over-expansion of credit and lax lending as the US did in '29-39. We are seeing the same attempts using the same methods to fix the problem as we did back then. The only difference is the size of the current crash when compared to the '30s.

It didn't work then and it will not work now. The only reason the US pulled out of the depression in the '30s was thanks to WW2 and the increase in demand that caused. Whilst I am not advocating WW3 as a cure, it will take a similar large scale, global increase in demand to allow business to recover. The hope would be that by the time of the next recovery the use of credit for expansion and consumption will no longer be tolerated.

In the meantime, get rid of debt, save cash and stop spending on anything that is not essential. The Governments of the world and their shills will try and tell you to do otherwise, as they did post 9/11, in an attempt to encourage profligate consumer spending. We are now living with the results of that wish, that patriotic demand. Now is not the time to fall for such rhetoric again.

Saving is the new "investing". Just make sure the savings are safe.